Essay: How To Turn Canada Into A Powerhouse

New leader Paul Martin needs to keep up the pressure for reform

Canada is raising eyebrows across America with its cheap prescription drugs, support for gay marriage, and moves to decriminalize marijuana. Its stance against the Iraq war didn't win many friends in Washington. Nor did former Prime Minister Jean Chrétien's obvious lack of love for George W. Bush. Yet in many ways, the countries have been on a similar track in recent years. Ottawa has cut taxes, opened industries to competition, and embraced free trade -- especially in the wake of NAFTA. Moreover, unlike Washington, it has learned to live within its means. Now, says the new Prime Minister, Paul Martin, who takes office on Dec. 12: "We want to move [growth] to the next stage."

To do that, Martin's going to have to take tough steps at a time when Canadians are clamoring for more services and anti-American rhetoric is running high. That means seriously addressing U.S. security concerns and fostering closer integration of the two economies. It also means further reducing the total tax burden on businesses and individuals, while reforming everything from antiquated protections in industries such as banking to unemployment-insurance policies that encourage inertia. Where there's money, Martin should use it to boost Canada's strained infrastructure.

A new drive to reform is needed, despite the gains of the Chrétien years. For all the accolades it deserves for reducing debt, Canada still lags far behind the U.S. in productivity and living standards. Its 2002 gross domestic product per capita, adjusted for purchasing-power parity, was 17.2% below the U.S. rate of $36,100. The country's share of global foreign direct investment dropped to 2.9% last year, from 7.1% in 1985, according to the Conference Board of Canada, and plunged against the U.S. and Mexico. "We are losing our fair share," complains Board CEO Anne Golden. One reason: Effective tax rates on capital are almost 12 percentage points higher than they are south of the border. In short, Canada has yet to create a climate that truly fosters innovation and investment. As Derek H. Burney, CEO of Montreal-based CAE Inc. (CGT ) and former ambassador to the U.S., puts it: "We start with one hand tied behind our backs."

HIGH-PRICED EXPORTS

After seven years of outperforming the U.S. and Europe on per capita GDP growth, Canada suddenly looks weak in the knees. The economy grew at an annual rate of 1.1% in the third quarter. The U.S. economy rocketed by 8.2%. Corporate pretax profits are expected to grow an average of 6.5% next year, according to Toronto-based investment firm BMO Nesbitt Burns Inc., compared with an estimated 12% U.S. average.

Martin has pressing reasons to take radical action quickly. Most important is the strong Canadian dollar, which has soared from 63 cents to 77 cents against the U.S. greenback in less than a year. Suddenly, cheap labor ain't so cheap, and the 84% of exports that head into the U.S. market (23% of U.S. products head north) are a lot more expensive. That has further exposed Canada's productivity gap, which will probably force businesses to cut payrolls and invest in new technology. While Canada's job creation has been strong, its 7.5% unemployment rate is still above its neighbor's 5.9% level.

At the same time, the province of Ontario, which contributes 42% of Canada's GDP, has raised corporate taxes to cope with its deficit. "I'm not ideologically opposed to tax cuts," explains Ontario Premier Dalton McGuinty. "But deficits are deferred taxes." Still, that makes his province less attractive just when tax rates are falling in other parts of North America. Given the total tax burden on new investments in Ontario -- which Toronto's C.D. Howe Institute figures to be at least seven percentage points higher than tax-happy California -- Martin should take action. One solution: drastic reductions in federal taxes to offset the impact of provincial tax increases. With his government running surpluses, he could easily do it.

STOPPING THE BRAIN DRAIN

But Martin will first have to avoid his apparent penchant for being all things to all people. This is a man who considers himself both a social liberal and a fiscal conservative. He has pledged more spending on everything from the military to innovation; he even had rock star Bono appear at his leadership convention to talk about Canada's role in fighting global poverty. A businessman who in large part engineered the country's fiscal turnaround as Finance Minister between 1993 and 2002, Martin has cut taxes but ramped up federal spending in recent years, thanks to surpluses. Canadian opposition leader Stephen Harper also worries about Martin's fondness for government intervention. "Contrary to his image, he's a massive public spender," charges Harper.

It's time to cut inefficient spending. Take the case of employment insurance, as it's called in Canada. It funds dubious job-creation schemes and pays about $16,000 for mothers or fathers to take a one-year parental leave. And it provides little incentive to get out of unsustainable jobs. In the fisheries industry, for instance, workers can get 26 weeks of benefits after a few good catches, notes Doug May, an economics professor at Newfoundland's Memorial University. "It's almost addictive," he says. What Martin needs to do: tighten standards and adopt a U.S.-style system that charges companies based on how much insurance employees use.

Martin can do more to nurture, attract, and retain top talent, too. While Canada invests a lot in education, it spends half as much per student at the university level, including private funding, and awards half as many master's degrees per capita as the U.S. "There's a lower propensity to go on to graduate education," notes Roger L. Martin, dean of the University of Toronto's Joseph L. Rotman School of Management. Once highly skilled workers do graduate, hefty taxes and better opportunities send many of them to the U.S. Martin can't make people stay, but he can push policies that reward entrepreneurialism and talent.

While Canada wants and needs to compete in a global economy, the U.S. must still be the gauge by which it judges itself. That's where most of its goods and services flow. At the moment, the federal and provincial governments simply take too much out of the economy to fully compete -- with total government revenue representing 41% of GDP in Canada, vs. 30% in the U.S. "They don't want to look like the U.S. in every respect, and maybe they're willing to pay the price for that," notes Pietro Catte, a senior economist at the Organization for Economic Cooperation & Development. "The question is, how much of a price do they want to pay?"

Under Martin, the answer should be nil. With a commanding majority that should last through next year's planned election, he has the latitude to turn his country into a true economic powerhouse. That means sacrificing some sacred cows and resisting the complacency that can come with strong surpluses and shrinking federal debt. After years of cost-cutting to rev up Canada's fortunes, it's time to transform it into a model of competition.

By Diane Brady

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