Realizing Canada's Prosperity Potential
Jim Milway & Claurelle Poole
Institute for Competitiveness & Prosperity
CANADIANS HAVE BUILT one of the world''s most prosperous economies, but we are still not realizing our full prosperity potential. To do this, individuals, businesses, and governments must work together to increase our investments for future prosperity and to strengthen market structures that stimulate innovation and upgrading.
In this paper we:
- Review Canada''s growing prosperity gap versus our most important trading partner, the United States
- Identify under investment by stakeholders in Canada''s prosperity as the key source of this prosperity gap
- Recommend actions for all stakeholders in Canada''s prosperity to realize our full economic potential.
Canada''s Prosperity Gap
Canada''s economy is among the strongest in the world. As measured by Gross Domestic Product (GDP) per capita, we rank behind only the United States when compared to jurisdictions of similar size. But while Canadians enjoy a high standard of living, we cannot be complacent. We must continuously strive to be internationally competitive with our main trading partners so we can maintain and raise our standard of living. Competitiveness is not an option in today''s global economy.
Against the United States, we have a large and widening prosperity gap (Exhibit 1). In 1981, Canada trailed the United States in GDP per capita by only $1,800, but the gap had risen dramatically to $7,200 in 2003. This gap translates into an unrealized potential of $15,000 in after tax disposable income for the average Canadian family and $90 billion in lost tax revenues for federal and provincial governments. The gap suggests that Canadians are not deriving the same benefits from our endowments in human and physical capital as our counterparts in the United States. But the Institute has concluded that there is no fundamental weakness in the Canadian economy that would prevent us from closing the gap.
Lagging productivity is the key driver of the prosperity gap
To help us understand the source of the prosperity gap, we look at two key factors:
- How many Canadians are working and how many hours are they working relative to our US counterparts?
- How productive are we in translating working hours into products and services of value to customers in Canada and around the world?
Our work indicates that productivity is the key challenge in closing the prosperity gap.
The first factor which tracks the supply of labour represents less than a third of the prosperity gap. While more of our population is of working age and is participating in the labour force, Canadians are less successful in finding employment and in working an equal number of hours. Taken together these factors account for $2,200 of the $7,200 prosperity gap.
The other factor, productivity, measures our success in creating value when we''re working. This accounts for nearly 70 percent of the prosperity gap. In a sense productivity measures how smart we work rather than how hard we work. Productivity is the only element that can grow indefinitely. Through continuous innovation and upgrading we can generate more output from our resources.
We have a good mix of industries, but we don't capitalize on this advantage.
Research by Michael Porter of the Harvard-based Institute for Strategy and Competitiveness has shown that clusters of traded industries achieve higher levels of productivity and innovation. Traded industries are those that are typically concentrated in specific geographic areas and sell to markets beyond their local region. Traded industries create opportunities for increased success of the local non-traded economy; the "tide" of traded clusters raises the prosperity level for both local and traded industries and everyone benefits.
Drawing on Porter's methodology, we have determined that a higher percentage of Canadian employment is in traded industries - 37.0 percent of employment in Canada versus 31.8 percent in the United States. Also, within traded industries, our mix is remarkably similar. Our analysis of Canada''s industry mix estimates a $1,100 per capita advantage. This benefit is derived from higher output than would be likely if the mix in Canada were the same as in the United States.
Our weaker cluster effectiveness is significant part of the Canada''s productivity gap.
While Canada has an excellent mix of industry clusters, productivity - as represented by wages - is much lower in Canadian clusters than in US clusters (Exhibit 2). So despite our endowment of attractive industries in Canada, we operate at a lower level of productivity than our US counterparts in nearly every one of the industries. We estimate this lower productivity in our clusters of traded industries reduces Canada''s GDP per capita by $1,400 per capita versus the United States .
Relatively low urbanization is a significant contributor to the productivity and prosperity gap.
Increased social and economic interaction of people and firms, the cost advantages of larger-scale markets, and a diversified pool of skilled labour all improve productivity in urban areas. There is a positive relationship between degree of urbanization and the labour productivity of the 60 jurisdictions in North America. Urbanization is defined as the percentage of the population living in city areas of greater than 50,000 people. Our analysis indicates that our lower rate of urbanization is a significant part of Canada''s productivity gap - a $3,300 per capita disadvantage.
Lower educational achievement weakens our productivity.
Most economists agree that the level of education attained across the workforce is an important determinant of the quality of an economy''s human capital. Our analyses reinforce the positive correlation between productivity and wages. Economic studies also show repeatedly that individuals'' earnings increase with their level of education. In fact, the best single predictor of personal income is level of educational attainment. Canada's under performance in educational attainment, mainly at university levels, translates into a negative impact on GDP per capita of $1,100 per capita.
Capital under investment is a drag on productivity growth.
In our work we have identified under investment in machinery and equipment in Canada compared to levels in the United States. This under investment slowly erodes the relative strength of our capital stock. This erosion in turn reduces the productivity of our labour and hence our prosperity. For Canada, we estimate this under investment to be worth at least $400 per capita in lost productivity and prosperity.
Taken together these factors account for $5,100, which is just slightly more than the overall productivity gap of $5,000 per capita.
Under investment in prosperity
As we have concluded, the key to closing our prosperity gap is to increase productivity. But currently, individuals, businesses and governments are not investing enough to raise productivity to levels in leading US states. Further, market structures are not providing the specialized support and competitive pressure that come from strong rivals and sophisticated customers to drive businesses to innovate and upgrade.
Canada''s capacity for innovation and upgrading is built on an integrated set of four factors, AIMS:
- Attitudes towards competitiveness, growth, and global excellence.
- Investments in education, machinery, research and development, and commercialization.
- Motivations for hiring, working, and upgrading as a result of tax policies and government policies and programs.
- Structures of markets and institutions that encourage and assist upgrading and innovation.
Canadians have positive attitudes towards competitiveness and innovation.
Our research in Ontario indicates that, in general, the public and business community have attitudes towards competitiveness, risk taking, innovation and other related issues which hardly differ from their US counterparts. There is nothing to suggest that we would not find similar results if the sample were extended across North America. In sum, poor attitudes are not a roadblock to strengthening Canada''s competitiveness and prosperity.
Despite these positive attitudes, Canadians under invest.
Competitive rates of investment in human and physical capital are necessary if we want to strengthen our capability for innovation and productivity enhancement. Our under investment is a major factor in explaining our prosperity gap with the United States.
Initially, as in the United States, we invest in the basic requirements for keeping our businesses and individuals competitive in the global setting. But after the last investment dollar in Canada is spent, US investors continue right on investing. Our under investment is wide ranging.
Canada lags in productivity enhancing capital investments.
In machinery, equipment and software, the component that research has identified as the most crucial for productivity growth, Canada''s business community invested an average of 13.1 percent less annually than US business from 1991 to 2003.
If Canada's private sector had kept pace with its US counterpart since 1981, our total capital stock would now be 4.8 percent higher. The Institute calculates that this under investment in physical capital costs Canadians $400 in lost GDP per capita.
Education investment trails at higher levels.
Similar to other areas of investment, Canada does a relatively good job at investing in the basics. At the primary and secondary levels, Canadian students perform well on international standardized tests, graduation rates, and their continuation on to post secondary level. Investment in the system and investment by individuals in their futures falls short, especially at the university level where the United States out spends Canada on a per capita basis by a margin of 2 to 1.
This lower rate of investment in university education can be seen in the difference in graduation rates. Canada trails the United States in degrees conferred per thousand population with the difference most pronounced at the master''s level where we graduate less than half the students they do.
Another example of our under investment in education is that only 31 percent of our managers possess a university degree versus 50 percent of US managers (Exhibit 3).
Our under investment by students, governments, and business in post secondary education is worrisome, since those with higher levels of education earn more over their lifetimes and our economy benefits more from their knowledge and capabilities. Raising educational aspirations and increasing investment in education at all levels by individuals, businesses, and governments is a critical way to increase productivity.
Under investing in integration processes reduces the benefits of immigration.
Canada must take full benefit of the competitive advantage it has over the United States - the immigration of highly qualified people. We are very successful at attracting highly skilled people, raising our overall educational attainment levels as more immigrants have post-secondary degrees. However, once here, immigrants have difficulty entering the professions and careers they once held, finding themselves settling for positions they are over qualified for because their credentials and experience are not recognized. As a result, we are forgoing opportunities to enjoy the true economic value of immigration in Canada. We must find ways to accelerate immigrant integration into our economy.
Government spending is shifting toward current consumption.
Governments have two important roles - spending on consumption that helps secure an adequate quality of life for all Canadians, and being a significant contributor to future prosperity through investment in upgrading and innovation.
Over the past ten years governments at all levels in Canada have been shifting their spending towards consumption, e.g. health care, social services, and away from investment, e.g. education, transport, and communication. In 1992 for every dollar of consumption by governments they invested 55 cents. By 2002 this had fallen to 50 cents. Meanwhile in the United States their investment per consumption dollar rose from 52 cents in 1992 to 55 cents in 2002. Canadian governments'' inability to match the investment spending by US governments limits our progress in raising productivity. Without addressing this under investment, Canada will not make progress in eliminating the prosperity gap.
Under investment in our future prosperity is a major contributor to our lower productivity. This under investment is the result of inappropriate motivations from high marginal effective tax burdens and the lack of vigorous market structures that drive competitiveness and productivity. We discuss these two factors in turn.
Inappropriate motivations and investment
Our research indicates that there is lower motivation to invest because of higher marginal effective tax burdens and a less attractive makeup of our tax structure in Canada than in the United States.
The Institute engaged Jack Mintz, a leading international tax expert, and Duanjie Chen, a research associate with the Institute of International Business at the University of Toronto''s Rotman School of Management, to assess the effective impact of taxation on the cost of doing business by taking into account all the taxes paid, net of public subsidies for health care, education, and others, on all factors used in producing goods and services. The approach calculates the tax associated with the decision to invest in capital and labour.
To represent Canada, Mintz and Chen assessed federal and provincial taxes in Ontario; to represent the United States, they looked at federal and state taxes in California, Georgia, Illinois, Massachusetts, and Michigan. Governments in Ontario tax capital investments at 2.0 times the tax burden in peer states, down from a 2.1 times disadvantage in 2003.
The marginal effective tax burden on labour in Ontario is 1.8 times higher than in the five states, up from 1.7 in 2003. Note, this disadvantage is after government funded health care and other subsidies.
Canada''s fiscal position, as represented by Ontario, is not competitive relative to similar US jurisdictions competing for capital investment and jobs.
Structures of competitive pressure and specialized support are inadequate.
We turn now to the final element of AIMS - structures.
Canada has many of the basic elements in place for driving innovation and higher productivity in our clusters of traded industries. But as we have seen our traded clusters are under performing, delivering poorer results than many clusters in the United States.
Under performance in our traded clusters is largely the result of market structures that are not providing the competitive pressure and specialized support so necessary for success. Drawing on research conducted by the World Economic Forum to produce the Business Competitiveness Index , we conclude Canada has solid general support structures - infrastructure and basic education - that underpin cluster performance (Exhibit 5). But our research indicates that our firms are not benefiting from an adequate level of specialized and sophisticated support. Nor have we created adequate competitive intensity - the pressure created through the presence of sophisticated buyers and significant rivalry. Without these upgraded supports and pressures, too few of our firms and industries have developed world-class strategies and operations that drive productivity and innovation so necessary to realizing our prosperity potential.
Realizing Canada''s prosperity potential
To close the prosperity gap and realize our full potential the Institute is encouraging all stakeholders in Canada''s prosperity to take action.
We encourage individuals to heighten their aspirations for future prosperity. This includes investing more in their own education. We recommend all Canadians develop a stronger commitment to life-long learning and skills enhancement.
We encourage businesses to invest more in their human capital - their employees - and physical capital - machinery, equipment, and software.
We encourage governments to enhance their spending in investments for future prosperity, to rethink our tax system to encourage business investment, and to continue improving processes for integrating immigrants, and to strengthen market structures to provide greater levels of competition in our industries.
Following these recommendations will put all Canadians on a path to realizing our prosperity potential and ensure the economic well being of future generations.
ABOUT THE AUTHORS
Jim Milway is the Executive Director of the Institute for Competitiveness and Prosperity, an independent, not-for-profit organization with a mandate to deepen public understanding of macro and microeconomic factors behind Ontario''s economic progress.
Claurelle Poole is a Researcher at the Institute for Competitiveness & Prosperity.