Unlocking private sector investment is key to boosting Canada’s productivity: Conference Board of Canada

Canada must focus on unlocking private sector investment to improve the country’s poor productivity performance, says a new report by the Conference Board of Canada (CBoC).

“The clearest path to improving productivity is to boost private investment,” says the report, “Cracking the Productivity Code: Creating a New Path to Prosperity.” It was written by CBoC chief economist Pedro Antunes and senior economist Liam Daly (photos  below).

The effort should start with a review of the competitiveness of Canada’s regulatory and corporate tax regime compared with other jurisdictions, the report says. “Eliminating internal trade barriers, a long-standing problem, could provide a solid boost to Canada’s productivity.”

The report also warns that the “carrot approach” currently being used by the federal government and some provincial governments to revamp Canada’s industry structure to drive the clean energy transition is financially costly and potentially dangerous.

The federal, Ontario and Quebec governments have teamed up to subsidize major investments in battery and electric vehicle production. Deals with Stellantis NV, Volkswagen AG, Northvolt AB, and Honda will add substantially to manufacturing investment and production over the coming years.

However, the four plants require nearly $10 billion in direct taxpayer-funded investment and another $33 billion in production tax credits, the CBoC’s report notes. “It also remains to be seen whether these investments will successfully attract more mining and other supply chain investment.”

There has been much talk from political leaders about developing critical minerals in northern Ontario and Quebec, the report adds, “but little has been done to develop transportation corridors to help make those projects viable.”

While the modern battery and EV manufacturing plants will likely help bolster productivity in manufacturing, they may also indirectly deter other investments by adding to public debt that could lift interest costs and crowd out investment, as well as by raising the prospects of future tax increases, the report points out.

“Such subsidies also set a precedence of dependence. Other companies looking to establish major capital projects will likely be expecting handouts from Canadian governments or play their hand at pitting one government against another for the most generous subsidies. This is a dangerous road for governments to navigate, since we’ve rarely seen alignment on subsidies across national borders.”

While federal and provincial governments often target specific subsidies or sectors when trying to create “wins” in private investment, a broad-based tax assessment to level the playing field with the U.S. may go a long way to help rekindle investment in Canada, the report says.

Tax cuts implemented by the U.S. government in late 2017 had a significant impact on Canada’s corporate tax competitiveness, and the gap between effective tax rates in the U.S. and in Canada coincides with a commensurate gap in investment.

The CBoC says that in addition to high corporate taxes, its survey of business confidence found that government policies, high capital costs and high cost of labour are impeding private investment.

Federal Budget 2024’s proposed increase in the capital gains tax may enhance fairness for taxpayers in Canada, but it could further diminish the country’s ability to attract new investment, the report says.

Tax reform may not be a top political priority, particularly when it comes to improving corporate tax competitiveness, the report adds, “but it is imperative that Canada address this issue despite the associated challenges.”

The report notes that a major barrier to investment in resource projects is the uncertainty about the approval requirements for environmental reviews and the associated timelines in Canada versus other jurisdictions.

The current review process is burdened not necessarily by strict regulations but by the length of the review process, which often involves federal, provincial, and territorial governments and Indigenous communities.

The federal government is looking to dramatically reduce the regulatory review process for proposed mines from 12 to 15 years to just five years, particularly for critical minerals required for the energy transition.

The plan hinges on conducting various reviews simultaneously rather than sequentially, boosting regulatory funding, and investing in infrastructure to support new mines, the report says. “A worthwhile effort – but it remains to be seen whether there will be success on this front.”

Labour productivity has plummeted in key industrial sectors

Increased educational attainment and skills have historically contributed steadily to Canada’s productivity growth, according to the CBoC’s report. But capital intensity and efficiency have had setbacks and have contributed unevenly across industries.

From the 1960s through to the 1980s, labour productivity growth slowed steadily in Canada, from above four percent to around one percent annually. Productivity then picked up through the second half of the 1990s, owing to growing trade and intensifying investments in information and communication technology.

Sagging productivity growth in the early 2000s can be partly attributed to the oil and gas sector, which saw its efficiency decline because of the transition from conventional oil production to oilsands production, the latter requiring much greater investment per barrel of output., the report says.

 Over the last few pre-COVID pandemic years to 2019, labour productivity settled at about 1.1 percent annual growth.

Labour productivity growth spiked in 2020 because COVID pandemic closures shut down mostly lower-pay jobs, but as the economy reopened and normalized, productivity fell sharply, the report notes.

In the fourth quarter of 2023, Canada’s labour productivity (essentially real income per hour worked in Canada’s business sector) was down 1.3 per cent from the 2022 average, and in line with where it was at the end of 2019.

Labour productivity growth is driven by the growth in the physical capital per worker (capital intensity) and the growth in efficiency (multifactor productivity), the report says. Capital intensity has a direct impact on labour productivity. “A worker equipped with a shovel and a wheelbarrow will get a lot less done in an hour than a worker using a backhoe.”

However, over the decade to 2019, the contribution from “capital deepening” (increases in the amount of real capital services per hour worked) waned to less than 0.5 percentage points per year, due to a slump in business investment growth – largely weaker resource sector investment, the report says.

The effect is cumulative. “If business sector labour productivity had grown by 0.5 percentage points more annually over the past decade, for instance, nominal GDP would be roughly $130 billion (4.2 per cent) higher today (in 2024).”

The weak annual labour productivity growth in construction (0.5 percent) and transportation (0.4 percent) is particularly concerning because both these sectors are large and play an important role in driving competitiveness in other sectors of the economy, the report says.

The construction sector “faces little external (or even internal interprovincial) competition, which perhaps explains the lack of capital deepening and innovation.”

Labour productivity in the construction sector has plummeted 12.1 percent since the pandemic. The sector accounts for roughly 7.5 per cent of GDP and is key in developing other productive assets such as mines and industrial space.

In the transportation sector, labour productivity is down 7.4 per cent since the pandemic. “Even with the economy reopened, lasting effects of the pandemic have not allowed these segments [air transportation, truck transportation and urban transit] to recover fully, resulting in a steep downward shift in aggregate productivity.”

Increase private investment and eliminate interprovincial trade barriers

The business cycle caused by the pandemic, which featured post-pandemic labour shortages, and the ensuing hiring surge while the economy flatlined resulted in an exceptional downswing in productivity, according to the CBoC’s report.

When the economy reopened post-pandemic, employers, desperate to find workers,   started to tap the temporary foreign worker stream of immigration. Through 2022 and 2023, the number of temporary foreign workers arriving in Canada skyrocketed – and employers continued to fill vacancies or hold on to their workforce, even as the Bank of Canada was quickly raising interest rates to put the brakes on the economy.

“Employment grew by 480,000 (2.4 percent) in 2023, while GDP growth flattened, resulting in the drastic decline in productivity facing Canada,” the report says. Essentially, there was “mistiming of rapid hiring during an economic slowdown.”

However the report points out that describing Canada’s current productivity problem as an “emergency” may be misplaced, because it suggests there may be a quick fix to productivity challenges. “Rather, restoring productivity growth may require addressing short-term industry disruptions with a more important focus on long-standing structural issues.”

Canada should prioritize unlocking private investment and fostering the knowledge economy, the report recommends.

In recent years, Canada has struggled to foster investment in productive capital. Private investment as a share of GDP, excluding non-productive residential investment, compares poorly with many developed countries, notably the U.S., the report says.

For example, real investment in machinery, a crucial driver of labour productivity, declined over the past two years and, at the end of 2023, sat 12 percent below where it was a decade ago.

“This seems extraordinary given how desperate firms have been to fill job vacancies since the economy reopened post-pandemic. It seems employers have preferred to hire rather than invest in labour-saving technologies.”

Studies show that competition plays a key role in driving investment, the report says. Firms operating in competitive markets are pushed to innovate and invest to maintain or improve their market share. Competition pushes firms to enhance efficiency, reduce costs and improve product quality to stay competitive.

Canada has worked hard to eliminate international barriers to trade, the report says, but “interprovincial trade barriers are a long-standing thorn in the side of competition.”

A panoply of non-tariff rules and restrictions and procurement policies prevent Canadian firms from competing for business across the country. While progress is being made on this front, there’s compelling evidence that eliminating these barriers could add as much as four percent to Canada’s real GDP per person, the report says.

The CBoC says it has previously advocated for adopting “mutual recognition regulation,” akin to Australia’s successful approach, to facilitate the flow of goods, services, and labour within Canada. This framework entails each jurisdiction recognizing regulations from others, even if they differ from their own.

“Canada needs to accelerate the move to a unified internal market to facilitate competition that drives investment and better productivity growth.”

Invest more in Canada’s knowledge economy and technology adoption

The CBoC says it is also worthwhile questioning whether the massive government subsidies for new battery and EV manufacturing plants align with Canada’s actual comparative advantage. Manufacturing employment, following a massive restructuring in the early 2000s, has remained essentially flat since 2010, the report points out.

On the flip side, Canada’s transition to a knowledge-based services economy is accelerating, the report says.

Since 2015, employment growth in professional services has far outpaced gains in other industries, posting average compound growth of four percent annually – four times the pace of employment in other private sector industries.

“Canadians are globally competitive and prospering in the knowledge economy,” the report says. While investment is lagging in other areas, recent trends in real intellectual property investment are more encouraging.

Private investment in research and development is trending positively, and software investment has posted robust gains since 2018. Despite Canada’s performance in these domains trailing that of the U.S., these positive trends are fostering productivity growth in several services sector industries, according to the report.

“Indeed, recent research suggests the knowledge sector, as well as other industries, may be adopting technologies that are not necessarily being captured in the national accounts.” The decline in tangible investment, such as structures and machinery, may be partly attributed to increases in investments in intangible assets, such as software and research and development.

Canada may also be missing additional capital investment in the official statistics if both domestic and foreign-controlled firms are adopting cloud-based technologies provided outside the country, the report says. The adoption of cloud-based intangible assets, including AI “holds promise for Canada’s future productivity.”

Federal and provincial governments have implemented measures and programs to accelerate tech adoption in the past, but Canada continues to lag the U.S. in this area, the report says. “A more targeted focus on Canada’s existing strengths is likely to pay greater dividends, particularly if artificial intelligence catalyzes the next productivity revolution as some are predicting.”

Clearly, the CBoC’s report concludes, Canada has fallen far behind on private investment and the impact of capital deepening on labour productivity is clear. “A focus on level-setting the country’s tax and investment incentives with those of the United States is needed,” along with removing interprovincial trade barriers.

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