Wake up—Canada has a business investment crisis

Capital investment is the lifeblood of economic growth and, therefore, of higher living standards. Increased capital, both tangible (machinery, equipment) and intangible (software, for example), boosts the productivity of workers and enables organizations to produce new products and implement more efficient production and organizational techniques.

Therefore, the collapse of business investment growth in Canada in recent years is cause for alarm. For the period 2015-2017, gross fixed capital formation (essentially all capital investment) in Canada increased by only 2.5 per cent—just slightly more than one-third the growth of total capital investment in the United States. Moreover, growth of Canada’s capital stock during this period largely reflects the construction of residential housing.

By way of illustration, household investment—essentially residential dwellings—increased to more than 36 per cent of total fixed capital formation in 2016 compared to about 33 per cent in 2014. In contrast, corporate investment’s share of total investment fell from around 53 per cent in 2014 to 47 per cent in 2016.

Simply put, business investment growth in Canada has vanished in recent years.

While Canadian cities such as Vancouver and Toronto enjoyed booming construction activity, there was essentially no growth in new machinery, equipment, software and other corporate assets that help make Canadian companies more efficient, profitable and capable of paying higher wages.

The growth of construction of residential dwellings was undoubtedly a response to surging housing prices, again, primarily in Vancouver and Toronto. The extent house price increases, including apartments and townhouses, were driven by speculation, as opposed to real final demand for places to live, remains undetermined. However, signs are emerging that house price increases are tapering off, perhaps even reversing.

It’s questionable whether business investment will increase to offset a likely slowdown of residential construction. While Canada’s “successful” negotiation of a new free trade agreement with the U.S. removes some political uncertainty that has discouraged business investment, the imposition of tariffs (in the name of national security) by the Trump administration remains a real threat.

Of greater concern, the U.S. corporate tax rate is now significantly lower than Canada’s rate. In addition, businesses in the U.S. now benefit from a substantial reduction in regulatory red tape while the regulatory environment in Canada, particularly in the energy sector, is becoming increasingly problematic for Canadian businesses.

And there’s more evidence Canada has become a less-desirable place for business investment (particularly compared to the U.S.). For example, from 2005 to 2014, inflows of foreign direct investment (FDI) to Canada averaged 24.2 per cent of FDI inflows to the U.S., compared to 8.5 per cent (or almost two-thirds less) from 2015 to 2017. Since FDI primarily represents investments to manage and operate host country businesses, the geographical distribution of FDI remains a reasonable indicator of the relative attractiveness of doing business in countries.

So what’s the solution?

While there’s no simple policy remedy to Canada’s business investment crisis, policymakers must first recognize the problem and its consequences. To date, the Trudeau government has downplayed concerns. But Canadians would be better served if Ottawa and the provinces acknowledged the country’s serious business investment problem and began proposing substantive solutions. Reducing corporate tax rates and increasing the excluded amount of capital gains subject taxes would be a good start.