 |
|
Alan Arcand
Principal Economist
Centre for Municipal Studies |
 |
|
Mario Lefebvre
Director
Centre for Municipal Studies |
Growth in Canada’s capital/labour ratio experienced a sharp slowdown beginning around 1984. Although growth has picked up in recent years, the country is still paying the price for the past weak increases in capital intensity, manifested in the form of weak productivity growth.
Why did growth in the country’s capital/labour ratio slow? Possible explanations include, but are not limited to, capital taxes, the exchange rate, a poorly functioning venture capital market, underinvestment in public infrastructure, and burdensome government regulation.
In general, taxing any activity discourages that activity. For instance, a consumption tax discourages consumption through higher prices. And a tax on capital discourages productivity-enhancing business investment through the higher cost of capital.
In fact, lowering capital taxes will provide the biggest bang for the buck for governments looking to cut taxes. A 2004 study published by the Department of Finance Canada measured the “economic well being” of reducing different types of taxes. It estimated that a cut in capital taxes would create the biggest impact: A $1.00 cut would result in a $1.40 increase in economic well-being. At the other end of the scale, a $1.00 reduction in consumption taxes would yield only a ¢10 benefit.
In Canada, the capital tax was first introduced at the federal level in 1985 as a temporary measure to fight the deficit, and applied only to large financial institutions. But it became permanent in 1988 and was extended to all large corporations in 1989.
Fortunately, governments have been cutting corporate taxes, including taxes on capital, in recent years. In fact, the federal government eliminated taxes on capital in 2006. But six provinces still collect capital taxes from non-financial institutions. One of these provinces — Ontario — plans to phase out capital taxes for all firms by 2010.
This may partly explain Canada’s improved capital intensity growth in the past few years. According to the C.D. Howe Institute’s 2007 Tax Competitiveness Report, Canada’s effective tax rates on capital investment were the 11th highest of 80 industrialized and developing countries, an improvement from Canada’s 2005 ranking when it had the fourth-highest effective tax rate. The country continued to show progress in 2009, as its effective marginal tax rate on capital fell slightly from 31.9% in 2007 to 28% in 2009. Moreover, planned tax changes, such as sales tax harmonization in Ontario and British Columbia, will bring the effective marginal tax rate even lower in the coming years.
Tax policy reform is a must if Canada’s long-term productivity performance is to improve. All provinces should join the federal government and Ontario by eliminating capital taxes in all sectors as soon as possible. In addition, corporate income taxes are still too high and should be cut further to improve the international competitiveness of all Canadian businesses.
Tax barriers to income growth should also be reduced for small businesses, which pay a lower rate of tax than larger firms up to a net income threshold of $400,000. Then the full corporate income tax (CIT) rate kicks in, creating a disincentive for firms to grow their business above this threshold. Governments should create a series of stepped increases in the CIT rate for small businesses, and enable the full CIT rate to kick in at a higher amount of business revenue.
The slowdown in capital intensity is also closely associated with fluctuations in the Canada–U.S. exchange rate, which change the relative price of domestic and foreign inputs, as well as the revenue firms receive from export sales in Canadian dollar terms. A weaker Canadian dollar makes productivity-enhancing machinery and equipment from the U.S. more expensive.
Under-investment in public infrastructure has likewise played a role in Canada’s lagging productivity growth performance. The infrastructure of Canada’s major cities is not keeping pace with the needs of the manufacturing and service businesses, whose competitive advantage is tied to the existence of a modern, accessible and reliable network of roads, rail and air transportation.
Government regulations have affected Canada’s productivity performance. Regulations can increase the costs of doing business, thus lowering the net return to investment. Moreover, if regulations change frequently, then uncertainty over future potential policy changes will increase the risk of investing.
Tax reform alone would go a long way to securing a better economic future for Canada. In The Conference Board of Canada’s 2006 report
Death by a Thousand Paper Cuts, we measured the impact of non-tariff barriers (NTBs) to trade on the Canadian–U.S. productivity gap. NTBs include quotas, technical standards, procurement restrictions, licensing and certification requirements, and restrictions on foreign ownership. The empirical results of the study suggested that “Canada could narrow the productivity gap with the U.S. by lowering barriers to competition in the tradable goods sector.” The report concluded that “Canada would benefit from a fresh dose of competition by reducing domestic and international barriers to competition, including both tariff and non-tariff barriers.” In particular, a great deal of work needs to be done internally, as interprovincial non-tariff trade barriers are particularly onerous.
As posted: January 25, 2010, in the Financial Post.