Post-COVID recovery should encourage growth of private sector in Canada

All developed economies, including Canada, face economic restructuring challenges post-COVID. Labour and capital must be reallocated across industrial sectors and locations, new investments must be made in services such as public health and remote learning, and housing and retail capacity must be relocated to reflect changed preferences in where people want to live and work.

At the same time, the overarching issue will be how to “resize” the government and private sectors.

Governments at all levels likely now play a larger role than the private sector in the Canadian economy. For example, total spending by all levels of government in 2018 accounted for around 40 per cent of Canada’s Gross Domestic Product (GDP). However, spending levels do not fully illustrate the role government plays in the economy.

There’s also indirect spending via tax deductions and tax credits for businesses that do certain things such as producing Canadian-content entertainment programming. Such indirect spending accounts for up to an estimated 25 per cent of direct government spending. This would bring direct and indirect government spending in Canada closer to 50 per cent, not 40 per cent.

But there’s more. This spending estimate ignores all the emergency federal spending in response to COVID. It also ignores the reduction in private-sector activity due to the collapse of major sectors of the economy including hospitality, tourism and airline transportation. While it’s impossible to be precise, it’s possible that the government sector currently accounts for more than half of all spending in the Canadian economy.

Why does government’s share of total spending matter?

Because spending by government must be financed through taxes and/or by borrowing. And corporate taxes reduce the ability of businesses to invest in new machinery and equipment, worker training, education and so forth. In other words, government borrowing indirectly reduces the ability of private businesses to improve productivity.

To be sure, some government spending—basic research, education, public health and safety, physical infrastructure—improves the economy’s productivity growth. Ensuring the rule of law and protecting property rights also helps create an environment conducive to productivity growth. However, direct and indirect government spending extends well beyond these obvious productivity-enhancing activities. Indeed, evidence suggests that Canada’s rate of real economic growth, which primarily reflects productivity growth, would increase consistently if government’s share of GDP dropped by as much as 20 to 30 percentage points.

A new Fraser Institute essay by Livio Di Matteo, professor of economics at Lakehead University, finds that across a large number of developed countries, the rate of real economic growth is maximized when government spending is between 25 per cent and 30 per cent of a country’s GDP. Up to that range, increased relative government size contributes to faster real economic growth. Beyond that range, however, further increases in government size are associated with consistently slower rates of economic growth. Clearly, the relative size of government in Canada is well beyond the “optimal” size for promoting productivity growth and resulting real economic growth that benefits Canadians and their families.

In a separate Fraser Institute essay, economist Jack Mintz, president’s fellow at the University of Calgary, argues for fiscal rules that set limits on government spending. A fiscal rule, if adopted, might move relative government spending to levels more conducive to improving productivity growth rates and living standards in Canada.

While shrinking the relative size of government is not a priority during the pandemic, it’s key to restoring economic growth in the post-COVID recovery.