Public Policy Sources #37:
What next? Prospects for policy and research

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There appear to be several factors contributing to Canada's poor productivity performance. How much each factor matters quantitatively is still debatable: the evidence accumulated so far suggests that no single factor dominates the others and this, of course, is largely due to the fact that empirical work on these issues is still in its infancy. It is encouraging that Canada's productivity slow-down is a major topic among academic and non-academic researchers at present although very few of the studies completed to date discuss the role that public policy plays in determining the rate of productivity growth. A few studies have been released that attempt to grapple with some of the policy implications of the productivity problem in a very general manner. An overview of some of the more frequently cited of these studies is provided in Appendix 2. However, as most of these studies are fairly non-technical, a professional consensus on the optimal policy response has yet to emerge. In the absence of greater professional consensus, definitive policy analysis is difficult.

Nonetheless, it is possible to draw a few conclusions from which some policy stance can be derived. While experts may disagree about which growth model best describes the growth process, few would disagree with the fact that technological progress is what ultimately drives growth. The accumulation of factors--bringing more people into the workforce, investing in more of the same machines and equipment--can only go so far in promoting economic growth. Canada's House of Commons Standing Committee on Finance (HCSCF 1999) makes this point quite forcefully in its recent report on productivity.

History shows us that economic growth is not simply about achieving efficiency in a static sense. Nor is it purely a matter of using more labour or more capital. Economic growth is much more about changes in technology, allowing us to produce new goods and services and produce them in new and innovative ways. It is about invention and innovation, scientific experimentation and new management techniques. ( HCSCF 1999: 29)

Thus, the key to economic progress is technological change. If advancing the living standards of Canadians is indeed the objective of government policy, then the role of government is to create an institutional environment that is conducive to the creation and diffusion of new knowledge and technologies. This, in turn, requires an institutional framework that rewards individual effort and entrepreneurial activity. Hence, analysis of how public policy affects productivity advance should focus on how policy influences the environment in which productive economic activity takes place. Future research on how policy affects productivity performance should, therefore, concentrate on the linkages between the institutional setting, the incentives in place, and the pace of productivity advance.

Most economists would likely agree that international trade and competition are important indirect determinants of productivity growth. I noted earlier that several studies find the international sector to be an important source of productivity growth. In addition, it should be noted that the increased competition brought about by free trade is also an important determinant of productivity growth. According to Trefler (1999), the Free Trade Agreement between Canada and the United States enhanced the productivity of those sectors that saw their tariff protection reduced. Increased international competition forces firms to adopt more efficient production methods, to increase the scale of their operations, and to innovate in both production techniques and product lines. As Richard G. Lipsey writes: "Competition among three or four large firms often produces more innovation but a single firm, especially if it serves a secure home market protected by trade barriers, seems much less inclined to innovate" (Lipsey 1996: 4). Firms exposed to international competition must introduce new technologies in order to compete effectively in the world marketplace. In addition, access to a large international market enables firms to increase their output and thereby take advantage of economies of scale. Hence, a policy of open international trade will raise economic growth because competition helps to foster an environment in which productivity growth may emerge.

Another policy lever through which government policy affects productivity growth and economic performance is taxation. Taxation affects productivity growth indirectly by changing the incentives faced by economic actors. By changing relative prices, taxes influence the way consumers and firms save, invest, consume, and produce. In so doing, taxes affect productivity growth and long-run economic performance.

Hence, another reason for Canada's poor productivity growth is the Canadian government's heavy reliance on taxes that impose large distortions on the Canadian economy. Relative to other OECD countries, Canada imposes high personal and capital taxes, and low consumption and labour (i.e. payroll) taxes. Emes and Walker (1999) compare the composition of total tax revenues in several industrialized nations. According to table 8.1 (Emes and Walker 1999: 85), income and profit taxes (i.e. personal and capital taxes) raise 47.3 percent of total tax revenue in Canada, compared to an OECD average of 37.7 percent. In contrast, social security taxes (i.e. payroll taxes) and goods and services taxes (i.e. consumption taxes) make up only 16.3 percent and 24.9 percent of total tax revenues in Canada. The corresponding OECD averages are 25.1 percent and 32.5 percent respectively. According to Kesselman (1999) and Mintz (1999), this mix of taxes is inefficient as capital and personal income taxes impose the largest dynamic efficiency losses on the economy. High marginal tax rates for personal income and capital income create the largest disincentives to save and invest--activities that are key to productivity advancement and long-run economic growth. In contrast, the dead-weight losses introduced by consumption and payroll taxes are very small.15 Hence, reductions in marginal tax rates on personal income and capital income are an important element of a fiscal policy that encourages productivity growth.

Most economists would also agree that the skill level of the labour force is an additional determinant of productivity advance. Highly skilled workers are generally highly paid, are more flexible, and are better able to adjust to a changing knowledge-based economy. In addition, highly skilled workers are better able to innovate and take advantage of opportunities in the growing knowledge-based sectors of our economy. How government policy affects the supply of skilled workers is, therefore, another way by which public policy affects productivity growth.

Among OECD countries, Canada's labour force ranks well in terms of years of education (OECD 1998). Most observers agree that Canadian workers are among the most skilled in the industrialized world. Canada has the highest post-secondary enrolment rate among OECD nations. Additionally, public expenditures in education in Canada, as a share of GDP, are one of the highest in the OECD. Hence, policy proposals that call for increased public funding for higher education and training are unlikely to be effective as measures to raise Canada's productivity performance.16

There is growing concern, however, that the high rate of personal income tax in Canada is inducing an exodus of Canada's most highly skilled (and also most mobile) personnel. Whether or not Canada suffers from a "brain drain" is one of the most hotly debated policy issues of the day.17 Nevertheless, a few important points need to be made. One is that, relative to the United States, Canada is not competitive with respect to personal income taxes. Personal marginal tax rates are higher in Canada than in the United States and take effect at a substantially lower level (Emes and Walker 1999). Hence, the private pecuniary gains from moving to the United States are large for many of Canada's most skilled workers. The existence of such large after-tax earnings gaps may therefore provide indirect evidence of a brain drain.

Another important point to be made is that, while the aggregate figures are difficult to interpret, it is clear that there is an exodus to the United States of skilled workers in many key sectors. According to the Conference Board of Canada (1998), Canada loses four times as many engineers as it receives in return, nine times as many health professionals, almost six times as many management professionals, and two and one-half times as many professors and teachers. Thus, small changes in the aggregate supply of skilled workers may mask large compositional shifts.

Small changes in the aggregate supply of skilled personnel in Canada may conceal the departure of the very best and brightest young Canadians. As the HCSCF (1999) notes, New York law firms recruit about one-half of all "A" students from Osgoode Hall Law School. Since innovation, invention, and entrepreneurial activity depend very much upon particular individuals, the loss of Canada's best and brightest ought to be a major policy concern.

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