Canada's rate of growth in productivity is the third lowest among 23 OECD countries.

Canada's Productivity Crisis

16 May 2007

• Policy Paper
• Authored by the London Chamber of Commerce Federal / Provincial Affairs Committee
• Approved by 2006/2007 London Chamber of Commerce Board of Directors in May 2007
• To be presented to the Canadian Chamber of Commerce in September 2007 with the intention of being accepted as the offical position of the Canadian Chamber

The Issue

Canada's productivity (footnote 1) standing in the Organization for Economic Co-operation and Development (OECD) has fallen from third in the 1950s and 1960s to sixteenth in 2006 (footnote 2).

Although the Federal Government has taken some positive first steps to begin addressing this disturbing trend, they are just that – first steps. More substantive steps are required to succeed in curbing the most significant threat to Canada's standard of living.

Background (footnote 3)

Productivity growth is an important determinant of future living standards. More productive workers are able to demand higher wages, companies are more profitable and competitive, and a productive economy results in a larger economic base from which governments are able to extract revenues. With the baby boom generation passing into retirement and as the proportion of the population of working age start to diminish, high productivity will become critical to Canada's ability to fund its health care system, public pensions and other social programs.

Canada's productivity performance in the 21st Century has so far been poor. Canada's rate of growth in productivity is the third lowest among 23 OECD countries. The business sector output per hour advanced only at 1.1 % average annual rate between 2000 and 2006.

This represents only 1/3 of the annual rate of advance of 2.9% recorded in Canada between 1996 and 2000. Canada's business labour productivity gap with the United States is 26 percentage points, 9 percentage points higher than in 2000.

The Federal Government has identified many of the obstacles to productivity in its Advantage Canada paper. In its 2006 and 2007 budgets, the Federal Government has provided some personal and business tax relief and removed some tax disincentives to investment in certain asset classes. These two changes should have some positive impact on productivity, but fall far short of the changes that need to be made to overcome two of the most significant barriers to productivity growth – Canada's taxation system and its competitive environment.

Taxation System

Business taxes in Canada are not neutral. Currently, Federal and Provincial governments offer tax rebates, reductions, exemptions and credits that reduce the tax burden for certain types of business investment or small businesses (Tax Incentives). A tax system that distorts investment decisions leads to an inefficient allocation of capital, thus adversely affecting productivity.

The OECD has recently commented on how Tax Incentives for small firms (footnote 4) may be encouraging those firms to stay small as opposed to growing to medium or large size firms that are better capable of exploiting economies of scale. Medium and large firms invest more in R&D and training – two important contributors to productivity.

Although Canada has a more generous array of tax credits and grant programs designed to encourage business R&D expenditures than most OECD countries, business expenditure on R&D as a share of GDP remains lower than in many OECD countries.

Some economists argue that this may, in part, be attributable to Canada having a much larger proportion of small firms than in other OECD countries, such as the United States, which have higher business expenditure on R&D as a share of GDP.

In addition to not having a neutral tax system, the current business tax mix in Canada comprises a number of economically damaging taxes, namely, capital taxes and sales taxes levied on capital.

These taxes are based on the amount of capital employed, regardless of profitability, and thus create a disincentive to expansion by way of new capital investment. Without new capital investment, productivity growth and diffusion of innovation are hampered.

Capital taxes and sales taxes are taken into consideration when calculating Canada's (Fed. / Prov. combined) Marginal Effective Tax Rate (METR)(footnote 5) on capital. On an all-sectors basis, Canada has one of the highest METRs among OECD countries.

Although the complete phase out of the general corporate capital tax expected by 2011 will have a favourable impact on Canada's METR, Canada's METR on an all-sectors basis is expected to be the seventh highest among international economies as of 2011.

The U.K., Norway, Italy, Sweden, Austria, Denmark, Finland, Mexico and Ireland will all have a lower METR than Canada.

Although the Federal Government is phasing out the general corporate capital tax, no reduction or elimination of the corporate capital tax on financial institutions is planned.

At the Provincial level, the Federal Government has provided incentives to Provinces to continue with the complete phase out of capital taxes, but no incentives have been given to Provinces to encourage the elimination of sales taxes on capital.

The OECD estimates that the Provinces that currently levy sales taxes on capital could cut their METR on business investment by between 7 to 12 percentage points. Elimination of these harmful sales taxes would further reduce Canada's METR on a combined basis.

Increasing the amount of new capital per worker does not necessarily mean that the capital will be used efficiently. Increased investment in capital will not necessarily result in higher productivity growth if it is not coupled with highly skilled workers and managers who can make efficient use of the capital.

In view of the high tax bill levied on Canadians, Canada will continue losing ground in attracting and retaining highly skilled workers and in encouraging workers to upgrade their skills.

The Fraser Institute (footnote 6) recently reported that the tax bill for the average Canadian family, including all types of taxes , has increased by 1,590 percent since 1961.

In 2006, the average Canadian family earned an income of $63,001 and paid total taxes equaling $28,311 (44.9%) (footnote 7). The average Canadian family today spends more of its income on taxes than it does on the basic necessities such as food, shelter and clothing.

Looking only at personal income taxes, the top marginal rate in Canada (Fed/ Prov. combined) averages about 46% compared to approximately 38% in the United States (on a weighted average basis). It is not surprising that Canada continues to experience a loss a highly skilled workers to the United States.

The lack of competitive intensity in an economy is often cited as the main reason for poor productivity growth. Although Canada has made some significant strides in removing barriers to competition in many sectors, there are important barriers that remain.

Canada has the most restrictive barriers to foreign direct investment in telecommunications and the second most restrictive in air transport among OECD countries. These restrictions have resulted in reduced opportunities for competition and sharper management and technology transfer through foreign direct investment.

The banking sector is still faced with restrictions on percentage ownership of banks and political restrictions on bank mergers. These restrictions impede gains in efficiency and work against large new players, foreign or domestic, entering the market. The Central Bank recently commented that based on a recent study Canadian Banks are less efficient with regard to the scale of their operations and if they could reap economies of scale, there would be efficiency benefits flowing through to the Canadian economy.

Studies have shown that countries that have chosen to delay or forgo deregulation in the airline, telecommunications and banking sectors, have suffered lower productivity levels than the early deregulators (footnote 8).

Despite the numerous reports on the need and recommendations for further deregulation of these sectors, little action has been taken by the Federal Government.

Proposed amendments to the Bank Act have been tabled, but the bigger issue of Bank merger approval and ownership restrictions have yet to be addressed.

Another impediment to competition is the numerous barriers to inter-provincial trade in goods and services and labour mobility among Provinces. Although as important as international trade is to productivity, inter provincial trade gets far less attention from the media and government.

As the Fraser Institute has commented on a number of occasions, a domestic market free of barriers is essential for promoting the competitiveness and productivity of Canadians. The Agreement on Internal Trade and several recent bilateral provincial agreements are steps in the right direction, but progress remains slow and sporadic.

The OECD identified the slow progress in lifting barriers to inter provincial trade in services as a concern and has proposed that Canada promote more vigorous competition in services by reducing the number of so-called regulated occupations to those where significant irreversible harm is likely and the benefits of restriction clearly outweigh the costs.

RECOMMENDATIONS

1. That the Federal Government move forward with more substantive changes to its tax system as follows:

• Phase out capital taxes on financial institutions within the next two years, thereby eliminating all capital taxes at the Federal Level.
• Continue to pursue initiatives as set out in its 2007 Budget aimed at encouraging Provinces to reduce or speed up the phase out of provincial capital taxes and pursue similar initiatives within the next year to encourage Provinces to phase out retail sales taxes on capital goods within the next three years.
• Move towards adopting a more neutral tax system by gradually eliminating over the next ten years Tax Incentives and, with the savings resulting from the gradual elimination of the Tax Incentives, bring into effect even greater reductions to Canada's Marginal Effective Tax Rate (METR) over the same time period. The reductions to Canada's METR should soften the impact of the loss of Tax Incentives for affected sectors / industries.
• Conduct a review of its current Tax Incentives for small businesses and consider the merit of phasing in the same Tax Incentives for medium sized companies over the next three years in order to encourage small firm expansion.

1. That the Federal Government phase out foreign direct investment restrictions in the telecommunications and airline sectors within the next two years.
2. That the Federal Government to remove any political barriers to Bank mergers within the next year and that once these barriers have been removed, phase out the current percentage ownership restrictions within the next two years that follow.
3. That the Federal Government take a leadership role and offer incentives to Provinces to phase out remaining barriers to inter-provincial trade over the next 3 years. One area that should be addressed in the shorter term (within the next year) would be trade in services and a concerted effort should be made to, as proposed by the OECD, reduce the number of so called regulated occupations.

Footnotes:

1. Labour productivity based on average value of output produced per hour worked. This is most common and widely understood measure of productivity. It is measured by dividing gross domestic product (GDP) an estimate of the total value of the goods and services produced in a jurisdiction, by the total number of hours worked by all employees and self-employed individuals.
2. Groningen Growth and Development Centre and the Conference Board, Total Economy Database, February 2007.
3. Based on 2006 data, which is the most recent data currently available
4. Less than 100 employees.
5. The marginal effective tax rate is a comprehensive measure that includes income taxes, capital taxes, depreciation and inventory cost deductions, and sales taxes imposed on business inputs.
6. The Canadian Consumer Tax Index, 2007.
7. Includes direct taxation, such as income taxes, sales taxes, Employment Insurance and Canadian Pension Plan contributions, as well as hidden taxes, such as import duties, gas taxes and excise taxes on tobacco and alcohol.
8. Reported by the McKinsey Global Institute, a think tank based in Washington, D.C.

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