Intelligence

Going Into The NAFTA Negotiations, Canada Has Trouble

Milton Ezrati

Chief Economist

Going into the NAFTA negotiations, Canada faces all sorts of troubles. The Mexico-U.S. deal puts its representatives at a distinct disadvantage. Perhaps even worse for Ottawa, the country’s economy faces fundamental economic problems. The government’s  admirable goals of offering citizens prosperity in a green and compassionate environment have failed to account for essential economic trade-offs that now threaten growth potentials, making a deal with the United States more important than ever. Even if Canada gets a reasonable deal from Trump and the Mexicans, the economy and Prime Minister Justin Trudeau will still face severe growth problems.

Most troubling in Canada’s economic picture is the shortfall in business spending on productive facilities. Whereas such spending south of the border in the United States has accelerated markedly in the past year and a half, Canadian business still shows reluctance to put dollars at risk to either modernize or expand. Industrial output has accelerated to be sure, growing 5.2% in 2017 and seeming to maintain a smart pace of advance this year. But Canadian business has failed to expand capacity with that rise in output. Instead it has managed by using existing capacity to its fullest extent. Utilization rates on average range over 86%, high by historic and international standards, suggesting that firms have begun to employ less profitable and outdated facilities to sustain output. Spending on new equipment did rise in the first quarter, hardly a wonder since business clearly already faces constraints. But even then, the flow of real investment in new machinery and equipment remained a mere 3.5% above year-ago levels.

The problem is long standing, too. According to Fraser Institute analyses, Canadian business investment after inflation has declined at almost a 5% annual rate since 2014. It has dropped from some 13.5% of the country’s gross domestic product (GDP) earlier in this century to a mere 11.0% recently. Monies spent to expand and modernize machinery and equipment have suffered the most dramatic relative decline, falling from 6.2% of GDP earlier in the century to barely 4.0% more recently. International comparisons are possibly the most telling. Capital investment per worker — the basis of productivity growth and real wage increases — stands far below most other developed countries. Canada spends more than a third less than Australia, for instance, to provide its workers with productive facilities and almost 40% less than the United States. It spends less even than France, almost 35%. These differences, though meaning little immediately, will tell over time as the additional facilities enhance the productivity of foreign workers while Canadian workers fall behind.

While neglecting domestic operations, Canadian business seems to see a future abroad. Canadian investment in the United States has grown a remarkable 18% a year during the three years through 2017, the last period for which complete data are available. Such spending flows jumped 19.0% in 2017 alone. Canadian investment dollars have flowed at an even higher rate to other countries. Gross investment outflows from Canada have increased a striking 35% a year during this same three-year period. Meanwhile, U.S. and other foreign investors seem determined to avoid Canada. Foreign direct investment in that country fell 26% in 2017 and stands at less than half the level recorded in 2015.

Various analyses have tried to identify the causes of Canada’s problem. While all admit that the influences on investment decisions remain less than fully understood, some observations are especially telling. The Bank of Canada has pointed to uncertainty about U.S. policy, especially under Trump, but that can account for only a small part of things, since the trend pre-dates his election and even his candidacy. More telling, perhaps, is the rise in corporate taxes in Canada. Back in the 1990s, Ottawa made a major effort at competitiveness by holding down corporate tax burdens. This had a powerful effect, especially since the United States at the time maintained one of the highest corporate tax rates in the world at 35%. But since, Canadian corporate taxes have edged up. According to Fraser Institute calculations, the marginal tax rate on capital investment has risen from 17.5% in 2012 to over 20% at present. It will not help that tax reform in the United States has now lowered corporate tax rates there.

Less easy to quantify are the ill effects of  Canadian regulatory obstructions. Industry has consistently pointed to labor and environmental issues as reason why they remain reluctant to expand in Canada.  Investment in oil and gas, for instance, has suffered from provincial resistance to the construction of pipelines.  Indeed, British Columbia recently so fought a trans-mountain pipeline project that industry completely abandoned the effort. This sort of problem would affect investment levels anywhere, but for Canada it looms especially large, since oil and gas stand as a huge part of that economy. Along with these sorts of problems, the large Ontario-based auto supplier, Magna, has pointed to restrictive labor laws as an additional investment disincentive. In testimony before a government inquest, Magna management explained how environmental and labor regulations have made them less inclined to build in Canada, especially when neighboring U.S. states have offered concessions. Not least is how all these restrictions have raised the cost of electric power throughout Canada. Indicative is the proposed carbon tax legislation that would have taxed 30% of emissions at C$10 a metric ton initially, rising to C$50 by 2022.

Many in Canada and across the developed world contend that environmental and labor rules of the sort Canada has adopted are entirely appropriate.  They have much reason on their side.  They argue, convincingly, that corporate tax burdens simply reflect companies’ obligations to the larger society. Reality, however, makes clear that business will leave if other nations fail to impose similarly imposing rules. Since Ottawa has little chance of getting other governments to its cause, especially the United States in these upcoming negotiations, it will either compromise or lose out. The compromise seems to have already begun. Recently, the Canadian government reduced to 20% the portion of emissions subject to the carbon tax and indicated a willingness to make further accommodations if companies can show competitiveness problems. It is apparent that Ottawa and the provinces will have to go further along this path to secure Canada’s productive future, even if they get a deal from Washington and Mexico City.

Originally published on Forbes.com.

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