World Marketplace
Northern Exposures
Jack M. Mintz
11/01/2004

Canada has enjoyed a remarkable economic recovery since the mid-1990s. Emerging from years of stagnant growth and poor government fiscal policy, the United States’ largest trading partner appears to be an attractive bet for capitalists. From energy and steel to financial services and telecommunications, many Canadian market sectors are enjoying impressive buoyancy, both domestically and abroad at least for now.

The durability of Canada’s economic success is about to be tested. In June, the Liberals, led by Prime Minister Paul Martin, won 135 seats in the House of Commons, 20 short of the 155 seats needed to form a clear majority government. Without support from members of other political groups, the Liberals will be challenged to implement policy. This leads some to fear that the government will squander hard-won economic gains in a public-spending spree to secure the support of opposition parties and avoid a parliamentary defeat. Such moves would mark a return to the days of heavy-handed government intervention in the economy, which has historically undermined competitiveness. It would also jeopardize Canada’s future as a competitive member of the world economy.

Return From The Brink
Until the mid-1990s, Canada’s fortunes were sputtering. Economic growth was anemic at best. An inability to compete in world markets and ineffective political leadership ushered in a national malaise, which reached its low point when the union barely survived a 1995 independence referendum in the French-speaking province of Quebec. Provincial secessionists lost by only 1.54 percent.

After languishing in economic doldrums during the early 1990s, Canada has enjoyed seven years of impressive growth.
In the decade leading up to the referendum, Canada suffered the fourth-lowest growth rate in per capita income among all industrialized economies. The country’s unemployment rate rose to double digits in 1992 and was still just under 10 percent in 1996—almost 5 points higher than the comparable rate in the United States. At the same time, inflation-adjusted per capita after-tax disposable income declined during those years, dipping to a level that was $7,500 less than the average in the United States. The Canadian dollar plummeted against its U.S. counterpart, leading the Wall Street Journal to proclaim that Canada was fast becoming a third-world nation. Migration of talented Canadians gained velocity, and policy makers debated how to counter the brain drain.

Weak economic growth reflected fiscal mismanagement that began during the administration of Liberal Prime Minister Pierre Trudeau, who governed, with only a brief interruption, from 1968 to 1984. As late as 1965, the Canadian and U.S. governments were about the same relative size, spending roughly 30 percent of their economies’ resources. After 1970, however, Canada’s federal and provincial governments expanded social programs dramatically, and that expenditure, in addition to relatively large interest payments needed to service the ensuing debt, drove annual government spending to 50 percent of its resources. By 1995, Canada had one of the highest government debt burdens of any member nation in the Organization for Economic Cooperation and Development (OECD), exceeding 110 percent of GDP, and total government tax and nontax revenue reached over 40 percent of GDP, almost 10 points higher than in the United States.

Canada Has prospered from being the United States’ largest trading partner; however, Canadians worry about maintaining independence as
their country’s economic reliance upon the United States increases.
At this nadir, seeds of change, sown by the electors in 1993 when they gave the Liberals under Jean Chrétien a strong majority in the House of Commons, began to sprout. By the mid-1990s, trade with the United States was beginning to boom, thanks in part to passage of the 1988 Free Trade Agreement between the United States and Canada and the approval of NAFTA in 1994, which brought Mexico into the fold. Today, more than $1.3 billion in two-way merchandise trade crosses the Canada-U.S. border every day, making it the most lucrative trading relationship in the world.

The Bank of Canada also led efforts, beginning in the mid-1990s, to reign in persistently high inflation; it currently stands at about 2 percent. The Chrétien government’s most significant achievement, however, was enabling finance minister—now prime minister—Paul Martin to eliminate the federal deficit by 1997, with annual budgetary surpluses every year since. Federal and provincial governments trimmed spending to about 43 percent of GDP by 2003 and began to institute tax cuts in 2000 to reverse at least some of the pain inflicted by excessive government spending.

To steel Canada’s markets for competition in the global economy, the government also reduced corporate taxes. Canada’s combined federal and provincial corporate income tax rate was 43 percent in 2000, the highest among all OECD countries. By 2003, it had been slashed to 35 percent, almost five points below the U.S. federal and state corporate income tax rate.

In contrast to 1996, Canadians were far more confident moving into 2004. No longer a low-growth economy, per capita incomes moved above their 1989 peak. Unemployment declined; in fact, the Canadian economy has consistently generated more jobs than the United States since 2000. Even the Canadian dollar has become more muscular, rising from a U.S. currency low of about 63 cents in early 2003 to as high as 76 cents recently.

In Quebec, the secessionist Parti Québécois lost power in 2003 to a provincial federalist party. Moreover, national Liberals, under Martin’s new leadership, seemed poised to win a commanding majority in Parliament, and perhaps rout the separatist Bloc Québécois—secessionists elected to the House of Commons from Quebec—in the next election.

Flies in the Ointment
This past spring, however, the auditor-general of Canada, the watchdog of government spending, accused the Liberal government of corruption involving an advertising campaign aimed at presenting a united Canada to Quebec secessionists. The scandal dampened the party’s power as it approached the June 28 general election, leaving the Liberals with a minority government and a regionally divided parliament. The Conservatives dominated in the Western vote and picked up seats in Ontario and the secessionists won most of the electoral districts in Quebec. The Liberals maintained most of their power base in Ontario, the country’s most populous province, and in eastern Canada.

Canada had two minority Liberal governments in the 1960s and one in the early 1970s; on these occasions the governing party relied heavily on the support of the social-democratic New Democratic Party (NDP). As the price of that support, federal spending on health, unemployment insurance, regional development and a host of other programs soared, setting the stage for fiscal problems in later years. The issue now facing the Liberal government is how to design affordable policies that will enable it to attract support from a shifting alliance of parties in the legislature, without being forced by an NDP-led coalition to either return to deficit financing or face defeat in the Commons.

While the political stakes for the Liberals are high, the economic stakes for Canada are perhaps even higher. The growth rate of Canada’s standard of living is still mediocre, despite a recent spurt in job creation. Labor productivity has improved recently, although it is still significantly below the rate in the United States. Underperforming private capital investment, which is critical to the adoption of new technologies, has hampered productivity increases. Simultaneously, Canada’s share of worldwide foreign direct investment has declined. Only the province of Alberta has seen large capital investment, driven by the development of its oil-sands deposits, which will feed energy needs throughout North America. Without improvements in labor productivity, Canadian businesses will find it difficult to pay workers higher salaries as they face stiff competition from other countries, including NAFTA partner Mexico.

Like other industrialized economies, Canada’s society is aging, far less quickly than Japan’s and Europe’s, but faster than the United States’. With a smaller working population relative to retirees, the pension, health and other age-related entitlements will require increased funding in the future. The OECD reports that Canadian governments, facing higher spending needs and lower tax revenues, may have to increase taxes by 2040 to more than 9 percent of GDP to balance budgets.

Canada’s productivity and demographic challenges are further complicated by the country’s uneasy relationship with the United States during much of the Chrétien era. Canada has prospered from being the United States’ largest trading partner; however, Canadians worry about maintaining independence as their country’s economic reliance upon the United States increases. With North America’s economy becoming integrated at an unexpectedly rapid pace, Canada must craft a more productive role for itself within NAFTA. Most industries are either drawn to the size of the dynamic U.S. market or to the low wage costs of Mexico. While rich in energy, minerals and timber, Canada can best attract manufacturing and other sectors only if it offers policy advantages superior to other countries, including its neighbors.

To craft this new economic future, Ottawa must pursue a dual strategy. First, the government must implement policies that sharply increase capital investment and job creation in the face of powerful competition from other countries in both the developed and developing worlds. This will require a strong education system and good communication and transportation infrastructure, coupled with lower taxes, especially on investments. Second, the country must forge a frictionless border with the United States to enable goods and people to easily move across it. After 9/11, border controls tightened dramatically because of security concerns; fortunately, authorities in Canada and the United States developed the Smart Border Declaration and eased this pressure. However, much work remains to be done to remove regulations that impede flows in North America.
 
Surveys show that Canadians oppose any return to deficits. However, other necessary economic reforms do not garner much support. The recent election campaign demonstrated that tax cuts do not necessarily attract votes, even though current levels are near historic highs and well above those in the United States. Opinion polls also suggested that many voters are interested in investing more tax dollars in the nation’s universal health care system, dwindling school populations and a host of new social programs such as national day care.

The productivity, demographic and trade challenges facing Canada are such that a return to the failed policy framework of the 1970s, with relatively high levels of deficit spending, would reverse the hard-won gains of the past seven years. Canada must stick to the path that will complete its transformation into an economic powerhouse—and be a full participant in and beneficiary of the NAFTA accords—or it will critically wound its future.

Jack M. Mintz is president and CEO of the C.D. Howe Institute and Deloitte & Touche professor of taxation at Toronto’s J.L. Rotman School of Management.