Canada is suffering from a serious productivity problem that, if not addressed, will threaten our future living standards. Thankfully, the solution is simple: Canadian tax policy must become more conducive to capital investment, the backbone of a more productive workforce. If advancing Canadian living standards is of concern to the federal government, then business tax relief ought to be the top priority, as this will spur productivity increases and create new wealth.

Most economists agree that productivity growth -- the increased efficiency with which an economy produces its output -- is essential for sustained increases in standards of living. Workers who produce more goods and services for each hour worked are able to demand higher wages. In addition, increasing the total value of goods and services produced results in a larger economic base from which governments can extract revenues. Hence, productivity growth should concern even those who prefer more government spending.

Regrettably, the productivity of Canada’s workforce has been falling behind that of our southern neighbour and that of most other industrialized countries. In 1985, Canada’s gross domestic product (GDP) per hour worked, a commonly used measure of labour productivity, was 90% of the U.S. level. The gap since then has grown significantly. Last year, Canada’s GDP per hour worked had fallen to 82% of that in the United States. Particularly worrying is the dramatic widening of the gap in the past four years. From 2001 to 2004, Canada’s labour productivity relative to the U.S. decreased by six full percentage points.

Canada’s performance has been equally dismal when compared internationally. From 1995 to 2004, Canada ranked 18th among 24 industrialized countries on average labour productivity growth.

Typically, the key to improved productivity growth lies in increased investment in human capital and physical capital. In terms of human capital, fortunately, Canada’s workforce is relatively well-educated. According to the Organization for Economic Co-operation and Development (OECD), Canada has the highest proportion of 25-to-34-year-olds and 45-to-54-year-olds with post-secondary education.

The real problem is Canada’s ability to attract physical capital. Canada simply does not have an economic environment that promotes high levels of investment. We have created a tax system that punishes, rather than promotes, capital investment. Jurisdictions with high levels of taxation on business effectively reduce the after-tax rate of return on investment. Lower returns reduce the incentive for investment and leave firms with less money to reinvest in new machinery, equipment and technology.

Canadian governments, more so than most of their counterparts in other industrialized countries, generate the largest portion of their revenues from the most costly types of taxation. Specifically, governments in Canada collected 46% of their total revenue in income and profit taxes in 2002, compared with an average of 35% among OECD countries.

More damaging is the fact that Canada has one of the highest tax rates on incremental capital investment in the world. When all taxes on capital are included and depreciation schedules are factored in, Canada’s marginal effective tax rate on capital is 31.3%; only China and Germany have higher rates.

A good place to start removing barriers to business investment would be to immediately eliminate the corporate capital tax, Canada’s most damaging tax. Next up, we should reduce the general corporate income tax rate and increase the small business tax threshold. Other recommendations include immediately eliminating the corporate income surtax, adjusting capital cost allowances to better reflect the true costs of replacing assets, and encouraging the provinces to harmonize sales taxes in order to avoid levying sales taxes on business inputs.

Canadians and policy-makers of all stripes must wake up to the fact that Canada has a serious productivity problem. The solution lies in creating an environment that is conducive to capital accumulation. Budget deals a la Prime Minister Martin and NDP leader Jack Layton, which cancelled nearly all of the business tax relief announced in February, will only push Canada further down the productivity growth ladder.