When Finance Minister Chrystia Freeland tabled her budget last year, Canada’s growth prospects were identified as a significant vulnerability and priority for the government. She sensibly recognized human capital and the green transition as the first two of three “pillars” required to tackle the problem, then identified the third as the “Achilles heel of the Canadian economy” – poor productivity.
Having recently torn my Achilles tendon, I can tell you the sharp, sudden pain experienced is quite unlike the slow, creeping problem that productivity growth has become in Canada. This is not an issue that suddenly emerged, rather it has sunk intrinsically into the fabric of our commercial activity and eroded Canada’s appetite for innovation.
Compared to peer countries, our productivity has been receding for decades, and its importance has been largely ignored by Canadian business and political leaders. An Achilles injury, while extremely unpleasant, means you hobble around for a few months until you get back on your feet – but that isn’t the case here. Our productivity stagnation continues to spread to all areas of the economy, like a malignant tumour.
While some economic indicators are rosy for Canada – unemployment is low, wages are rising – productivity rates are not. Labour productivity growth has slowed to less than 1 per cent today from 2.7 per cent in the 1960s and 1970s. The OECD has us ranked dead last of all the advanced economic countries in the world in its predictions for realGDP per capita growth from both 2020-30 and 2030-60.
While it’s widely known that Canada lags the United States, we have also fallen behind France, Germany, Britain, Australia and Italy in productivity. The Canadian work force is less productive because, on average, companies here use less capital and technology, are less innovative, and operate at a smaller scale in an economy plagued by insularity. And it’s getting worse.
It’s not just about having a more market-driven economy. Germany is outperforming us with a highly socialized economy and massive government investments in information and communications technology, as well as an advanced apprenticeship system and a business culture that prioritizes worker training.
When one works through the numbers, it is clear that the primary reason for our malaise is a lack of private-sector investment in research and development and in work force upskilling. Canada ranks 17th of OECD countries regarding the percentage of GDP spent on R&D and among the lowest of G7 peers.
To catch up, Canada must show discipline in focusing incentives to catalyze the private sector where it can have the greatest impact. We must prioritize R&D and training incentives that contribute to physical and human capital efficiency strategies.
Stagnation was less concerning during the longest bull market in history, when a forceful rising tide of monetary policy fuelling economic growth was able to mask many concerning, deeper trends. But that veil has now been removed, revealing that Canadian firms are not well-positioned to innovate and grow.
The United States contributes to our economy through its innovation and production, but it is also our biggest competitor. The number of patent applications submitted by Canadian businesses in 2020 was roughly 1.6 per cent of those submitted by American businesses, which is staggering underperformance even when GDP-adjusted.
Foreign companies and investors looking at Canada will always use the U.S. as a benchmark, given our shared geographic and cultural features. The Americans, recognizing we are at an industrial and economic turning point, have thrown down the gauntlet with public policy and private-sector initiatives to further advance their productivity growth over the coming decades. The most significant being the Inflation Reduction Act, earmarking US$500-billion in new spending and tax incentives to boost clean energy, labour skills and other areas that will contribute to future productivity growth.
To avoid falling further behind, our government should respond meaningfully in the federal budget this week. Last year’s budget introduced the yet-to-be-defined $15-billion Canada Growth Fund, which would use public money to entice more capital to invest in Canadian industry and is one of several bodies created to help Canadian firms innovate. While these are steps in the right direction, they lack the scale the U.S. can deploy and run the risk of having the government or other public bodies choosing winners, something that private capital is much more adept at.
A policy lever that Canada has considered but never implemented is an “intellectual property box,” which would tax income from patents and other intellectual property at a lower rate, effectively guarding against “poaching” from lower tax jurisdictions.
Recent budgets have attempted incentivization through things like the scientific research and development program that provides tax incentives to businesses that conduct qualifying R&D activities. These are available for eligible R&D expenditures, including depreciation expenses on capital assets – matching them to the revenue they generate over time. But programs like these need to be expanded broadly across industry and made straightforward. Unfortunately, eligible candidates often don’t receive the intended incentives owing to narrow application of the rules by our tax regulators.
The 2022 budget included some tax incentives for small businesses, but these appear more driven by politics than sound economic planning. OECD data shows that productivity growth is typically driven by the top 10 per cent of firms in an industry – the biggest players. This year’s budget should include incentives for large firms located in sectors rife for innovation, in energy, e-commerce, advanced manufacturing, transportation and finance, to spend directly on R&D, and simplify the process so they can move with alacrity to get things built and skills developed.
On skills development, Canada has a natural advantage with its broad public support for immigration and merit-based application program that brings in a high percentage of working-age people with credentials. But immigration already accounts for almost our entire labour force growth – the greater challenge lies in ensuring new workers can contribute with their potential and skillsets.
According to Statistics Canada, more than 25 per cent of immigrants with foreign degrees end up in jobs that they are overqualified for, in roles that require a high-school diploma at most. Improving recognition of foreign credentials, simplifying our immigration processes, and strengthening training and education opportunities are all important ways to gear our human capital strategy towards productivity. With economic demands shifting quickly, employers have skin in the game and will need to intensify efforts to implement work-integrated learning.
The future of our country depends on a more productive economy, underpinned by improved R&D spend and a more skilled work force. In this budget, the government must embrace every tool at its disposal and commit to bold action if it wants to be the architect of a prosperous, innovative Canada that stands tall in the face of international competition.
Stephanie Hughes of the National Post also reports that budget spending that grows economic capacity may fight inflation, not fuel it, Poloz says:
The rash of new spending measures unveiled in the federal budget on March 28 may not have the inflationary effect some are predicting because much of the money is being directed to adding capacity to the economy, according to former Bank of Canada governor Stephen Poloz.
“It will be much harder to argue now that fiscal policy is still contributing to above-normal inflation and interest rates,” said Poloz, who now serves as a special adviser to the law firm Osler, Hoskin & Harcourt LLP.
“Indeed, a budget focused on ‘investments’ arguably boosts the supply side of the economy — the child-care program or the completion of the TransMountain pipeline would fall into this category — which is not fiscal stimulus really, but more a disinflationary policy aimed at expanding economic capacity,” he wrote.
Economists cautioned the department of finance to take a more conservative approach in the budget, saying excessive spending could make the central bank’s job in eliminating high price pressures much more difficult. It’s a plea that Finance Minister Chrystia Freeland addressed leading up to the budget, emphasizing a need to balance fiscal restraint with targeted measures.
But Poloz said it was too late for that.
“Arguably, that horse has already left the barn,” Poloz said. “If the government had reduced its fiscal stimulus a year ago, it would have meant fewer inflation pressures and a lower profile for Bank of Canada interest rates, and therefore less collateral damage to the economy — a missed opportunity to benefit many Canadians.”
That said, Poloz suggested the government’s overall spending was manageable.
The $43-billion deficit for the outgoing fiscal year is lower than the $52.8 billion that was projected for this time in budget 2022. However, plans to balance the budget by 2027-2028 outlined in the Fall Economic Statement have gone out the window, too. Instead of a $4.3-billion surplus in 2027, a deficit of $14 billion is now being projected.
Running a persistent deficit, as long as it adds to government debt at a rate lower than the growth in the economy, gives the government wiggle room to bring new initiatives each year that could help Canada address its structural weaknesses, Poloz said.
He noted that the degree to which these new measures tip the balance towards future inflation risks depend how the economy holds up when the new spending takes hold and how much these new measures contribute to future economic capacity.
“Given that the demand side of the economy is already slowing sharply and most of the effects of last year’s increases in interest rates have yet to appear, it is even possible that budget 2023 will help improve the odds of a soft landing in the economy, by buffering demand and boosting supply,” Poloz said. “Given the complexity of the situation, and the uncertainty around the outlook, it is simply too close to call.”
These are two excellent comments and even though they're discussing two different topics, there is common ground on how to spend public money more productively.
First, Mark Wiseman is right, our productivity stagnation continues to spread to all areas of the economy, like a malignant tumour.
He rightly notes we are not only falling behind the US but other nations, now ranking17th of OECD countries regarding the percentage of GDP spent on R&D and among the lowest of G7 peers.
He also states:
When one works through the numbers, it is clear that the primary reason for our malaise is a lack of private-sector investment in research and development and in work force upskilling.
To catch up, Canada must show discipline in focusing incentives to catalyze the private sector where it can have the greatest impact. We must prioritize R&D and training incentives that contribute to physical and human capital efficiency strategies.
He explains how we are under-utilizing immigrants who are highly skilled and how we need to incentivize the private sector to contribute to physical and human capital efficiency strategies.
Of course, Mark recognizes that improving Canada's productivity necessarily means playing the long game to achieve structural and long-lasting changes.
He also understands that foreign investors will always compare Canada to the US and he demonstrates how far behind we lag.
A couple of years ago, the Business Council of Alberta looked into the US-Canada productivity gap:
To put the difference in perspective, Canadians make around $54,000 CAD per year on average while their American counterparts make around $67,000 CAD. In other words, by traveling just a few hours south, incomes increase almost 25% on average. What is it about the US or Americans that is different?
Part of the gap is unrelated to productivity: Americans work more hours than we do—about 3.5% more. If Canadians worked the same number of hours as Americans, they would instead make closer to $56,000. That closes the gap a little, but the remaining 20%-point disparity is due to a difference in the value of output produced per hour worked (i.e., productivity). While the average American worker produces $66 of value per hour, the average Canadian workers produces just $50 of value per hour. What enables Americans to work not harder but rather smarter than Canadians.
What doesn’t explain the gap?
Much research has focused narrowly on differences in taxes as the key driver. Some have even gone so far as to say that lowering taxes alone will eliminate the gap entirely. Interestingly, though it is likely one component of a bigger puzzle, research has not conclusively proven that tax differences are a primary driver of the gap.
A difference in industrial composition, for the most part, can also be ruled out as a major driver. In fact, the Canada-US productivity gap is seen across almost all industries.
Finally, the share of the population living in urban areas is surprisingly similar between the two. Though there is greater proximity to a larger number of major cities in the US than in Canada—which could have some synergies for innovation—this factor has not been extensively researched to date.
What does contribute to the gap?
Businesses’ investment in tools and technologies for employees, the skills and ability of the workforce, innovation, and business size are all essential in explaining the labour productivity gap.
Greater investment in tools and technology
Perhaps the biggest factor is the notable difference in the amount spent on machines, tools, and technologies (capital) per worker—what economists call “capital intensity”. As of the first half of 2019, Canadian businesses spent about $13,000 per worker on capital, while their US counterparts spent $20,500. The gap is especially notable in spending on information and communications technology (ICT) capital where Canada spends at a level of less than 50% that of the US.
However, focusing narrowly on this factor by itself ignores the important interplay with the others. For instance, if individuals and businesses do not know about or know how to adopt and use the tools or technologies effectively, just telling Canadian businesses to “buy more capital” does little to address the problem.
Underlying the gap in capital is both a skills and innovation gap between the US and Canada. These gaps have been found to be important contributors to the difference in business investment of machinery and equipment and ICT.
Difference in skills and education
The skills gap isn’t obvious at first blush. In terms of years of schooling, Canada and the US have equally educated populations so it is easy to dismiss that as a contributing factor. However, there are some important differences: as of 2019, the proportion of the population with a Bachelor’s degree or higher is 38% in the US versus 33% in Canada; while 2% of the population aged 25-64 have received a PhD in the US, this number is less than 1% in Canada.
A compounding factor is the persistent emigration from Canada of people with specific highly productive skill sets. In particular, tech talent developed in Canada is likely to move south of the border upon graduation. With 25% of STEM graduates from top universities working abroad, Canada is left with persistent skill shortages in these areas.
Additionally, the larger presence of research universities in the US compared with Canada creates a fertile environment for not just generating new ideas but also incorporating these ideas into practice.
More emphasis on innovation
Relatedly, the innovation gap is also believed to contribute to the lack of business investment. This is seen in both the “input” of innovation and the “output”. R&D spending, a proxy for input, represents 2.7% of US GDP but only 1.6% of Canada GDP.
Unsurprisingly, output of innovation is similarly imbalanced: the US produces roughly double the number of patents per person than Canada which, as many have noted, lacks a strategy to ensure Canadians benefit from Intellectual Property developed domestically.
Greater proportion of large corporations
Finally, compared to the US, Canada is home to a relatively large number of small companies (those with less than 500 employees), and comparatively few large businesses. Small businesses are, on average, less productive than larger companies. According to research by Statistics Canada, the greater prominence of small businesses explains a large part of the productivity gap between the two countries.
In addition to greater efficiencies of production and management, bigger businesses may also be better suited to invest in the scale of R&D and take the financial risks necessary to drive major change.
Why we see more small businesses in Canada is less clear. One thought is there may be barriers—trade, financing, institutional, regulatory, or taxation, among others—limiting the ability of small firms in Canada to grow. This is an area worth investigating further to ensure Canadians can scale and commercialize their ideas into valuable products and services.
What does this mean for Canada?
While we may be envious of the higher productivity in the US, there is more to the story. The lesser-known truth is that growth over the last few decades has not greatly benefited the average worker. Since 1970, productivity in the US has more than doubled while workers’ wages have increased by just 15%. This “decoupling” of productivity and wages has occurred across most OECD countries, including Canada; however, it has been more prominent in the US. This is an important consideration for Canada’s own policies.
This exercise provides some insights into the important interplay of human capital, business investment, innovation, and business size and has also raised several questions for further analysis, such as why Canadian firms are smaller.
But it also serves as a cautionary tale that productivity growth does not always drive the increase in wages that we expect. In developing policies to encourage greater productivity, therefore, we cannot lose sight of our ultimate aim of this work: improving the lives of Canadians, generation after generation.
Did you catch that last part about how productivity gains alone do not ensure rising wages. In the US, they have disproportionately benefited the capital owners not the average worker.
Still, productivity growth does benefit everyone, including the average American worker and is a prerequisite for sustained economic growth.
Now, in my last comment, I explained why PSP was selected by the federal government to run the new $15 billion Canada Growth Fund.
I did not provide the technical backgrounder to this new Canada Growth Fund which you can read here.
Mark Wiseman is right, $15 billion is nothing to sneeze at but compared to the US and Germany, we are lagging behind (adjusted per capita).
This brings me to Stephen Poloz's comment on why the rash of new spending measures unveiled in the federal budget on March 28 may not have the inflationary effect some are predicting because much of the money is being directed to adding capacity to the economy.
Steve is a really good economist, I worked with him years ago at BCA Research. He was really good back then, he's even better now.
Of course, he's right, spending alone doesn't lead to higher inflation if the spending adds to the capacity of the economy but let there be no mistake, more spending can crowd out private sector investment and lead to higher rates down the road (the crowding out effect).
Also, I've been warning my readers that we are heading into a deep and prolonged global economic recession.
This too will exacerbate Canada's productivity gap and lead to more crowding out.
So, while the new spending measures will likely not exacerbate inflation, they will have an effect on private investment and we need to monitor this carefully.
Lastly, our governments need to figure out ways on how we can create winning conditions to allow Canada's large pension funds to invest more domestically.
And here I'm thinking more in large brownfield and greenfield infrastructure projects, not more in Canadian equities like Letko-Brosseau argue for.
There are structural reasons why Canada's large pension funds aren't investing more domestically, it's not just because they want to diversify properly outside of Canada (although, minus CDPQ which has a dual mandate, this is their mandate to invest in the best opportunities all over the world).
When it comes to what is ailing the Canadian economy, we need more collaboration between private and public entities and we need to play the long game.
Below, as global trends continue to influence Canada’s future economy, we will need to have infrastructure that will allow us to grow, stay competitive, and become sustainable. Mark Wiseman, Chairman of the Board of the Alberta Investment Management Corporation Capital, talks about how corporations and government must coordinate to create an industrial policy for Canada that is future-proof.
And former Bank of Canada governor Stephen Poloz and former federal finance minister John Manley discuss what they will be looking out for in the budget.
We've got some very smart people in Canada but we need to get things done!