Closing the Productivity Gap between Canada and the United States

The last decade has been a prosperous one for Canada: the resource sector is booming and the fortuitous avoidance of an American-style financial crisis conspired to make our middle-class the wealthiest in the world, according to the 2014 Luxembourg Income Study.

Canada’s success seems to suggest that relative differences in labour productivity growth are not necessarily indicative of improving living standards, at least in the short-run. Following the 2008 recession, for instance, American firms laid-off their least productive workers and labour productivity spiked: average per-employee contribution to output increased even as total output fell. In Canada, higher prices for goods produced in our country raised incomes independent of productivity gains.

In the long-run, it is much clearer that productivity growth is the primary means of raising real purchasing power. Trade terms rise and fall, however, fundamental innovations in technology, the division of labour, and organizational structure imply greater prosperity without reference to exchange rates. If American labour force participation fully recovers, for example, productivity gains will be much slower as new hires cause the trend to revert to its mean. In other words, while short-run demand fluctuations and statistical artifacts garner the most media attention, closing the Canada-United States productivity gap means addressing structural issues in a serious manner.

Studies analyzing productivity gaps have placed blame on a variety of different sources: weak demand growth, industry composition, capital intensity, information and communication technologies uptake, and taxation structures. The central limitation of these studies is that their focus is too narrow.  A Bank of Canada study, for instance, found the average size of smaller firms in Canada to depress productivity. Yet, without a meta-effort to relate the findings in that study with others, firm size can only be a proximate, as opposed to ultimate, explanation.

In The Wealth of Nations, Adam Smith begins the third chapter with his famous maxim that the extent of the market limits the division of labour. His point was that a smaller market decreases the potential for specialization and, therefore, gains from trade. Contemporary research shows that market size constrains productivity, firm concentration (and, by association, size and innovation), and the scope of technology transfers, among other things. The Canadian market is much smaller than is the case in the United States or the European Union, despite serious efforts to integrate economies through free trade agreements. Even with bilateral trade agreements between Canada and the United States, intangible border effects–known as “gravity”–suppress the gains from trade. Indeed, Canada is the quintessential case, since the “gravity equation” literature flourished after John McCallum’s 1995 estimate that two Canadian provinces were roughly twenty times as likely to trade with another province as any of the 50 states in the United States.

Canada’s small market is made all the worse by internal barriers to trade. The best effort at quantifying this problem in the Canadian context to date is “Internal Trade and Aggregate Productivity: Evidence from Canada” by Trevor Tombe and Jennifer Winter of the University of Calgary. They find that internal trade costs are 30 per cent on average, net of physical distance. They further estimate that eliminating internal trade barriers would increase aggregate labour productivity by over 8 per cent and close the Canada-United States productivity gap by half. Historical examples, such as the productivity gains from the EU’s common market harmonization, make these estimates believable.

The good news about this explanation is that it means closing the productivity gap between Canada and the United States is eminently possible. The bad news is that, as with so many supply-side problems, the main constraint is political in nature. Reducing barriers between provinces requires convincing premiers to sign a new internal trade agreement, which in turn means having each premier simultaneously do battle and win against the incumbents that stand to lose. And with the resource boom masking the wage effects of lower productivity, present prosperity threatens to undermine the full seriousness of the issue under negotiation.

Samuel Hammond is an AIMS on Campus Student Fellow who is pursuing a graduate degree in economics at Carleton University. The views expressed are the opinion of the author and not necessarily that of the Atlantic Institute for Market Studies

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