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The Canadian dream is thriving, except for one big blind spot

To be a Canadian is to live in a dream world, my Mediterranean friends tell me.

They are awestruck by Canada's growth, sinking unemployment rates, non-punitive taxes, rising house values and seemingly endless job opportunities for university grads.

In Italy, for instance, youth unemployment is 33 per cent and living with your parents is the norm, because the jobless can barely afford a cappuccino, let alone rent. Ten years after the financial crisis, Italian house prices are still falling.

Their amazement about all things Canadian is largely justified, for Canada has been a razzle-dazzle performer in recent years. Between 1995 and 2016, Canada's average gross domestic product growth rate was 2.4 per cent - higher than that of any other Group of Seven country.

In December, Canada's unemployment rate was 5.7 per cent, the lowest in more than four decades. Job creation is at its strongest level since 2002. If you own a detached house in central Toronto or Vancouver, there's a good chance you are a paper millionaire.

What could go wrong? Lots to, be sure, but few of the potential pitfalls that economists, analysts and investment geeks blather on about is unique to Canada. Sure, a decade of ultracheap money has created what looks like housing and stock market bubbles - bubbles are never proven until they burst.

Sure, rising interest rates could trigger all sorts of nastiness, from defaults on the debt held by overleveraged borrowers to hellishness in the $400-trillion (U.S.) - notional amount - bubbling away in the over-the-counter swaps market.

Canada, however, does have some peculiar risks that, added together, would paint a gloomy picture for the economy.

One of the biggies is the North American free-trade agreement and what U.S. President Donald Trump will do to alter it. Under no scenario will the revised NAFTA work better for Canada than the current version. At best, the Trump-edition NAFTA will be mildly damaging to the Canadian economy; at worst, NAFTA will cease to exist, with catastrophic consequences to the economy. Forget the World Trade Organization and the new Canada-EU trade agreement; Canada's main trading partner is the United States and that will not change. The two economies are essentially fully integrated. Some car parts, for instance, cross the border six or seven times before final assembly.

Mr. Trump is placing ridiculous demands on Canada and Mexico, such as the insistence that all cars exported to the United States contain a minimum of 50 per cent U.S.-made parts.

While Mr. Trump, as a businessman, must instinctively know that scrapping NAFTA would damage a lot of American manufacturers and exporters, he is volatile and mercurial. Anything is possible. This week, he told the Wall Street Journal "I think [terminating NAFTA] would be frankly positive for our country" even if he insisted that renegotiation talks are "moving along nicely."

Certainly, his administration has been no slouch in slapping hefty tariffs on key exports. The near-300-per-cent tariffs on Bombardier's C Series jet so threatened to cripple Bombardier, Canada's premier engineering company, that it handed the entire project to Airbus for one dollar.

Mr. Trump's new tax plan does not bode well for Canada.

The posted U.S. corporate tax rate will fall from one of the highest in the Western world (35 per cent) to one of the lowest (21 per cent). The new rate will deal a blow to international tax arbitrage and will no doubt encourage Canadian, Mexican and other foreign companies to relocate to the United State or expand their American subsidiaries. Canada's federal corporate tax rate, at 15 per cent after abatements and other reductions, is still competitive but far less so than it was before Mr. Trump's landmark tax legislation (provincial rates of 11 per cent to 16 per cent come on top of the federal rate).

But NAFTA's overhaul, or disappearance, and low U.S. tax rates are not the greatest threat to the Canadian economy. The greatest threat over the long term is perennial lack of innovation. "Studies undertaken over many years by research groups in Canada and abroad reveal that Canada's innovation performance has been lamentably poor," Andrei Sulzenko wrote in an analysis of Canadian innovation, or lack thereof, published in 2016 by the Institute for Research on Public Policy.

Taxation isn't the problem - Canadian corporate tax rates have dropped substantially. Nor is profitability. Canadian companies, relatively speaking, are more profitable than their U.S. equivalents. You could blame the oligopoly status of some big Canadian industries, such as telecommunications and financial services. These industries have been so fat and happy that innovation has never been a top priority. But the world is becoming more competitive by the day and Canada can no longer afford to be an innovation laggard.

Too bad the Canadian government's innovation policies, while improving, are still inadequate. There is no flow-through share scheme for Canada's lifesciences startups, though there is for junior mining companies (flow-through shares pass the companies' tax losses onto shareholders, effectively reducing the net cost of the investment by 50 per cent). The feds are sitting on about $3-billion (Canadian) of offset credits from U.S. defence contractors. The money could be used to fund innovation but has yet to be deployed.

Canada has had a great run, making it the envy of the Western world. A slowdown in growth is inevitable. You could blame Mr. Trump, but Canada's shabby innovation record is also at fault.

Associated Graphic

Pedestrians walk along Sparks Street in Ottawa in March of last year. Canada's economy has been a top performer lately, but the world is becoming more competitive by the day.


© The Globe and Mail

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