Canada’s productivity crisis is obvious, but fixing the problem is complicated, Canada's Productivity Summit hears

There’s no question that Canada has a productivity “emergency,” as described by Carolyn Rogers, senior deputy governor of the Bank of Canada.

But pinpointing the causes of the country’s dismal productivity performance, and finding and implementing solutions, is more of a puzzle, policy and economics experts told the Canada's Productivity Summit in Calgary.

“Productivity is kind of the black box in economics. We know it’s super-important. But we really don’t know where it comes from,” said Chris Ragan (photo at right), associate professor and founding director of McGill University’ School of Public Policy.

“Increases in productivity – GDP per hour worked – are almost like magic, because there’s a potential that everybody can be made better off,” he told the summit, presented by the School of Public Policy at the University of Calgary.

However, Canada has lost its productivity “magic,” all the panelists agreed in a session titled, “Canada’s Productivity Challenge: Why It Matters.”

Since 1995, productivity in Canada has been growing at just a little over one percent per year. In contrast, productivity in the U.S. has been growing much faster on average during that same period.

“Last year, our output in Canada was more than 30 percent below the levels in the U.S.,” said Tim Sargent (photo at left), senior fellow and director of the domestic policy program at the Macdonald-Laurier Institute.

“If we look at productivity levels in other advanced countries, such as in Western Europe and Australia, Canada is basically at the bottom of that league,” he said. Canada’s productivity is below that of the U.K., France and Italy – even Spain.

In Sargent’s view, three industry sectors are most responsible for Canada’s essentially zero growth in productivity – or output per hours worked – since 2019.

The first is the construction sector, particularly when it comes to buildings, houses and condos, he said. “We’re really bad at building those things, and we’re not getting any better. In fact, we’re getting worse.”

The second sector is manufacturing, which has seen almost no productivity growth and is particularly bad on output in auto manufacturing.

The third sector is transportation, such as in urban transit where fewer people are taking the same amount of available public transit than before the COVID pandemic.

In such sectors, Sargent said, productivity can be measured by counting the numbers of autos manufactured, or houses built, or passenger-miles travelled.

Productivity also can be separated into its fundamental components: labour quality, capital-labour ratios, and “total factor productivity” (the efficiency with which labour and capital are used).

“If we look at why productivity has essentially disappeared in Canada over the last four to five years, the capital-labour ratio is the biggest culprit,” Sargent said.

The amount of capital stock in Canada once grew faster than the labour force. But the amount of new capital – like equipment, machinery, mines and factories that the workforce requires to be productive – hasn’t grown at all since 2019.

“This is in contrast to the U.S., where we’ve seen capital stock [growing] significantly faster than the labour force,” Sargent said.

Even with disruptive technologies like artificial intelligence, the real productivity gains don’t result from producing AI, but from businesses adopting and using AI and other technologies, he noted.

“That’s why the Findlands and the Swedens and the Denmarks are doing so well. They’re really good at commercializing [technologies] and getting them into their factories and workplaces.”

Canada’s productivity is moving in the wrong direction by many measures

“Absolutely, there is a productivity crisis in this country,” with almost every industry showing negative productivity numbers, said Michelle Alexopoulos (photo at left), a professor of economics at the University of Toronto.

Research by Carlos Rosell, Kaleigh Dowsett and Nelson Paterson at Finance Canada suggested that if Canada just maintains the average productivity of the G7 nations until 2060, the country will end up ranking No. 15 among Organisation for Economic Co-operation and Development (OECD) countries, she said.

However, if Canada maintains our current levels of productivity, the country will wind up being No. 23 in the OECD.

“So it’s not just: ‘Are we poorer than we think we are?’ It could get a lot worse if we just maintain the status quo right now.”

Compounding Canada’s productivity problem is that the world is entering what is likely to be a technological boom, Alexopoulos said, with technologies such as AI, robotics, nanotech and cleantech disrupting countries’ industrial sectors and economies.

“What’s happened before is that Canada hasn’t managed to fully capture the full benefit of the waves of these new technologies coming in. But we should be,” she said.

For example, Canada was a pioneer in AI research and has been a world leader in this area, she said.

“But what we’re having problems with, it seems, is the adoption and commercialization of things that are actually developed here at home – which is feeding into the problem [with productivity] that we have.”

Latest numbers from Statistics Canada indicate that about 6.1 percent of Canadian firms, on average, have adopted some form of AI, Alexopoulos noted. But U.S. businesses reached that level of AI adoption in 2018. “We’re already behind where we could be.”

Labour productivity includes three components: capital per unit of labour, the composition of skills in Canada’s workforce, and total factor productivity, or the efficiency factor.

It is possible that Canadian management techniques and processes could be barriers when it comes to taking inputs like capital and labour and producing output, Alexopoulos said.

Another barrier could be regulatory burdens and tax structures that interfere with the allocation of capital and labour during production.

“We tend to have higher taxes,” she said. “We tend to put in different types of regulations and barriers.”

“Regulations and barriers cost business. Not only do they cost business, but they also affect the decisions on what kinds of investments are made.”

For example, investment in machinery and equipment in Canada has been declining for at least a decade, she noted. “From a productivity per capita perspective, the average member of the Canadian workforce has eight percent less capital to work with than they did in 2015.”

Moreover, Canada spends about only about one percent of GDP on research and development, or about half the average R&D expenditure by OECD countries.

“We’re also seeing evidence that even though we have pretty strong patents, we don’t get the same bang for the buck for our patents in terms of translating into growth as other countries do,” Alexopoulos said.

Another big factor underlying Canada’s poor productivity is interprovincial trade barriers, she said. Some estimates suggest Canada could achieve a three-percent to four-percent increase in GDP just by eliminating the many interprovincial trade barriers that exist.

“In general, any policies that are going to be limiting our competition, increasing non-essential regulations, [impacting] the quality and quantity of the skills our workforce possesses, are going to be very important for thinking about productivity – not just for existing firms but for startups and the dynamic firms that are trying to grow,” Alexopoulos said.

Lack of competition, liberal immigration policy, too much government spending are all factors in Canada’s poor productivity

Another factor underlying Canada’s poor productivity performance is that many industrial sectors here face much less competition compared with the other countries Canada is often benchmarked against.

“There are a lot of Canadian industries and not just the obvious ones – banking, telcos, grocery chains, the airlines and railways – that are non-headline industries that are remarkably uncompetitive,” Ragan said.

Those other industries, he added, include funeral services, big project construction, prescription eyewear providers, and others.

Just one lesser-known example, according to a report from IBIS World: Dispensing prescription glasses is highly regulated, because prescription glasses and contact lenses are considered medical devices in all provinces except B.C.

In many provinces and territories, only optometrists and opticians can dispense prescription eyewear to consumers. As a result, Canada’s $2.4-billion prescription eyewear industry has been relatively insulated from competition from online retailers.

Without competition, a predictable outcome is that firms will make high profits, and they’ll do less investment, because they don’t have to do more investment to innovate, Ragan said.

“If you can immerse them in a more competitive environment, most of them will be led to do more investment, more R&D, more innovation, because they have to,” he said. “In a well-functioning market economy, there are incentives to invest and to innovate and to get better.”

Ragan cited a new book, The Big Fix: How Companies Capture Markets and Harm Canadians, by Denis Hearn and Vass Bednar, that shows how corporate concentration is growing across many industries, leading to higher prices for consumers, lower workers’ wages, more inequality, fewer startups, less innovation, and lower growth and productivity.

Sargent pointed out that Canada also doesn’t have as many big firms that do R&D and are export-oriented, compared with the U.S., Germany, Sweden and other countries.

That means, he said, “in the Canadian economy, if you don’t innovate, you won’t necessarily die,” he said.

But Alexopoulos said that for Canadian firms to make R&D investments and take risks, Canada has to create an environment that’s conducive to these companies earning profits on the risks they take.

If Canada doesn’t do that, companies will increasingly move disruptive technologies like AI and non-tangible assets like data and intellectual property to the U.S., which has a more attractive tax structure and business environment, she warned.

Jean-Francois Perrault (photo at right), senior vice-president and senior economist at Scotiabank, said he sees three major challenges in the productivity space.

For one, immigration policy in Canada has been extremely progressive, making it very easy for businesses to hire internationally, he said.

“Perhaps we’ve made it too easy for businesses. Our immigration, in effect, has depressed the cost of labour relative to what it otherwise would have been.”

At the same time that Canada is depressing the cost of labour, the cost of capital is increasing, Perrault said. “So businesses hire [cheap] labour, and they don’t invest so much in technology.”

The federal government announced in August it will no longer process employer’s applications for new Labour Market Impact Assessments – a key pre-hiring step in hiring temporary foreign workers – in regions where the unemployment rate is six percent or higher. Firms will only be allowed to hire up to 10 percent of their workforce via the program.

But a Scotiabank report released on October 21 says Ottawa’s measures, including a newly announced federal cut in annual immigration targets, could translate into contraction of Canada’s labour force by about one percent over the next two years – and almost 20 percent of non-permanent residents currently in the labour force.

That could have “a potentially commensurate impact on output levels absent a productivity response. Dealing with a sudden drop in the number of workers could pose a substantial challenge to businesses,” the report warns.

 Along with the influence of temporary foreign workers, Perrault told the Canada Productivity Summit that there’s a more macroeconomic issue underlying Canada’s productivity woes.

Canada saw a dramatic increase in government spending during the COVID pandemic and coming out of the pandemic. This occurred at a time when inflation was an issue, and central banks around the world were trying to slow their countries’ economies to get control of inflation.

“So interest rates went higher than otherwise would have been the case,” he said.

Scotiabank researchers looked at what would have happened to the cost of capital if government spending hadn’t markedly increased, but remained at 2020-21 levels.

They found that likely 2 ½ to three percent of the interest rate increases the Bank of Canada engineered resulted from the fact that all levels of government – federal, provincial and municipal – increased spending a lot.

This resulted in another barrier to investment, in a world where the cost of capital was rising on purpose, and this distorted the relative cost of capital, Perrault said.

“That’s basic stuff: monetary and fiscal policy not being aligned, and there’s a cost. And it’s substantial. So productivity has suffered – not a surprise when we think of it ex post.”

Canada needs to address productivity problem in SMEs

However, governments aren’t interested in having a serious conversation about productivity and taking the measures that could help, such as eliminating interprovincial trade barriers that result in billions of dollars of lost economic activity, Perrault said.

“It’s a protection mindset. And governments are extremely hesitant to move down that path [of taking action],” he said.

It is also a major issue when governments are, effectively, deliberately reducing the size of the economic pie and making sure there’s less, rather than more, competition in the country, he added.

Another issue is how Canada treats SMEs, Perrault said. “We have a mindset in this country where we protect those, and we want them to grow through preferential tax treatment and various [other incentives].”

“If you change the tax code to favour small businesses, there’s a political reward there. But it sets up incentives that are perverse.”

In comparison to SMEs, Canadian businesses invest as much as their counterparts in other countries, invest in R&D, are exporters, and compete in world markets, he noted. “So they can’t afford not to be innovative [in how] they create and how they invest.”

There are a lot more small and medium-sized businesses in Canada (98 percent of all businesses) compared with the U.S. About 50 percent of employment in Canada is within SMEs, compared with about 30 percent in the U.S., Perrault said.

Studies show SMEs aren’t as productive as large firms, don’t spend as much on R&D, and export much less. Compared with large firms, SMEs also have less access to capital, invest less, and are more vulnerable to economic shocks, he said.

“There’s clearly an issue in the productivity space related to these SMEs and how to get them to behave differently,” Perrault said.

Alexopoulos said Canadians need to have a conversation about “how many zombie firms we potentially have out there, and whether government flooding markets with support is the right way of driving things in the long run.”

She pointed out that one of Canada’s most productive industries is the oil and natural gas sector. However, investment in the sector has dropped significantly since 2015.

“There’s a disconnect between economic growth, productivity and the regulatory piece that fits into all this, and how we need to change the mindset in government so that we can unlock that investment,” Alexopoulos said. "Why constrain a really important part of your economy that is so productive?”

Ragan agreed that there’s a huge difference between decarbonizing Canada’s economy and producing less oil.

He’s a big fan of using carbon pricing to drive decarbonization, he said. “But at the same time, I actually think expanding our oil production and natural gas and LNG to a world that wants it, and will probably want it for the next 20, 30, 40 years, is perfectly consistent, perfectly coherent.”

Another problem is Canada’s federal environmental assessment process, which creates regulatory uncertainty, Sargent said.

Many projects are still hung up in the assessment process and are waiting more than 10 years to either see their projects approved or turned down, he said.

“We seem to have created a system that can’t get things done. We just can’t build things in the energy sector,” and in infrastructure and in mining, Sargent said. “So of course the investment stays away.”

Perrault warned that if Donald Trump, who rejects the idea of fossil fuel emissions being responsible for global warming, is elected in November and decides to abandon the electricity-driven energy transition, Canada’s $50-billion investment to support electric vehicle and EV battery manufacturers could end up being a bad bet.

Sargent said whoever is elected U.S. president, Canada needs to be looking for areas that don’t involve large subsidies and find other ways to leverage sectors in which Canada has an advantage in competing globally.

Canada needs to be mindful that any decisions made here at home will have impacts on things like brain drain, managing the existing talent and workforce, attracting new talent, and retaining and building companies, Alexopoulos said.

“If we lose key players, if we are not as efficient in our firms, we will end up paying the price,” she said. “It will shape not just what we what we have now, it will shape the kinds of jobs and size of the pie going into the future.”

More than 700 business and community leaders attended Canada's Productivity Summit, which was organized by the School of Public Policy, with the Government of Alberta as its presenting sponsor.

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