Policy’s role in innovation and productivity –necessary but not sufficient
Canadian business has only been as innovative as it needs to be
Policy shortcomings are often blamed for Canada’s long-term decline in productivity growth, but do they adequately explain the destructive trend? That’s the provocative question recently posed by Andrew Sharpe and Stephen Tapp1 in an authoritative, evidence-rich investigation, covering almost six decades of Canadian policies aimed at promoting productivity. Here, in the authors’ words, is the paper’s conclusion:
“Over the past half century, Canada’s labour productivity growth has slowed dramatically, falling from 3.7 per cent annually in 1947–73 to less than 1 per cent since 2000. Our analysis suggests that successive Canadian governments have generally pursued relatively market-oriented, pro- productivity reforms — such as liberalizing trade, delivering a stable, predictable inflation environment, modernizing and cutting taxes, and investing in human capital — yet productivity growth continued to falter. The main drivers appear to be declining technological progress and inadequate business investment, not an absence of policy effort. We conclude that, while new policy reforms are desirable and worthwhile they are unlikely to deliver a major revival of Canada’s long-term productivity growth.”
The purpose of the present note is to provide further context for, and some implications of, the conclusion of Sharpe & Tapp by positing ‘why’ Canada’s weak productivity growth has consistently resisted policy solution. Most current discussion of the conundrum lacks historical perspective, leading to several faulty diagnoses and consequently to a relatively unproductive debate as to what might realistically be done.
To begin with a cold dose of historical perspective, consider the following observation by the Lamontagne Senate Committee in its monumental 1970 report, A Science Policy for Canada (a principal focus of which, even then, was Canada’s shortcomings regarding innovation and productivity growth):
“Since 1916, the main objective of science policy has been to promote technological innovation by industry…. Almost every decade since the 1920s has witnessed renewed attempts by successive governments to achieve it but, on the whole, they have all failed. What progress has been made results almost exclusively from the initiative of industry itself.” (Volume 1, p 111)
The Lamontagne Report—essentially the equivalent of a Royal Commission—led to many policy and program initiatives but, as Sharpe & Tapp demonstrate, those and others that have followed have not led to the anticipated improvement of the innovation and productivity performance of Canadian business. This is perhaps to be expected in light of the observation more than 50 years ago by V.O. Marquez, then the CEO of Northern Electric (the forerunner of Nortel), based on his experience on the front lines of technology-based business in Canada.
“It is uncertain whether any incentive plan to stimulate the growth of domestic technology and innovation, or to make corporations expand aggressively into foreign markets, can deliver significant success when applied to companies in which the drive to do these things has not already been forced to emerge because of exposure to a real stimulus from the economic environment.” (Building an Innovative Organization—Wanted: Small Catastrophes; Business Quarterly, 37(4): p40-47, 1972)
Of course, government programs in the form of tax incentives, direct subsidies, and various other pro-innovation policies do provide a “real stimulus from the economic environment” of which government itself forms a significant part. But evidence covering many decades demonstrates that government stimulus has not been sufficient to shift Canadian business out of its “low-innovation equilibrium”. While one could always argue that the stimulus has simply been insufficient, Sharpe & Tapp demonstrate that Canada’s innovation-productivity policy mix compares favourably with that of peer countries and has, by and large, followed the consensus advice of growth economists and policy research groups like the OECD and IMF.
Here’s the paradox. If innovation is good for the bottom line—because it leads to cost efficiency and new products, and thus to profitable growth—why does Canadian business, on the whole, continue to be an innovation laggard by peer group standards?2 While an individual company can get its strategy wrong, and suffer the market consequences, the same cannot be said for the entire business sector extended over decades. It follows that the low-innovation behaviour of the “average” Canadian business must be a commercially rational response to the specific circumstances that have prevailed in this country over decades. I believe that three have been most influential.
The first follows from Canada’s comparative advantage in a North American market integrated with the world’s technology leader for close to a century. Canada’s business response from the start has been, in effect, to trade commodities for technology -- illustrated by our persistent trade surplus on resource commodities and a mirror image deficit on advanced manufacturing—and to host US branch plants in the more technologically sophisticated and innovative sectors. In short, we have outsourced innovation to Uncle Sam. That’s comparative advantage at work.
The second incentive—affecting primarily banking, transportation, telecom, cultural industries, and certain agricultural products—arises from Canadian ownership/control regulations that directly or indirectly protect very significant parts of the economy from the full impact of the innovation-stimulating effect of foreign, largely US, competition. Restrictions on interprovincial trade have had a similar but less significant effect.
The third, and most compelling incentive for sustaining the low-innovation status quo, is that it nevertheless continues, on average, to be profitable—e.g., the chart illustrates strong growth both of business revenue and profit margin.3 So, where is the motivation to change a formula that appears to be working? While one might hope to do better, that would require developing new capabilities and new markets, which would inevitably bring new risks. For most, the status quo has proven to be the easier course. Moreover, Canadian business cannot re-engineer its skills and deeply embedded habits overnight; or at least not without the motivation of a truly existential crisis, as it may now face (see below).
The result of these persistent marketplace factors is that Canadian business has been only as innovative as it has needed to be. Plainly, that is much less innovative and entrepreneurial than most outside observers—pundits, consultants, academics, and politicians—believe is necessary if business itself, and the economy at large, are to prosper going forward. Despite having heard these warnings for decades they have gone largely unheeded by the business sector. Consider this quotation from the Lamontagne report 55 years ago:
“…we consider the 1970s a transitional period. But Canada has already reached the crossroads. Major decisions cannot be delayed. This nation may choose to maintain its passive attitude toward emerging world trends, let the secondary manufacturing sector of its economy gradually deteriorate, and rely mainly on the rapid depletion of its resources…to sustain growth. In the short term, this is the easy way….In the long run, however, that choice will almost inevitably lead to an economic dead end that only annexation to the United States could delay.” (Volume 2, p 607)
More than a half-century later the sky has not fallen. But are we finally approaching the end point feared by Senator Lamontagne and his colleagues? Consider two scenarios.
In the first, American economic isolationism persists, and even intensifies, after Donald Trump departs the scene. To date, the effect on Canada of US tariffs has been muted by the carve-out for most products that comply with the free trade agreement (with important exceptions such as steel and aluminum.) A more aggressive isolationism would feature cancellation or sharp pull back from CUSMA, new tariff protections, and imposition of a broad range of “Buy America” preferences, all with the objective of import replacement wherever possible and notwithstanding the economic cost to the US itself. That would upend the commercial environment to which Canadian business has successfully adapted over a century. It would represent an existential threat that could finally jolt business out of its low-innovation equilibrium in a desperate attempt to win new markets.
But the transition to circumstances in which the share of Canada’s exports going to the US fell from three-quarters to, say, a third would be enormously disruptive during the many years it would take to largely unwind what a century of economic integration has knit together. Prime Minister Carney’s trade diversification objective to double Canada’s non-US exports over the next ten years would only reduce the US share to about 60% - 70% by 2036, depending on the overall growth rate of our exports. This pace of diversification would not nearly offset a determined US effort to replace imports from Canada with domestic production. We might wonder how a long and painful adjustment transition would influence shorter-term sentiment in Canada regarding economic, or even political, annexation by the United States as the only way to avert the “economic dead end” that was warned of by Lamontagne.
The second, and in my view more likely, scenario is that post-Trump America will turn away from aggressively isolationist policies, at least not directed against its traditional friends. Quite apart from the material benefits of (relatively) free trade, the outcome of America’s geopolitical rivalry with China will depend on strengthening its alliances and no alliance is more natural than with Canada. American economic self-interest would still pose challenges for particular sectors of our economy, as it always has, but commercial and geopolitical logic would likely result in the US favouring even tighter integration with Canada over the medium term.
Under these circumstances, Canadian business would not feel existentially challenged immediately. But as the United States continued to forge ahead technologically, particularly in applications of AI, the pressure on the bottom line of Canadian business would continue to intensify. This would be the case whether in the presence of closer integration, or in the alternative where Canadian business sought to diversify its exports and was forced to become more innovative and productive in order to do so. The point is that geopolitical and market forces, more than any government initiatives, would serve as the prime motivator for Canada’s business sectors to become more innovative, productive, and globally competitive.
While Canada cannot expect to exceed the US economically, neither can we afford to fall too far behind, as we have been doing. This country certainly has the human and physical resources to narrow the present productivity and per capita income gaps, and it must. Government policy in respect of science, technology, and innovation will play an important role. But our history demonstrates the limits of government’s ability to determine the long-term productivity growth trajectory of the economy. National and global market forces, amplified by technological change, are more influential than the domestic policy mix.
The risk in stating this conclusion so bluntly is that it may induce a fatalism—a belief that there is little or nothing that we can do collectively to set our economic course. That most definitely is not the case. Pro-growth policies are absolutely necessary. Today, more than ever, they need the new impetus that the Carney government is urgently seeking to provide via a focus, for example, on resource development, public infrastructure, and AI.
That said, Andrew Sharpe and Stephen Tapp have contributed importantly to a more mature understanding of both the potential and limits of innovation-productivity policy. The essential message of their analysis is that if we expect government to provide the silver bullet that will overcome Canada’s innovation and productivity shortcomings, we will be disappointed. To avoid disillusionment we must be realistic. The behaviour of business is what determines the innovation and productivity trajectory of Canada’s economy and history has shown that business behaviour has been shaped primarily by market forces combined with our unique adjacency to the United States. So, what does it now mean that our adjacency has suddenly become an existential vulnerability? It means that many of our key business sectors must become more innovative, more productive, and more competitive—fast. In this they will need support. That’s why in these unprecedented circumstances government policy and business strategy must act more closely in concert than has recently been the case. There has never been greater opportunity, and necessity, for policy in support of innovation and productivity to have decisive impact.
Sharpe and Tapp are respectively Emeritus Executive Director and CEO of the Centre for the Study of Living Standards.
To assert that Canadian business is not innovative is a generalization that has many exceptions. Even as a generalization, it is only true when compared with most of Canada’s peer group of economically advanced countries; and notably the US.
Source: StatsCan Table 30-10-0500-01. Data are for non-financial corporations.
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