Only two years ago, Canada’s business environment was rated the best in the world. Now it sits in third place, behind Denmark and Singapore. True, third is still good – and two places ahead of the US in fifth pace, but Canadians hoping to reclaim the number one spot anytime soon are likely to be disappointed.
According to a report from the Economist Intelligence Unit, Canada’s decline is a result of other countries catching up, rather than the Canadians doing anything wrong. Even so, its position among the premier locations risks being eroded, unless the country engages with some big challenges.
Top among these, according to the report – “Not left behind: How Canada can compete” – are its political effectiveness (particularly the ability to implement policy), taxation and the labour market.
On the first of these, Canada slipped to 15th among the 60 countries surveyed in terms of political effectiveness – better only than Japan and Italy among the G7 nations. Many governments, especially in smaller European countries, are expected to become more efficient.
Why the sudden fall? The quality of government in Canada has been under scrutiny lately. A long running corruption scandal led to a vote of no-confidence in the federal government last year, which, in turn, prompted a snap election. The Liberal Party of Canada was defeated after 12 years in power and the Conservatives formed a new government in February 2006. The scandal was particularly damaging because it was deeply mired in the bête noire of Canadian politics: rivalry between the country’s ten provinces. It is this kind of internecinebattling that has helped to create a bureaucratic environment for business.
The provinces have a constitutionally mandated responsibility for public services and are the main check on the federal government. But the federal government in Ottawa uses its stronger fiscal position and role as redistributor of tax revenue to meddle in provincial areas, according to the EIU report. “The resulting turf battles and arguments over money make for inefficient government and lack of accountability, as politicians would rather finger-point than push through the needed reforms. And taxpayers remain confused as to where their dollars are being spent,” it says.
In Canada’s case, federalism also means barriers to internal trade and the movement of people, “which prove vexing to the business community.” The barriers take numerous forms, including product standards and container sizes unique to a particular province and restrictive government procurement practices. According to the World Bank, the monetary costs of negotiating the bureaucracy in Canada are much higher than the Organisation for Economic Co-operation and Development’s (OECD) average and rate only better than Italy among the G7.
Companies in Canada also face a significant tax burden, shouldering a higher share of government tax revenue than in most other countries, says the EIU report. And they pay the highest marginal effective tax rate on capital in the developed world. The complex fiscal relationship between the federal government and the provinces hampers.
The tax system itself is also in need of reform, says the EIU, because it is too complex. Although Canada scores no worse than many of its peers in the G7 and OECD, and in many cases better, its score is not expected to improve. The OECD has recommended refunding provincial sales taxes levied on capital goods and abolishing provincial capital taxes. “Few countries levy such taxes, which discourage expansion and do not reflect the underlying profitability of the firms being taxed,” says the EIU.
The final area in need of attention, according to the EIU report, is the labour environment. This is the category where Canada scores worst, and its performance is expected to deteriorate in future. The labour force is highly educated and skilled. But Canada’s employer-unfriendly labour laws, lack of market flexibility and costs dent its rankings. “Controls exacerbate some short-term shortages of skilled and specialised labour, especially in the booming western provinces of Alberta and British Columbia,” says the report. “These are expected to worsen in the short to medium term.” And Canada’s employment insurance system reduces labour flexibility, as it gives weak incentives to the unemployed to actively seek relocation.
The need to improve the business environment in Canada was also highlighted in a recent report on the country from the International Monetary Fund (IMF). The organisation’s economists said sustained productivity growth was essential if living standards are to rise at a time when the population is ageing.
The IMF said the tax system could be made friendlier for saving and investment, noting that Canada’s effective marginal tax rates on investment are among the highest in the world, partly reflecting provincial sales and capital taxes. While the IMF welcomed a recent decision to end the tax advantage for income trusts, other aspects of the tax system, including the differential between rates applying to large and small firms, could distort capital allocations. There was also scope to support personal saving through lowering taxes on dividends and capital gains and also by raising contribution limits on tax-advantaged retirement plans, it said.
While Canada’s federal regulatory system is generally given high marksinternationally, according to the IMF, specific reforms could encourage product market efficiency. “In particular, regulations on foreign direct investment—especially for network industries such as airlines, communications, and the media—as well as public ownership in the electricity sector appeared outmoded,” it said.
The regulatory impediments to bank entry and consolidation should also be lowered, the IMF said, as a way of increasing the efficiency and dynamism of the financial sector. Under the existing system, it was not clear how or why the government approved bank mergers, said the IMF, and the liberalising of bank ownership rules would “lower uncertainty, increase contestability in the banking system, and help stimulate innovation.”
The IMF also called for employers to have better access to skilled workers. A booming economy in Alberta, for example, was creating skill shortages in other provinces, but barriers to free movement remain in place, such as limited recognition of professional qualifications across provinces.
The new federal government has published a strategic plan, called Advantage Canada: Building a Strong Economy for Canadians, aimed at addressing many of these concerns. Finance minister Jim Flaherty calls it “a long-term, national economic plan designed to make Canada a true world economic leader.” The plan features a new national objective to eliminate Canada’s total government net debt in less than a generation and further reduce taxes for all Canadians.
“The Canadian economy as a whole is performing extremely well and is among the fastest growing in the G7,” said Flaherty when he unveiled the plan in November. “If we are to remain at the economic forefront, we need a long-term plan that will shape Canada’s future, and improve the quality of life for families, students, workers and seniors.”
Advantage Canada builds on what the government says are Canada’s strengths, and seeks to gain a global competitive advantage in five key areas. These are: to reduce taxes for all Canadians and establish the lowest tax rate on new business investment in the G7, while eliminating Canada’s total government net debt in less than a generation; to reduce unnecessary regulation and red tape and increase competition in the Canadian marketplace; and to create the best educated, most skilled and most flexible workforce in the world, while investing in a modernisation of the country’s infrastructure.
Those goals are all backed up by a set of ‘core principles’ that the government says will guide all its future policy decisions. The principles are: Focusing government effort on what it does best – which means being responsible in its spending, efficient in its operations, effective in its results and accountable to taxpayers; Creating new opportunities and choices for people – which entails creating incentives for people to excel – “right here at home” – while reducing taxes and investing in education, training and transition to work opportunities; Investing for sustainable growth – which means investing and seeking partnerships with the provinces and the private sector in strategic areas that contribute to strong economies, including primary scientific research, a clean environment and modern infrastructure; and “Freeing businesses to grow and succeed” – which will see the government creating “the right economic conditions to encourage firms to invest and flourish.”
Fine goals, if somewhat vague. But, fundamentally, the government needs to do something about the growing economic divide between Canada’s provinces. This economic disparity reached a new high last year, says Sébastien Lavoie, economist at Laurentian Bank Securities. His recent Provincial Economic Outlook for this year and next noted that a run-up in commodity prices provided an economic boost for the resource-based provinces of Saskatchewan, British Columbia, Alberta, and Newfoundland & Labrador during the last four years, while over the same time the manufacturing-based economies of Ontario and Quebec suffered. “They lost their mojo, hit by the unprecedented run-up in the Canadian dollar and most recently, the US mid-cycle slowdown,” he says.
The Central Canada province has borne the brunt of the weakening in US demand. Lavoie estimates that Ontario and Quebec’s real GDP advanced at a pace lower than two percent in 2006, amid a contraction in the key manufacturing sector. The continued ascent in commodity prices added fuel to the fire in Alberta and British Columbia, where the economy rolled at a pace two to three times faster than other provinces last year. The diversified economies of Manitoba and Saskatchewan performed better than Central Canada, but not as well as Alberta and British Columbia. Lastly, the performance of Atlantic provinces was in the middle of the pack, with real GDP growth surrounding two percent.
Exceptions to the rule
His forecast is that real output growth in seven out of ten provinces will be the same or a tad weaker in 2007 compared to last year. The only exceptions to the rule will be Nova Scotia, Saskatchewan and Newfoundland & Labrador. Saskatchewan will benefit from a rebound in mining activity, whereas a surge in oil production will fuel growth in Newfoundland & Labrador. He expects economic growth to stay moderate in the rest of Atlantic Canada. In Central Canada, Quebec and Ontario the economies are forecast to advance below the two percent mark for a second consecutive year, as the restructuring in export-oriented forestry and automotive sectors continues. On the fiscal side, Lavoie says the provinces are on track to meet objectives set during the previous 2006 budget season for the current fiscal year 2006-07, although the moderate slowdown in the North American economy could translate into softer than expected revenues in coffers.
So, the economic outlook is mixed: things are looking good for the country as a whole, but there are pockets where people will suffer. That’s the same in any countries; growth and depression are always unequally distributed. But the problem for Canada – or maybe even the problem of Canada – is whether there is political will among the winners to do anything to help the losers. In the meantime, if the climate for business continues to worsen, then the climate for all things Canadian will go that way eventually.