Canada 2020: Part 5

Don Drummond
Don Drummond joined the federal Department of Finance upon completing his studies at Queen's University. During almost 23 years at Finance, he held a series of progressively more senior positions in the areas of economic analysis and forecasting, fiscal policy and tax policy. He joined the TD Bank in June 2000 as senior vice-president and chief economist.

Whither the Canadian economy?
Don Drummond July 24, 2006

What will Canada look like in the year 2020? To encourage a debate about the major challenges Canada will face in the coming decades, the Dominion Institute and the Toronto Star have invited 20 leading thinkers to write about an issue or event that they think could transform the country by 2020.

Manufacturing accounts for more than one-sixth of Canada's output and is a source of well-paying jobs. The industry has survived a number of transformational events — North American free trade, the lapsed Auto Pact and the end of import quotas in the textile and clothing industries.

Now China and other emerging Asian economies present new competition just as the Canadian dollar is soaring. Can Canada's industrial base prosper under these challenges or will it wither by 2020? Will manufacturing wages be driven down to the low levels some of our competitors pay?
The challenges of emerging competitors and the stronger dollar are most acute for Canada's manufacturing sector. That largely means Ontario and Quebec, where manufacturing accounts for about 21 per cent of total output, double the average in the other eight provinces.

On the surface, the economies of these two provinces — Ontario's in particular — appear to be in good shape. Only five countries have a higher standard of living than Ontario's and it lags only the United States among countries of equal or larger population. Quebec's standard of living is smack in the middle of the 30 developed economies in the Organization for Co-operation and Development (OECD).

Dig deeper and you find that, relative to 14 comparable U.S. states, Ontario and Quebec are at the bottom of the pile, according to Ontario's Institute for Competitiveness and Prosperity. Ontario's real GDP per capita was $6,000 below the median in 2004 while Quebec had a $13,000 deficiency. The main culprit? Inferior productivity.

As if a 90-cent dollar and Canadian private-sector productivity of 79 per cent of the United States weren't worrying enough, there is a growing factory base in the southern United States where workers accept low wages with few benefits. Increasing the threat even more is that Canada's trade balance in manufactured goods with China has deteriorated by one per cent of GDP over the past decade. Chinese imports are no longer just T-shirts and simple toys. The strongest increases have come in machinery and mechanical goods.

Ontario's economy has been hardest hit, with an increased deficit with China of two per cent of Ontario's GDP, most of it in capital-intensive goods. Quebec's minor deterioration in its trade balance with China in manufactured products masks a significant deterioration in trade in other goods and with other countries. In order to improve efficiency, manufacturers have shed nine per cent of the sector's jobs in Ontario and 13 per cent in Quebec since November 2002. But that can't be the sole response.

Will the strong survive?

So should we throw up our hands in despair? Advanced economies have faced new competitiveness threats from an emerging economy before. The United Kingdom has been through this many times with former colonies, most notably the rise of the U.S. economic empire. Yet the U.K. economy is still one of the wealthiest in the world.

Japan went from 29 per cent of U.S. real per capita incomes in 1950 to exceeding the U.S. level by 1986, while producing one-quarter of all U.S. imports. Despite predictions, the U.S. did not cede its economic supremacy to Japan. Since the early 1990s, U.S. output per capita grew twice as fast as Japan's. In general, advanced economies have shifted away from goods toward services and picked niches where their productivity advantage is greatest. At the same time, rising incomes in the emerging economies have created demand for the goods and services of the wealthiest countries.

There is no guarantee this experience will hold true today. The emerging economies are speedily reaping the benefits of the capital and brains of the advanced economies. They are embracing free trade and foreign investment, providing incentives for leading-edge technologies and massively investing in education and infrastructure.

Since 1997, Korea, China and India have improved their productivity by 81, 67 and 46 per cent respectively. In the same period, Canada's productivity advanced only 11 per cent. Even the U.S. outpaced us at 17 per cent. Real per capita incomes have risen more than 500 per cent in China and more than doubled in India since 1980, but Canadian companies have not taken advantage of that through higher exports, despite the commodity price boom. All the emerging economies are aiming production at a pretty high rung on the value-added ladder, and some, like India, are formidable competitors in key service industries.

One option for Canada, between now and the year 2020, would be to allow emerging economies to use their huge surplus savings to purchase our assets while we use the proceeds to maintain our consumption standards. But surely we have greater aspirations than this. To stay at the top of the world economic order we need ample, well-paying jobs matched to strong output growth. An economy can only sustain high wages if it has strong productivity.

Invest for productivity

So how do we tackle this challenge and ensure Canada in 2020 has a robust and competitive economy? We first need to understand how increases in productivity occur. The conventional view is that productivity rises as firms and workers find smarter ways of doing things. But as a Statistics Canada study shows, less than half of productivity gains occur this way. The bulk of productivity growth comes from shifting market share toward more productive plants — existing or new. Over a decade, plant closures or downsizing eliminated two out of every five jobs in manufacturing in Canada. The more dynamic industries differ from declining ones by their investment in new productive capacity (e.g., plants, factories, infrastructure).

Internationally, productivity gains have come from combinations of greater trade liberalization, increased investment, better education, and above all, rapid change. But change can be uncomfortable and has a disproportionate impact on the least educated and least skilled. So while fostering change you also need support mechanisms for those most adversely affected.

How can we use these experiences to raise productivity in Canada and in particular its industrial base in Ontario and Quebec by the year 2020?

Canadian firms need to invest more, particularly in machinery and equipment, where our stock per hour worked is only 55 per cent of that in the U.S. This is an excellent time to do so, because the strong Canadian dollar has slashed the cost of imported capital. Governments need to cut capital taxes, which in Canada are the second highest of 35 countries studied by the C.D. Howe Institute. Ontario's tax burden is the second highest in the country, with its high corporate income tax rate, its large capital tax, high industrial and commercial property taxes and inclusion of capital in the retail sales tax base.

Quebec's is not far behind and will rise with the increase in its corporate income tax rate from 8.9 per cent last year to 11.9 per cent by 2009. Ontario and Quebec both need to reduce marginal personal income tax rates. At almost 50 per cent for high-income workers and effectively much higher for modest-income families, they dull the incentives to work, save and invest. Both governments have appropriately been increasing investment in education and infrastructure in recent years and need to continue.

With an aging population, a particular worry in Quebec because of its low birth rate, immigration will be the source of most labour force growth to the year 2020 and beyond. The provinces must work with the federal government to improve the economic benefits of immigration.

This needs to go beyond the recent focus on improved credential recognition and settlement services to include a more active search for potential immigrants whose skills are needed. Companies and individuals in Ontario need to devote more time and money to lifelong learning and training. Both provinces need to complete the adjustment to market pricing for electricity and encourage new supply to limit price increases.

Demographics and taxes

Ontario and Quebec each have specific challenges that need to be addressed to ensure prosperity in 2020.

The Ontario economy and its taxpayers are handicapped because the federal government extracts more in taxes from Ontario than it spends in the province. Statistics Canada estimates the net outflow was $18.2 billion in 2003. That's a fiscal drag of 3.7 per cent of Ontario's economy, whereas, excluding Alberta, the other provinces had a net federal fiscal injection of 3.9 per cent. Similarly, most U.S. states have a net fiscal injection from their federal government.

The point is not that federal governments should run deficits. Rather, it is to ponder how much redistribution the taxpayers of provinces with above-average incomes can finance when they need to be competitive not only with other jurisdictions in Canada, but with the rest of the world.

The current situation also makes it difficult for the Ontario government to finance, at competitive tax rates, the services its residents and businesses need. In 2005 Ontario received $1,235 per capita less in federal transfers than the median of all provinces. Its own revenues were right on the provincial median, but excluding resource revenues — where Ontario is disadvantaged by not having the commodity base some of the other provinces enjoy — own-source revenues were almost 10 per cent above the median thanks to a combination of fairly high tax rates and strong incomes. The balancing item was that Ontario spent $1,109 less than the provincial median, putting it in 10th or last place among provinces. Education was one of the components that ended up in that last-place standing, compromising the province's ability to meet its competitiveness challenges.

Quebec's particular fiscal challenge is its debt burden, which per capita is the second highest in Canada, and relative to income is among the highest in the world. The cost of financing that debt leaves Quebecers facing the second-highest tax burden in Canada and impedes public initiatives that could bolster productivity. The recent commitment to reduce the absolute level of the debt burden is to be commended.

Progress needs to be made soon, as Quebec's labour force could come to a standstill by 2020; its population has been growing at half the rate of the rest of Canada and the gap is even wider with the U.S. Quebec has no option to raise its already high personal and corporate income taxes, but it should examine raising the cost of some public services such as cutting subsidies to electricity and post-secondary education and raising some consumption taxes.

History suggests that advanced economies like Canada's not only survive but actually benefit from emerging competitors. That may be particularly difficult to pull off between now and 2020 in the case of Canada's industrial base in Ontario and Quebec. The key will be whether they can bolster their dismal records on productivity. Attention is being paid to this requirement, but the fire seems to be missing. Somebody had better light the match soon.

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