Investment and Productivity

Why is M&E investment important to labour productivity?

HCP Investment Labour and Productivity video still

Key Messages

  • Historical data for the peer countries reveal a strong positive relationship between investment in machinery and equipment (M&E) and labour productivity.
  • Canada’s investment in M&E as a share of GDP is among the lowest of its peers.
  • The gap in investment in information and communications technology between Canada and the U.S. accounts for a large proportion of the labour productivity gap between the two countries.

The economy is doing well—why dwell on labour productivity?

“Our ambitions for the Canadian economy should be bold. We are a country of immense strengths and, as demonstrated during the recent crisis, considerable resilience. Yet Canada does underperform. We are not as productive as we could be. Our potential growth is slowing. Moreover, this is occurring as the very nature of the global economy, in which we previously thrived, is under threat. This debate can no longer be avoided.”

—Mark Carney, Governor of the Bank of Canada1

On the surface, Canada seems to be doing well. We came out of the recent economic crisis relatively unscathed compared with our neighbour, the United States. In fact, Canada fared better than most industrialized countries thanks to its strong banking sector and fiscal prudence. Also, the deficit created by stimulus spending and lower revenues is expected by The Conference Board of Canada to be eliminated on schedule or even a bit ahead of plan. But all is not well on the home front. One of the key economic challenges for Canada is improving labour productivity. Canada remains at the back of the class on this critical indicator. On labour productivity growth, Canada ranks 12th among 17 peer countries.

Why dwell on labour productivity? Labour productivity can be a confusing concept to grasp. It’s not about working harder, longer hours. It’s about working smarter and getting more for less—more output per unit of input, which is usually hours worked.

Labour productivity is the key determinant of standard of living, or GDP per capita, over the longer term. Low productivity in Canada is a huge challenge to future prosperity—especially given the country’s aging population. As the baby boomers retire and the demographic structure continues to shift, Canada will have to rely on labour productivity to boost incomes.

Growing competition from emerging economies—particularly China and India—further highlights the productivity imperative. Although the U.S. fared much worse than Canada in the recent recession, Canada’s low labour productivity will prevent it from closing the income gap with its neighbour. In fact, the trend has been for both the productivity gap and the income gap between the two countries to widen, not narrow. (The income gap narrowed somewhat in the 2008–09 recession but is forecast to start growing again.)

Why is investment in machinery and equipment so important?

Investment is widely recognized as essential to improving labour productivity. Investment in physical capital, and specifically machinery and equipment (M&E), is associated with the adoption and diffusion of the latest technologies—key to growth in labour productivity. By investing in M&E, workers are equipped with the latest technologies, which, in turn, allow them to improve their business processes and produce more and higher-quality goods and services. This means companies can contain their costs and grow their output. Capital accumulation (which includes M&E) also raises labour productivity by increasing the capital-labour ratio (substituting capital for labour)—important at a time of impending labour market tightness in Canada.

Yet Canada’s investment pattern continues to be as dismal as its productivity growth. Canada's proportion of M&E investment as a share of GDP is among the lowest of the peer countries.

The federal government highlighted the importance of M&E investment in the 2010 budget: “Budget 2010 takes action to improve the environment for investment, enhance competition and reduce barriers for businesses. This includes making Canada a tariff-free zone for manufacturers, by eliminating all remaining tariffs on productivity-improving machinery and equipment and goods imported for further manufacturing in Canada.”2 In addition to eliminating tariffs on M&E imports, the government has been incrementally lowering the federal general corporate income tax rate—from 19 per cent in 2009, to 18 per cent on January 1, 2010, to 16.5 per cent on January 1, 2011. It will be further reduced to 15 per cent in January 2012. This reduction and the phase-out of the capital tax at the federal level and by some provinces demonstrate governments’ commitment to promoting investment among Canadian firms.

Is there a noticeable relationship between M&E investment and labour productivity? We looked at the relationship between M&E investment and labour productivity for the peer countries over the past few decades. A time-series regression (fixed-effects panel analysis) between 1970 and 2009 revealed a strong positive relationship (with a correlation coefficient, or R2, of 0.64) between investment in M&E and labour productivity.3

Isolating the data for Canada and the U.S., the chart shows the strong relationship between M&E investment and labour productivity for the two countries.

Canada’s investment in M&E as a share of GDP remains among the lowest of its peers. In fact, Canada’s average M&E investment as a share of GDP in the 1970s, 1980s, and 1990s was the second lowest—only France had a poorer investment record.4 In the 2000s, Canada ranked 11th among the 16 countries—a modest improvement that reflects lower investment shares in other countries rather than an increased investment share in Canada.5

The bar chart shows the peer countries’ M&E investment as a share of GDP for the past four decades (where data are available), sorted by their share in the 2000s.

Interestingly, Norway, the peer country with the highest GDP per capita, had one of the lowest M&E investment ratios for the past two decades. M&E investment as a share of GDP has fallen in Norway since the early 1970s, yet GDP per capita has grown by over two and a half times since 1970. Like Canada, Norway has benefitted from rising world energy prices—Norway has benefitted to a greater extent, however, since the oil and gas sector accounts for a much larger proportion of its economy (over 20 per cent of total industry GDP in 2010).6

Ireland is another country that stands out with a historically low proportion of M&E investment relative to its labour productivity. In the 1990s, Ireland ranked 12th out of the 17 countries on M&E investment as a share of GDP. In the 2000s, Ireland had the lowest M&E investment ratio among its peers. Yet this is a country that was known as the Celtic Tiger in the 1990s and early to mid-2000s thanks to its phenomenal labour productivity and GDP growth. It was not domestic investment but foreign investment that paved the way. Much of Ireland’s growth was thanks to a substantial increase in inward foreign direct investment (FDI) flows in the 1990s. Similar to domestic M&E investment, inward foreign direct investment can also lead to productivity gains.

What kind of M&E should Canada be investing in?

Machinery and equipment can be broadly divided into two categories: information and communications technology (ICT) equipment and non-ICT equipment. ICT equipment is made up of three components: telecommunications equipment, software, and computer and related equipment.

The gap in M&E investment between Canada and the U.S. is a key contributor to the labour productivity gap between the two countries—more specifically, though, it is the gap in ICT investment between these two countries that accounts for a large proportion of the labour productivity gap.7 In 2003, differences in the stock of ICT accounted for 56 per cent of the Canada–U.S. labour productivity gap, whereas non-ICT equipment differences accounted for only 5 per cent of the gap.8

Between 1995 and 2001, ICT capital contributed 0.5 percentage points on average to annual GDP growth in OECD countries. The U.S. and Canada recorded the strongest ICT contributions, amounting to one-quarter of GDP growth between 1995 and 2001.9 With the widespread diffusion of the Internet and broadband networks, and the growing use of smartphones like RIM’s Blackberry and Apple’s iPhone, ICT is critical to the operation of successful businesses.

Use the bubble diagram below to track the history of ICT investment per worker and labour productivity over time for Canada and the United States. Follow these steps:

  1. Under “Color,” choose “Country.” That way, each colour will represent a specific country. .
  2. Under “Size,” choose “Normalized GDP per capita” as the variable that determines the size of the bubble.
  3. Choose “ICT investment per worker” as the variable to track on the horizontal axis.
  4. Choose “Labour productivity” as the variable to track on the vertical axis.
  5. To see a trail for each country, click in the “Trails” box, and then click in the box for Canada and the U.S. Each country will be represented by a trail of bubbles in its unique colour.
  6. Finally, click the play button in the bottom left to begin the show.

The bubble chart shows that the gap in ICT investment per worker between Canada and the U.S. has grown since the late 1980s, as has the gap in labour productivity. In 2009, ICT investment per worker in Canada was only 60 per cent that of the United States.10

The size of the bubbles represents normalized GDP per capita—that is, GDP per capita on a 1 to 10 scale. For each year, a value of 1 is assigned to the country in our study with the lowest GDP per capita while a value of 10 is assigned to the country with the highest GDP per capita. All other countries’ GDP per capita are normalized to fall somewhere between 1 and 10. Normalized rankings allow us to see whether a country’s GDP per capita has risen or fallen relative to that of its peers. In this bubble chart, the shrinking blue bubbles show that Canada’s normalized relative GDP per capita has fallen significantly since the 1980s—in other words, the standard of living in the peer countries has increased relative to Canada’s.

The line chart shows the results of a time-series regression that reveals a strong positive relationship between ICT investment per worker and labour productivity between 1988 and 2009 in Canada and the United States.11

So why is Canada’s share of investment so low?

In the past, under-investment in M&E was attributed to the low value of the Canadian dollar. This makes sense, given that Canada imports most of its machinery and equipment—a low dollar meant higher M&E import costs for firms. When the loonie rose relative to the U.S. dollar thanks to the commodity boom in the mid-2000s, so did investment. In 2005 and 2006, real M&E investment grew by 13.8 per cent and 10.7 per cent, respectively. Despite this growth, Canada’s M&E investment as a share of GDP remained below that of most of its peers.

Given that ICT accounts for a significant proportion of the productivity gap between the two countries, it’s worth focusing on the reasons for the ICT gap in particular. Aside from the exchange rate, other factors that may account for Canada’s relatively low investment intensity include:

  • industry structure
  • firm size
  • labour-to-capital cost ratio

In terms of industry structure, if a smaller proportion of employment in Canada is in ICT-intensive industries, then it would make sense that overall ICT intensity in Canada is lower. The Centre for the Study of Living Standards explored the impact of industry structure on ICT investment by weighting ICT investment by industry in Canada using U.S. employment shares. The study found that total business sector ICT investment in Canada might be 4.9 per cent higher if the same proportion of Canadians as Americans worked in ICT industries.12

Firm size has a significant effect on ICT use and investment.13 Smaller firms are at a disadvantage when it comes to access to capital. Also, they may be more risk averse than more profitable larger firms that can afford to try the latest technologies. Smaller firms also tend to do less R&D than larger ones, and higher R&D typically means increased investment. Average firm size differs greatly between the U.S. and Canada. Canada has a much greater proportion of small- and medium-sized enterprises (SMEs) than the United States.

A lower labour-to-capital cost ratio in Canada than in the U.S. may also explain the difference in investment intensity between the two countries—because it costs relatively less to hire people rather than invest in new M&E in Canada. According to KPMG’s 2010 Competitive Alternatives report, Canada’s total average labour costs, including benefits, are lower than those of the United States.14 Comparable data on ICT costs in Canada and the U.S. are not available; however, given the historically low value of the Canadian dollar vis-à-vis the U.S. dollar, it is likely that ICT import costs have been higher for Canadian firms over the years. But even if ICT costs are the same in both countries, Canada’s lower labour costs still mean that the labour-to-ICT-capital cost ratio is lower in Canada.

Canada’s lack of competition in the telecom services industry may also factor in to Canadian firms’ costs of using ICT. It was not until relatively recently that the federal government reduced barriers to the operation of foreign-owned telecommunications firms in Canada—but the telecom industry foreign-ownership debate is far from over.15 Given that Canada has a limited number of service providers, broadband and mobile subscription rates are much higher here than in many of Canada’s peer countries. According to OECD data, in 2009, Canada had the third highest range of subscription broadband prices among the 17 peer countries included in the How Canada Performs report cards.16 Canada is also among the countries with the highest prices for mobile phone calls in the OECD.17

Footnotes

1  Mark Carney, remarks made at the Ottawa Economics Association, March 24, 2010.

2  Budget 2010, Leading the Way on Jobs and Growth.Tabled in the House of Commons by James M. Flaherty, Minister of Finance, March 4, 2010, 9 (accessed February 22, 2011).

3  Because of the unavailability of M&E investment data, Belgium, Netherlands, and Switzerland were not included in the time-series analysis. Data for M&E were lagged by one year to reflect the fact that investment in a given year will not take effect until the following year. The correlation coefficient, or R2, for this panel analysis was 0.64, suggesting a strong positive relationship between the variables. Both the constant term and the coefficient were positive and highly statistically significant. The t-ratios were high, further demonstrating the statistical significance of the results.

4  Data are missing for the 1970s for Denmark, Germany, Ireland, Japan, Netherlands, Sweden, Switzerland, and United Kingdom. Data are missing for the 1980s for Ireland and Switzerland.

5  Data for Belgium are not available.

6  Statistics Norway, Table 06130: Gross Domestic Product and Value Added by Industry (accessed January 20, 2011).

7  Centre for the Study of Living Standards, What Explains the Canada–U.S. ICT Investment Intensity Gap? (Ottawa: CSLS, December 2005), 11 (accessed February 22, 2011).

8  Melvyn Fuss and Leonard Waverman, “Canada’s Productivity Dilemma: The Role of Computers and Telecom,” Bell Canada’s Submission to the Telecommunications Policy Review Panel, 2005, 4–5.

9  Organisation for Economic Co-operation and Development, The Economic Impact of ICT: Measurement, Evidence and Implications (Paris: OECD, 2004), 78.

10  Centre for the Study of Living Standards, Database of Information and Communication Technology (ICT) Investment and Capital Stock Trends: Canada vs United States (accessed June 1, 2010).

11  A fixed-effects panel analysis was done for the two countries to investigate the relationship between ICT investment per worker and labour productivity. Data from 1987 to 2008 were used. The correlation coefficient, or R2, for this panel analysis in 0.96 suggesting a very strong positive relationship between the variables. Both the constant term and the coefficient are positive and statistically significant. The t-ratios are high further demonstrating the statistical significance of the results.

12  Centre for the Study of Living Standards, What Explains the Canada–U.S. ICT Investment Intensity Gap? (Ottawa: CSLS, December 2005), 79 (accessed February 22, 2011).

13  Ibid., 90.

14  KPMG, Competitive Alternatives: KPMG’s Guide to International Business Location, 2010 Edition (KPMG LLG, March 22, 2010, 54 (accessed February 22, 2011).

15  In December 2009, the federal government announced that Globalive, a foreign-owned company, could launch its Wind Mobile Brand in Canada, overruling a decision from the Canada Radio-television Telecommunications Commission (CRTC) that found Globalive in breach of Canada’s limits on foreign ownership. On February 2011, the Federal Court ruled that Globalive does not have enough Canadian ownership to operate in Canada. The federal government plans to challenge this decision.

16  Organisation for Economic Co-operation and Development, “Broadband Portal” (accessed August 26, 2010).

17  Organisation for Economic Co-operation and Development, “OECD Communications Outlook 2009” (Paris: OECD, August 2009). (Accessed February 22, 2011.)