The negative effects of big government on business and on the economy in general have been reported in far too many studies and journals to mention. With respect to modern Canadian economics in particular, the Fraser Institute and the Montreal Economic Institute are doing an excellent job of educating the public about the dangers of "leaving it to Big Brother". The following report by Reuven Brenner is an excellent survey of the problems, inefficiencies and waste associated with a dirigiste economy such as ours. Although the report was originally presented in June 1998, the analysis continues to apply, even more so, today.
CANADA: Failure of a Promised Land
As the United States’ economic expansion approaches a nearly unprecedented eighth year, investors look incredulously at Canada and wonder how the recovery has bypassed America’s developed neighbor and largest trade partner. In the decade since 1989, the Dow Jones Industrials nearly quadrupled while the Toronto Stock Exchange (TSE) has barely managed an 80% rise in U.S. dollar terms. Sadly, the performance differential represents not a buying opportunity, but rather, the market’s efficient assessment of mediocre Canadian commercial prospects. This reality flies in the face of frequently glowing assessments by such observers as the United Nations, OECD and, recently, the consultancy KPMG. All rest upon dubious statistical measures such as GDP trends, deficits and debt relative to national income, and business costs.
Such figures are ultimately cosmetic, putting a veil of objectivity on political rationalizations. It is democratic, objective market values that best reflect the wealth-creating dynamic within a political economy over the long term. Favorable returns obtain where productive energies are liberated and managerial leadership is nurtured. There is prosperity where entrepreneurial ambition is harnessed in the creation of new businesses, the expansion of mid-size ones, and the revitalization of the largest. And by this measure, Canada today is no success -- nor will it return to robust wealth-creation and prosperity without crucial policy changes.
The outlook has not always been so bleak; Canadian economic growth and market performance were the equal, even the envy, of Wall Street within the memory of many active investment professionals. In the late 1970s, following the dollar’s inflationary break from gold, TSE gains outpaced the DJIA, Canadian policymakers having been prescient enough to inflation-index income tax brackets while the U.S. at first did not. In the period from 1959 to 1973, Canada prospered more than the U.S. The conventional explanation then was that Canada did not have a race problem, a crime problem, an inner-city problem, a poverty problem, or the military burden the United States was shouldering. Yet if anything, these differentials are wider today, even as the DJIA has rocketed past the TSE and the U.S. economy booms while the Canadian economy languishes and declines.
This paper on Canada’s prospects was undertaken on the assumption that the Wall Street and Canadian financial communities expect a correction of this imbalance but don’t know how or when it will begin. The analysis and commentary are intended to give a thorough sense of how the divergence began and the myriad barriers that stand in the way of convergence. The seeds of Canada’s chronic relative decline took root in the 1970s with the purposeful emasculation of institutions that once guaranteed Ottawa’s fiscal accountability, allowing the unchecked rise of ambitious, but ultimately inefficient, high-tax governments (federal and provincial) that today takes up half of domestic output. Similarly well-meaning but unsuccessful policy experiments were ventured by other western democracies in the 1960s and 1970s but have been largely disbanded since. Features unique to Canada’s political mechanics have prevented Ottawa’s coming-to-terms with its Keynesian folly, however, leaving emigration often the best option for the country’s top talent. America’s ongoing expansion was born in the return to supply-side fiscal principles and monetary probity ushered in during Ronald Reagan’s presidency. If Canada’s markets are to benefit from a similar return to prosperity, the ground must first be paved by Canadian policymakers, working against massive inertia to dismantle the political impediments we identify below.
Note: Tables, Diagrams not included.
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Although the Economist rates the Canadian Statistical Bureau as the best in the world, many of the numbers on which investors typically rely are utterly useless in Canada. Neither GDP measures nor growth rates provide a good picture of expected wealth creation, as these numbers are backward-looking and, in Canada's case, measured in a depreciating currency. (It is one thing to grow, say, 5% in terms of a monetary standard; it means something entirely different to grow 5% in terms of a currency depreciating at 10% per year.) And GDP is simply a catch-all that adds up everything in sight, whether private sector activity or nonproductive government investment. In Canada, where government spending on federal and provincial levels adds up to nearly half of the measured GDP (the OECD underestimates it at 47 percent) one learns little about wealth creation by looking at this figure.
OECD figures underestimate the cost of government not only because the effects of regulations are not measured, but also because the total cost of roads, harbors and other so-called "capital projects" are not included -- not to mention the omission of unfunded liabilities for a variety of programs and projects. Perhaps half the government’s capital budget is misspent, although it is accounted for as "service" or "investment." It can take years, though, before anyone realizes that what was counted as investment was, in fact, waste. Of course, increased taxes are invoked to cover the costs of such mistakes -- which have compounded over time.
It is in the nature of government to be inefficient relative to the private sector: having the right to tax, governments can persist with mistaken strategies longer than could any firm. In Canada, the waste has reached embarrassing levels. Canadian government institutions once held fiscally accountable have deteriorated to the point where the officials responsible for spending tax revenues no longer understand the economic consequences of the programs they administer. We get some hint of this vacuum in the comments of Paul Dick, Member of Parliament for 23 years and Minister of Supply and Services during the period 1989-93. He acknowledged the following in a recent detailed, yet-unpublished interview in the three-year "Day of Reckoning" project to investigate Canada’s lagging economic performance:
The government doesn't cost its programs the way a company costs. It does not have a costing system. It really is just a cash receipt and cash disbursement system dressed up to look like a full accrual system...I got the managing partners of each of the six major accounting firms in Ottawa area to come and sit on a committee for something I was trying to develop and five out of six said that they could not understand the government's accounting systems or the government books and they could not read them. The other one did admit that he could understand them [i.e. their language], but he had worked in government for ten years...Quite frankly, the government's accounting system would be considered illegal if you happened to be a corporation...Accounting's a kind of dry subject to try and make it sexy, but it runs every company and every organization. They all have to do a little balance sheet and an income statement and show where their expenditures are. Except I've never seen an income statement and expenditures in the government of Canada. I've never seen a balance sheet in the government of Canada. There aren't any.
Kenneth Dye, Canada's Auditor General during 1981-91, confirmed that the government's accounting practices are "based in the quill-and-ink age." Alan Ross, a career civil servant who served as Assistant Deputy Minister in Supply and Services, 1986-93, added, "if you were to go and say ‘I want to know what the cost of the Indian program is, what the cost of Old Age Security program is, or the Young Offenders program is, how are they going to manage those costs in any way over one, three, five years?’ you would find it very difficult to find out...And if you asked what were the major cost determinants, I wonder if some of the senior managers would even know, because it is not important. Has anybody asked to see the financial operations of the department of Health and Welfare, or the National defense? No. If nobody asks the questions, then who cares?"
There are auditors general who try to inject some discipline, but their increasingly embarrassing reports are simply "managed" by the government. In 1997, auditors in Quebec reported that funds spent on roads did not appear on the books, as the government was trying to disguise a deficit. Two days later the news is forgotten when auditors find in Ottawa that $2.5 billion has been "spent" on a millennium fund that isn't actually in place yet; the government has been trying to hide a surplus. If such unreliable accounting was routinely discovered in private corporations, they would have to pay premiums on bond finance. Governments do not because the obligations are backed by the right and ability to tax. As long as Canada's taxed wealth is sufficient to forestall expectations of default or devaluation (which is a particular form of default even if not called so), capital markets advance credit at low rates. It is the private sector that bears these costs indirectly, as capital markets must discount the tax premium for government waste into private debt and equity. There is no free lunch.
At one time, Canadians -- prominent among them 1960-73 Auditor General Maxwell Henderson -- persisted in taking dubious government practices to task. What happened? How did Canadian government become so unaccountable, notwithstanding the country’s civic democracy? Tracing that decline also provides the illustration why the TSE is not likely to begin discounting for renewed prosperity in the near term.
The Loss of Fiscal Accountability
Henderson notes that until the early 1960s, Canadian MPs truly understood government budgets. The report of his predecessor, Watson Sellers, was 80 pages long and simple. Today the Auditor General’s report is routinely more than 1,000 pages. The Minister of Finance and the President of the Treasury should have been the guardians of public money. The erosion of their role began in the 1960s with the rise of Keynesian-trained planners to senior policy positions -- bringing with them the political lies that underpin tax-supported program spending. Former Deputy Minister Ross recalls:
The currency of the day, as far as the major bureaucrats were concerned, was ideas and new programs. That's what you got good marks for. Any idea was a good idea. And any program was a good program. And it was an exciting time for being a politician because you were building new programs, you were building bridges, you were building monuments, you could do anything you wanted. And the philosophy of the managers was growth -- I'm going to be promoted. I'm going to have more people reporting to me...and the whole idea therefore of accounting for your resources, demonstrating your cost management skills, just seemed redundant. The people who were in power considered those kind of discussions about program costs to be what they called the book-keeper mentality and real managers didn't bother themselves with that kind of nonsense. We were interested in the big picture, the strategic thinking and those kind of things.
Beginning in the 1960s, government departments all made thousands of recommendations and hired armies of management consultants to examine them and prepare reports. The consultants, of course, wrote the reports department heads wanted to hear: Increase the size of the office, hire more staff -- and send the bill to Treasury. In fact, Alan Ross was appointed specifically to bring new, modern management controls to the bureaucracy. The mandate of the Glasgow Royal Commission was to find out how to manage this new size, how actually to animate the Keynesian creation. The Commission's recommendation was that managers should be left alone to manage. Although this "decentralization" looked good on paper, in practice it suffered from an oversight, as Ross admits: The "managers" were not responsible for their programs’ costs.
By the first year of the Trudeau administration in 1969, this Keynesian spend-more, deficits-are-good philosophy had captured the imaginations of Ottawa, the federal bureaucracy, and most economists -- not only in Canada, but throughout the Western world. Indeed, the economic boom in the United States that followed the Kennedy tax cuts was taken in Canada as a proof of Keynesian dynamics. Ottawa policymakers were impressed with the Great Society programs being financed in the States on the assumption that good times would never end. The "problem" for Trudeau’s ambitions for Canada was that large-scale spending for all the new programs required scrupulous vetting by the parliament prior to approval. So the House of Commons changed the rules.
Prior to Trudeau, spending estimates were discussed in the House; now "there was no time," so deliberations were moved outside the House to "standing" committees. It was stipulated that if these committees did not vote on spending measures by June 15, they automatically passed. Paul Dick, then Parliament member and later Minister under Brian Mulroney, recalls that once this rule passed, "people started arguing and discussing policy at the standing committees, but they didn't discuss the finances of a department anymore. And we lost public scrutiny of parliament...Nobody was taking a look at the beans anymore. Nobody was taking a look at what was happening with the dollars and cents."
In this general breakdown of legislative discipline, which remains to this day, the change of rules was accompanied by the circumvention of the office of controller general. Politicians no longer had to follow budgets for which the controller general held responsibility. By the late 1960s, the cabinet gave spending authority to ministers reporting to the Treasury Board. The problem was, and still is, that the Board is headed by another minister of cabinet. Thus, if the cabinet approves spending, the Board is unlikely to deny it.
The auditor general's office did not fare much better. Max Henderson, who occupied that office during the key period 1960-73 -- when big-spending theory was translated into budgetary reality -- attempted to expose the government’s waste and extravagance. In 1970, the Trudeau cabinet's reaction was to introduce a bill in the House of Commons cutting staff salaries in the Auditor General's office and freezing its size. There was sufficient uproar across Canada that Trudeau was forced to withdraw the bill late in the year. Following Henderson's 1973 retirement, though, the measure was revived and pushed through. In a recent interview before his death, Henderson observed: "They curtailed the fellow in that office so he would behave himself. That was a tragedy...I hate to brag, but I prophesied what was going to happen. The depreciated dollar, the incredible size of the national debt, the terrifically high taxes that would sap the incentive of our people."
Kenneth Dye, Auditor General during the 1980s, faced an uphill battle. Dye produced reports warning in vain about the accumulation of debt. Meanwhile, the Keynesian vocabulary of the time presented the economy in terms of deficits relative to National Income, with government spending "creating jobs" and moving the economy along the Phillips curve (that imaginary relationship between higher inflation and lower unemployment in which the vast majority of the economists still believe). In Canada's public discourse, the Auditors' General reports revealing the spending waste and demonstrating the compounding costs of these mistakes were eclipsed by Keynesian activism’s rosy language. The spend-and-borrow revolution was complete, and government accountability gone. Following the grand detour blazed by Paul Samuelson and James Tobin, now Nobel Laureates, this is still the framework of the vast majority of economists. The Keynesian approach is still taught in every macro-economics course around the world, and although its foundations have crumbled, its language still permeates worldwide public discourse -- particularly in Canada.
Nowhere is this more visible than when Canadian governments talk about "job creation." The rosy published employment statistics simply have no relationship with increased standards of living. Employment in Canada largely reflects continued government guarantees and subsidies to a wide variety of companies. Just as aggregate statistics and employment figures proved meaningless in the former communist countries, so they still are in countries where governments control more than 50% of spending in an economy -- for which, as we saw, there is no Canadian accountable. One saving grace between the formerly socialist countries and Canada is that we can extract some valuable information about Canada by looking at the auction markets in stocks, bonds and real estate, a source unavailable in the Soviet bloc.
"Job Creation" -- Canadian Style
Canadian steel analyst Jay Gordon made a detailed analysis of the Canadian experience in that industry, and concluded: "What is interesting in the Canadian experience is that the companies which have been the greatest beneficiaries of government largesse have been the greatest flops. The most egregious example is Sydney Steel (SYSCO) in Sydney, Nova Scotia. Essentially what SYSCO proves is that you cannot save jobs which don't have an economic raison d'etre. It's that simple."
The company was formed in 1967, when turn-of-the-century steel company DOSCO was shut down, having long since become commercially unviable. Ralph Hindson, then federal Director of the Materials Branch, published a study in October of that year confirming previous assessments (including from private-sector consultants) that the plant could no longer operate economically. But DOSCO was the major employer in the province, with more than 20,000 on its payroll at one point. Despite the federal government’s initial refusal to help beyond $2 million and half of the cost of another study, the provincial cabinet decided to keep the plant open. Arnie Patterson, Prime Minister Trudeau's press secretary, recalls the decision and its consequences: "If the SYSCO plant in Sydney were in Wheeling, West Virginia, it would have been closed 25 years ago, because the Americans make those decisions on the basis of profit and loss statements. We're a little slower to arrive at those decisions because...we deal with them on the basis of social welfare. And it's never an easy decision because people who make those decisions have to be elected."
Hindson recalls that by 1974, seven years later, the company was in more serious trouble because SYSCO's management persuaded the Nova Scotia government to "invest" an additional $125 million -- for which, as it turned out, the company could not even pay the interest. That interest was still compounding when, in the early 1990s, the government injected another $200 million. There were other, less explicit costs as well. Since the government approved SYSCO's sales to countries such as Bangladesh, the booked sales were a fiction; payment was never really expected (indeed, under Prime Minister Joe Clark the federal government wrote-off these obligations). The government also subsidized SYSCO’s coal inputs; and local air and water were contaminated, with effects and costs that have only just begun to surface.
How much did the province lose? If the original $125 million were legitimately invested 24 years ago at an 8% annual return, the sum would have accumulated to $650 million today. Add to that the $340 million return on the later $200 million injection, and Nova Scotians would have about $1 billion, instead of the holes in the ground their government dug for them. (Nova Scotia’s politicians apparently studied all too literally the now-discredited Keynesian assertion that "digging holes in the ground can be better than saving.") Unfortunately, in the 1970s there were no leveraged buy-outs to discourage or correct the effects of mistaken fiscal policies and bad management, and therefore to prevent widely imprudent expansions.
Nova Scotia was by no means the only government trying to "save" the Canadian steel industry. Quebec, for example, threw hundreds of millions of dollars into Dominion Steel and Coal in Montreal. Fire Lake Iron Ore cost at least $450 million, and was shut down because it did not work. STELCO in Hamilton went ahead with the largest, most modern greenfield mill in North America. Twenty years later, it operates at about 20% of capacity. As industry analyst Gordon relates, "If you make a lot of money, you tend to incur income tax liabilities. So steel companies like STELCO figure out that if we pay tens of millions of dollars in corporate income taxes, the government is just going to blow the money on subsidies to some other industry, or on welfare...If, on the other hand, we invest that money and we build a nice new steel mill, we're going to be able to generate revenues...and hey, we may even create a few jobs." According to Gordon, the company Algoma survives today "not to make steel and certainly not to make money. Algoma exists to save jobs. Because the provincial government and the federal government hired accountants who figured out that even Victoria, BC, would be adversely affected if Algoma were allowed to go down."
Then there is the $55 billion cost incurred during 1974-85, when the federal government controlled oil prices, subsidizing wasteful consumption. And if all these mistakes did not impose enough costs on Canada -- reflected in the accumulated $600 billion visible federal debt -- the government, in nationalistic response to miscalculated private-sector lobbying, granted Canadian-owned oil companies advantages over foreign ones. This set the stage for firms such as Dome to borrow large amounts to buy up the "foreign" assets. What happened? The foreigners took their money out of Canada, and Dome's stock price went from a high of $25 to almost zero once the price of oil dropped.
To be fair, it is not that Canada’s politicians in most cases acted out of ignorance or deliberate venality, but rather, that they were caught unwitting in a vicious circle. As taxes rose to pay for well-intentioned (if ultimately wasteful) programs, creeping fiscal disincentives increasingly snuffed out private-sector job creation. In order to soak up unutilized manpower, governments were compelled to expand wasteful enterprise subsidies -- requiring additional tax revenues, and so on. While tragic, it can at least be said that the proliferation of inefficient "job" programs preserved a basic fabric among Canadian society by preventing the total dissolution of its communities. This is the social benefit that Keynes meant when he said that it would be better to pay to dig holes and fill them up rather than to have breadwinners sitting at home on the government dole. The people, of course, prefer the kind of productive work that flows from a well-designed capitalist economy. If their political leaders fail in providing such a system, however, the people have no choice but to support a second- or third-best system of socialism.
"Regional Development" and Jobs
Both the steel industry supports and intervention in the oil business reflected a broader theme in Pierre Trudeau's "Just Society" vision of the late 1960s. Trudeau believed Canada faced two problems as a country: the language divide and the gap between rich and poor provinces. He confronted both with mistaken policies, including a wide variety of "regional development schemes," the devastating consequences of which persist today.
Subsequent Prime Ministers did nothing to correct Trudeau’s errors. When in 1983, Prime Minister Brian Mulroney scrapped the Department of Regional Industrial Expansion, for example, he simply replaced it with the Department of Industry for all Canada. This new ministry immediately gave $1.8 billion for the Atlantic Canada Opportunities Agency (ACOA). Three weeks later, to satisfy the West, the government established the Western Economic Diversification (WED) agency with $1.1 billion. Quebec got the FORQUE agency with its $1 billion budget. Although these sums were intended for "private sector" development in their respective regions, they ended up going instead toward local "job creation" programs, with bureaucrats supposedly picking industry "winners," which of course they could not.
In addition to such direct industrial subsidies, other interventions, such as the 1974 extension of unemployment insurance to seasonal workers, have kept many Canadians in obsolete jobs. Lloyd Francis, Parliamentary Secretary to the President of the Treasury Board in the 1970s, recalls in a recent interview for the Day of Reckoning project how this policy change came about. Bryce Mackasey, then Minister of Labor, after consultations with regional politicians, expanded the definition of "seasonal" to include people employed in fisheries, agriculture and forestry. Clifford Murcheson, Chairman of the Unemployment Insurance Commission at the time, opposed the plan, arguing that permanent subsidy would keep too many people in "seasonal" industries and destroy the fairly conventional insurance principles on which the program was built. But Murcheson and Francis lost the political battle to regional interests.
It is more than the simple issue of unknown, unfunded liabilities. Subsidizing seasonal industry had the unintended consequence of discouraging a wide range of other skills -- a cost not directly reflected in any statistics, but which certainly contributes to the 10+% unemployment in the poorer regions (17% in Newfoundland) these programs were supposed to help. Prior to the new policy, Newfoundland's fishermen found off-season employment in logging, farming, and net-weaving. The generous unemployment benefits (paid for 42 weeks after only 10 weeks of employment) killed incentives to look for and do these other jobs. Imperceptibly over a single generation, fishermen ceased to pass on the complex knowledge of people, activities, and secondary employment markets they once possessed. Today, Canada has 60,000 fishermen who are unemployed for most of the year. Iceland's 6,000 fishermen produce more than Canada's 60,000, who have 6,000 fishing bureaucrats tending them. This is another good illustration of the limitations of aggregate figures in Canada. These 66,000 people have depended on taxes for their living, employed in the business of transferring wealth rather than creating any.
Seasonal workers in other provinces learned to adapt to the unemployment insurance scheme in their own ways. Woodworkers in New Brunswick, for example, asked contractors for layoff slips after exactly ten weeks. If the contractor refused, the workers threatened to sabotage equipment. In Nova Scotia, which has a beautiful autumn season, hotel owners found they could not extend the tourist season into the three autumn months, because potential employees had their unemployment benefits and were enjoying the fall themselves. Opportunistic provincial governments pursued a parasitic political strategy of hiring people through their various agencies for ten-week periods and then farming them out to the federal unemployment scheme. Now, as of June 1998, the federal government is trying to buy out Newfoundland’s idle fishermen, but lacking any alternative skills, they react violently. It is not clear how much taxpayers will pay to buy back the rights for seasonal unemployment benefits previously bestowed with so little forethought.
Ottawa also encouraged exploratory drilling in the Arctic ocean. According to Wilf Gobert, oil industry investment analyst at Peters & Co., "if that money had been invested in Western Canada, instead of the 50 or so wells in the Arctic at, say, $50 million each, you could have drilled 8,000 wells and at today's prices each well would generate a revenue of about 4 million dollars, so with a hundred percent success rate you would have $32 billion. Royalties average 20%, so the Alberta government would have made 6.5 billion dollars." Even with a more realistic 50% success rate, there is no comparison. Instead, the government subsidized private companies to sink the money in unproductive holes in the Beaufort Sea, the Melville Peninsula and Labrador Straits.
All the government interventions have distorted the links between job creation, measures of domestic output, and prosperity. One simply can not infer from official figures today that when employment increases it is necessarily a good sign. It could be the effect of a yet-undetected, commercially unviable government subsidy or guarantee -- or for that matter, a signal of increased poverty requiring people to take second jobs simply to make ends meet. In other words, the Keynesian language stating that governments can create jobs is superficially accurate. We saw similar situations in communist countries, where official statistics showed full employment but many jobs made no contribution to the economy. This pattern continues today: both French software company Ubi Soft and U.S. truck maker Kenworth received generous federal and provincial aid to invest in Quebec. The most flagrant recent example is the Karbomont project in Montreal east, which will receive $38 million in government help for a project that is expected to create 45 jobs. The others created jobs too, no doubt -- but how many jobs were prevented by these subsidies, or by the higher taxes to pay for them?
The Policy Divergence, 1975
When the world left the Bretton Woods gold standard in 1971-73, economic contraction followed in all the industrial countries, but Canada had the benefit of a Finance Minister, John Turner, who had a basic supply-side insight about inflation. In his budget speech of February, 1973, he told the Parliament of his plan to eliminate "the unfair and unintended increase in taxes which occurs automatically as a consequence of the interaction of inflation and a progressive tax structure." In the succeeding years, Canada was the only one of the industrial countries with an indexed income-tax. But even with this scheme, and though having plenty of oil and natural resources whose prices were high at the time, the TSE was highly correlated with the DJIA, and did not reflect expectations that Canada will do better than the U.S. (though Canada’s mismeasured GDP was rising faster at the time).
What went wrong in spite of the indexation? As Jude Wanniski pointed out in his 1978 book, The Way the World Works, the indexing worked beautifully in national aggregate, but there was a flaw: Of the 10 provinces, only Quebec failed to index its provincial income tax, which ranged from 10% to 28%, and as the dollar inflation hit the whole economy, Quebec was hit the worst. "Each year, the wedge between Quebec and the other provinces deepened, setting up economic and political tensions. The separatist movement among the French-speaking people of Quebec, already in existence, was inflamed by these tensions, and Trudeau made serious errors in trying to combat the Quebec problem." Over the years, I’ve made several attempts to find out why Quebec never followed the example of the other provinces in indexing, but cannot find anybody who has any idea of why this happened.
It was not the only thing that went wrong at the time. As Wanniski explained, Trudeau on October 1975 tried to fight the inflation problem with a statutory prices and incomes policy, applying enforceable guidelines to prices, profits, wages, professional fees, and dividends. He then compounded the problem by pushing through Parliament a 10% surtax on all incomes above $30,000, which took effect on January 1, 1976. Unwittingly, he had made the problem worse for his home province, believing the surtax would hit higher-income Ontario and British Columbia harder than Quebec. He failed to take into account Quebec’s absence of indexing. The rising separatist political force, and the surtax (the first reaction might not have been independent of the second) was followed by an exodus of talent from Quebec to the other provinces. John Turner, incidentally, resigned in protest over Trudeau’s surtax. The separatist party won the following elections and Trudeau’s national popularity dropped to a career low. Though as the U.S. economy fell deeper into decline as a result of the horrendous monetary and fiscal errors of Jimmy Carter’s presidency, 1977-81, and the DJIA stayed flat, the TSE rose rapidly.
The rise reflected expectations that the Progressive Conservative Party had its best chance to make amends in March 1979, when Trudeau called for elections. During the campaign, Conservative leader Joe Clark criticized the Liberals for high unemployment and inflation, promised to cut taxes, reduce government spending, and encourage private investment. Clark also promised mortgage interest and property tax deductions while Trudeau and the Liberal Party concentrated on unity, the French language, and cultural issues. The voters rewarded Clark and the Conservatives with their first victory in 16 years, giving them 135 of 282 seats in the House of Commons, Liberals 115, and the rest to small parties. The TSE rose sharply. Clark promptly announced there would be no more tax reduction and no deductions for mortgage interest. Nothing. The budget deficit was "too big." The TSE plunged. Opposition to his government quickly became widespread, and the government fell on a vote concerning the budget, which called for a sharp increase in gasoline prices. Clark called for general elections in February 1980 and Trudeau became Prime Minister again. Investors probably assuming that he learned from his and Clark’s mistakes, led to a rally on the TSE. They were proven wrong.
Still there was no recognition that ordinary Canadians knew better than their leaders that the tax system was smothering economic growth. Clark remained as Conservative leader until June of 1983, when his unpopularity reached a point where the party replaced him with Brian Mulroney (who kept Clark on in his Cabinet on the external affairs desk). Mulroney’s contribution to the Canadian economy was his advocacy of the North American Free Trade Agreement, which gave him a second term as PM. The Reagan tax reform of 1986, which lowered the top marginal rate in the U.S. to 28%, while raising the capital gains tax to that level from 20%, was emulated by the Mulroney government in 1988. A grave mistake was made, though, by failing to understand the greater impact the Canadian capital gains tax would have on its economy because of the income-tax structure of the combined federal and provincial governments. By our reckoning, the most populous provinces of Canada now have the highest combined capital gains tax rates in the developed world. Yet there is presently no discussion in any political party of making any correction.
When Mulroney’s unpopularity in putting a balanced budget highest on his agenda forced him to retire when new elections were required, his successor, Kim Campbell, went to the electorate oblivious to the reason for Mulroney’s unpopularity. She based her entire campaign on fiscal frugality and budget balance. The electorate threw all but three Conservatives out of the House of Commons in an attempt to make their feelings clear. Except for a bit of movement in Ontario and Alberta on the tax issue, the party remains intellectually bankrupt. In discussion of the next Tory PM, Clark and Hugh Segal are near the top of the list.
Finding a Comparative Yardstick: Financial Markets
Given the poor utility of available official statistics, how can we know the wealth a country such as Canada has created and -- more importantly -- is expected to create? Without a reliable comparative measure of wealth creation, little can be said regarding the management of national policy or improvements thereto. When financial markets are deep and transparent -- as in both the U.S. and Canada -- they provide the best indicators of anticipated wealth creation, particularly when both are measured in terms of the global standard unit of account: today it is the U.S. dollar. The market value of debt and equity is usually a much better and up-to-date approximation of a company's value than backward-looking accounting statements. The deeper the financial markets, the more will market growth rates approximate the rate at which wealth in a society is expected to be created. The market value of government bonds is backed by the government's right and ability to tax; the interest rates at which governments borrow reflect investors' best aggregate estimate of the probability of a government default.
The story told by the financial auction markets is not encouraging: Since 1989, the Dow Jones Industrial Average (DJIA) nearly quadrupled (from about 2,300 to approximately 9,000), whereas the Toronto Stock Exchange barely doubled -- from around 3,600 to just above 7,200 today. After adjusting for the depreciation of the Canadian dollar since 1989, the return on the TSE falls to 75%. The contrast between the DJIA’s 280% increase versus Canada’s 75% is the best indicator of the difference in expectations of rates of wealth creation in the two countries.
Other statistical measures reflect the difference, although with less precision. Canada's unemployment rate of roughly 9% is double that of the U.S. The Canadian dollar dropped 22% since 1991, hovering now around US70¢. Family incomes dropped by about 4% since 1993, and Canadians have lower real incomes in 1996 than in 1980 (not just in U.S. dollars terms, but even in terms of the depreciating Canadian dollar). Disposable income has been falling steadily since 1989, when average Canadian take-home pay was $18,200; now it is $16,800 -- this trend, too, in terms of the depreciating local currency.
For the last 14 years the United States has prospered almost continuously, the consequence of supply-side tax cuts and lower inflation. This has allowed the U.S. dollar to become "as good as gold" in the eyes of many investors. [In fact, as Polyconomics has observed for more than 12 months, the dollar has performed more strongly than gold, with the dollar gold price falling from $385/oz. in November 1996 to approximately $285 today. This trend carries negative consequences of its own, as Polyconomics has discussed elsewhere and the author observes in a forthcoming issue of Jobs & Capital.] Of course, one cannot be certain dollar strength will continue after the future departure of Federal Reserve Chairman Alan Greenspan. Judging from the yield curve, however, the market expects the continuation of the "Greenspan standard." And notwithstanding superficial headlines about "downsizing," unemployment in the U.S., at about 4.5%, is significantly lower than in either Europe or Canada. The U.S. private -- not public -- sector created approximately 35 million jobs during the 1989-98 sample period of this study.
In contrast, Canada's stock market is forecasting a much slower pace of wealth creation, which is why more attention is paid to Canadian government debts than to those of the United States. Relative to market capitalization, U.S. government debt has fallen, whereas Canada’s has increased. These are the relevant figures to consider, as all derive from market-based numbers rather than the backward-looking abstractions of subjective government statistical bureaus, the products of which presume that such measures have meaning independent of national political institutions and monetary and fiscal policies.
Liquidity Demand and the Canadian Dollar
Other market-based numbers complement the picture. After rising from US73¢ to nearly US75¢ during January 1997, the currency fell below US70¢ during 4Q97, and hovers today at approximately US68¢. Both the settling of the Canadian dollar at its current low level (it was in the US85¢ range at the beginning of the 1990s) and the relatively dismal performance of the Canadian stock market happened while Canada was experiencing record current account surpluses. Canada’s exports exceeded imports by CA$1.15 billion (US$850 million) in 1997, whereas the U.S. still has a large current account deficit. Why then has the market for the Canadian dollar been so weak? Because world demand for Canadian dollars relative to other currencies has diminished. This decreased demand is not the result of inflationary expectations, anticipated devaluation, or threats of a Quebec separation (which have now diminished significantly), but for another simple reason: slower Canadian growth relative to the U.S. because of high taxes.
We can detect this link by looking at the demand for currency from the following angle. As the federal and most provincial governments have balanced their budgets and even run surpluses (though, as noted above, the federal government tries to disguise them), there is an increased relative liquidity of Canadian dollars as debt issues decline. If taxes were lowered, this liquidity would be absorbed by new bond and equity issues to finance companies’ expansions. But while some provinces, such as Alberta and Ontario, have slightly lowered taxes (by no more than 2.3 percentage points in the top bracket), others such as Quebec and British Columbia have increased them or imposed burdensome new regulations. On the federal level there is no serious talk of tax reductions. Since bond redemptions are expected to continue -- Randall Powley, of Scotia Capital Markets, expects redemptions on the order of $15-20 billion each quarter for the next few years -- the Canadian dollar is not expected to appreciate significantly. Instead, the added liquidity is expected to be absorbed either by rising commodity prices once Asia recovers, by slow, externally-driven growth, or perhaps by Bank of Canada (BOC) rate hikes.
The story is not uniformly negative, however. The most recent depreciation of the Canadian dollar can be viewed not as a depreciation at all, but rather a positive adjustment to the deflation of the U.S. dollar against gold. In the last 18 months, the U.S. dollar price of gold has plunged 24% to the $295 level from the $385 level in late 1996, where it had been for three years. If Canada had not allowed its dollar to slide by 11% against the U.S. dollar, it would have imported the entire monetary deflation and its destructive effects on the financial system without the offsetting growth effects of the 1997 tax cuts in the United States. Indeed, Thailand’s failure to adjust to the U.S. dollar deflation early enough appears to be what triggered the crisis across South Asia.
It was the U.S. cuts in capital gains, estate and pension taxation -- the Roth IRA’s -- that induced the very increased demand for dollar liquidity that led to the deflation when the Federal Reserve refused to supply it. Without having commensurate tax cuts that feed capital formation, Canada’s banks could not have withstood a firm link with the U.S. dollar, but would be in a position similar to Japan’s. In other words, while the monetary deflation in the states was overwhelmed by the positive effects of the 1997 budget agreement and its powerful tax cuts, Canada would have felt only the negatives by deflating its dollar against gold as well. Even with the weakening, the Canadian dollar is still stronger against gold than 18 months ago. It was CA$500 then and it is roughly CA$435 today. Taking the assumption, as Polyconomics does, that the optimum U.S. dollar gold price is somewhere near $350 and it has deflated by about 18% from there, the Canadian dollar has offset part of the deflation, deflating by 13%. The small difference could be explained by the positive effects on liquidity demand of being the largest trading partner of the expanding United States. Since the beginning of 1997, when the process began, the bigger difference shows up on the stock exchanges. The DJIA is up 38%, with the TSE up only 16% in US$ terms.
In a May 28, 1998 interview, BOC governor Gordon Thiessen repeated many outdated academic cliches that contradict recent objective evidence, stating "Monetary policy autonomy requires a flexible exchange-rate regime." Yet in this instance, while his arguments are obsolete, his policy is correct, partially shielding the Canadian economy from the deflation that more rigidly linked monetary systems such as Hong Kong’s confront. With Canadian governments not lowering those tax rates that discourage capital formation, which would cause an increase in demand for liquidity, there is little Thiessen could do but allow the Canadian dollar to slide against the U.S. dollar. There are some who argue that increasing Canadian interest rates would increase the demand for Canadian currency permanently by increasing the relative yields on CA$-denominated debt. If this policy were adopted, it would be short-lived. The rate increase may indeed lead to a temporary increase in the value of the Canadian dollar relative to other currencies, but it would not last, as it would lead to recession. John Crow, BOC’s previous governor, carried out just such an experiment in early 1990, indeed bringing about a recession as a result. Once he abandoned the experiment, the Canadian dollar sank.
The only way permanently to increase the value of the Canadian dollar relative to the U.S. dollar would be to lower taxes significantly. Such policy change is not even under discussion at the moment. None of the political parties operating on the federal level has significant tax-reduction on its platform. And even if one party does eventually adopt such a platform -- because the costly consequences of high taxes are now accumulating rapidly -- Canada will not have anything resembling the U.S. fiscal structure in the foreseeable future. The only likely near-term boost in the currency’s value could come if prices of Canada’s natural resource exports were to increase dramatically. Even then, the rise would be temporary. A permanent rise would require tax cuts or a Federal Reserve reversal of its deflation, permitting the U.S. dollar gold price to rise toward the $350 level -- which would take the Canadian dollar back to US75¢.
Thus, the differential that now exists between U.S. and Canadian income and capital gains taxes cannot long persist without compounding negative consequences, as the much lower U.S. rates have drawn, and will continue to draw away, too much top-tier Canadian talent and investment. The differential will get much bigger if the U.S. Congress succeeds this year in cutting the top capgains rate to 15%, with Canada’s effective capgains rate ranging close to 40% in some provinces. The different performances of Canada's higher- and lower-taxed provinces will also become more evident. American investors who are tempted to assume Canada will soon replicate the more attractive tax structure of the U.S. -- as has happened at times in the past -- will be disappointed in the short run. For the foreseeable future, Canada will reserve a greater role for government and more-redistributive policies than the U.S., not only because of the loss of internal accountability discussed above (which will take time and great effort to restore), but also because of additional features unique to Canada and its political institutions which we discuss below.
Natural Riches, Human Talent, and Politics
In part, Canada also has been suffering from the government-spending illness typical of nearly every resource-rich country. Only governments able to extract rents from natural resources (or other sources) can "generate" increased riches while disavowing the contradiction between high taxes and prosperity. Canada has a population of 30 million in a vast land endowed with oil, forests, gold, nickel, water, and spectacular landscape. The resource extraction industries comprise 42% of exports and about a third of the TSE is resource-based. In such countries, people too easily confuse "riches" for "prosperity," with devastating long-term consequences. (Similar dynamics have been observed in the past in Spain, Mexico, Argentina, Venezuela, and Zaire.)
The 1960s ramping-up of Keynesian spending without cost accountability could not have taken place if Canada were not resource rich. In places lacking natural resources, such as Taiwan and Hong Kong, wealth must be produced by brainpower before it can be redistributed. If such human talent were not retained, attracted, and effectively mobilized, there quickly would be no wealth to redistribute. Thus, in a world competing for brainpower, the economies that impose significantly lower taxes and offer more open capital markets prevail. Indeed, beginning in 1984 Canada experienced the brief "Hong Kong effect," as thousands of nervous Hong Kongers moved to Vancouver to obtain alternate citizenship before the Chinese takeover. This influx has since ended, as most now rationally choose Chinese political risk over Canada's 55% marginal income tax rate and 40% capital gains tax. With, say, $500,000 annual income and no capital gains, one saves about $200,000 per year under Hong Kong's flat 15% income tax (a $2 million net present value discounted forward at 10%). Chinese talent and money is turning tails, and Vancouver real estate is slumping. (The provincial policies of B.C.'s socialist premier, Glen Clark, were no help.)
In fact, from the 1950s until roughly a decade ago, Canada, as one of the world’s dozen-or-so politically stable nations, attracted talent from many countries as citizens fled communism or other dictatorships. For these refugee-newcomers, even the increasing taxes of Western democracies provided incentives relative to the systems they abandoned. The rents from these two sources -- natural endowments and the migration of human talent -- helped counteract accumulating Keynesian fiscal mistakes. Unfortunately, this compensation helped delay Canada’s coming-to-terms with its policy errors, as it has obscured the reality that a country can not tax heavily, redistribute wealth, fix wages and prices (as in the ill-conceived energy program, for example) and still prosper. Correlation is easily confused for causation -- especially when it serves political interests.
Canada’s delusion probably reached its peak with the Montreal Expo of 1967. What else but collective folly could explain the uncontested political decision to host the event on islands built for the occasion in the St. Lawrence river? Reclaiming lands makes sense in Holland and Hong Kong, two of the world’s most densely populated places -- but in empty Canada, the most thinly populated country? Admittedly, ambitious ideas were in vogue during the 1960s. If the U.S. could work to put a man on the moon, certainly other governments could pursue lesser glories -- making islands, building dams, and building a "Just Society" in Canada like the "Great" one under construction in the U.S. The fact that the moon does not change its course in response to human action, whereas masses of people adjust to changed incentives was out of sight and mind.
The breathless optimism that accompanied those programs has since dimmed as the costs of accumulating mistakes has compounded and as the inflow of talented people to Canada reversed with the fall of worldwide communism and passage of significant tax reduction in the U.S. There were, though, minor periods of apparent prosperity along the way, each one slowing the realization among Canadians that they were falling significantly behind their U.S. neighbors. One was the temporary increase in resource prices at the beginning of this decade. Between 1981 and 1990, Canadian resource commodity prices had been falling in line with the U.S. dollar’s strengthening against gold in the Reagan years. But in the period 1990-94, as the U.S. gold price rose to a $385 plateau from several years at $350, that trend reversed and commodity prices rose by an average of 20%. Wheat gained 39%, lumber 54%, nickel 43%, and oil 20%. As mentioned above, these industries make up about two-fifths of Canada's exports; the price rise led to a turnaround in Canada's current account balance, as well as in federal and provincial tax revenues. Expectations gradually formed that the higher prices would last, "because of increased Asian demands" according to one line of thought. This was the sole "positive" factor driving even the relatively unimpressive TSE performance this decade. Of course the turnaround did not last. Commodity prices have plummeted by more than 20% during the last year, dragged down by the excessively strong U.S. dollar -- with gold deflating to $285, collapsing global commerce.
Thus Canada in 1998 faces a moment of truth. Over the course of a generation the electorate has grown accustomed to government largesse while its government has lost all internal accountability. As a result the country is stuck with high taxes, extensive commitments, and a crippling outflow of top talent while immobile administrative personnel stay. Growth increasingly relies on external demand rather than internal dynamism.
Canadian Democracy: Constitutional Inertia
It is reasonable to expect in a healthy civic democracy that such entrenched political-economic pathologies as Canada’s would be recognized, discussed, and acted upon. Why then hasn't Canadian democracy corrected its mistakes? This question especially nags given Canada’s proximity to the U.S., where taxes have been lowered with unimpeachable success during the nearly two decades since President Ronald Reagan first revived the notion of supply-side economic regeneration.
As noted, part of the answer lies in Canada's natural resource endowment. Another is that Canada’s constitutional framework features fewer checks and balances than does that of the U.S. (Otherwise the legislation that sidelined Ottawa’s fiscally accountable institutions almost certainly could never have passed.) Even more important is the entrenched lack of political entrepreneurialism in the Canadian legislative process. This is not because the Canadian Senate is a powerless institution. It is because MPs at both federal and provincial levels must adhere to party lines far more closely than do U.S. legislators, due to parties’ power to punish stray lawmakers, with campaign procedure and finance. Once elected, U.S. congressmen often vote independently; accountability to voters rather than pressure to toe the party line serves as a reality check. Coalitions can even form between different fragments of each party to defy the established leadership and its bias toward the status quo. The absence of such features in Canadian democracy, legacy of its British heritage, prevents consequential debate and perpetuates mistaken policies long beyond when the U.S. would have abandoned them.
Thus, whereas in the U.S., topics such as tax reform, flat taxes, and IRS reorganization are regularly given serious attention, in Canada governments get away with paying them mere lip service. They frequently set up Commissions on Tax Reform, but oblivious to the very notion of supply-side stimulus, they then stack the deck by mandating that any recommended tax cuts be compensated for, in zero-sum fashion, by tax increases elsewhere. The latest such study -- on Canadian corporate taxes, finished this year by two academics from the University of Toronto (Jack Mintz and Thomas Wilson) -- is now collecting dust alongside all the previous others. It garnered one day’s mention in the financial press, with the federal government distancing itself even from the report’s mild tax-reduction recommendations.
Political rigidity has far more painful long-term consequences for Canada than similar sclerosis would have, for example, in Europe. The reason is that most of Canada lives within easy commuting distance of the U.S. and except for Quebec, Canada's culture is not significantly different from that of the U.S. (notwithstanding attempts by Ottawa's Ministry of Culture). Thus, Canada's best and brightest more easily can realize their ambitions in the far less taxed and far more open U.S. economy, while the rest of Canada's institutions continue in blissful rigidity. Meanwhile, the less-mobile Canadians that remain fall farther and more hopelessly behind.
The role of what late historian Jonathan Hughes called the "vital few," whom Canada is now losing quickly, is indispensable. Prosperity is significantly diminished by their loss, as the hangers-on cannot alone attract substantial financing -- although they could be organized into efficient teams worthy of investment if competent managerial talent remained. The outflow leads to mediocrity in politics as much as in business. Uniqueness attracts financing, and uniqueness brings about debate. This key point is under appreciated in both business and politics. As it is crucial in understanding the unspectacular prospects for both Canadian public policy and asset values, we examine it in greater detail below.
The "Vital Few" in Business
Even if more people were immigrating to Canada than leaving, the demographics would be useless without some assessment of the productive quality of those entering versus those leaving. Individuals matter: One Michael Jordan restores a sports team to commercial health, a James Cameron produces a movie of Titanic commercial proportions, a Conrad Black builds a media empire, or an Eisner-Katzenberg-Wells triumvirate creates more than $20 billion in market value for Disney within a few years. Individuals create wealth for countries just as they do for corporate shareholders. Thousands of immigrants over a generation might not establish any significant commercial enterprises on their own, yet they may perform brilliantly in concert under talented leadership. Market statistics clearly support this: The loss or gain of an individual CEO or CFO often effects share prices within minutes after its public announcement. Statistics on migration patterns simply do not recognize losses or gains according to this real value measure. Note the following examples:
- (1) When Walt Disney died in 1966, profits at his company stood at record levels, with 6 films released that year and $24 million invested in Disneyland’s expansion. From 1967 to 1972, the stock continued to perform well, the people in the company continuing on the road set by Walt Disney, completing Orlando's DisneyWorld in 1971. A $100 investment on December 15, 1966 would have grown to $1,390 by December 1972 (versus $178 for the S&P 500 stock index).
However, between 1973 and 1984, the stock declined. In 1983 the company produced only three movies, none successful. A $100 investment in Disney on December 31, 1972 was worth $58 by September 1984, while a similar investment in the S&P 500 would have grown to $241. After a takeover threat by Reliance Group, a new management team was brought in, consisting of Frank Wells (who died a few years ago in a helicopter crash), Jeffrey Katzenberg (now a partner at SKG Dreamworks, the Spielberg/Geffen/Katzenberg studio venture) and Michael Eisner (still CEO of Disney). From September 1984 until June 1993, this team increased Disney's market value by $22 billion. This meant that a $100 investment in Disney in September 1984 grew to $1,258 in June 1993, versus $364 for the same investment in the S&P 500 stock index.
- (2) Or consider Coca-Cola. Roberto C. Goizueta was a penniless but well-educated Cuban immigrant when he arrived in the U.S. He became the CEO of Coca Cola in 1981, a time when Coke was, while omnipresent, floundering, with a market value of "only" $4 billion. Coke was not growing, and the company was mixed up in non-core businesses from shrimps to wine. Goizueta liquidated these distractions, refocusing the company around its trademarks and soft drinks. When Goizueta died last October the company was valued at $150 billion.
- (3) Grasping how fear of making mistakes prevents innovation, William McGowan, CEO of MCI, pushed a policy of enlightened decentralization. McGowan gave his employees great freedoms and discretionary initiative (with the understanding that uncommercial ideas would eventually be dropped). The company held regular focus groups to develop consumer-friendly products and approaches. At higher management levels, similar meetings addressed another set of questions: What do you wish you had done a few years ago to get where you would like to be now? Could it have been done then? How? Can it now?
When Mr. McGowan was suddenly hospitalized, the company tried to keep the development secret, fearing a drop in the stock price. Yet when a journalist finally did reveal the story, the market did not budge.
Share price stability in the cases of Goizueta’s recent death and McGowan’s illness does not indicate indifference to these individuals’ talents. Rather, such cases suggest the leaders effected credible succession plans. At Coca-Cola, Mr. Goizueta often referred to his #2 executive, Douglas Ivester, as his "partner." Warren Buffet, who owns 200 million shares of Coca-Cola, said that "Mr. Goizueta's greatest legacy is the way he so carefully selected and then nurtured the future leadership of his company." The fact that the stock price of Coca-Cola did not fall on the news of his death means the company was expected to stay on course under his successor.
- (4) The stock market reactions to the appointments and resignations of Christopher Steffen and George Fisher at Eastman-Kodak demonstrate the value of individuals in a different way. Steffen was announced as Kodak’s new CFO at 8:15 AM on November 1, 1993. By market close that day, the stock had risen 7.8% from the previous day’s $41.75, a change in total market value of about $1 billion. When Steffen resigned three months later, the stock dropped to $47.25 from $52.38 -- a loss of $1.7 billion. In October the same year, George Fisher was named both CEO and chairman at Kodak. The stock jumped from $58.75 to $63.75, adding $1.6 billion. Traded volume was much higher than on average on all these days. Though during the last year, the Kodak stock dropped significantly with still Fisher at the helm, signalling to the company that while Fisher might have been good for solving some problems, he might not be good when he had to deal with other problems.
- (5) Los Angeles based Jefferies has emerged as the most aggressive underwriter in the high-yield debt market in the past decade, its stock price rising from $18 in January 1995 to $70 in October 1997. The firm achieved this status by hiring a core group that had previously worked with Mike Milken (Business Week last November featured a piece entitled "Jeffries Picks up Where Milken Left Off"). Jeffries has the lowest default rate of the big high-yield underwriters: 1%, vs. 10.8% for Donaldson, Lufkin & Jenrette. It was the movement of skilled people, trained by Milken at ill-fated Drexel, that set the stage for this success.
While the above examples tell somewhat different stories, each demonstrates the market’s facility in discounting not only for the talents of individuals, but also for their ability to inspire others, organize teams, and inculcate lasting corporate cultures. While the notion comes off as somewhat elitist, market movements reflect the real economic value of the "vital few." There is no clearer illustration of this than in professional sports, the only industry that actually lists star performers and teams on corporate balance sheets. The year before Larry Bird joined the Boston Celtics, the team won 29 games and lost 53; they won 61 in his first year and took the NBA title the next. In 1984, before Michael Jordan joined the Chicago Bulls, attendance was 260,000. In Jordan's first year it jumped by more than 80% to 487,370, and to 736,934 in 1989.
Taxes and the Brain Drain
In recent interviews, a number of Canadian CEOs have stated bluntly that they moved from Canada because of its high taxes and inability to attract talent. Peggy White, CEO of Royal Oak Mines, says her firm left because "high Canadian taxes made it very hard to attract top-notch talent from outside the country and sometimes even to keep top-notch talent home." The CEO of McCain Foods, one of the largest Canadian conglomerates, observes: "Our income tax is too far out of whack with the U.S. We can't handle that indefinitely. We can't afford to be in Canada." And Chris Laubitz, principal at Caldwell Partners, Canada's major headhunting firm, laments he cannot hire talent from abroad.
Gaylen Duncan, president of the Information Technology Association of Canada stated that "We steal from places like Eastern Europe and Asia, while the U.S. steals from us," adding that Canadian firms are losing senior people, but importing only juniors. Keith Parsonage, senior official at Industry Canada acknowledges that "we are definitely losing some of the best and brightest." Don deVoretz, a Simon Fraser economist, found that in the mid-1980s Canada lost about 2,700 managerial and professional emigrants to the U.S. each year. By the mid-1990s that number was 13,600. In a 1997 survey of 826 information technology companies, 44% said they had to postpone projects because of inability to recruit highly skilled personnel. Some 37% hired less-qualified personnel, and 15% relocated operations, often to the U.S., to retain talent. The companies also confirmed why Canadians firms and individuals flee: higher pay, significantly lower taxes, and the fact that critical masses of on-the-edge talent are only found in the U.S.
It is not just the tax rates that matter, but the thresholds at which they kick in. The top marginal Canadian rate on income, 54%, does not compare particularly unfavorably with the U.S. 40% given Canada’s provision of public health insurance. But a U.S. citizen can earn up to US$250,000 before the top rate kicks in. In Canada, the 54% rate hits at CA$50,000 in depreciated Canadian dollars, or roughly US$40,000. The rate is almost dizzily progressive because neither mortgages, provincial taxes, nor any other local taxes can be deducted from gross income to determine taxable income, as in the U.S. When politicians and statistical bureaus compare tax regimes, they tend to compare only rates and emphasize that the difference between the Canadian system and others covers health care costs and represents a premium on Canada’s "better quality of life." But when the highest rates apply at such low incomes as they do in Canada, it means that Canadians have a far smaller chance to accumulate wealth -- and less incentive to try. Entrepreneurial capitalism is being smothered in the process, which means men and women with an entrepreneurial impulse head south to have any chance to satisfy it. Little wonder that gambling has become so popular in Canada. It is the only way for the vast majority of Canadians to sustain hopes of getting rich without emigrating -- and, unlike the U.S., prizes are not taxed.
Few Canadians have the drop-dead looks, legs – no obstacles to success those - and also brains of those two internationally well-known Canadian journalists: Barbara Amiel (now Black, Conrad Black's wife), and Marie-Josee Drouin (now Kravis, Henry Kravis' wife), both writing on Canadian affairs the first from London, the second, from New York, her column titled "National Viewpoint" for the Toronto-based Financial Post. Now that's "globalization."
Envy thrives in high-taxed countries, though usually disguised under platitudes about "fairness" and "justice." [It is no accident there is no apparent envy toward Canadian star Celine Dion, although she earns more per year than most Canadian CEOs. Dion’s success jibes with the implicit Canadian belief that it is acceptable to get rich by exploiting "natural resources" -- which is what a rare voice is. But to grow wealthy through ambition and business acumen is painted as wrong.] In Canada, because governments control 50% of spending in the economy, acquiring wealth comes to be viewed as a matter of favoritism or political connections rather than talent. The few who manage to nurture and sustain their ambition against such onerous disincentives eventually either relocate abroad or rationalize tax evasion. But success on a national level requires the participation of these entrepreneurs and the teams inspired by them, both in economics and in national discourse. When they exit, the whole quickly ceases to perform. Once they are gone, it is hard to attract back critical masses of talent even if taxes are lowered.
The "Vital Few" in Politics
As in business, the role of talented individuals is equally decisive in politics. In the worst cases, the loss of top quality political leadership can touch off chronic national downturns. Canada is in danger of slipping into just such an intractable decline. Though the comparison may seem thick, Canada, with its largely state-run economy, displays much of the vitality-subverting dynamic that afflicted the Soviet Union.
The pattern was established early in the life of the Soviet state by Lenin and Stalin, neither of whom arranged for a proper succession. To the contrary, they both wiped out the competent people around them out of paranoia, replacing them with non-threatening mediocrities. Under the threat of death or life in the gulags and mental institutions, Russia's talented people opted not to jeopardize themselves, resigning themselves to lives of sad, safe obscurity. Nikita Khrushchev was the first product of this system to rise to the top. He was neither educated nor intelligent, though energetic enough to commit one devastating domestic and international blunder after another. The Politburo, fed up with Khrushchev’s mistakes, threw him out in 1964 -- only to replace him with a second mediocrity, Leonid Brezhnev. There were no better choices; good thinkers were purged at lower levels or cowed long before reaching senior positions. Reflecting the system that formed them, successors Yuri Andropov and Konstantin Chernenko, too, displayed only rigid political orthodoxy and typical career-bureaucratism.
Only the urgency of political and economic near-bankruptcy motivated Mikhail Gorbachev to face down the inertial bureaucracy that protected the USSR’s geriatric leadership. However, by then it was too late. Hastened into real bankruptcy by Reagan's "Star Wars" missile-defense program and awed by the supply-side economic boom in the U.S., the fabric that bound the old Soviet empire disintegrated in a flash. This generally happens when companies or governments lose access to credit.
With its best and brightest avoiding politics for business or even moving to the U.S., the quality of Canadian political leadership has witnessed its own creeping mediocrity for the last ten years, as illustrated in the provinces by former Ontario Premier Bob Rae and current BC Premier Glen Clark, both dogmatic socialist anachronisms. Rae and Clark each increased taxes significantly, passed a wide variety of regulations, and increased spending. Premier Mike Harris of Ontario only now is slowly dismantling Rae’s mistakes. [If Quebec is still doing comparatively well -- although pretty badly in absolute terms -- it is in part because many talented people have stayed, preferring the risks associated with the province’s separatist movement to the shortcomings of Rae's drastic socialist experiment. Another reason fewer Quebec citizens migrate, of course, is the linguistic and cultural divide.] On the federal level, Canada produced the likes of Kim Campbell, Jean Chretien, Paul Martin, and Sheila Copps, each about as bold, inspiring and discerning as the geriatric Soviet leadership of the last four decades of communist rule.
This trend toward mediocrity in Canada's political life, combined with inelastic party discipline and the loss of accountability, explains all too easily both the disappearance of serious policy debate and the constantly increasing federal taxes. In the provinces, only Alberta, and recently Ontario have generated the political creativity to attempt diminished spending and taxes but as we noted above, these tax cuts are minimal. There simply is no national level public discourse acknowledging that the key to Canada's long-term success lies in restoring government accountability at all levels. How long this pattern continues will depend on the speed at which the best young minds leave the country without putting up a fight. And why would they stay, with a more open U.S. only a half hour south? Until then, only external, accidental events provide any measure of relief. Increased U.S. or Asian demand for natural resources benefits the extractive industries but helps sustain the present rigidity and the political establishment presiding over it. If other countries attempt their own disastrous political experiments, they may push a few talented emigres to Canada's shores.
The performance and accountability of political institutions is a key consideration in pre-investment due diligence. Institutions and privileges, whether constructive or wasteful, take on lives of their own, creating interest groups who fight tooth and nail for the status quo. If a country puts significant resources at stake in ultimately ineffective institutions (or denudes the effective ones as in Canada’s case) and there are no mechanisms to reverse mistakes before interest groups coalesce, the market rationally reacts. In such an environment, stocks should perform poorly relative to places where mechanisms exist to insure speedier policy corrections. Historian Barbara Tuchman once wrote that history is full of people who, after a point, could not change and then lost everything, as we saw in the USSR. With its present tax regime, Canada is on its way. Like the former Soviet Union, Canada may not face the need for change until it faces bankruptcy. Unfortunately, it’s too rich in resources for that to happen anytime soon. The price of oil goes up, explorers stumble on diamonds, and, push come to shove, Canada can always cut a few more trees and start selling its stock of clean water. Once accountability was lost in Ottawa, and by now so many depending on money flowing through the federal and provincial governments, one would need a combination of devastating external shock and a Margaret Thatcher to restore the country to accountability. (Recall, Thatcher came to power when the UK fell way behind other countries – and it isn’t resource rich).
Don’t hold your breath.
In the business-world examples provided previously, mistakes were corrected relatively quickly. In the politics world, though, responsiveness to failure is a less brutal, less effective cleansing process. Mistaken commercial ventures cannot survive long because mistakes cost money, and a company will have access to finance at harsher and harsher terms as they accumulate. False ideas in the policy sphere can survive longer and even become dogma because governments have the power to tax as well as to promote rationalizations in national discourse. Subsidizing what governments call "culture" is just one way of achieving this goal. Having ministries of education and subsidizing universities -- while sliding former political office-holders into influential academic positions -- is another. Canada does all of these with a vengeance. Eventually, the emptiness of such dogma becomes unavoidable with the realization that it does not get the economic-financial principles right. But this can take a very long time. Communism, under carefully cultivated substandard leadership, survived 70 years. Canada, with its 50/50 mix of socialism and the market, could survive much longer in resource-subsidized-mediocrity, with mediocre wealth creation reflected in mediocre stock market returns.
As noted, Canada is not the only resource-rich country where such debilitating dynamics evolved. We have seen similar phenomena again and again in Argentina, Venezuela, and Mexico for example -- each endowed with abundant natural resources. Bordering the U.S., with the world’s most open financial markets and among the West’s lowest taxes, is no guarantee Canada will follow the U.S. example. Mexico, too, shares a border with the U.S. and has been a democracy on paper for many decades, yet where is its prosperity?
Taxes: the Devil in the Details
As discussed previously, Canada’s yield curve structure vis-a-vis that of the U.S. suggests, encouragingly, that there are no market inflationary expectations. It would be doubly encouraging if this reflected broad confidence that the BOC learned lessons on inflation from the U.S. monetary experience, or that the electorate rejected specious Phillips curve justifications of inflationary policies. In fact, Canadian governments simply have a fiscal incentive to keep inflation low. Since 1985, under a system of partial indexing of brackets and tax credits, inflation must be more than 3% before triggering bracket adjustments. Maintaining inflation just below that trigger rate has allowed governments an estimated $20 billion tax-grab per year. (Furthermore, the basic personal and married credits have not been adjusted for inflation since 1992. The basic personal exemption is about CA$6,500. Had it been fully indexed since 1988, it would be CA$7,480.)
Calculating the marginal income tax in Canada is a complicated affair. Here is a ballpark calculation: For all provinces and territories except Quebec, provincial taxes add onto federal tax as a multiple (called "Basic Tax Rate") of the applicable federal rate. For example, the marginal federal rate for the CA$29,590-59,180 income bracket is 26%. British Columbia's "Basic Tax Rate," is 51% (of the federal rate in that bracket), or just more than 13% of income. Thus the marginal tax rate for a BC resident in the sample income bracket is 26%+13%, or 39%. In the top (29%) federal bracket, the combined marginal rate in BC is 44%.
However, in addition to this rate, each province has introduced its own fiscal "innovations" under various names. There are "Provincial Surtaxes" on the top of the "Basic Rates," varying from Manitoba’s low of 2% to a high of 30% in BC, thus putting the marginal tax in the latter example at 53%. Other provinces have "Provincial Flat Taxes" in addition to the "Surtaxes." Factoring in all such supplementary revenue sources, the top marginal tax rates across Canada range from percentages in the low 40s as in Alberta, to the 50s in British Columbia. In centrist Quebec, the top marginal rate approaches 54%. One of the province’s latest surtaxes (0.3%, introduced in 1997) is not even called a tax. In a feat of rhetorical obfuscation, the separatist Parti Quebecois decided to call it "Funds for the Fight Against Poverty by Retraining for Re-entry Into the Labor Force." One wonders where did all the other money go.
Further complicating the picture, Quebec's mandarins decided, in the name of provincial sovereignty and distinction, against using the other provinces' simpler tax-computation formula over established federal income brackets. The federal government defines four tax bracket categories. Quebec has five. The zero Federal rate is for income to CA $6455. The tax rates start at 17% for incomes of CA$6,456-29,590. Quebec's tax rates are 19% for CA$7,000-14,000, 21% for CA$14,000-23,000, and 23% for CA$23,000-$50,000. The top Quebec rate, 24%, starts at this point. Added to (not a multiple of) the 29% top federal tax, this gives a 53% combined top marginal rate, but that is without considering various surtaxes on "the rich" -- which in Canada has come to mean those with incomes of approximately US$40,000! And remember, there are neither mortgage deductions, nor tax deductions from one level of government to the next.
Canadian taxes must be considered in contrast with those in the U.S., its competitor for human talent, where one stays at the 28% marginal rate until reaching an income of $100,000 (on joint returns), not moving to 39.6% until $271,050. There are no joint returns in Canada. It was no shock to Polyconomics when, during the production of this report, the May 11 Canadian edition of Time published the cover story, "Brain Drain: Canada's Best and Brightest Are Feeling a Pull from the South. What Can Be Done About It?" The title misleads. They are not "feeling the pull," they are already gone. The article’s most startling illustration of the differential between Canada and the U.S. is its computation of each country’s "Tax Freedom Day," the calendar date after which people’s income stays with them rather than going to governments. In 1981, Canada's tax freedom day was May 30, vs. May 4 in the U.S. By 1997, it was June 30 in Canada, and May 9 in the U.S. This difference will get worse before it gets better because these numbers do not even take into account the significant U.S. tax reductions last year. These include not only the eight percentage point cut in capital gains taxes, to 20%, but also the Roth IRA savings account allowing tax-free interest and dividends on deposits up to $2,000 annually. Individual states have also been lowering tax rates in a wide variety of ways.
The term "income tax" is a misnomer, as it in fact taxes returns to human capital. Financial capital is driven-off and discouraged from entry by the same onerous confiscatory burden as human capital. The big difference is that financial capital can be assembled only from the after-tax returns on human capital. Canadians of ordinary means thus carry a double burden relative to the U.S. in trying to achieve wealth through entrepreneurial enterprise. They are first taxed at high rates on their work, which means it takes longer to accumulate a stake for a start-up enterprise. Then the enterprise has to grow larger without external equity help, because the capital gains tax to outside equity if the enterprise succeeds is so much higher in Canada. To use a horserace metaphor, the Canadians are burdening its horse with a heavier jockey than the U.S. horse and are taking twice as much out of the purse -- 40% compared to 20%.
If the Republican U.S. Congress this year succeeds in bringing its capital gains tax rate to 15%, the difference will be greater and the exodus of talent and financial capital from Canada will accelerate. Canadian capital gains taxes are relatively simple to calculate: one pays the tax fitting one's income bracket -- but only on 75% of the sums gained. This means that if capital gains were, say, $1,000, and one was in the 50% tax bracket, one pays $375, or 50% of $750. That's about double the U.S. rate; little wonder, then, that entrepreneurial ventures are not getting financed in Canada. Increasingly, the capital gains tax differential will put more ownership of Canada in American hands, as U.S. investors -- taxed at the U.S. rate -- at the margin will have greater incentive to risk capital on Canadian enterprise than will Canadians.
False Language, False Ideas
Before any robust, sustained financial market recovery is possible, the policy ground must be prepared through a reassessment of the basic assumptions underlying Canada’s fiscal system. Yet, while many Canadians intrinsically sense the economic malaise caused by their tax-and-spend government (the ones who vote with their feet, for example), the broad electorate have not awakened specifically to the Keynesian folly brought to devastating life. And without explicit grass-roots pressure, Canada’s self-interested policy elites can be expected to hang on to the old paradigm. The Keynes-inspired whiz kids hired in the 1960s and 1970s are today's senior bureaucrats in their mid-to-late 50s and 60s. Finance Minister Paul Martin, a member of that generation, talks about reducing debts and balancing budgets (he has little choice), yet still declares repeatedly that he regrets not being able to finance great new programs. Under this continuing paradigm, there is no doubt Martin would spend any surpluses and oppose tax reduction.
The policy elite are supported by "academic" and "objective" studies that appear regularly ranking Canada high among the countries of the world. The United Nations places the country first in terms of some impractical definition of living standards – as high-ranking Ottawa's politicians never fail to trumpet. Even the methodology and implications of ostensibly private-sector studies, which have recently ranked Canada as "the best for costs of business," invite skeptical scrutiny.
A seven-nation study conducted in 1997 by the Canadian office of KPMG Peat-Marwick, for example, ranked Canada ahead of the U.S. and five European countries as the lowest-cost industrialized country in which to do business. The fact that the report was underwritten by Canada’s Ministry of Foreign Affairs & International Trade should raise suspicions as to its value. The fact that it ranks Sweden second raises additional suspicions (it ranks Britain 3rd, the U.S. 4th, Italy 5th, France 6th, and Germany last). Trade Minister Sergio Marchi is on record as having said he wants "to use the study to sell the benefits of investing in Canada." According to the report, 17 of the top 20 (out of 42 examined, cheapest on top) -- are Canadian.
The report, which compared the costs of locating businesses in various cities, found "Canada has significant advantages as a result of low land prices and construction costs." It also lauds Canada for having among the lowest labor costs, electricity prices and telecommunications fees, as well as the lowest corporate income-tax and interest rates. However, Canada would lose its cost advantages versus the U.S., comes the depreciationist warning, if the Canadian dollar (hovering near US70¢) were allowed to strengthen back above US83¢. KPMG has it all wrong and upside down, yet another example of how Canadian political image-management is postponing Ottawa’s difficult day of reckoning. It is useful to review critically the points made in the report to make it clear where Canadian policy delusion continues.
The accounting costs of doing business are irrelevant to commercial decisions. It is expected returns that matter. If after-tax returns are lower elsewhere, then the costs of doing business in Canada can be low, yet no one will invest. If labor seems "cheap," for example, it is because the authors of the report are comparing apples with oranges. Those with the greatest skills and ambition either cannot be attracted, have already left, or cannot be expected to put in the same level of effort as they would in a less-taxed environment.
The KPMG report uses as a proxy for the quality of Canadian workers the country's expenditures on education, which at 7.4% of GDP stands out at the highest among sampled OECD countries. That number, of course, is another meaningless statistic. Throwing money at education does not mean that human capital is being developed. And if one is educated, it does not imply that individual economic actors will put to use what they have learned. Consider Russians under communism, a highly educated people. Yet they brought their intellect to bear only after communism fell, many by then in Israel or the other countries to which they emigrated, rather than the one that invested in their education. The lower pay employers offer in Canada reflects lower expectations of worker knowledge and productivity among those who stayed behind. (A recent CIBC Wood Gundy report calculated that whereas ten years ago Canadian factories were about 5% less productive than their U.S. counterparts, the discrepancy now stands at approximately 20%.)
If business opportunities depended on low land and labor costs, everyone would invest in Newfoundland. Indeed, in the KPMG report, St. John's, Newfoundland is rated the least expensive place -- 10% cheaper than what KPMG presumably mismeasured as the U.S. urban average. Yet the study does not even raise this question as to why corporations hardly flock there.
People or shareholders pay rents with after-tax dollars. The price of a building is simply the present value of anticipated rents. The smaller the after-tax rewards, the smaller the value of the building, and the smaller will be the value of land and of construction costs. One recalls the calculations being made in 1989, when it was reckoned that the dollar value of real estate in Tokyo was higher than the dollar value of all the real estate in Canada. The comparison no longer holds, of course, as Tokyo real estate values have steadily declined as the government increased land taxes and capital gains taxation on real property. The point is that Tokyo was where the world wanted to be, at that time the global center of capital formation. To boast about cheap land prices is to advertise something is wrong, that this is not the place to expect high returns on capital investment. The decline in Canadian real estate values occurred partly because provincial governments shifted the tax burden from income to property taxes -- downloading on municipalities, which by law cannot run deficits. And property cannot pack its bags and emigrate.
Thus the loss of real estate values, which for many Canadians has been their main savings, is another signal of the deteriorating situation in Canada. In the U.S., on the other hand, the value of savings in stocks exceeds that of real estate. More than any other factor, this change has created a strong constituency in the U.S. that will elect pro-growth politicians. In Canada, the high property taxes prevent the emergence of a pro-growth electorate. This is another reason not to expect the TSE to catch up anytime soon with the U.S. stock markets.
KPMG and Canadian economists both contend that the low Canadian interest rates will bring about a "boomlet." This conclusion confuses cause and effect. When there is not much demand for investment, interest rates stay low, as recently demonstrated in Japan. Hence the 2% spread between Canadian lending and borrowing rates, vs. about 3% in the U.S. Of course, with lower interest rates, people will finance more durable goods purchases and spend less on less-durable items. But that's all it is -- substitution.
Lastly, KPMG mentions that Canada has the lowest corporate taxes. By now one would have expected that a firm of KPMG's reputation understood that corporations do not pay taxes. Corporations are complex webs of contracts between investors, entrepreneurs, managers, employees, and customers or clients. Corporate income tax will be paid by one of these stakeholders. Which one(s) depends on the parties’ relative mobility. Taxes may be passed along to the Canadian consumer in the form of higher prices. Or backward, either to workers (in the form of lower wages) or owners (lower dividends). When the financial backers of companies can no longer shift this burden, and consider the after-tax dividends or capital gains insufficiently high to compensate them for their risks, they disinvest. Corporate taxes are thus a matter of paper definition. Who really pays them is an entirely different story and it is the least mobile who usually pay. Investors are the most mobile, being able to withdraw their capital to an abundance of alternate investment destinations. Today there are more such fiscally hospitable havens than ten years ago, before the fall of communism and the emergence of new political stability in Latin America and Asia (despite recent currency upheavals).
Thus, Canada’s lower labor costs, lower cost of land, and lower construction costs compared to the U.S. are a reflection of Canada's destructively high income and capital gains taxes -- not a sign that Canada is a wonderful place to invest.
* * * * *
China’s sage Confucius wrote more than 2,000 years ago that "Good government obtains when those who are near are made happy, and those who are far off are attracted." Unfortunately in Canada, politics and fiscal folly have caused the opposite, increasing misery for those who are near, driving many away, and repelling "those who are far off." That these policy errors were born of good intentions in an era more optimistic about government power to drive human progress can no longer excuse Canadian policymakers from tough reforms. The key lies in returning the country to a dynamic of private sector-driven growth: divesting massively wasteful state enterprises; lowering income taxes to provide incentive for personal wealth accumulation through productive activity; and reducing capital gains taxes to increase returns on the investment of after-tax personal wealth in capital stock. Economic empowerment will also require the reconstruction of fiduciary responsibility in government and freeing the political process to allow lawmakers to respond to the electorate’s collective wisdom.
The urgent need for these reforms is best addressed now, while the U.S. post-cold war boom, in full stride, continues to benefit North America. But if not, changes will still have to be made later -- at the point of near-bankruptcy and after the complete exodus of Canada’s top human talent. How ironic that Confucius’s home country, "communist" China, has significantly lowered central tax collection as a percentage of GDP (to 11%) in the two decades since Deng Xiaoping began reforms, and under current leadership is progressing with large-scale state enterprise divestiture. With the Chinese state’s share of the total economy down from effectively 100% to about 60% today, versus Canada’s 50%, it will not be long before the two nations’ lines cross. Only if Canada undertakes a supply-side fiscal rebirth such as the one that has revitalized the U.S. -- and slowly attracts back and retains talent -- will it avoid assuming the mantle of the world’s largest socialist economy and prevent a repeat of the Soviet Union’s economic fate. Only with these changes can investors in Canada finally expect to harvest the returns that have eluded them since the 1980s -- with the greatest returns accruing to those who see it coming first.
Reuven Brenner is a partner in Match Strategic Partners. Dr. Brenner also holds the Repap Chair at McGill’s Desautels Faculty of Management. For more information on Dr. Brenner, please consult his bio.
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