Focus
November 03, 2023 | 12:59
Canada’s Perennial Productivity Puzzle
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Canada’s Perennial Productivity Puzzle |
|
The backdrop |
It’s not news that Canada’s productivity performance is listless and lagging U.S. trends. That has been going on for decades. But what is news is that productivity has actually gone into reverse in the past five years—i.e., it has declined, taking real GDP per capita with it on a downward path. The sustained decline in recent years is without precedent in the post-war era. And we can’t (entirely) blame the pandemic for the recent sickly productivity trends, as the U.S. has managed near-normal growth, on average, over the past five years (Chart 1). To be clear, productivity is not simply some obscure, esoteric statistic that only academic economists would care about; GDP per hour worked is the very fundamental building block of living standards. Thus, the recent fall in productivity is stark evidence that Canadians on average are worse off than prior to the pandemic—it’s not just perception. As a result, Canada has steadily drifted down the relative productivity rankings in the OECD (Chart 2). Not only have the Nordic economies moved well north of Canada, along with the U.S., but so have most of Western Europe and Australia. True, Canada is a touch above the OECD average, but the OECD now includes heavily-populated, lesser-developed economies such as Turkey, Poland and Mexico. Our closest comparables are Italy and Spain; feel free to draw your own conclusions. And note that the OECD data only go up to 2021; Canada’s output per hour has since dropped. Digging into some details, Canada’s productivity in the business sector has seen an average annual decline of 0.3% over the past five years, while the U.S. has managed a 1.7% gain. That two percentage point performance gap is at the high end of norms—it’s double the 40-year average of nearly one percentage point—but it’s not extraordinary, which is a discouraging fact. Over those 40 years, a “normal” productivity growth rate in Canada has been 1.0% per year, although even that modest tally was boosted by the internet boom from 1993 to 2003 (Table 1). The past two decades have seen productivity cool to barely a 0.5% growth rate, a full point below the U.S. average. |
|
The implicationsThis wide divergence in recent years has seen real GDP growth sag, and even stall in the past six months, despite still-robust job growth. As a result, GDP per capita has famously dropped over the past year, and is now no higher than it was in 2017. After mostly keeping pace with the U.S. on this measure for 25 years, Canada has fallen far behind since 2015 (Chart 3). The textbooks suggest that productivity mainly matters for the average person because it drives real income growth. Yet, curiously, despite decades of relatively weak productivity, real compensation per hour in Canada has almost exactly matched that of the U.S. over the past 40 years (Table 1, again). In turn, that combination of weak productivity with similar wage growth equals higher unit labour costs (the wage costs per unit of output)—and they have indeed been 0.6 ppts higher per year in Canada than the U.S. over the past four decades. The textbooks would suggest that higher unit labour costs point to higher inflation in Canada; yet, inflation has actually been a tad lower in Canada since the early 1980s. So where’s the cost to the economy from lower productivity and higher unit labour costs? These higher costs have crimped margins and thus capital spending. But, the great equalizer has been the exchange rate. Looking beyond the many ups and downs, the big picture is that the Canadian dollar has weakened by roughly 20% versus the U.S. dollar over the past 40 years (comparing it to its 10-year average up to 1983). That underlying depreciation has occurred despite similar inflation rates in the two economies, and improved terms of trade for Canada over that stretch (a 15% rise in export prices relative to import prices). Essentially, weak productivity has ultimately been reflected in a weaker real exchange rate, which imparts a quiet yet corrosive effect on living standards (as any snowbird can attest). |
|
The whyThere are short-term dynamics, structural realities, and longer-term policy tradeoffs which help explain Canada’s weak productivity. The short-term dynamics speak to the adjustment of the economy to the surge in interest rates, the population burst of recent years, and the aftermath of the pandemic, which all presumably are making a tough productivity backdrop even more challenging (assuming it’s being properly estimated). For example, even the U.S. has seen some cooldown in productivity since 2019 versus its long-run trend. But Canada has taken the cooldown to a whole new level. Some of the structural realities, which policymakers can’t easily change yet weigh longer-term include:
Notably, Australia has similar geography, demographics and industry structure to Canada, and is also well below the top tier of OECD economies on the productivity ranks (Chart 2 again). But it’s also more than 10% higher than Canada on the level of output per hour. And resource-rich Norway is near the top of the board. So, there’s more than industry structure and geography going on. On top of the short-term factors and structural issues are some longer-term policy choices that keep productivity weak. This is where things get a bit more controversial, as seemingly everyone has their own favourite villain. But some commonly cited top causes:
|
There is likely some element of truth to all of these factors, and at times each has seized the role of being viewed as the prime culprit (lack of competition appears to be the latest flavour of the month). We would add that the relatively low level of business investment (and, related, low foreign direct investment) is as much a symptom of the challenges facing Canada as a cause. To some extent, that weakness was really only unveiled when capital outlays cratered in the resource sector after oil prices plunged in 2015. Moreover, issues surrounding low investment levels are amplified by strong population growth, as the combination drives down the capital-to-labour ratio—which, almost by definition, hits productivity. |
|
What can be done?This is the hard part. Not to be flippant, but if there was a straightforward formula to dealing with Canada’s perennial productivity problem, it would have been long since unleashed. The reality is that policymakers and pundits have been grappling with the issue of improving productivity for at least 40 years (going back to the Macdonald Commission on the Economy in 1982), with only sporadic and short-lived gains. On the list above of drags on productivity, some are inter-related, and, we would assert, some have common root causes. Specifically, an inefficient tax system, including relatively high marginal tax rates, arguably has a hand in almost all of these drags. The last time that marginal tax rates were seriously reduced in Canada, in 2000, it was associated with a period of solid productivity growth. But the U.S. also experienced a big bump at the time, and the upswing proved transitory for both economies. While a more efficient tax system is undoubtedly part of the solution, it’s no silver bullet. However, at the very least, a broader re-examination of the tax system is long overdue—the last full review was carried out by the Carter Commission in the mid-1960s. More broadly, if we are serious about rejuvenating our standard of living, policies need to be re-aligned in that direction. Instead, the primary focus in recent years has often been on divvying resources rather than expanding them, and supporting short-term consumption rather than long-term investment. It is safe to say that the problem won’t be fixed by raising taxes on some sectors or increasing regulation. Finally, rather than force-feeding capital spending through heavy-duty subsidies, policymakers should address a fundamental question: Why are businesses so reluctant to invest in Canada? |