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Friday, February 25, 2005

Canada's Productivity Problem

by StFerdIII

Canada’s level of output per person was 81 % of the US level in 2002 worsened during 2003. Since 1994 the productivity gap with the US has surged causing a standard of living gap with the US that is at least 20 % and widening. The only way to arrest GDP per capita – and therefore real wealth – decline, is to increase productivity. Considering the lowering dollar, poorer investment climate, protectionism and monopolies in key sectors, artificially higher interest rate regime [in order to ephemerally boost the C$], and regulatory encumbrances that tax away profits, which exists in Canada, an increase or investment in productivity is not to be expected.

The main reasons for lower productivity and living standards in Canada are:
- Lower capital intensity in business in Canada
- Innovation gap in Canada
- Underdeveloped high tech sector in Canada
- Less human capital in engineering, R&D in Canada
- Limited economies of scale in Canada

These primary factors need to be addressed by Canadian society if Canada wants to maintain its high standard of living and social welfare programs.

Capital Productivity:
The use of capital in the
US to drive output is quite a bit higher than in Canada. Canadian firms are famous for employing low cost labor in lieu of investing in capital and productivity enhancing equipment. A key component of the overall capital productivity equation is the capital per labor ratio in machinery. This ratio is much lower in Canada than in the US running at about 52-57 % of the US level. Another way to view capital productivity is to look at the capital intensity as measured by the capital-labor ratio [capital per worker or capital per hour worked] which is much lower in Canada than in the USA. In Canada this ratio is approximately 85 % of the US level in recent years. Combined these two measures suggest that Canada is falling further behind the US in productivity assets.

It is estimated that this lack of capital intensity in
Canada accounts for about 20-26 % of the productivity gap with the US. This lack of capital investment severely affects profit per employee, profit per plant and the ability of Canadian business to respond effectively to competitive challenges from abroad including cost pressures, innovations and new market penetration. Relying on cheap labor has allowed Canadian jobs to be maintained but a future cost that comprises profits and future wages.

Technological Innovation:
In addition to the productivity gap with the
US there is an innovation gap. There is a huge discrepancy in R&D expenditures. Recent data states that Canada spends 1.67 % of its GDP on R&D vs. 2.7 % in the US. Part of the gap is due to the resource intensive nature of the Canadian economy [30 % directly, 50 % overall of the economy is resourced based] and the many foreign owned affiliates that operate in Canada which do R&D in the home country.

Canadian patents are also lower. According to Trajtenberg [2002 study] Canada is mid way in the G7 in patents per capita and has been overtaken in recent years by Finland, Israel, Taiwan and soon South Korea. The rate of success according to this study of Canadian patents is low versus other nations. Critical areas lacking patent input are computer, electrical and electrical product areas.

Human Capital:
The profiles of educational attainment differ as well between the two countries. By 2000 about 40 % of Canadian women and 38 % of Canadian men between ages 25-64 had attained a tertiary education versus 36 and 37 % in the
US. Upper education %’s are however lower in Canada with about 88 % of 25-34 attaining upper education, versus 90 % in the USA.

In the graduation rate for advanced research programs the
US outperforms Canada with 1.3 % of the population attaining a PhD vs. 0.8 % in Canada. A major strength for the US is the high quality of its research universities. The US has proportionally 35 % more scientists and engineers in R&D and far more Noble prizes per capita. Such research strength greatly impacts productivity, new technology developments and applied patents. It is estimated that Canada’s weakness in human capital accounts for a large proportion of the productivity gap with the US – with some studies suggesting 80 %or more of the productivity gap due to human capital weakness.

Economies of Scale: There is still a strong east-west trade pattern in
Canada as well as the North – South pull. Such intra-Canada trade patterns typically result in smaller plants and longer distances. This is the ‘border effect’ which economists estimate reduces trade flows by 25-50 %. With NAFTA in force now for 8 years, the trade barriers and border affect will continue to decline but there will always remain a border diversion which for Canada. This means that in a smaller geographically spread market, there will continue to be smaller and less capitalized plants and firms and less profits per unit. Such lower rates of profit growth mean less capital human capital investments.

The government is far larger in
Canada than in the US [42 % vs. 31 % if one counts tax and non tax receipts, 2003 figures]. The link with Taxes and productivity [forwarded for instance by J. Mintz at the CD Howe Institute] is the following:
- High corporate taxes stifle investment
- High personal taxes negatively affect labor supply and helps create a brain drain
- Lower small business taxes in the US allow faster capital and job creation and investments
- Higher indirect taxes and regulations add about $12 billion in costs to Canadian business a substantially higher sum than proportionally endured by US businesses. This decreases capital formation.

There is not a direct irrefutable link between taxes and productivity. But no doubt it aggravates a bad situation. The
Netherlands for instance has a far higher tax base than the US but enjoys a productivity level in some sectors that is higher than the US level. Nevertheless the Dutch standard of living is below even that of Canada though it has a more comprehensive tax and social welfare framework. Without question higher taxation impeded capital investment, job creation and profits.

In the
US payroll taxes as a % of total pay are actually higher than in Canada. For Canadian firms this motivates them to employ labor and not capital while in the US the opposite impulse is created. Coupled with a lower dollar value in Canada it is cheaper for Canadian firms to forego importation of capital equipment and technology from US suppliers and compete on labor cost advantage. In the US the emphasis is on labor utilization and plant productivity and capacity usage. Technology and investments in plants and assets play a more meaningful role in US business than in Canada.

As well Canadian firms due to a smaller more dispersed market are under less intense competition than their
US peers. Regulatory barriers are higher in Canada which decreases competition and there are social and behavioural differences in market competition between the 2 countries which impacts productivity.

Due to range of factors that comprise productivity the
US enjoys a more productive, wealthier environment with a 20 % advantage in living standards over Canada. Canadians in various studies downplay this gap by pointing to greater economic and social equality and ‘certainty’ in Canada vs. the United States.

The productivity problem shows up in GDP per capita and living standards. GDP per capita which is the main rubric for how well a society is doing – was likewise only at 85 % of US levels from 1990-2003. As
US growth and productivity continue to accelerate, this gap will only widen. As the levels of productivity and GDP per capita decline relative to the US, Canada’s standard of living will continue to fall relative to US levels.

- International Productivity Monitor - various issues 2003.
- The Sources of Economic Growth in OECD Countries - 2003.
- P.J. Nicholson,
Canada’s Long Run Economic Prospects, 2003
- Statistics Canada
- OECD Accounts 2003
- Centre for the Study of Living Standards

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