Canada's Productivity Gap

Canada has a productivity gap with the United States. For every dollar of value a U.S. worker creates, a Canadian worker produces about 72 to 73 cents.

One of the main causes is insufficient investment, not a lack of effort. Canadian companies have invested less in machinery and equipment per worker than American companies for at least 20 years. Canadian investment per worker has fallen to between 30 and 35 cents for every dollar that U.S. companies spend.

The Bank of Canada has described the country's productivity growth as being at emergency levels of low.

The Productivity Mega Deduction

The federal government's proposed solution, or part of it, is the productivity mega deduction. The government presents it as the centerpiece of the most comprehensive revamp of business incentives in generations. The measure builds on the super deduction introduced in the previous budget, which the government has now expanded.

The Parliamentary Budget Officer estimates the measure will cost about $36 billion.

The mega deduction is a corporate tax incentive. The government expects it to attract domestic and foreign companies to invest in Canada. Increased investment in equipment and technology would, in the government's view, raise productivity, expand the economy, and generate more tax revenue.

How Business Income Tax Works

Tax treatment depends on the type of expense.

• Operating expenses are costs needed to run a business, such as fuel for a delivery fleet. Businesses deduct these costs immediately from revenue, which reduces taxable income.
• Capital expenses are purchases of long-lived assets that generate income over several years, such as trucks, machinery, or a lathe. For tax purposes, businesses do not deduct the full cost in the year of purchase.

Under the old rules, a business recovers the cost of a capital asset gradually over several years.

Example: A $120,000 Lathe

Consider a business that buys a $120,000 metalworking lathe.

Under the previous rules:

• The business claims 30% of the declining balance each year.
• At an 11.2% corporate income tax rate, the business saves about $4,000 in year one, under$3,000 in year two, and under $2,000 in year three.
• The cumulative tax savings reach $13,440 after the full cost is written off.

Under the mega deduction:

• The business expenses the full $120,000 in year one.
• Taxable income falls by the full amount in year one.
• The total tax savings remain $13,440.

The total tax benefit is the same under both systems. The difference is timing. The mega deduction returns the savings to the business immediately. The business can reinvest these funds, which earn returns over time. Inflation also reduces the purchasing power of money received later.

Fiscal Cost

The Parliamentary Budget Officer reported that new measures announced since the government's spring update have a combined net cost of $52.6 billion. The productivity mega deduction accounts for$36 billion of that total, making it the largest single driver of lower federal revenue.

This cost is spread over five years, not incurred in year one. The $36 billion figure represents the difference between the new policy and the old policy.

Because businesses can deduct large investments immediately, federal revenue will rise and fall depending on the timing of business spending. This makes revenue less predictable than under the previous system.

Forgone revenue also means the government has fewer funds available today for infrastructure, training, and other economic investment.

The Government's Projections

The government's analysis states the following:

• The mega deduction lowers the marginal effective tax rate on business investment by half, from 13% to 6.4%.
• Over a 10-year horizon, the government expects an increase in economic activity of 1.4 to 3 times the federal cost. This equals about $22 billion annually.
• The government projects up to 80,000 additional jobs annually 10 years after implementation.

These figures measure economic activity, not additional tax revenue. The government therefore accepts a short-term revenue loss in expectation of broader economic gains.

Key Uncertainty: Behavioral Change

The central assumption is whether the incentive changes business decisions. Two outcomes are possible:

1. Behavioral change: The tax break leads companies to invest more, or to make investments they would not otherwise have made.
2. Subsidy of existing plans: The tax break reduces the tax bill on investments that companies already planned to make.

The second outcome adds cost without adding investment.

Research cited in the discussion concludes that similar measures induce businesses that would not have invested, or would have invested less, to increase investment or make new investments. One assessment holds that the mega deduction is likely to succeed in this respect.

Another factor is market access. Whether a company invests depends on what it produces and where it can sell. The Canadian market is not large, and Canada borders the United States. The ability to sell goods in the United States will be a major factor in investment decisions.

Outlook

Arguments on both sides rely on projections, not observed results. The actual cost of the mega deduction depends on how businesses respond. The actual economic return depends on the same response.

The measure is a bet of billions of dollars at a time when the federal government is already running large deficits. The government intends the change to be permanent. Once businesses come to expect the deduction, reversing it may be difficult.