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Economic Freedom

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Public Policy Sources #37:
Appendix 2 Overview of recent policy papers on productivity

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In this Appendix, I briefly discuss a few of the major policy studies that have been released to date. In particular, I will give an overview and a critique those studies that have been most frequently cited in public discussions about Canada's productivity.

OECD Economic Surveys 1997-1998: Canada

One of the first studies to highlight Canada's poor productivity was produced by the Organisation for Econmomic Cooperation and Development (OECD 1998). In this study, Canada's poor total factor productivity performance is documented. The study attributes Canada's poor productivity to several factors, including unused capacity, low rates of capital accumulation, low levels of research and development, and poor labour mobility across regions. The study also notes that relative to the United States and other nations of the OECD, Canada has a large number of small- and medium-sized enterprises that appear to be less internationally oriented and less innovative than their foreign counterparts. The OECD recommends that Canada improve its productivity performance by: (i) a reduction in its relatively high tax burden and a lowering of marginal income tax rates; (ii) a reduction in both interprovincial and international trade barriers; (iii) an increased focus on the acquisition of skills and training as well as innovation.

Factors such as the slow rate of capital accumulation, the large number of small- and medium-sized enterprises, poor factor mobility and low levels of research and development have probably contributed to Canada's poor productivity growth. Policy measures such as reduced tax rates and reductions in trade barriers--both international and interprovincial--will likely help boost Canada's productivity performance. However, a greater emphasis should be placed on reducing Canada's capital taxes--which are high by international standards--for capital accumulation is key to technological progress and productivity advance. Moreover, the overall tax mix should be shifted away from highly distortionary capital and income taxes and toward less distortionary consumption taxes (see Kesselman 1998). Such measures would increase the dynamic efficiency of the economy and raise the rate of productivity advance.

While an increased focus on training and skills acquisition are important in a knowledge-based economy, it is not clear that Canada can do much in this regard as educational attainment in Canada is already high by international standards. As the OECD (1998) notes, Canada already invests heavily in education and training as measured by the proportion of GDP Canada spends on formal schooling. The problem is, therefore, not insufficient investment in training and higher education but, rather, a misallocation of investment brought about by widespread government intervention in the higher education and training market (see West 1988). Less government intervention in the market for training and higher education would likely improve the allocation of resources and thereby raise productivity growth over the long term.

Productivity with a Purpose: Improving the Standard of Living of Canadians (House of Commons Standing Committee on Finance)

The House of Commons Standing Committee on Finance (1999) takes a view of Canada's faltering productivity similar to that of the OECD. In this paper, the HCSCF discusses the importance of productivity advance for increases in long-run living standards and gives an overview of the causes and consequences of Canada's low productivity. The HCSCF also offers some policy measures that could be adopted to improve Canada's productivity performance. These include: (i) reducing the ratio of debt to GDP and maintaining a low interest rate and a low inflation rate; (ii) reducing marginal income tax rates (in particular, elimination of the 5 percent surtax) and changing the corporate tax system to make it more neutral; (iii) enhancing tax support for training, higher education and research, and development activities; (iv) increasing reliance on market forces through reductions in both international and interprovincial trade barriers and through less government intervention in the marketplace.

As I discuss throughout this paper, productivity advance is what drives long run improvements in material standards. Hence, the HCSCF's focus on productivity growth is sound. The policy recommendations made by the HCSCF are also sensible. Reductions in the debt-to-GDP ratio will allow tax rates to fall over time, thereby reducing the efficiency losses induced by high marginal tax rates. Changing the tax mix--in particular, reducing marginal income tax rates and capital taxes--will also improve the dynamic efficiency of the economy as such taxes deter investment in productivity-enhancing capital accumulation. It is doubtful, however, that enhanced tax support for training, higher education, and research will improve Canada's productivity performance significantly. As Palda (1993) notes, Canada's R&D tax-support system is already among the most generous in the world. Moreover, Canada's labour force is highly educated compared with other industrialized nations (OECD 1998): there is sufficient investment in the market for higher education and training but it is misallocated as a result of government intervention. Hence, what is required here is less, rather than more, government intervention in the market for higher education and training.

Papers from Industry Canada

Industry Canada has released several papers dealing with Canada's productivity problem. In its major summary paper, Sustaining Growth, Human Development, and Social Cohesion in a Global World (Policy Research Initiative 1999), Industry Canada provides an excellent non-technical overview of Canada's productivity problem. Most of the results from Industry Canada's research program have been discussed at length in this paper already and I will not reiterate those findings here. While some of these results point to possible avenues for policy, no policy recommendations are made in this paper.

In a subsequent document, however, Industry Canada does discuss some of the policy options available to enhance Canada's productivity growth (Gherson 1999). In particular, the need for reduction of both personal and business taxes to improve productivity growth is discussed at length. In this paper, Industry Canada argues that lower business taxes would help encourage firms to invest more in state-of-the-art plant and equipment. Lower business taxes would also encourage more foreign direct investment in Canada, which could bring with it more technological know-how. Lower personal income taxes would raise the return to investing in additional training and skills for Canadian workers and thereby increase the level of human capital. Since more skilled workers are better able to adjust in a dynamic, knowledge-based economy, the result will be enhanced productivity performance.

Productivity: Key to Success
(Centre for the Study of Living Standards)

The Centre for the Study of Living Standards has also released papers dealing with Canada's low level of productivity and its policy implications. Productivity: Key to Success (Sharpe 1998) provides an excellent non-technical overview of Canada's productivity problem. In addition, Sharpe discusses the problems associated with productivity measurement and pays special attention to the so-called "computer paradox" of productivity measurement. Sharpe argues that Canada has a unique productivity problem that is apparent in Canada's poor performance in manufacturing productivity. Sharpe also offers a few policy suggestions. Like the HCSCF, Sharpe discusses the importance of a stable macro­economic environment with low real interest rates and points to the importance of increased public support for training, higher education, and research and development. He also argues that increased reliance on market forces will likely raise productivity performance but he does not believe the impact will be large.

Unlike the OECD and the HCSCF, however, Sharpe is skeptical about the impact of tax reductions or changes in Canada's overall tax mix on productivity performance. In particular, he argues that Canada's corporate tax burden is already very low from an international perspective and that the gains to be had from reducing taxes are small.

While Sharpe does produce valuable insights into the nature and causes of Canada's productivity problems, I take issue with some of his policy conclusions. Sharpe is too dismissive of the need for fundamental tax reform and, in particular, the need for a change in the overall tax mix away from capital and personal income taxes and toward consumption taxes. High personal marginal income tax rates and high rates of capital taxation deter entrepreneurial activity and capital accumulation--activities that raise the long run productive capacity of the economy. Moreover, Sharpe is simply incorrect in his assertion that Canada's corporate tax burden is low from an international perspective. According to Jack Mintz, the average corporate tax rate among industrialized countries is 34 percent, far below Canada's general corporate tax rate of 43 percent (Mintz 1999). Mintz estimates that, by next year, Canada will have the second highest general corporate tax rate among all OECD countries. In addition, he notes that Canada's knowledge-based service sectors--sectors that are key to productivity advancement and economic growth--face the highest overall business tax rates among the G-7 nations. Hence, there is a pressing need for fundamental tax reform in Canada.

The Competitive Alternatives: A Comparison of Business Costs
in North America, Europe and Japan (KPMG)

In recent public statements, both Prime Minister Jean Chetien and Finance Minister Paul Martin have argued that Canada's productivity is not lower than it should be. In support of their position, both the Prime Minister and the Minister of Finance have cited the study recently released by KPMG (1999). According to this study, which compares business costs in all G-7 countries as well as Austria, Canada takes the top position as the country with the lowest overall business costs. The study finds that, over nine major industries, overall business costs in Canada are 7.8 percent lower than costs in the United States, 14.6 percent lower than costs in Germany, and 24.4 percent lower than costs in Japan.The Chretien government claims that lower business costs imply that Canada is an attractive place to invest and infer, therefore, that Canada does not have a productivity problem.

This inference is incorrect. Productivity and cost competitiveness are related but not identical concepts. Productivity refers to the efficiency with which an economy transforms inputs--labour and capital--into useful outputs (i.e. goods and services). A more productive economy requires fewer inputs to produce a given quantity of output. Cost competitiveness, in contrast, is simply a ranking of the amount it costs in a given currency to produce a given amount of output in a particular country at a given point in time. While more productive economies are likely to have lower business costs, other factors, such as the exchange rates, tax rates, and regulations will also affect costs. Moreover, while productivity growth tells us something about how material living standards are likely to evolve over time, cost comparisons tells us nothing about the future. KPMG's cost comparison study tells us only how much it costs to do business in various countries today.

In the KPMG study, costs in each country are measured in current American dollars. Hence, fluctuations in the exchange rate will affect each country's position in the ranking. A quick glance at the KPMG study reveals that one major source of Canada's cost competitiveness is the low value of the Canadian dollar (relative to the American dollar).18 According to the study, Canada's cost advantage over the United States vanishes if the Canadian dollar appreciates to US$0.79 or higher. Many economists estimate that the purchasing power parity value of the Canadian dollar is roughly US$0.82. Hence, an appreciation of the Canadian dollar to its estimated long-run value would eliminate Canada's cost advantage relative to the United States. To draw broad conclusions about the future performance of the Canadian economy from a cost-comparison study can therefore be seriously misleading.

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