Brenner   Wall Street Journal   02-Jan-1998   Canada's best talent leaves the country
Just as Canada plunders Ukraine, it in turn is plundered by the United States.  Ukraine can learn from the lesson of Canada: to keep brains, one must invest in research and development, and one must not tax away the fruits of labor.
How Canada Scares Away Investors and Talent

The Americas
By Reuven Brenner

In a recent seven-nation study, KPMG Peat Marwick ranked Canada as the lowest-cost Western industrialized country in which to do business.  The study ranked Sweden second, Britain third, the U.S. fourth, Italy fifth, France sixth and Germany last.

Unfortunately for Canadians, being a low-cost country does not mean that their economy is competitive or that it is a good place to invest.  If low cost is the criterion for investment, why not invest in Newfoundland, land of low incomes and low rents?

In October, Canadian Industry Minister John Manley hit upon the more important factors for investment, economic growth and price stability, noting in a speech that a shortage of skilled workers prompts companies to leave Canada.  He also noted that although Canada is one of the biggest spenders on education, it experienced the lowest rate of productivity growth among the G7 countries in the last 15 years, has low research and development spending, and hosts a smaller share of high-tech manufacturing than any other G7 country.

The financial markets confirm these observations, as does the performance of the Canadian dollar.  The Dow Jones Industrial Average has more than tripled since 1989, whereas the Toronto Stock Exchange average increased just 70%.  After adjusting for the 20% depreciation of the Canadian dollar since 1989, the return on the TSE in U.S. dollars between 1989-1997 falls to less than 50%.  Much of the small gain in the TSE is based on a recent pickup in commodity prices, reflecting Canada's resource-based economy.

Meanwhile, the Canadian dollar stays low while the country has record surpluses in the current account of its international balance of payments (whereas the U.S. has continuous deficits).  The current-account surplus merely reflects the fact that Canada is not a good place to invest, and capital both top-notch human and financial is leaving the country.

One of the main reasons is high marginal tax rates.  In Canada's most populous provinces, Quebec and Ontario, the combined marginal income-tax burden (federal and provincial) for earners in the $40,000 range stands at 55%.  This punitive rate in fact taxes human capital, as demonstrated by the fact that Canada's best talent leaves the country.  A number of CEOs have stated bluntly that they moved from Canada because its high taxes limited their ability to attract talent.  As Peggy white, Royal Oak Mines' CEO, says: "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 emphasis is on "top-notch."  Canada can attract the not too ambitious or those denied entry visas to the U.S.  But the "vital few" those who can move a company's market value by hundreds of millions of dollars, or, as Michael Jordan, bring a team form oblivion to championship matter the most.  This is the talent that Canada has been losing and fails to attract.

Canada taxes capital gains at approximately 40%, double the U.S. rate for investments held over 18 months.  If untaxed, a $1,000 investment compounding at 20% brings $1.4 million after 40 years.  If that investment is taxed yearly at 20%, the U.S. rate, the owner ends up with around $400,00.  If it is taxed at 40% the net return is 12% per annum, and the owner ends up with $93,000 after 40 years.  Even the best ideas will not find financial backing with this differential in returns.

With brains and capital moving out of Canada, only finance ministers indulging in political calculations can claim surprise that trade surpluses have not strengthened the Canadian dollar.  Nor that low interest rates neither brought about much investment or significant decreases in unemployment (which has been holding at a stubborn 9% to 10%).

This punitive rate in fact taxes human capital, as demonstrated by the fact that Canada's best talent leaves the country.

When businesses decide where to locate in the G7 countries, they are measuring their ability to attract and retain skilled people to countries whose currencies are expected to be stable.  If Canada's labor seems "cheap," that's because the authors of the KPMG report are comparing apples and oranges.  A recent CIBC Wood Gundy study calculated that Canadian factories are 20% less productive than their U.S. counterparts.  It is not surprising that Canadians are paid less.

The KPMG Peat Marwick study also celebrates Canada's low land and construction prices.  But the price of a building is the present value of anticipated rents.  The smaller the after-tax rewards, the smaller the value of the building, and the smaller the value of land and of construction costs.

Low interest rates are not the issue, either.  When there is not much demand for investment, real interest rates stay low (see Japan).  No wonder the spread between lending and borrowing stands at about three percentage points in the U.S., and only two percentage points in Canada.  Of course, with lower interest rates, people may change consumption patterns, buying more durables and fewer goods and services of immediate consumption.  But the substitution does not make them richer.  The smaller demand for funds to be invested in Canada means that the future does not hold great options.

Last, but not least:  The KPMG report mentions that Canada has the lowest corporate-income taxes.  Since corporations are only a complex associations of contracts, any corporate income tax is of consequence only in the sense that investors will evaluate who will pay it: consumers in higher prices, employees in lower wages, or shareholders.  Even low corporate income taxes will be paid only if investors cannot negotiate a better investment deal elsewhere in the world.  Taxes on dividends, on capital gains and on incomes are the issue, not the incidence of taxes based on legal entities.

Some of Canada's provinces Alberta, for example have cut provincial taxes.  In Ontario, the new provincial government tries to dismantle its disastrous fiscal and regulatory inheritance from its predecessor, Bob Rae.  But on the federal level the situation does not seem promising.  With no effective opposition, and forecasts that next year the federal government may have a surplus in the budget, Paul Martin, the federal finance minister, who never saw a tax he did not like, announced in an October speech how the government will spend the anticipated "fiscal dividend."

The U.S. will be pleased to hear that it is among the major recipients:  One of the contemplated programs would spend an additional $800 million subsidy to higher education, which will train, no doubt, some excellent people who will end up working in the U.S.

Mr. Brenner is a professor at the School of Management, McGill University, Montreal.