Fraser Forum

Business investment down, taxes up—bad news for Canadians

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With less than three months left in 2017, despite recent headlines espousing positive economic news, Canada’s economy faces many near and long-term challenges that the Trudeau government must consider as it crafts its fiscal update (due in coming weeks).

While there have been signs over the past couple months of strong second-quarter growth, the economy is actually only rebounding from slow growth in the previous two years and from a drop in commodity prices—in fact, nearly 40 per cent of growth in the second quarter came directly from the energy sector. Moreover, the economy may already be slowing again, with new data pointing to slower growth in the third quarter.

Beyond 2017, the Bank of Canada expects growth to be moderate and drop to 2.0 per cent in 2018 and 1.6 per cent in 2019. The fact that the Bank of Canada, private-sector forecasters, and even the Department of Finance, expect growth to slow in coming years reveals a deeper concern regarding the state of Canada’s economy.

A critical concern is our economic fundamentals, and particularly the slowdown in business investment, which receives little media attention but is a key driver of economic growth. When businesses invest in the latest technologies and production techniques and expand their operations, it spurs economic growth and raises living standards for workers because it makes them more productive, which in turn allows them to command higher incomes.

But business investment in Canada has been falling. In fact, as noted in a recent Fraser Institute study, since the end of the third quarter of 2014, business investment in Canada has declined a staggering 18 per cent (after accounting for inflation). By international standards, Canada’s rate of business investment (both as a share of the economy and per worker) is exceptionally low, ranking second lowest among 17 comparable industrialized countries in annual investment as a percentage of GDP from 2015 to 2017. Looking at longer-term trends, investment in machinery and equipment—a critical type of investment and driver of rising productivity—has fallen steadily since 1998.

There are many possible explanations for Canada’s recent weak business-sector investment including the recent drop in commodity prices. While some factors affecting growth and investment are beyond the government’s purview, policy decisions also matter. And on this front, the Trudeau government has enacted a series of policies and sent signals that discourage economic growth.

For example, it raised the top federal income tax rate to 33 per cent from 29 per cent, which has been layered on top several provincial top rate hikes. As a result, the top personal income tax rate in every province is now close to or even more than 50 per cent. Ontario, for example, at 53.5 per cent now has one of the highest top rates in the developed world.

With this tax rate hike, Ottawa by extension has also increased capital gains taxes, which entrepreneurs are particularly sensitive to. And it has yet to clarify whether additional increases to capital gains and new taxes for stock options are still on the table.

The proposed tax hikes on private corporations, which will negatively affect entrepreneurs and skilled professionals, stand to make matters worse. For a strong economy, we need these people to invest in their businesses and take risks to expand so they can supply the goods and services demanded by Canadians.

The Trudeau government’s carbon-price mandate will also dampen economic performance. Specifically, it will increase costs for firms, particularly in carbon-intensive industries such as agriculture, manufacturing and resources.

Significant payroll tax increases are also on the way as the Canada Pension Plan expansion is phased-in. An unstable fiscal framework, characterized by persistent deficits and growing government debt, raises the spectre of future tax hikes. Because debt is essentially deferred taxation, increased debt signals higher taxes in the future to potential investors, which creates uncertainty today.

Crucially, these federal policies are exacerbated by similarly economically damaging provincial policies, which include higher marginal tax rates on skilled workers, increased corporate income taxes, unstable fiscal frameworks, dramatically higher minimum wages, increased labour regulations and skyrocketing energy costs.

All these policy changes in Canada are made more poignant as the United States is poised to move in the opposite direction as it considers pro-growth tax and regulatory changes, which do not include a national carbon tax. Canada competes with the U.S. and other jurisdictions for investment dollars, so we stand to lose economically by enacting policies that make our country less attractive as a place to work and do business.

It’s no wonder Canada’s investment climate has deteriorated in recent years. For instance, Canada’s ranking in the World Bank’s Ease of Doing Business report has dropped to 22nd from 14th the previous year. Also, in a recent survey of large firms, the Business Council of Canada found that 64 percent of CEOs said Canada’s investment climate had worsened in the last five years, noting growth in the tax and regulatory burden. Increased red tape can discourage companies from making large investments in Canada, such as the now-cancelled Energy East pipeline. Meanwhile, confidence among small businesses has plummeted according to reports from the Canadian Federation of Independent Businesses.

While sparking near-term business investment and economic growth are important, there are also challenges looming in the long-term, which governments today must address to prepare for future headwinds.

Canada’s population is aging, an issue that is often discussed but continues to be critical for a government interested in fostering long-term economic growth. An older population is likely to be less entrepreneurial and participate in the labour force, hampering future growth.

This demographic shift is one reason that projections from the Department of Finance point to an extended period of slow economic growth in Canada—between 1.6 and 1.7 per cent annually over the next 35 years. This level of growth is much lower than the historical record over the past 45 years which saw average economic growth of 2.8 per cent annually.

In response to these challenges, there are several key moves the government can make to help foster business investment and labour force participation, albeit much of it would involve taking a different approach than we saw in the last two budgets.     

Most importantly, the upcoming fiscal update must create more certainty about the investment climate. For starters, that means charting a plan to return to a balanced budget in short order. Doing so will minimize the risks to public finances should another economic downturn occur. It also means clarifying whether and which major changes in tax policy are forthcoming or not.

Comprehensive, pro-growth tax reform would help make Canada more attractive for investment. A more competitive tax system—both personal and business—will help attract and retain high-skilled workers and investment, while fostering entrepreneurship.

As for counteracting the challenges of an aging population, the federal government has unfortunately enacted policies (lowering the eligibility age for Old Age Security, increasing marginal tax rates, raising payroll taxes) that discourage labour force participation at a time when Canada needs more of it. These policies should be reconsidered, for the future prosperity of Canada.

The federal government, and Canadians more generally, should not be complacent about the state of the economy. There are fundamental challenges facing the Canadian economy in the short and long term. Government policy can either help overcome or worsen these challenges.

This post is gleaned from the opening remarks by Charles Lammam, director of Fiscal Studies at the Fraser Institute, before a House of Commons Standing Committee on Finance (regarding pre-budget consultations) on Oct. 4, 2017

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