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CHAPTER 2: THE PRODUCTIVITY COVENANT: A COMMITMENT TO A BETTER STANDARD OF LIVING FOR CANADIANS

Canadians have traditionally enjoyed a high standard of living. This is due to a remarkably rare combination of factors. To begin with, our country has been blessed by nature. Canada has vast stretches of rich soil, which has made it a world leader in agriculture. We also enjoy abundance in the areas of forest products, precious metals, base metals, minerals, oil and gas, and several other sectors.

We have also benefitted from our geographical proximity to the United States, the world's largest and most dynamic economy, an immense market for goods produced in Canada, and a convenient supplier of the latest goods and techniques.

Finally, and most importantly, our standard of living is due to the kind of people who settled and developed this country. For centuries, the land now known as Canada has been built by hard-working, determined men and women who have always believed that tomorrow would be better than today. In the face of such obstacles as great distances, difficult terrain and a harsh climate, they carved out a rich country.

Canada has changed a lot over the years, going from being a largely rural, agrarian society to a leading industrial power during and after the Second World War. Our country has continued to innovate in the years since, securing a strong position for itself in such areas as telecommunications, transportation and information technology. The rest of the world is also changing, and our competitors are transforming themselves quickly. To maintain our enviable standard of living, we have only one option: we must increase Canada's productivity.

Before going on, it is important to understand what is meant by "increased productivity." Increased productivity means getting better results with the same effort. It is the result of innovation and invention, from doing new things with the tools we already have. Higher productivity means producing different and more highly valued goods, or providing a more richly rewarded service.

Improving productivity means helping Canada become a nation of high-skills, high-wage jobs. In the global economy, this will be the only way to maintain our high standard of living over the long term. In other words, higher productivity is the key to future prosperity.

The relationship between productivity and prosperity becomes clear when one considers recent trends. Of course, Canadians take great pride in the fact that the United Nations has repeatedly ranked Canada number one in the world according to its Human Development Index. This measure of the quality of economic, social, and political life is a composite of objective and subjective indices, meant to provide a sense of overall well-being. Yet in their day-to-day lives, an increasing number of Canadians are concerned about their economic well-being.

There is no perfect measure of living standards. The most commonly used measure is real GDP per capita, which provides us with a gauge of the amount of goods and services that can be made available to each Canadian. This measure, while imperfect, is readily available and free of value judgments. An improvement in the standard of living of Canadians comes about from two factors, an increase in productivity of those Canadians who are working, by either organizing our production in more efficient ways, or by having access to more capital, and an increase in the proportion of Canadians who have jobs.

PRODUCTIVITY: HOW CANADA COMPARES

By this measure, Canadians appear to enjoy a high standard of living. According to the Conference Board of Canada, we are fourth in a group of seven comparator countries. Using GDP as a measure, our standard of living is about four-fifths that of the United States and approximately equal to that of Germany and Japan. What really matters, though, is how we stand compared to the United States, our geographical neighbour, by far our most important trading partner, and our cultural parallel, which is sometimes a source of highly skilled labour and at other times a destination for our highly skilled labour. Whether it be goods and services, capital or labour, the United States is the country most like our own and thus the close second choice as a market for our goods, investment opportunities and place of residence. It is therefore the country against which we will naturally make comparisons.

The rate of growth in labour productivity has decreased steadily since the 1960s in all of the G-7 countries.

The Economic and Fiscal Update, October 14, 1998

Source: Economic and Fiscal Update, October 14, 1998

In the 1970s, Canada's standard of living relative to the United States improved substantially. In the 1980s, it was relatively stable at the new, higher level. In the 1990s, we have seen a sharp decline, eliminating all of the gains of the 1970s. Indeed, in 1990 our standard of living stood at 95% of that enjoyed by Americans.5 The 1990s, therefore have been very different economic periods for Canada and the United States, as we have lost ground. This can be seen in the accompanying chart that shows no growth in real GDP per capita from 1990 to 1995. But as importantly, the chart shows a pronounced decline over the longer term, in the rate of growth of real GDP per capita. Even the increase in 1996-97, which is lower when combined with the results for 1990-95, does not contradict the long-term decline. In other words, it is more difficult to provide the increasing living standards to which an earlier generation had become accustomed.

``The stagnation of the rate of growth of the GDP in the first half of this decade...''

The Economic and Fiscal Update, October 14, 1998

Canadian labour productivity in the manufacturing sector has lagged behind growth in American productivity throughout this decade. At 2% annual growth, it pales beside the 3.5% annual growth in American manufacturing productivity. As labour compensation in Canada is increasing at only slightly less than in the United States, the stage is being set for a Canadian manufacturing sector that cannot compete with its American counterpart.

Due to the declining dollar (it fell by 22% against the American dollar this decade) a large part of the manufacturing sector has been able to maintain its competitiveness. But the external value of the dollar is a variable which is not under the control of manufacturers. Indeed, the consensus is that the external value of the dollar is worth about 83 cents American. This is based on the concept of purchasing power parity, which compares the amount of goods and services the Canadian dollar can buy in Canada, and determines how many American dollars are needed to buy the same basket of goods and services in the United States. As a measure of the long-term value of the dollar, it suggests that the Canadian dollar is significantly undervalued today. This does not bode well for any sector of the economy that is relying upon a low-valued dollar to be able to profitably compete with foreign rivals. The Conference Board of canada has concluded that this relative decline in labour productivity is not a temporary phenomenon.6 This will have a negative impact on our ability to attract investment from outside Canada.

Taken in isolation, Canada's performance in relation to the United States might be interpreted as a reflection of the phenomenal performance of the American economy rather than any fundamental weakness in the Canadian economy. Yet over the past decade or so, Canadian labour productivity in manufacturing has lost ground against a number of other industrialized countries, such as Japan, Germany, France, the United Kingdom, Belgium and Finland.7 Clearly, then, the decline in Canadian productivity is an indication of a fundamental weakness within our system. The Minister of Finance's 1998 Economic and Fiscal Update makes essentially the same point. It notes that although productivity growth has declined in all G-7 nations since the 1960s, Canada has recorded the lowest rate of labour productivity growth of all G-7 nations during the last two decades.

In Canada, the rate of growth of labour productivity has declined from more than 2% per year.

The Economic and Fiscal Update, October 14, 1998

Economic growth can come about in essentially two ways, by using more inputs to produce more output, or by using the same inputs more efficiently and hence raising their productivity. An examination of 19 OECD countries for the period 1979 to 1996 indicates that Canada has achieved its growth in the same way the Swiss have achieved their growth. Both countries have relied upon a greater use of capital and labour to offset declines in total factor productivity. Every other country surveyed had been able to augment growth via productivity gains.8 This presents challenges for the Canadian economy. The Economic and Fiscal Update notes that the bulk of the baby-boom generation will be retiring within the next 25 years. This could reduce substantially the proportion of the population that is working. This may challenge future growth as Canada has relied on rising employment rates and not enhanced productivity to fuel its growth.

Principles of Enhanced Productivity

That economic growth can have a powerful effect on our standard of living is evident from the arithmetic of compounding. As economist Richard Lipsey explains: "Economic growth at 3% per year doubles national income every 24 years and doubles it again until income has been multiplied by 20-fold in a century! Typical catchup growth rates of 7%, which have been registered by some Asian countries over recent decades, double the national income every 10 years and have raised citizens from abject poverty to levels about half those currently enjoyed in Canada and the United States (and to levels that Canadians and Americans experienced as recently as the early 1960s)."9 Clearly, then, strong economic growth can be a powerful tool for resolving many of society's economic and social ills.

History shows that economic growth is not simply about achieving efficiency in a static sense. Nor is it purely a matter of using more labour or more capital, or doing the same job more
effectively. While increasing the capital stock and the employment rate, and finding new ways to extract resources do contribute to growth, these factors cannot by themselves explain the growth in our prosperity during this century.

Economic growth is much more about changes in technology that allow us to produce new goods and services and to produce them in new and innovative ways. It is about invention and innovation, scientific experimentation and new management techniques.

Economic growth does not kill jobs, it creates more and better jobs. It changes the nature of work. For more and more people in the industrialized world, work is becoming more interesting, challenging and creative. Those with higher levels of education have access to greater opportunities while those with little education are left options only in low-wage, declining sectors.

Obviously, as the entity responsible for knowledge and learning, industrial standards, tax policy and numerous other areas, government has a crucial role to play in increasing productivity. Governments can positively affect productivity gains and economic growth. This is done primarily by creating a socio-economic system that fosters change, by allowing for the freedom to innovate, by allowing the market to reward success and by refusing to impose a particular model of development on the economy. Some key principles are:

• Embrace change and resist the temptation to protect vested interests from such change. Free trade represented the embrace of change. Financial sector restructuring can also be seen in the same light.
• Keep regulation flexible so that new techniques and new service providers are allowed to enter the market and serve consumers. This requires a lack of entry barriers and a lack of restrictions on innovative ways of providing goods and services.
• Recognize that important assets are created by human initiative and are very mobile. Less and less is our wealth the result of resources in and on the ground, or in the sea, and more and more is it the result of tangible and intangible assets that humans create. We need incentives to create those assets and to keep them here.
• With globalization, we must be aware of the importance of foreign direct investment, both into and out of Canada.
• Recognize that there is a legitimate role for government in producing an educated workforce and investing in human capital. There is also a legitimate government role in the creation and diffusion of scientific knowledge wherever the market cannot do so.

Setting up the Framework for Change

Being committed to a Productivity Covenant means setting up a framework in which it can be applied. The following is a strategy for change.

1. Establishing a Healthy Fiscal, Monetary and Social Climate

• Government should contribute to the savings of the economy, not be a drain upon it, i.e., it should reduce the burden of the debt.
• Price stability should continue to be the focus of monetary policy.
• A climate for good jobs and a solid society should be established, with world-class education and health care, plus safe homes and safe streets.

2. Getting Government Right

• Government should be revolutionized to take advantage of the same management innovations being used by the private sector.
• Crown corporations' continued status as affiliated agencies of the government should be regularly evaluated.
• Resources should be used more efficiently.
• Accountability for spending should be clearly established.
• Program review should be continued and integrated into the Productivity Covenant.

3. Capitalizing on Market Strengths

• Government policy should allow the market to work efficiently so that resources (human, capital and technical) are directed to their most efficient uses and are not burdened with excessive regulatory costs. At the same time, government policy must ensure that the extremes of the marketplace do not undermine the health of the economy.
• The tax/transfer system should encourage saving and investment, and work effort.
• Tax fairness should apply to working families so that policy does not distort economic behaviour.
• Individuals should take responsibility for their actions and enjoy the rewards of their successes.

4. Investments for a Productive Economy

• The development of human capital should be promoted, along with the recognition that this capital needs to be continually upgraded.
• It should be recognized that infrastructure includes a state of the art and widely diffused knowledge base.
• Physical infrastructure should support productivity.

5. Fostering Openness, Competition and Innovation

• Free trade should be further encouraged, internationally and especially internally.
• Barriers to entry should be eliminated.
• New techniques for producing goods and services or serving customers should be allowed. A framework for E-commerce should be established.

Having established a framework for the promotion of productivity enhancement, it is useful to examine correct measures taken by the government that would meet the Productivity Covenant.

Productivity Steps in the Right Direction

The most dramatic features that distinguish government policy today from that of a decade ago lie in fiscal and monetary policy. The federal government is running surpluses for the first time in three decades and inflation is at a historic low. These two facts combine to bring us sustainably low interest rates that have not been seen for a generation and a half.

This is important for promoting productivity growth because it leads to more investment, and more efficient investment. The elimination of government deficits means that the government sector is no longer a drain on the savings of Canadians. Resulting low interest rates also make investment more attractive. Moreover, low and stable inflation also adds to a climate that promotes investment.

The next most important initiative of the government was to reform the system of (un)employment insurance. The primary effect is to make the labour market work more efficiently. In the past, employers too often had to compete for labour with an unemployment insurance program that promoted unemployment and attracted labour to the less promising sectors of the economy. The system did not encourage the unemployed to acquire new skills, explore opportunities in new industries or take advantage of stronger economies in new locations. With the reforms in place, workers are more likely to be directed to sectors where their potential is put to the best use. They benefit materially from this, and so does our society.

Not only is productivity enhanced when labour markets function well, it is enhanced when the markets for goods and services work well. Trade increases competition, promotes specialization and consequently enhances productivity. The liberalization of international trade has been promoted via The North American Free Trade Agreement (NAFTA) and the World Trade Organization (WTO) and further initiatives have been undertaken to support free trade within Canada.

For markets to work well, they must be relatively free of barriers to entry, as well as regulations and subsidies that distort the allocation of resources. Initiatives that have reduced subsidies and privatized government commercial enterprises have led to enhanced efficiency.

Tax policy also has an important effect on productivity. The child benefit initiatives are meant to support working parents and thus help to break down the welfare wall that has traditionally existed. General tax relief will reduce the disincentives to work and invest, and will help to make the Canadian tax system competitive with its American counterpart. By reducing high-marginal and average tax rates, Canadians and foreigners will be encouraged to invest and work in Canada.

With NAFTA, the North American market can be served from Canada, the United States or Mexico. The cost-benefit calculus undertaken by individuals and companies can be helped by lower future tax rates in Canada. This is not a trivial concern. By 1996, the United States was attracting almost one in every four dollars of foreign direct investment. This was substantially higher than earlier in the decade. At the same time, China's share of foreign direct investment had also grown to between 10% and 15%. Canada's share grew slightly over the same period, only to fall in 1996.10 As the Conference Board further points out, we are being subjected to more vigorous competition for foreign investment. The country of choice for American investors is now China. The country of choice for those wishing to invest in North America is the United States. The Canadian economy needs to develop some real advantage if it is to continue to attract foreign investment the way it did in the past. Investors now have many more choices.11

If Canada wants that foreign investment, it must offer better profit opportunities than those new market economies.

Ten years ago, a billion people lived in a market economy. Today, 5 billion people live in a market economy.

Finally, the government has initiated a number of measures designed to enhance accessibility to post-secondary education and to help finance research and development in Canada. These are the areas in which government initiatives come closest to directly supporting productivity growth. The measures include the Canada Millennium Scholarships, the Canada Foundation for Innovation, Networks of Centres of Excellence, renewed funding for the granting councils, and tax measures to help students, among others. These measures are designed to enable young Canadians to access post-secondary education, and use that education as productive participants in the workforce. They also recognize the need for lifelong learning.

It is this kind of approach that can help to increase the standard of living of Canadians. It is the kind of approach that ensures that the increase in real GDP per capita enjoyed during the past two years will be part of a longer-term trend and not just a short-term anomaly.

Canadians take pride in a society that is caring and compassionate, that is concerned about poverty and unequal incomes. But to do all that we need a prosperous economy. Enhanced productivity promotes a prosperous economy. It is society's best friend.

There are many historical examples of productivity gains benefitting human welfare, from the industrialization of the English textile industry which helped to clothe the world, to the agricultural revolution that fed the world and released huge amounts of labour to work in the manufacturing sectors, to the computer revolution which is changing the face of our daily lives. All of these developments presented some challenges to workers and entrepreneurs, but in the end they all generated significant benefits to workers and consumers. History has demonstrated that productivity has also served Canadians well.

It is vital that government policy exploit the benefits that come from enhanced productivity. The federal government should, therefore, commit to a Productivity Covenant with Canadians. Just as Program Review is an ongoing examination of federal spending, this Covenant should subject all existing government initiatives (spending, taxation and regulation) to an assessment which evaluates their expected effects on productivity and hence the standard of living of Canadians. Every new budgetary initiative should be judged according to this productivity benchmark. In the past, governments have pursued a number of policies that have adversely affected Canadian productivity growth, not deliberately but inadvertently. By requiring that every new or enhanced action be subjected to a productivity test, government policy will actively promote growth in our standard of living.

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5 Canadian Federalism and Economic Union: Partnership for Prosperity, Canada, 1991, p. 3.

6 Conference Board of Canada, Performance and Potential 1998, Ottawa, 1998, p. 29.

7 Richard Harris, "Long-Term Productivity Issues," in T.J. Courchene and T.A. Wilson eds., Fiscal Targets and Economic Growth, John Deutsch Institute for the Study of Economic Policy, 1997.

8 William Robson, "Fiscal Policy for Economic Growth: Comments," in T.J. Courchene and T.A. Wilson eds., Fiscal Targets and Economic Growth, John Deutsch Institute for the Study of Economic Policy, 1997.

9 Richard G. Lipsey, "Economic Growth, Technological Change, and Canadian Economic Policy," C.D. Howe Institute Benefactors Lecture, 1996, p. 4.

10 Conference Board of Canada, Performance and Potential 1998, Ottawa, 1998, p. 64.

11 James D. Wolfensohn, "Remarks at the Council of Foundations Luncheon," Washington, D.C., 1998.