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PUBLIC POLICY SOURCES Number 37 Productivity and Economic Performance An Overview of the Issues Marc T. Law Contents Executive summary...............................................................................................................3 Introduction.......................................................................................................................... 5 Growth accounting: determining the sources of economic growth ............................................ 6 Empirical growth accounting: what do the data tell us?........................................................... 10 Growth theory: the causes of economic growth....................................................................... 12 Productivity growth and economic performance in Canada..................................................... 17 What next? Prospects for policy and research ......................................................................... 24 Appendix 1 The algebra of growth accounting .................................................................... 27 Appendix 2 An overview of recent policy papers on productivity .......................................... 28 References ........................................................................................................................... 32 About the author ................................................................................................................. 36 Acknowledgments ................................................................................................................36 A FRASER INSTITUTE OCCASIONAL PAPER Public Policy Sources is published periodically throughout the year by The Fraser Institute, Vancouver, British Columbia, Canada. The Fraser Institute is an independent Canadian economic and social research and educational organ- ization. It has as its objective the redirection of public attention to the role of competitive markets in providing for the well-being of Canadians. Where markets work, the Institute’s interest lies in trying to discover prospects for improvement. Where markets do not work, its interest lies in finding the reasons. Where competitive markets have been replaced by government control, the interest of the Institute lies in documenting objectively the nature of the improvement or deterioration resulting from government intervention. The work of the Institute is assisted by an Editorial Advisory Board of internationally renowned economists. The Fraser Institute is a national, federally chartered non-profit organization financed by the sale of its publications and the tax-deductible contributions of its members, founda- tions, and other supporters; it receives no government funding. 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The author of this study has worked independently and opinions expressed by him are, therefore, his own, and do not necessarily reflect the opinions of the members or trustees of The Fraser Institute. Editing and design: Kristin McCahon and Lindsey Thomas Martin Printed and bound in Canada. ISSN 1206–6257. PUBLIC POLICY SOURCES, NUMBER 37 Executive summary One of the most hotly debated policy issues in After surveying the relevant literature and exam- Ottawa these days is whether or not Canada has ining the empirical evidence, I find that Canada’s a productivity problem. The official line of the productivity performance has indeed been poor. federal government is that Canada does not have In particular, the data reveals that Canada’s pro- a productivity problem. Politicians at the highest ductivity growth has been among the worst in level of the country have stated publicly that the OECD since the 1970s. Moreover, Canada is they think that Canada’s productivity perform- the only G-7 country to experience negative pro- ance has been satisfactory. But, studies released ductivity growth during the period from 1979 to by several organizations—including the Organi- 1996. As a result, real income per capita has stag- sation for Economic Co-operation and Develop- nated: during the 1990s, Canada’s per-capita in- ment (OECD), the Centre for the Study of Living come dropped from third to ninth place among Standards, and even one of the federal govern- OECD countries. This is why Industry Canada ment’s own ministries, Industry Canada—have and other observers believe that Canada has very made the opposite claim, that Canada does in- poor productivity. deed suffer from very poor productivity and, without major improvements here, Canada’s liv- While there is much disagreement about the ing standards are in jeopardy. productivity statistics themselves, it cannot be that Canada’s poor productivity performance is This study provides a non-technical overview of simply “measurement error.” In this study, I dis- the issues surrounding the debate about produc- cuss the problems associated with productivity tivity and discusses why productivity growth is measurement and find that Canada’s poor pro- essential if Canadians want a high and rising ductivity is not merely a statistical artifact. standard of living. Productivity refers to the effi- While the rapidly growing services sector may ciency with which an economy transforms in- have resulted in Canada’s productivity growth puts (capital and labour) into outputs (goods and being underestimated, this cannot explain Can- services). A more productive economy requires ada’s poor productivity performance relative to fewer inputs to produce a given amount of out- other OECD countries—in particular, the Unit- put. Most economists would agree that growth in ed States—that have also experienced growth in productivity—being able to produce more with the service sector. In addition, Canada’s manu- less—is necessary for increases in per-capita in- facturing productivity growth has been the come over the long term. Developed countries weakest among G-7 countries. The annual are wealthier than Third-World countries pre- growth rate of output per hour in Canada’s cisely because they are more productive. Esti- manufacturing sector from 1979 to 1996 was 1.8 mates suggest that productivity growth accounts percent a year while the growth rate in the G-7 for one-quarter to one-third of the increase in was 3.2 percent a year. This is cause for serious real living standards in the period since World concern, for the theoretical and empirical litera- War II. It is for this reason that productivity ture supports the view that manufacturing pro- growth is the cornerstone of economic growth ductivity growth has important spill-over and wealth creation. effects for the economy as a whole. The Fraser Institute 3 Productivity and Economic Performance PUBLIC POLICY SOURCES, NUMBER 37 To date, little attention has been given by re- dustrialized countries. For one thing, Canada’s searchers to examining the policy issues sur- current tax structure is not conducive to the accu- rounding the productivity debate. Nonetheless, mulation of inputs of higher quality—more pro- it is clear that if advancing the standard of living ductive machines and equipment and more of Canadians is indeed the objective of govern- highly educated personnel. There is growing ev- ment policy, then the role of the state is to pro- idence that high marginal tax rates on personal vide an institutional environment that is and capital income have imposed large dynamic conducive to the creation and diffusion of new efficiency losses on the economy. Additionally, knowledge and new technologies—the very many studies suggest that, in the absence of sig- sources of productivity growth. This, in turn, re- nificant reductions in personal income-tax rates, quires an institutional framework that rewards Canada will lose many of its best and brightest individual effort and entrepreneurial activity. innovators to the United States. Hence, a neces- While Canada is a nation with fine institutions, it sary ingredient in an economic policy that will is becoming increasingly clear that without cer- encourage the growth of productivity is a reduc- tain reforms—in particular, tax reform and more tion in marginal tax rates on personal and capital deregulation—Canada will fall behind other in- income. Productivity and Economic Performance 4 The Fraser Institute PUBLIC POLICY SOURCES, NUMBER 37 Introduction Recently the economics of productivity has be- measurement: the reliability of our current meas- come a hot topic among Canadian politicians and ures of productivity are suspect given the poor policy-makers. Evidence of a growing gap be- quality of our data. Hence, increasingly, econo- tween Canadian and American per-capita in- mists have