Asset-based Financing, Investment and Economic Growth in ...€¦ · business or person to qualify on generated cash flow rather than on a net worth lending formula basis as typically

The Centre for Spatial Economics Assessing past, present and future economic and demographic change in Canada

Asset-based Financing, Investment and Economic Growth in Canada

Prepared for:

Canadian Finance & Leasing Association 15 Toronto Street, Suite 301 Toronto, ON M5C 2E3

Prepared by:

The Centre for Spatial Economics 15 Martin Street, Suite 203 Milton, ON L9T 2R1

December 15, 2004

Abstract This report examines the linkages between the financial services sector, productivity and economic growth. The authors review the evidence that investment, particularly in machinery and equipment (including vehicles), is a principal driver of long-term productivity gains and economic growth. The research conducted in this report finds that financial services development, including for the first time asset-based financing, raises investment. The research also finds that financial systems support gains in living standards beyond those associated just with the higher investment. Asset-based financing makes a significant positive contribution to increasing national living standards. The authors conclude that government policies should support financial market choice and innovation. The authors go on to note that tax policies that encourage business investment in machinery, equipment and vehicles will boost productivity and help create the economy Canada needs in the 21st Century.

About this Report This report was prepared by The Centre for Spatial Economics, a consulting organisation created to improve the quality of spatial economic and demographic research in Canada. The report was sponsored by the Canadian Finance & Leasing Association (CFLA) to examine the links between investment, growth and asset-based financing.

The authors wish to thank Dr. Jack M. Mintz, President and Chief Executive Officer, C.D. Howe Institute and the Deloitte & Touche LLP Professor of Taxation, Joseph L. Rotman School of Management and Jim Stanford, Canadian Auto Workers union economist for their many helpful comments on earlier drafts of this report. The authors accept all responsibility for any remaining errors or omissions. The views in this report reflect those of the authors and do not necessarily reflect those of the CFLA or its member companies.

Questions or comments about this report can be sent to:

Robin Somerville Director, Corporate Research Services 905-337-3855 rsomerville@c4se.com

Robert Fairholm Director, Canadian Forecast Service 416-346-2739 rfairholm@c4se.com

The Centre for Spatial Economics 15 Martin Street, Suite 203 Milton, ON L9T 2R1 telephone: 905-878-8292 fax: 905-878-8502 web: www.c4se.com

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Who is the Canadian Finance & Leasing Association (CFLA)? e CFLA is the only organisation advocating the interests of the asset-based financing, vehicle and uipment leasing industry in Canada. The Association's 250-plus members range from large ultinationals to national and smaller regional domestic companies, crossing the financial services ectrum from manufacturers' finance companies and independent leasing companies, to banks, surance companies, and suppliers to the industry. The customers of this industry are Canadian all, medium and large businesses as well as consumers.

nding for this industry comes from commercial markets, notably from pension funds, insurance mpanies and banks. In addition, well-capitalised manufacturing and servicing companies with bstantial earnings have decided to leverage their own equity base and core competencies rather than ing third parties. This has led to many manufacturers establishing their own financing arms or rtnering with those who manage it for them. Many CFLA members fall into this category.

What is Asset-based Financing? fter the traditional lenders (banks and credit unions), the members of the asset-based financing dustry are the largest providers of debt financing in this country. About 60% of the industry’s stomers are estimated to be small and medium-sized businesses.

ccording to the 2004 Annual Survey of Asset-Based Financing and Leasing in Canada, the asset-sed financing industry’s portfolio of assets (owned and managed) was estimated to be worth $116.7 llion in 2003. The value of assets under management by equipment finance companies is estimated be $67 billion. The value of the consumer vehicle leasing portfolio is estimated to be $39.7 billion ith an additional $9.9 billion in commercial vehicle leasing.

February 2004, Statistics Canada reported that machinery and equipment investment intentions for 04 are estimated to be $84.5 billion. Between 20% and 25% of annual new investment in achinery, equipment and commercial vehicles is financed by the asset-based financing industry.

sset-based financing is the financing of equipment, vehicles and related assets by way of specific set-based priority financing, that is, the financing of particular equipment and vehicles and related ms or services, primarily by way of lease, but also by secured loan or conditional sales contract.

e specific assets financed secure the borrower's unconditional obligation to make payments over e term of the agreement. In this way, users of equipment and vehicles can use the value of the asset security to finance its acquisition. This form of financing relies on cash-flow-based credit analysis. cause the financing company retains legal ownership of the asset until lease end, it allows a siness or person to qualify on generated cash flow rather than on a net worth lending formula basis typically offered by traditional lenders.

e services of the asset-based financing, equipment and vehicle leasing industry are complementary traditional banking and other financial lending in providing incremental capital to increase the pool available credit in Canada and provide a vital competitive alternative in the financial services ctor.

Table of Contents

EXECUTIVE SUMMARY .......................................................................................I

ASSET-BASED FINANCING, INVESTMENT AND ECONOMIC GROWTH........1

INVESTMENT AND ECONOMIC GROWTH ........................................................3 Neoclassical Model ................................................................................................................................... 5 New Growth Theory ................................................................................................................................ 9 Empirical Evidence ................................................................................................................................ 12

PRODUCTIVITY AND CANADIAN LIVING STANDARDS ................................15 Labour Productivity Decomposition .................................................................................................... 20 Canada in an International Context..................................................................................................... 23 Productivity and Employment .............................................................................................................. 27 Concluding Remarks on Productivity and Investment....................................................................... 29

FINANCIAL SYSTEM DEVELOPMENT AND ECONOMIC GROWTH..............31 Theory ..................................................................................................................................................... 31 Evidence .................................................................................................................................................. 32

ASSET-BASED FINANCING .............................................................................34 Current Industry Structure .................................................................................................................. 35 Origins of Asset-based Financing ......................................................................................................... 36 Trends in Financial Innovation............................................................................................................. 36 Global Asset-based Financing Profile................................................................................................... 38 Canadian Leasing Market ..................................................................................................................... 43 Small Business and Leasing................................................................................................................... 46

FINANCIAL SYSTEM DEVELOPMENT, INVESTMENT AND GROWTH: EVIDENCE FROM THE INTERNATIONAL DATA.............................................52

Indicators of Financial Development and Investment ........................................................................ 53 Asset-based Financing’s Contribution to Living Standards in Canada in the 1990s ....................... 59 Concluding Remarks ............................................................................................................................. 61

GOVERNMENT POLICY AND ECONOMIC GROWTH .....................................63 Tax Reform Options .............................................................................................................................. 65 Productivity and Tax Reform ............................................................................................................... 71

REFERENCES ...................................................................................................74

Appendix A: Growth Theory..................................................................................................................... 81

The Centre for Spatial Economics

Appendix B: Physical Capital and Long-term Growth: Studies Based on OECD Countries.............. 82

Appendix C: Benefits of Leasing............................................................................................................... 83

Appendix D: Model Specification ............................................................................................................. 85

Appendix E: Asset-based Financing’s Economic Impact........................................................................ 87

Appendix F: The Canadian Multi-Sector Model ..................................................................................... 89

Asset-based Financing, Investment and Economic Growth in Canada Page i

Executive Summary Banks, brokerage houses, insurance companies and various other financial services organisations are a major component of Canada’s economy. Countless millions of financial transactions take place every day in Canada. While it is easy to see how important they are in every-day life, it is much harder to measure the benefits they confer in terms of economic growth and prosperity.

The Canadian Finance & Leasing Association (CFLA) sponsored this report to examine the relationship between equipment investment, economic growth and asset-based financing. This summary provides some of the highlights from that research; interested readers are encouraged to consult the remainder of the report for more information.

Key Findings Investment drives productivity – economic research states that machinery and

equipment investment directly contributes to labour productivity gains by increasing the amount of productive capital available for workers to use. Research also suggests that machinery and equipment investment is either directly the agent of technological change, or else an important facilitator in the diffusion of new technology.

Productivity raises living standards – in order to boost living standards either labour productivity needs to rise, or people need to work harder, or more people need to become employed, or more people of working age need to enter society relative to total population. Canadian living standard gains rely primarily on labour productivity growth.

Financial system development promotes investment – research conducted by the OECD1 supports the notion that financial system development promotes capital spending and that countries with weaker financial systems are unable to effectively channel domestic or global savings towards new investment opportunities.

Asset-based financing adds significantly to the financial system – the analysis in this report finds that asset-based financing was responsible for a 2.3% increase in Canada’s living standards over the decade 1992 to 2002 (or about 8% of the total increase in Canada’s living standards over that decade). Asset-based financing makes a significant positive contribution to increasing national living standards.

Policy Implications Financial innovation – financial choice and innovation need to be encouraged in order

to maintain a healthy and growing financial system. A dynamic financial system is one of the key factors in promoting investment, raising productivity and, therefore, improving our standard of living.

Tax policy – government policy in Canada does not encourage investment in machinery and equipment to the degree that the economic research suggests would be optimal. Therefore, a strategy of improving the economic climate for machinery and equipment investment should pay significant dividends in terms of stronger economic growth, higher productivity and living standards for Canadians for many years to come. This could be done in a horizontally equitable manner by encouraging all forms of investment spending because of the potential complementary nature of machinery and non-machinery investment in boosting economic growth and productivity.

1 The Organisation for Economic Co-operation and Development (OECD) is an international economic research institute with 30 member countries.

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Investment and Productivity “It is becoming increasingly evident that certain forms of investment matter much more for growth compared with others. In particular, equipment investment has a significantly positive and robust association with growth”2

Over the past 20 years there has been an explosion of theoretical and empirical research that examines the relationship between investment, productivity and economic growth. The major current economic theories agree on the central importance of investment and capital accumulation to economic growth. Some of this research focused on broad measures of physical capital, of which machinery and equipment investment is an important part, while other research examined machinery and equipment investment specifically.

In a series of studies, De Long and Summers explored the relationship between machinery and equipment investment, long-term economic growth and productivity to see if there were positive spillovers from machinery and equipment (M&E) investment. They concluded that the return to society of equipment investment is large and exceeds the private return. They found that increasing the M&E investment share by one percentage point could increase long-run productivity growth by 0.2 to 0.3 percentage points. De Long (1991) replicated the analysis for industrialized nations for a period in excess of 100 years—1870 to 1979—and found similar results, with a one percentage point rise in M&E investment share leading to a 0.7 percentage point rise in GDP per capita. Figure 1 shows the relationship he found for advanced countries.

Figure 1

Source: De Long (1991)

A number of studies use Canadian data as part of their cross country analysis, which generally support the findings of De Long and Summers. Abdi (2004) shows that there is a strong relationship between M&E investment, economic growth and total factor productivity growth3. He used panel data on 20 Canadian manufacturing industries over the period from 1961 to 1997, 2 Ahn and Hemmings “Policy Influences on Economic Growth in OECD Countries: An Evaluation of the Evidence”. OECD, 2000. Working Papers No. 246. p 17. 3 Total factor productivity (TFP) tries to capture the contribution to output of everything except labour and capital, such as technical change, managerial skill, and organisational efficiencies.

Asset-based Financing, Investment and Economic Growth in Canada Page iii

and time series data from 1961 to 2000 for the entire manufacturing sector in his analysis (See Figure 2). He divided capital into machinery and equipment and non-machinery and equipment investment and found the elasticities of output with respect to M&E capital stock of 0.67, which is above capital’s share of national income. Notably, he found that the elasticity of output with respect to non-M&E capital stock was 0.24, which is also well above its share of national income. This suggests that M&E and non-M&E investment could be complements, and not substitutes. It was also found that both M&E and non-M&E investment positively affect TFP levels. A doubling of M&E investment could raise TFP levels by about 20% and doubling non-M&E investment could raise TFP levels by almost 23%.

Most other researchers that examined Canada did not differentiate between M&E and non-M&E investment, but their results seem to support the view that there are positive spillovers from investment onto productivity and growth. Li (2002) finds that the aggregate physical capital investment rate is positive, with a 1% rise in the investment rate leading to a 0.2% rise in long-term growth, but the results are not particularly robust. Sargent and James (1997) estimated the effect of physical capital on output growth in Canada over the period from 1947 to 1995. They found estimates for the elasticity of output with respect to capital were in the range 0.61–0.88, which is well above capital’s share of national income.

Figure 2

M&E Helps to Boost Productivity

0.4 0.45 0.5 0.55 0.6 0.65 0.7Share of M&E

Productivity

Source: Abdi (2004)

Economic research has found that business investment and the accumulation of physical capital is a significant source of economic and labour productivity growth over the medium term in the neo-classical tradition. And machinery and equipment investment has been found to be directly or indirectly associated with the key drivers of knowledge in the economy as advocated by new growth theories and by the evidence.

Productivity and Living Standards For Canadians, the improvement of living standards is of fundamental importance. Productivity is an essential ingredient in fostering improving living standards. This can be seen by considering a traditional measure of living standards, GDP per capita, which can be decomposed into the following:

Labour productivity (output per worker hour)

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Work effort (hours worked per worker)

Employment rate (number of people working relative to the working age population)

Working age population share (people of working age relative to the total population)

Living standards can rise if one, or more, of these measures rise. The combination of the last three measures is referred to as labour utilisation (total hours worked per capita).

In Canada, living standards as measured by real GDP per capita grew strongly in the 1960s then slowed appreciably in the mid-1970s. The slowdown in the growth of living standards lasted until the mid-1990s after which there was a significant bounce back in the pace of growth. The same pattern is found in labour productivity growth, which also experienced a strong pace of growth in the 1960s, slowed in the mid-1970s and has started to accelerate again after the mid-1990s. Notably, labour utilization follows a different pattern: it can be characterized as having significant cyclical variation around a long-term upward trend.

The importance of labour productivity to long-term improvements in living standards can also been seen by decomposing the growth of real GDP per capita over long periods of time. In, Figure 3, the average annual growth of labour productivity and utilization are shown by decade averages (1961-71, 1971-81, 1981-91 and 1991-2003). Most of the gain in real GDP per capita is because of labour productivity over these long time intervals. Over the whole 1961-2003 period, labour productivity was responsible for roughly 80% of the rise in living standards, and has ranged from 56% to over 100% of the increase in GDP per capita over the decades shown.

Figure 3

Labour Productivity Boosts Living Standards

1961-2003 1961-1971 1971-1981 1981-1991 1991-2003

Contribution to Real GDP per Capita GrowthLabour Utilization

Labour Productivity

Source: Statistics Canada data, calculations by author.

Given the importance of labour productivity growth to the overall gains in living standards it is instructive to examine the reasons for labour productivity growth. Three factors combine to generate labour productivity:

Total factor productivity or multifactor productivity

Capital deepening or intensity (amount of capital services per worker hour)

Changes in the quality of labour inputs (improvements in the level of skills)

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Of these three measures, capital deepening was the most important contributor to labour productivity growth over the whole 1981-2000 period, and the improvement in labour quality was the second most important factor. Notably, with capital, researchers generally have found that the accumulation of M&E capital to be the more important contributor to labour productivity growth. Changes in Canadian living standards can, therefore, be directly linked to the amount of capital – or investment –in the economy in general, and machinery and equipment in particular.

Financial Systems and Investment The economics profession has spent much of the last few decades trying to understand why economies grow. In particular, the sustained growth of the US economy in the 1980s and 1990s has led to interest in its financial system and the efficiency with which it appears to channel funds to new and productive investment projects. Research has focused on whether financial systems in other countries can and do play similar roles and whether financial structures have an impact on resource allocation and growth.

Recent research by the OECD has found evidence suggesting that financial system characteristics are linked to growth patterns in OECD countries and are able to draw the following general conclusions:

Legal and regulatory framework conditions for financial systems, particularly their enforcement and transparency, support innovation and investment in new enterprises.

Significant relationships between investment and financial development, as measured by indicators of the scale of financial activity, exist among OECD countries.

Traditional macro-economic theories consider population growth, technological change and capital accumulation4 as the driving forces behind sustained economic growth. Financial systems are important because they are integral to the provision of funding for capital accumulation and for the diffusion of new technologies.

The micro-economic rationale for financial systems is usually based on the existence of frictions in the trading system. The writing, issuing and enforcing of contracts consumes resources and, in a world in which information is not symmetric and its acquisition is costly, properly functioning financial systems can reduce these information and transactions costs. In the process, savers and investors are brought together more efficiently and, ultimately, economic growth is positively affected. In doing this, financial systems provide four general services:

Mobilising savings – the pooling of individuals savings through financial intermediaries or securities markets provides a readily accessible source of investment funds. The pooling of the savings of individuals through financial intermediaries or securities markets makes the funding of profitable large-scale investments possible.

Diversifying risk – financial systems allow individual savers to diversify against the risk that a single investment pays no return and liquidity risk that occurs because savers may need to withdraw investments before returns are available.

Allocating savings – the cost of acquiring and evaluating information on prospective investments can be very high for individual savers. For a small fee, financial intermediaries that specialize in acquiring and evaluating this information enable small investors to locate higher return investments.

4 Capital in this sense includes both physical and human capital.

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Monitoring the allocations of managers – financial systems also reduce the risk that resources are mismanaged. Financial intermediaries can monitor investments for groups of savers reducing their need to duplicate this activity.

Many empirical studies of the determinants of growth in a broad group of countries conclude that financial development makes a significant contribution5. Recent research by the OECD has focussed on two significant channels. First, financial development appears to be related to economic growth through its relationship with fixed investment. Investment, in turn, plays an important role in the process of economic growth. The OECD research was able to establish a link between financial development and fixed investment. Different indicators of financial development were used with the results appearing strongest for stock market capitalisation and somewhat weaker, though still significant, for private credit of deposit money banks. Second, measures of financial development were significant in growth equations for OECD countries, even after controlling for the level of investment. They conclude that other channels – beyond fixed investment – appear to link financial system development and economic activity.

A link between the development in a country’s financial system and long-term growth has been made in both theory and practical evidence. Financial market development contributes to growth. To date most research linking economic growth and financial market development has focused on banking and equity markets. This report breaks new ground by extending the analysis to include leasing – a component of asset-based financing.

Asset-based Financing Asset-based financing is the financing of equipment (including vehicles for business/commercial use) by way of a secured loan, conditional sales contract, or lease. The largest segment of asset-based financing is leasing. A lease is an agreement between the equipment owner (lessor) and the business that wants to lease the equipment (lessee). Through leasing, the lessee acquires the right to use the equipment for a fee over time, but the lessor retains ownership of the asset.

One major advantage of leasing is that the asset secures the borrower's unconditional obligation to make payments over the term of the agreement. As a result, leases typically finance a higher percentage of the capital cost of a needed piece of equipment than bank borrowing, often with little or no initial down payment required. This allows the lessee to preserve its cash or bank facilities to meet working capital needs.

Leasing is generally a far more flexible means of financing equipment than traditional lending and can be tailored to the client’s specific needs in a number of ways. For instance, payment schedules can be adjusted to accommodate a business’ cash flow needs. Payments can be low at the beginning and increase throughout the term of the lease, balloon payments, or for seasonal payments where the firm pays more during the time period when the equipment is being used the most. There is also a higher approval rate for leases than for bank loans. Other attractive features of lease financing include: long-term financing, usually at a fixed rate; possibility of upgrading equipment during or at the end of a lease contract; and sales-tax deferral in a capital lease.

Unlike traditional banks, lessors offer a variety of services depending on the type of equipment leased. The level of service can range from simply procuring the equipment, to maintenance and agreeing to exchange it periodically for more up-to-date versions. Lessors are frequently responsible for the equipment leased from the time of purchase to disposal. The hands-on day-to-

5 King and Levine (1993) found that financial development was strongly associated with real GDP per capita growth, the rate of capital accumulation and productivity.

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day management and maintenance of equipment by lessors for their clients is an important customer service.

While interest expenses are typically higher in leases than traditional bank lending, transaction costs can be lower. For example, the costs of assigning collateral, legal documentation and slower processing times for traditional bank borrowing can be significant, particularly for small and medium sized enterprises (SMEs) where many of the conventional financing costs are fixed and not based on the size of the loan. These differences in costs and benefits between leasing and bank lending mean that they each serve distinct market niches.

In developed economies, asset-based financing is used by every industry to finance some of the equipment it uses. This activity ranges from the office photocopier and printer to airplanes, construction equipment, rail cars and commercial vehicles. Globally, asset-based financing has grown over 10% a year from about $40 billion in 1978 to over $460 in 2002 (see Figure 4). North America is the largest regional market and accounted for nearly 47% of global activity in 2002 followed by Europe with 35% and Asia with 15%. The rest of the world accounted for less than 3% in 2002. The leasing statistics presented in this report were generously provided by the London Financial Group and are published regularly in the World Leasing Yearbook.

Figure 4

Asset-Based Financing

North America

Europe

South America

Australia/NZ

Africa

1978 1982 1986 1990 1994 1998 2002

Source: London Financial Group, World Leasing Yearbook

While asset-based financing occurs in nearly every country around the world, the global market is currently dominated by the G-7 nations. These seven countries account for over 80% of global leasing activity in 2002. In Canada, asset-based financing is used to finance between 20% and 25% of all new capital spending and, as such, has a profound influence on industries throughout the economy.

Finance and leasing companies are infrequently included in surveys of major financial institutions and, as such, the industry is often omitted from many discussions on trends in financial services. This omission is telling since the finance and leasing industry has provided some of the most significant innovations in financial services over the last couple of decades. Quite simply, the evolution of financing institutions has outpaced the capacity of tracking systems to understand what is really going on. Government research and regulations are currently trying catch up.

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Leasing and Economic Growth To date, there has not been a study that has considered leasing as part of the financial system and its potential role in the finance-growth link. Given the innovative nature of the asset-based financing industry in promoting the overall financial system’s ability to operate effectively, it seemed natural to contribute to the economic literature by including this sector. Using data provided by the London Financial Group, leasing was added to the group of financial systems measures used by the OECD in their analysis.

Our empirical results confirm the OECD’s finding of the important role that financial systems play in supporting investment and economic growth. Table 1 provides an estimate of the impact of a 10% increase in Canada’s equipment leasing as a share of GDP (1.4% in 2002) or its stock market capitalisation as a share of GDP (101% in 2001) from recent levels6. Investment is 1.3% higher as a result of the increase in leasing and 3.9% higher with the increase in stock market capitalisation. The resulting increase in investment associated with both leasing and the stock market directly raises living standards 0.2%. Table 1 also shows that the increase in the financial services indicators provides a significant boost to living standards through other channels (beyond the direct investment impact): leasing raises living standards 4.3% and stock market capitalisation by 2.3%. These increases are consistent with new growth theory which contends that TFP can be positively influenced by higher investment.

Table 1 Estimated Contribution from a 10%

Increase in the share of GDP for:Equipment

LeasingStock Market Capitalisation

Impact on:

Investment (per cent increase) 1.3 3.9

GDP per capita (per cent increase) 4.5 2.5 from the investment channel 0.2 0.2 from other channels 4.3 2.3

Using this information it is possible to determine the contribution of the growth in asset-based financing to the Canadian economy over the last decade. From 1992 to 2002, asset-based financing of equipment as a share of GDP rose from 0.776% to 1.419% – an 82.8% increase – and, through the direct impact on investment, raised living standards 2.3%.

Over this same period, national living standards rose from $26.6 thousand to $34.3 thousand: a 28.6% increase. The increase in living standards resulting from the rise in asset-based financing was, therefore, responsible for about 8% of the total increase in Canada’s living standards experienced from 1992 to 2002. In other words, 8% of the 26.8% increase was due to the asset-based financing of equipment.

To put this in perspective, asset-based financing’s contribution to living standards was larger than many of the better known sectors of the Canadian economy: e.g. residential construction (4.7%), the transportation equipment industry (4.6%), government services (2.1%) and mining (1.8%).

The asset-based financing industry provides access to capital outside the banking sector. This incremental capital, and its impact on investment, is one of the principal benefits the asset-based financing industry confers on the economy. The analysis in this report confirms that, in the absence of the asset-based financing industry, capital formation would be adversely affected, growth in equipment investment would be lower – and Canadian living standards would suffer. 6 This implies a new level for leasing as a share of GDP of 1.6% and of 111% for market capitalization.

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Policy Options As discussed, the evidence strongly suggests that machinery and equipment investment is a critical contributor to productivity and economic growth. While this proposition is not without debate, many researchers have gone further in suggesting that this investment is the strategic factor in long-run productivity growth7 because of its role as either the key driver of economic growth or as a facilitator in the diffusion of knowledge within countries and throughout the world.

Economic evidence suggests a positive macro-economic climate of low/stable inflation, sound fiscal policy, as well as a highly educated, well trained workforce are important factors in supporting strong long-term productivity and economic growth. The addition of strong equipment investment is, however, necessary to ensure the other factors deliver stronger productivity gains and economic growth. Furthermore, given the complementary nature of other types of investment in public infrastructure and non-machinery private investment, these investments are also helpful to long-term productivity and economic growth.

Given the central role of the financial system in channelling savings to productive investment, and thereby promoting gains in productivity and living standards, the health and competitiveness of the broad range of financial services available to businesses and consumers should be of considerable importance to policy makers. Each segment of the financial services sector provides a set of services that support the activities of different parts of the economy. The breadth of financial services available helps ensure that the needs of all sectors are addressed. Asset-based financing expands the financing options available to businesses in Canada. Without the ability to lease, many businesses would find it more difficult, more risky or even impossible to acquire equipment. Consequently, business choice would be restricted to either buying the equipment and financing the purchase through internal or borrowed funds, or not acquiring the equipment at all.

Implications for Government Tax Policy For Canada many of the conditions are in place to ensure success in the world economy. The workforce has a relatively high level of formal education, monetary policy is keeping inflation low and relatively stable, and federal fiscal policy is producing a surplus over the course of the business cycle. Despite these positive attributes, Canada faces many challenges to improve future livings standards because labour utilization is likely to stagnate or decline in the future because of the inevitable aging of society. Consequently, improvements in living standards will increasingly rely on gains in labour productivity.

Given the importance of machinery and equipment investment to productivity and economic growth combined with the fact that this type of investment tends to be the most mobile factor of production over the long run and considering the evidence that the world economy is undergoing a significant technological transformation, it is not hard to reach the conclusion that governments should encourage this type of investment.8

Government policy in Canada, however, is not encouraging investment in machinery and equipment to the degree that the economic research suggests would be best for the economy. For example, positive externalities (spillovers) from machinery and equipment investment as 7 De Long (1991) 8 An external reviewer suggested that government policy should not discriminate between types of investment, but instead foster a tax system that encourages business investment in general. This view is consistent with the empirical evidence that suggests that machinery and non-machinery investment are complementary in boosting productivity and economic growth.

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suggested by new growth theory could mean that private benefits are less than the benefits to society as a whole, therefore, investment will be below what is optimal. A strategy of improving the economic climate for machinery and equipment investment should pay significant dividends in terms of stronger economic growth, higher productivity and living standards for Canadians for many years to come.

The analysis conducted in this report illustrates the economic impact of various tax policy options available to Canadian governments. The policies considered were far from exhaustive – there exist a huge array of policy options available to governments. The traditional personal and corporate income tax cut options are the least attractive policy options available to governments that we examined. They both yield relatively limited economic benefits while leaving the government that initiates them with a permanent fiscal hole to fill.

There are a multitude of possible changes to sales taxes that could be introduced in Canada. This report examined one option in which provincial sales taxes on capital goods are eliminated. This yielded economic benefits but left provincial governments short of revenue.

Figure 5

Tax Policy Impacts(after 10 years)

0.0 0.2 0.4 0.6 0.8Impact on Living Standards(% change in real GDP per capita)

Eliminate provincial corporate capital

Raise capital cost allowance for machinery & equipment by 25% of current levels

Remove provincial sales taxes from business capital

Reduce federal personal income taxes by 10%

Reduce federal corporate income tax rates by 5%

Impact on per capita government revenue, in inflation adjusted terms, is positive for simulations above the dotted red line

The more attractive options are to reduce, and ideally to eliminate, corporate capital taxes and to raise capital cost allowances. Both policy options yield significant economic benefits with minimal short term fiscal cost. The long-term impacts of these policy options are summarised in Figure 5.

With renewed demands for higher government spending on new social programs coupled with razor thin federal surpluses and provincial deficits, tax reform is low on the political agenda around the country. Building the type of economy that can sustain new spending initiatives will, however, mean that the Canadian economy must produce more than before. It must, in other words, become more productive. Tax reform can help.

There is a degree of urgency to the need to construct an appropriate policy environment because evidence suggests the world economy is undergoing a significant technological transformation. This view is held by a number of commentators, for example Sharpe and Gharani (2001) state that “Appropriate economic policy is always important to foster growth but it becomes even more crucial at times of rapid technological change. The economic landscape has changed, and thus

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new policy regimes more consistent with the New Economy must be employed in order to ensure our potential productivity gains are translated into actual gains.”

A more productive economy is fundamental to government’s ability to provide new services. It is also the key to improving opportunities and living standards for all Canadians. Policies that encourage business investment in machinery, equipment and vehicles will boost productivity and help create the economy Canada needs in the 21st Century.

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Asset-Based Financing, Investment and Economic Growth

Introduction About twenty years ago, various theoretical and empirical studies trying to establish the link between financial intermediation, investment and economic growth began appearing in academic journals. There is now a growing body of international research supporting the benefits of banking, securities markets and insurance. To date, however, there has not been any work looking at the relationship between asset-based financing and economic performance. This report draws the link from the development of the financial system to include asset-based financing, greater equipment investment, higher productivity, stronger economic growth and improving prosperity for Canadians.

Although business investment in machinery and equipment accounts for only about 7% of the Canadian economy, it is a key determinant of productivity growth. While business investment is rising at present, and is expected to continue to do so over the next few years, it is still significantly below that of our major trading partner: the United States. Canadian productivity has, as a result, lagged over the last few years.

As a result many experts currently argue that Canada needs to become more productive in order to be competitive it the global economy. But does becoming more productive mean that fewer people must have jobs and those that do have them must work harder? The recent “jobless recovery” in the United States has raised concerns about the societal impacts of ongoing gains in productivity.

This report shows that higher productivity is vital if we are to continue raising the standard of living for all Canadians. Productivity provides opportunities for all Canadians – more jobs at higher wages. It is important, therefore, to try and understand why business investment is not higher. It may be that there is no easy answer to that question. Businesses are free to choose the level of investment that best meets their expectations of future needs. Government policy can, however, create an environment in which business believes their future needs will be higher.

The first section of this report focuses on the relationship between investment and economic growth. It reviews both the theoretical and empirical economic literature and finds that machinery and equipment investment is a fundamental determinant of economic growth – far more so than its relatively small share of national output would indicate.

The second section examines productivity and living standards. Productivity growth is an essential ingredient in boosting living standards. Canada, however, lags behind other major economies in terms of labour productivity growth, relying instead on rising utilisation. This is an unsustainable reliance in the future given the aging of society.

The report then goes on to review the theoretical reasons and empirical evidence for a positive relationship between financial system development and economic growth. This relationship appears, at least in part, to flow from the role that financial system development plays in supporting investment. The existence of this relationship becomes important when considering the role that investment plays in determining productivity and economic growth.

The next section provides a profile of the asset-based financing industry. To date, there has not been a study that has considered leasing as part of the financial system and its potential role in the

finance-growth link. Finance and leasing companies are infrequently included in surveys of major financial institutions and, as such, the industry is often omitted from many discussions on trends in financial services. This omission is telling since finance and leasing industries have provided some of the most significant innovations in financial services over the last couple of decades.

This report extends empirical work conducted by the OECD to examine the linkage between financial system measures, investment and economic growth to include asset-based financing. A set of econometric models are constructed to test the hypothesis that the financial services sector, and asset-based financing in particular, support investment and economic growth. The findings from this research provide a key message for the role of public policy in promoting the health and competitiveness of financial services available to businesses and consumers. Each component of the financial services sector provides a set of services that support the activities of different parts of the economy. The breadth of financial services available helps ensure that the needs of all sectors are addressed. Asset-based financing is similar to other parts of the financial services system in that it supports investment and economic growth. It does this by providing services that help match savings with investment opportunities, thereby raising investment and ultimately improving economic growth.

Finally, the report reviews some of the policy options available to governments in Canada to encourage higher investment and evaluates them in terms of their impact on economic growth, productivity, investment, employment and personal income as well as their fiscal impact.

Tax reform can help stimulate business capital spending. The analysis conducted in this report illustrates the economic impact of various tax policy options available to Canadian governments. The policies considered were far from exhaustive – there exist a huge array of policy options available to governments. These range from traditional personal and corporate income tax cut options to sales tax reform or changes in other taxes and tax allowances.

A more productive economy is fundamental to government’s ability to provide new services. It is also the key to improving opportunities and living standards for all Canadians. Policies that encourage business investment will boost productivity and help create the economy Canada needs in the 21st Century.

Investment and Economic Growth “It is becoming increasingly evident that certain forms of investment matter much more for growth compared with others. In particular, equipment investment has a significantly positive and robust association with growth”9

Investment spending makes a direct contribution to economic activity because investment is one of the components of total expenditure in an economy, GDP equals personal consumption plus investment plus government expenditures plus net exports (i.e.: GDP=C+I+G+(X-M)). These expenditures reflect the total level of demand in the economy. Unlike other expenditures, such as personal expenditure on restaurant meals, capital expenditures are doubly important because capital is one of the factors of production (capital and labour) that directly determine the economy’s productive capacity or aggregate supply. While in the short run, fluctuations in demand determine the level of GDP, over the long run, it is the growth in the economy’s ability to supply output that determines the speed at which an economy can grow. Consequently, growth theories and the associated empirical work focus on the supply side of the economy.

Over the past 20 years there has been an explosion of theoretical and empirical research that examines the relationship between investment, productivity and long-term economic growth. On a theoretical level, this research has two basic schools of thought: the neoclassical model as first described by Solow (1956 and 1957) and new growth theory (also know as endogenous growth theory) articulated by Romer (1986, 1987 and 1990), Lucas (1988) and Grossman and Helpman (1991).

The neoclassical model originally focused on investment in tangible assets, and the resulting accumulation of physical assets to help explain economic growth. Recently the concept of investment has been broadened from private investment in tangible assets to include human capital, research and development expenditures and investment in public infrastructure. While emphasising a broader view of investment, this literature remains in the neoclassical tradition where benefits of investment are internal in the form of enhanced productivity or higher wages. New growth theory moves away from the neoclassical model and explores alternate productivity channels through which investment affects growth. This school attaches greater significance to certain types of investment that create externalities and generate an additional productivity boost through production spillovers or the associated diffusion of technology.10

Both models share similarities concerning the central importance of investment and capital accumulation to economic growth, but differences between these models have important implications for the impact of investment on productivity and economic growth and the role that government policy can and should play. Notably, what these models say about productivity and economic growth depends on the time period and measure of productivity under consideration (see section on productivity for further elaboration). For example, a distinction has to be made between short-and medium-term economic growth and long-term economic growth, when the economy reaches a steady state growth path.

9 Ahn and Hemmings (2000), “Policy Influences on Economic Growth in OECD Countries: An Evaluation of the Evidence”. OECD. Working Papers No. 246. p 17. 10 Stiroh (2000), “Investment And Productivity Growth: A Survey From The Neoclassical And New Growth Perspectives”. Industry Canada. p. 1.

The neoclassical model suggests that in the long run total factor productivity and labour growth determine economic growth, and that government policies to encourage investment will not influence the steady state growth rate because of diminishing returns to capital investment. Although a higher investment rate will cause a level effect on income per capita in the short-to-medium term. In contrast, new growth theory suggests that a higher investment rate (in the key asset(s)) would boost the steady state growth rate. Furthermore, the positive externalities flowing from investment in the key asset(s) suggest a role for government policy to boost investment toward the socially optimal investment rate, which would be greater than the privately optimal investment rate.

The empirical literature also shows this duality. Some researchers have extended the neoclassical model by incorporating a broader concept of investment and hence capital accumulation and by improving the measures of investment and capital accumulation used in the empirical research, for example, Jorgenson and Stiroh (2000), Oliner and Sichel (2000) and Jorgenson (2004) among others. According to recent estimates, asset accumulation and labour growth now explain more than 80% of economic growth, with the accumulation in tangible assets the most important factor. Jorgenson (2004) found that “investment in tangible assets is the most important source of economic growth in the G7 nations. The contribution of capital input exceeds that of productivity for all countries for all periods.” These recent calculations leave less than 20% in the Solow residual that is thought to represent technological change. This is a significant advance from Solow’s first estimate that 90% of the per capita growth in the US economy was unexplained and in the technological change residual.

Other researchers have concentrated on elements of new growth theory to try to explain technological progress, productivity and long-term economic growth. There are three branches of new growth theory that emphasise different drivers of long-term productivity and economic growth: machinery and equipment, human capital, and research and development. Some propose hybrid models whereby more than one of these drivers are needed to boost productivity.

The empirical research has found a strong link between machinery and equipment investment in particular and economic growth—De Long and Summers (1991, 1992, 1993 and 1994), De Long (1991), McGrattan (1998), Sala-i-Martin (1997), Hoover and Perez (2004), and Abdi (2004) among others. These results are suggestive that machinery and equipment investment has a central role to play in long-term economic growth, possibly because technological change is embodied in recent vintages of capital. At this stage, however, given measurement problems in the data it is not clear if the observed linkage between growth and machinery investment supports the neoclassical view, which suggests that a higher investment rate would boost the level of GDP, but not the long-term growth rate, or new growth theory, which supports the view that a rising investment rate could also boost the steady state growth rate. Part of this uncertainty relates to the question of how long is the long run.

Several researchers have estimated the speed at which the economy reaches a new steady state growth path. Some have calculated a fairly fast pace of transition, with the rate being in the neighbourhood of 10%, while others have calculated a much slower transition path. Jorgenson (2004) for example using a neoclassical framework and updated measures of capital and labour quality states that “The transition path to balanced growth equilibrium after a change in policies that affects investment in tangible assets requires decades, while the transition after a change affecting investment in human capital requires as much as a century.” A longer transition path, however, may make the distinction between a series of one time level adjustments to income per capita in the short-to-medium term and a higher long-term growth rate moot to policymakers.

To understand this literature it is helpful to start with the neoclassical model. This knowledge will place recent theory and evidence about the importance of machinery and equipment investment for productivity and economic growth into the appropriate context.

Neoclassical Model The standard neoclassical growth model was originated by Solow (1956, 1957). 11 The role of investment in this framework can be summarised by two equations, the production function and the capital accumulation equation. The production function shows the relationship between output, technology and capital and labour inputs:

Y = A•f(K,L)

Where:

Y is output A is technology K is capital L is labour

The three central assumptions that underlie the neoclassical model are:

1. Constant returns to scale 2. Perfect competition 3. Exogenous technological change

The assumption of constant returns to scale means that increasing all inputs by the same proportion raises output by that proportion. For example, a doubling of all factor inputs will double output. In a two factor model, such as a Cobb-Douglas production function, the constant returns to scale assumption means that factor shares sum to one and that there are diminishing returns to each factor of production alone. As capital is accumulated, each unit of capital will increase output by less than the previous unit of capital, which means that the economy can not grow forever simply by adding extra units of capital.

The assumption of perfect competition means that factor inputs (capital and labour) are paid what their marginal products (rise in output from an additional unit of the factor input) are worth when the economy is in equilibrium. If the wage rate is less than the revenue derived from the marginal product of labour, then there is an incentive to boost labour inputs and output. Thus for labour, L•MPL/Y=w•L/Y, where MPL is the marginal product of labour, and w is the real wage rate. The right hand side of the equation is the share of labour in total output.

For a two factor Cobb-Douglas production function, these assumptions mean the production function will be of the form:

Yt = At • (Ktα • Lt

(1-α))

Or in natural logarithms:

ln Yt=ln At + α•ln Kt + (1-α)•ln Lt (1)

11 This section loosely follows Stiroh (2000).

where:

α is the marginal product of capital, which is equal to capital’s share of output (1-α) is the marginal product of labour, which is equal to labour’s share of output

The assumption that technological change is exogenous means that technological progress is not dependent on factor inputs. In other words, a rise in physical or human capital or labour employed in the economy will not have any effect on technological progress. This assumption is tied to the notion that all benefits are internal and there are no externalities or spillover effects. Since a positive externality would cause the measured level of technological progress to increase with the accumulation of the factor input that has the associated positive externality.

The capital accumulation equation governs the relationship between investment in tangible assets, I, and the capital stock, K, in a perpetual inventory relationship:

∆Kt = It – δ•Kt-1 (2)

where:

∆Kt is the change in the capital stock δ is the depreciation rate It is investment

Under these assumptions, the standard growth accounting decomposition relates output growth to the share-weighted growth rates of primary inputs and technological progress (see equation 3 below). Given that technological progress is not directly measurable, it is calculated residually in this model. This term is the Solow residual, and combines technological progress, organisational efficiencies, greater employee effort and any other factor that is not specifically measured as either capital or labour, but which relates to rising output. It is also known as Total Factor Productivity (TFP) and Multi-Factor Productivity (MFP).

∆lnY = α•∆lnK + (1-α)•∆lnL + ∆lnA (3)

Equations (2) and (3) show the direct link between investment in tangible assets and economic growth as the accumulation of capital contributes to growth in proportion to capital’s share of national income.

In this model, income per capita will rise in the short-to-medium term as the investment rate rises. This, however, is a level effect, since in the long run the steady state growth rate does not depend on the investment rate as discussed above. The only thing that can boost long-term per capita growth is TFP growth. And since TFP growth is independent of the factors of production, there is nothing that economic agents can do to alter its rate of growth. Technical change is simply manna from heaven.

In the neoclassical model, long-term growth is determined by the accumulation of capital and labour along with technical change. Technical change is calculated residually and is assumed to grow regardless of the pace of accumulation in the factors of production. In this model, the accumulation of machinery and equipment will directly contribute to economic growth based on its share of income.

Problems of the Neoclassical Model The Neoclassical model retained a central position in growth economics for decades. Over time, however, the model came under attack on an empirical and theoretical basis. From the empirical

perspective, many of the neoclassical model’s predictions about growth over time and across countries were not supported by the evidence. The following examples are from Ahn and Hemmings (2000), for a more thorough discussion of the empirical shortcomings of the neoclassical model see Fortin and Helpman (1995), and Sargent and James (1997).

The Solow model does not account for the magnitude of income differences observed between rich and poor countries. Applying reasonable estimates of the differences in savings rates between countries and differences in population growth only goes a small way to account for output differences.

Calibration of the Solow model using reasonable estimates of the share of capital and other parameters implies rates of convergence to the steady state that are much faster than those found in empirical studies.

The model suggests differences between rates of return to capital across countries are much greater than those actually observed. Calibration of the Solow model based on a Cobb-Douglas production function implies that the rates of return to capital in poor countries should be very large multiples of those in rich countries, something that is not borne out in the data.

On a theoretical basis, the three underlying assumptions of the neoclassical model were also being questioned—perfect competition, constant returns to scale and exogenous technological change. Some of these assumptions, such as perfect competition and constant returns, were in conflict with advances in other areas of economics that emphasised market power and scale economies.12 As well the idea that innovation and knowledge are exogenously determined and available to all firms at zero cost was also questioned.

If either perfect competition or constant returns to scale do not hold then the factor’s marginal product would not equal the factor’s share of income at equilibrium and estimates of labour and capital’s contribution to economic growth will not be correct. An underestimate of capital’s contribution to growth has significant implications for the pace of convergence to the steady state path, as well as the impact of a rising investment rate on growth. (See the new growth theory section and Appendix A for a further elaboration)

The assumption of exogenous technological change raises the question, where does technical change comes from? Indeed, some researchers show that in a neoclassical world where the factors of production are paid their marginal products, so that firms do not have any pure profits, and technological developments are non-rival (available to all to use at the same time), there would not be any incentive for developing technological improvements. This is because the cost of this research would cause the firm to lose money.13

Some researchers tackled this issue by assuming that technological progress is embodied in new machinery and equipment and thus investment is required to affect output and productivity growth in the long run. This distinction reopens an old debate in the growth literature that goes back to Solow (1960) and Jorgenson (1966). Solow suggested that newer vintages of capital would be more productive than older capital. Jorgenson, however, illustrated that if investment is 12 Sargent and James (1997), “Potential Output, Productivity, and the New Growth Theory”. Canadian Department of Finance.. p. 4. 13 Sala-i-Martin, X (2002), “15 years of New Growth Theory: What have We Learnt?” Columbia University. Department of Economics Discussion Paper #:0102-47.

properly adjusted for quality, then embodied technical change is the same as the neoclassical model with disembodied technical change. Others, however, suggest that these adjustments mean that there would have to be substantial mismeasurement of capital prices in the official data, which they do not think likely.14

Many researchers consider that innovation is embodied within new equipment. There is a large literature on the embodiment of technological change, starting with Solow, who argued that, “Many, if not most innovations need to be embodied in new kinds of durable equipment before they can be made effective”.15 Secondly, adopting new technologies usually requires large amounts of capital, training and reorganisation. Making capital more expensive to acquire may decrease the desire to adopt new technologies.16

Over time the neoclassical model was questioned on theoretical and empirical grounds. Some of the proposed solutions to this disagreement raise the prospect that machinery and equipment investment in particular is an essential ingredient for long-term economic growth in that it embodies or facilitates the diffusion of technological advancement. If Jorgenson’s view is correct, then the quality adjustments needed in the extensions of the neoclassical model could significantly boost the importance of machinery equipment investment in explaining labour productivity and economic growth in the short-to-medium term. Either way, machinery and equipment investment is essential to economic growth, and the improvement in living standards.

Extensions of the Neoclassical Model The neoclassical model can easily be extended beyond investment in tangible assets discussed above to account for the accumulation of any input that contributes to production. Recent research tends to use a broader definition of what constitutes investment than simply investment in physical assets. Jorgenson (1996), for example, states that “Investment is the commitment of current resources in the expectation of future returns and can take a multiplicity of forms”. Investment, therefore, can include a variety of private tangible assets (from airplanes to computers), plus investment in human capital through education and worker training, research and development, and public infrastructure.

Given the disparate nature of these assets, it is argued that the appropriate way to combine them is to define capital in the production function as being a measure of the service flow from capital inputs. Capital would therefore include the services from many heterogeneous assets, ranging from long-lived structures to short-lived equipment. By recognising that tangible assets have different acquisition prices, service lives, depreciation rates, tax treatments, and ultimately marginal products, Jorgenson and Griliches (1967) formally incorporated the heterogeneity of inputs by creating constant quality indices of capital and labour inputs.17

14 Sargent and James (1997) p. 6. 15 Solow, R. (1960), “Investment and Technical Progress”, in Arrow, K., S. Karlin and P. Suppes, eds., Mathematical Methods in the Social Sciences, Palo Alto: Stanford University Press. 16 Greenwood, J., Z. Hercowitz and P. Krusell (1997), “Long-run Implications of Investment-Specific Technological Change”, American Economic Review 87, 3, pp. 342-362 argue that large amounts of the growth of capital stock reflect an endogenous response of capital accumulation to technological change. 17 Stiroh (2000) p. 6.

Jorgenson and Stiroh (2000), for example, included 57 types of private investment assets. They found that after accounting for this expanded list of investment categories, the accumulation of tangible assets is the most important source of growth. Others focused more intently on computers or information and communication technology, such as Oliner and Sichel (2000). Most of this research centered on the US because of the surge in growth and ICT (information and communications technologies) investment over the latter half of the 1990s. Jorgenson (2004) extended this research to the G7 group of nations and found that after properly adjusting capital input prices to reflect quality differences that 87% of the growth in output is accounted for by input accumulation and that only roughly 13% is left explained by disembodied technological change from 1980 to 2001. His results for Canada finds that the accumulation of capital represents roughly 54% of the growth in output, while labour represents 40% and TFP 6% from 1981 to 2001.

By using a broader definition of investment, this extension of the neoclassical model has brought the Solow model closer to reality. Indeed, the role of human capital has been widely acknowledged and confirmed by empirical evidence18. The use of a wider definition of investment, however, could also mean that capital’s share of income would be larger than is traditionally assumed. Consequently, estimates of factor shares could overstate the importance of labour and understate the importance of capital. Indeed, if any or all of the three underlying assumptions of the neoclassical model do not hold, then capital’s share of income may not represent its marginal product, and understate capital’s contribution to growth.

As mentioned above, it can be shown that in a neoclassical model, that a larger share of capital in income increases the impact of the rate of saving on output because investment and capital are more important. It also extends the length of time required to converge to steady state since the larger the capital share the less rapidly the average product declines. And finally, a larger share of capital in income reduces the differences implied by the model in the returns to capital by diluting the marginal gains of capital.19

The view of investment in the neoclassical model was broadened by recent research, which has enhanced the importance of capital accumulation in explaining short-to-medium-term growth. While the use of a broader definition of investment has reduced the importance of the residual in explaining growth, the residual still remains. Consequently, there remains the underlying question of what drives disembodied technological change. This is arguably where new growth theory can help in explaining long-term productivity and growth.

New Growth Theory The empirical evidence and perceived shortcomings of the neoclassical model spawned a considerable amount of research over the past 20 years. One of the major theoretical advances was new growth or endogenous growth theory. Endogenous growth theory is “an equilibrium model of endogenous technological change in which long-run growth is driven primarily by the

18 See Stiroh (2000) p 9 & 13 and Ahn and Hemmings (2000) for discussions on empirical work linking human capital and growth. Some models are neoclassical, while others are new growth theory models. 19. Ahn and Hemmings (2000). p.4. See Appendix A for their more formal treatment.

accumulation of knowledge by forward-looking, profit-maximising agents.”20 The accumulation of knowledge in this model boosts total factor productivity and long-term economic growth.

What is crucial for new growth theory is a departure from the assumption of diminishing returns for the economy as a whole (as distinct from individual firms that face diminishing returns), typically because of externalities or spillovers from the creation of knowledge. In this system spillovers exist because knowledge cannot be perfectly patented or kept secret. For example, the fact that a new machine is produced is a signal to competitors that its creation is feasible. Furthermore, reverse engineering can unlock the secrets of a new invention or the people who worked on the invention can get jobs with competitors. Since knowledge is non-rival, which means that its use by a second party does not diminish its value to the firm that created the invention, it can be considered a pure public good.

Within the realm of new growth theory three principal avenues are proposed through which knowledge is transmitted to the rest of the economy, and hence drives long-term economic growth: capital goods, research and development, and human capital accumulation. Some economists propose hybrid solutions, whereby physical and human capital, for example, experience diminishing returns alone, but in combination they exhibit increasing returns. And Romer (1987) departed from the use of knowledge spillovers as the driving force in the economy, by suggesting an alternate mechanism based on capital specialisation.

The possibility that investment generates external productivity effects dates back at least to Arrow (1962), who formalised the idea by making productivity-enhancing experience a function of the cumulative capital stock. Wolff (1991) explores this idea and lists five channels that could link investment and technological progress: 1) investment is needed to put new inventions into practice, as in Solow (1960); 2) investment leads to organisational changes; 3) learning-by-doing, as in Arrow (1962); 4) technology offers a higher rate of return, which stimulates investment; and 5) positive feedback effects through aggregate demand growth. Wolff (1991, Table 3) finds a statistical relationship between TFP growth and growth in the capital-labour ratio for 7 countries from 1870 to 1979.21

Even work that concentrated on R&D as the engine of long-term growth suggests a central importance of equipment investment.22 Aghion and Howitt (1998), for example, argue that “technological progress cannot be sustained indefinitely without the accumulation of capital to be used in the R&D process.”23 This view is also stated in Fortin’s C.D. Howe Benefactors Lecture in 1999 in which he stressed that Canada’s M&E gap with the US is a major cause of Canada’s productivity gap.

Others have linked openness to trade with capital accumulation to explain economic growth. Beaudry and Collard (2003) developed a model of globalisation – which emphasises gains from specialisation and its interaction with capital accumulation– that provides a concise and

20 Romer, P. (1986), “Increasing Returns and Long-Run Growth”. Journal of Political Economy. p. 1003. 21 Stiroh (2000) p 22. 22 Hoover and Perez (2004) find that openness to international trade the most important contributor to economic growth, followed by machinery and equipment investment. 23 Howitt, P. and P. Aghion (1998), “Capital Accumulation and Innovation as Complementary Factor in Long-run Growth”, Journal of Economic Growth 3, pp. 111-130.

empirically relevant explanation to recent changes in the cross–country distribution of output per worker.24

A class of models that deserves special mention relates to “general purpose technologies” (GPTs). Originated by Bresnahan and Trajtenberg (1995), this research characterises a GPT innovation “by the potential for pervasive use in a wide range of sectors and by their technological dynamism” (p. 84). The authors argue that investing in and adopting GPT innovations like the steam engine, electricity, and semi-conductors, brings productivity gains to a wide range of industries and applications. Helpman (1998) provides a review and a collection of recent studies. GPTs fall into the class of endogenous growth models because they explicitly include two types of investment-related spillovers. First, there are “innovational complementarities,” which raise the productivity of R&D in sectors that use the GPT. For example, the computer chip may allow a financial service firm to innovate in more profitable and productive ways. Second, there are horizontal externalities since many sectors reap the benefits of the GPT, but coordination problems lead to under provision of the GPT. These externalities can lead the market to provide a sub-optimal amount of the GPT.25

Finally, it is likely that the adoption of new technology is not instantaneous. Greenwood and Jovanovic (2000) reviews the reasons why there may be long lags in the diffusion of new technology including: benefits to waiting, adoption costs, lack of awareness and there could be a long learning curve. The result is that there can be long lags from the introduction of a new technology to when the productivity enhancement shows up in the aggregate data. This effect occurs in technology diffusion models (e.g., Hornstein and Krusell (1996); Jovanovic and MacDonald (1994); Greenwood and Yorukoglu (1997); Andolfatto and MacDonald (1998); Hornstein (1999)) and has been suggested in other types of models, such as the adoption of general purpose technology as in Helpman (1998).

David (1990) looked at the introduction of the electric dynamo in the US economy and found that it took decades before there was a significant boost to productivity for the economy as a whole. Specifically, he found that it was only when the diffusion of electric dynamo reached 50% of US manufactures that there was a significant boost to aggregate productivity. A similar situation may have occurred in the 1990s, when the computer utilisation reached a critical level, after which a significant boost to economic growth and productivity was observed.

New growth theory suggests that machinery and equipment investment is either directly the agent of technological change, or else an important facilitator in the diffusion of technological developments that could be the result of human capital development or research and development expenditures. Furthermore, other explanations of economic development and long-term growth that focus on international trade, for example, have also focused on physical capital accumulation in general, and machinery investment in particular to explain economic growth.

24 Beaudry, P. and F. Collard (2003), “Globalization, Gains from Specialization and the World Distribution of Output”. 25 Stiroh (2000) p 14.

Empirical Evidence A considerable amount of research has examined the sources of long-term growth. Some of these studies included one or more of the three principal avenues suggested by new growth theory. Many analysts extended the research to include other factors such as openness to trade, political stability, financial development, inflation (rate and variability), government fiscal position, and social capital. From the perspective of physical capital, some research examined the importance of aggregate capital accumulation to long-term economic growth and productivity, while others examined specific types of investment like machinery and equipment investment. Most studies have included a large range of developed and developing economies. Fewer studies have examined the situation for advanced economies.

For a listing of some of the research that explores the importance of physical capital for long-term growth for OECD countries see Appendix B. Notably, most of these studies find that the accumulation of physical capital in general, and machinery and equipment in particular was strongly related to productivity and/or economic growth. Some of the examinations were for very long periods of time, lasting decades or over a century in some instances.

In a series of studies, De Long and Summers explored the relationship between machinery and equipment investment, productivity and long-term economic growth to see if there were positive spillovers from M&E investment. They concluded that the social return to equipment investment is large and exceeds the private return. They found that increasing the M&E investment share by one percentage point could increase long-run productivity growth by 0.2 to 0.3 percentage points. De Long (1991) replicated the analysis for industrialised nations for a period in excess of 100 years—1870 to 1979—and found similar results, with a one percentage point rise in M&E investment share leading to a 0.7 percentage point rise in GDP per capita. Figure 6 shows the relationship he found for advanced countries.

Figure 6

Source: De Long (1991)

De Long and Summers’s results were at first subject to criticism. Levine and Renelt (1992) for example used Leamers’ (1985) extreme-bounds analysis and found that machinery and equipment

was not significant. Subsequent analysis by Sala-i-Martin (1997), however, demonstrated that while the test Levine and Renelt used reduced the number of false positives, it was at the cost of too many false negatives. Sala-i-Martin re-examined the evidence using a less onerous testing technique for a large number of factors that researcher had suggested were important for economic growth and found that machinery and equipment investment was a significant contributor to long-term growth. He found that a one percentage point increase in equipment investment led to a 0.2 percentage point increase in output growth, while a one-percentage point increase in non-equipment investment leads to only a 0.06 percentage point increase in output growth. De Long and Summers’s view was also corroborated by Hoover and Perez (2004) who used another testing technique that lay between Levine and Renelt’s approach and the one employed by Sala-i-Martin. Notably, they found that M&E investment was a significant contributor to long-term growth and productivity, but that non-equipment investment was not.

Some economists have examined whether productivity lags the rate of technological advance. Many find that productivity does lag technological developments. For example, Cummins and Violante (2002) calculated that the “technology gap”—the gap between the productivity of the best technology that is embodied in the most recent vintage of capital and average productivity—rose from 15 percent in 1975 to 40 percent in 2000. Pakko (2002b) shows that even in the absence of explicit diffusion lags, the adjustment of the capital stock to changes in technology growth trends give rise to long lags between technology and productivity—particularly when technology growth is investment-specific.26 Licandro, Maroto and Puch (2002) found that expansionary and innovative Spanish manufacturing firms increase their productivity after an investment spike, but a long lag is associated with innovative investments.

Jovanovic (1993) finds that capital accumulation and product diversification seem to move together, which supports models such as Romer (1987), in which capital accumulation is linked to the creation of new types of intermediate goods. Ades and Glaeser (1994) examine US states in the 19th Century and LDCs in the 20th Century and find that the increasing returns act to foster growth by expanding the size of the market, because a larger market allows a greater division of labour.27

A number of the studies use Canadian data as part of the analysis for cross country analysis for either total capital or M&E capital. In terms of single country analysis for Canada, Li (2002) finds that the aggregate physical capital investment rate is positive, with a 1% rise in the investment rate leading to a 0.2% rise in long-term growth, but the results are not particularly robust. Sargent and James (1997) estimated the effect of physical capital on output growth in Canada over the period from 1947 to 1995. They found the estimates for the elasticity of output with respect to capital were in the range 0.61–0.88, which is well above capital’s share of national income.

There are fewer studies that specifically examine M&E investment for Canada alone. Abdi (2004) shows that there is a strong short-and long-term relationship between M&E investment and economic growth and total factor productivity growth (See Figure 7). The analysis used panel data for 20 Canadian manufacturing industries over the period from 1961 to 1997, and time series data from 1961 to 2000 for the entire manufacturing sector. He divided capital into 26 Pakko, M. (2002), “Investment-Specific Technology Growth: Concepts and Recent Estimates”, The Federal Reserve Bank of St. Louis. p. 47. 27 Sargent and James (1997) p. 21.

machinery and equipment and non-machinery and equipment investment and found the elasticities of output with respect to M&E capital stock of 0.67, which is above capital’s share of national income. Notably, in his research he found that the elasticity of output with respect to non-M&E capital stock was 0.24, which is also well above its share of national income. This suggests that M&E and non-M&E investment could be complements, and not substitutes. It was also found that M&E and non-M&E investment positively affect TFP levels. A doubling of M&E investment could raise TFP levels by about 20% and doubling non-M&E investment could raise TFP levels by almost 23%.

The available empirical evidence supports the view that capital accumulation boosts short-to-medium economic growth as well as long-term economic growth and productivity. Several studies corroborate the view that machinery and equipment investment is particularly important for productivity and long-term economic growth. This result is found in cross country analysis and also in studies for Canada, and key sectors, such as manufacturing.

Figure 7

M&E Helps to Boost Productivity

0.4 0.45 0.5 0.55 0.6 0.65 0.7Share of M&E

Productivity

Source: Abdi (2004)

Productivity and Canadian Living Standards In both the neoclassical model and new growth theory productivity retains a central role in determining long-term economic growth. What is different is that in the neoclassical model, productivity is assumed to be exogenously determined, while new growth theory explores alternate channels through which investment affects productivity and growth. Given the central role that productivity plays in these models, it is helpful to explore this concept more thoroughly and how it influences growth and living standards.

Productivity: Definitions Productivity is output per unit of input. Productivity can be defined in two basic ways: labour productivity (LP) and total factor productivity (TFP).

Labour productivity is simply output divided by labour input. Labour input can be measured by the number of workers or by the number of hours worked. For the economy as a whole, labour productivity is typically measured as gross domestic product per person hour. Since no other input is utilised in this calculation labour productivity captures the contribution to output from all other inputs and technological change.

Total factor productivity, which is also called multi-factor productivity (MFP), tries to capture the contribution to output of everything except labour and capital, such as technical change, managerial skill, and organisational efficiencies. In the basic neoclassical model, TFP growth is measured as a residual, by subtracting the relative contributions of the growth in labour and capital inputs from output growth, and is assumed to be exogenously determined. Reorganising equation 3 from the previous section provides the Solow residual estimate of TFP growth:

∆lnA =∆lnY-α•∆lnK-(1- α)•∆lnL

There is a debate in academic and policy circles as to which measure of productivity is the best one to use. Some argue that TFP is the most appropriate measure and that labour productivity too crude, while others suggest that TFP depends too much on arbitrary assumptions and that labour productivity is more closely related to standards of living, which is what society ultimately cares about.28

The debate has three parts: the time period under consideration, quality of the data, and the underlying model of growth.

The neoclassical model is often the starting point for analysis of productivity growth because of the ease of computation. From the neoclassical model, it can be shown that after dividing each side of equation one by labour input, labour productivity growth is equal to TFP growth and capital intensity or capital deepening.

∆ln lp = α•∆ln k + ∆ln a

where: lp is labour productivity (or output per unit of labour input) a TFP

28 This section follows the discussion found in: Sargent, T. and E. Rodriguez (2000), “Labour or Total Factor Productivity: Do We Need To Choose?” Canadian Department of Finance.

k capital/labour ratio (or capital intensity) α marginal product of capital (or share of capital in output)

In the short run, labour productivity will deviate from TFP growth based on changes in capital deepening. When capital deepening is rising, labour productivity growth will be greater than TFP growth.

In the very long run, however, when the economy reaches a steady state growth path, all per capita variables are growing at a constant rate. Under these conditions, it can be shown that for the standard neoclassical model labour productivity growth will equal capital intensity growth. So that the above equation becomes:

∆ln lp = ∆ln k = ∆ln a/(1-α)

This equation essentially states that in the long run labour productivity growth is dependent on TFP growth. Diminishing returns to capital are responsible for this outcome. In the long run, therefore, the only way to offset the phenomenon of diminishing returns to capital is if TFP grows, which makes capital more productive.

Accurate estimates of TFP require accurate measures of capital and labour inputs. Unfortunately, the capital stock is generally difficult to measure and poses serious difficulties in estimating TFP growth. The two areas that create the greatest difficulty for capital stock estimates are the service life of capital and the construction of the price deflators, for which there are a variety of methods and approximations.29 A better solution would be to follow Jorgenson’s example and utilise quality adjusted indexes of capital services and labour inputs. However, these estimates are often not available from national data sources.

If capital and labour are mismeasured then more economic growth will be unexplained, and fall into the Solow residual and therefore be thought of as exogenous technical change and not due to the accumulation of a factor input. Since capital is thought to be the more difficult concept to measure, growth accounting would typically understate the importance of investment and capital accumulation in economic growth.

For the endogenous growth models, where TFP growth depends on capital accumulation, such as in Romer (1987) and Arrow (1962), standard growth accounting procedures will understate the importance of capital. TFP growth, therefore, will not be a better guide to long run productivity than labour productivity, since TFP in these models follows capital accumulation, rather than being the cause of it.30

In contrast, new growth models where the transmission mechanism is R&D or human capital accumulation, then the growth accounting approach remains largely intact. This is because there are still diminishing returns to physical capital, the (physical) capital-labour ratio cannot grow faster than adjusted TFP in the long run, and so TFP growth is still a good guide to long-term growth trends. The pattern of causation still runs from TFP to physical capital: the only change is

29 See Ahn and Hemmings (2000) pp 10-11 for a more complete discussion. Human capital and R&D spending are also notoriously difficult to measure. 30 Sargent and Rodriguez (2000) p. 10.

that now TFP is determined by some other factor, such as investment in human capital or R&D spending.31

Given the problems inherent with measuring and interpreting TFP, it would appear that labour productivity would likely be the more useful measure of productivity to follow, particularly for policymakers, since one of the objectives of government policy is the improvement of living standards, which labour productivity more accurately measures.

Living Standards: A Definition For Canadians, improving living standards is a primary concern. The development of the financial system contributes to improvements in living standards by boosting investment and productivity. Productivity is an essential ingredient in fostering improving living standards. This can be seen by considering a traditional measure of living standards, GDP per capita, which can be decomposed into the following:

GDP per capita=Y/N

=(Y/H)•(H/N) (labour productivity and labour utilisation)

=(Y/H)•(H/E)•(E/N)

=(Y/H) •(H/E)• (E/N15O) •(N15O/N)

Where: Y is real GDP N is total population

H is Hours worked E is Employment N15O is Population 15 years and over (working age population)

In log terms this relationship can be described as the following.

ln Y/N = ln Y/H + ln H/E + ln E/N15O + ln N15O/N

The first term in the expression is output relative to hours worked, which is labour productivity. The latter three terms are derived from and equal to the number of hours worked per capita, which is referred to as labour utilisation.32

In growth rate terms the relationship becomes:

∆ln Y/N = ∆ln Y/H + ∆ln H/E + ∆ln E/N15O + ∆ln N15O/N

This relationship helps to identify what drives improvements in living standards. To boost overall GDP per capita either labour productivity needs to rise, or people need to work harder (rise in hours worked per employee) or more people need to become employed (rise in employment to working age population ratio), or more people of working age need to enter society relative to total population.

31 ibid p. 9. 32 Harchaoui, T., J. Jean and F. Tarkhani (2003), “Prosperity and productivity: A Canada- Australia Comparison”. Statistics Canada. 11F0027MIE No. 018.

For Canada, the historical picture shows that real GDP per capita grew strongly in the 1960s then slowed appreciably in the mid-1970s (Figure 8). The slowdown in the growth of living standards lasted until the mid-1990s after which there was a significant bounce back in the pace of growth. The same pattern is found in labour productivity growth, which also experienced a strong pace of growth in the 1960s, slowed in the mid-1970s and has started to accelerate again after the mid-1990s (Figure 9). Notably, labour utilisation follows a different pattern (Figure 10). It can be characterised as having significant cyclical variation around a long-term upward trend. The trend line in this chart—expressed as a third degree polynomial expression, as are those in the charts for GDP per capita and labour productivity—does not have the same mid-1970s to mid-1990s slowdown as do real GDP per capita and labour productivity.

Figure 8

Real GDP per Capita, Log Scale

1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 Figure 9

Labour Productivity, Log Scale

1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 Source: Statistics Canada data

Figure 10

Labour Utilisation, Log Scale

1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 Source: Statistics Canada data

Figure 11

Labour Productivity Boosts Living Standards

1961-2003 1961-1971 1971-1981 1981-1991 1991-2003

Contribution to Real GDP per Capita GrowthLabour Utilization

Labour Productivity

Figure 12

Post-1973 Productivity Slowdown Reversal

1961-2003 1961-73 1973-2003 1973-1996 1996-2003

Contribution to Real GDP per Capita Growth

Labour Utilization

Labour Productivity

It is also instructive to examine the contribution to real GDP per capita growth before, during and after the growth slowdown in living standards that occurred from 1974 to 1996. This is done in Figure 12 which shows that most of the slowdown in living standards was due to the deceleration in labour productivity growth. Labour productivity slowed from an average increase of 3.4% during 1961-73 to 1.0% from 1973 to 1996, while labour utilisation slowed less dramatically, from 0.7% to 0.3%. Since 1996 labour productivity bounced back, averaging 2% compared with 0.7% for labour utilisation.

Labour Productivity Decomposition Given the importance of labour productivity growth to the overall gains in living standards it is instructive to examine the reasons for labour productivity growth. As discussed in the section on Investment and Economic Growth, labour productivity growth can be decomposed into the following.

∆ln lp = α•∆ln k + ∆ln a

While labour productivity is output per worker hour, some researchers make a distinction between the measure of labour input used in the production function and hours worked used in the estimate of labour productivity. The difference is because the quality of labour varies over time as the level of skills change in society. From this perspective labour productivity can be written and decomposed as follows:

Labour Productivity =GDP/H

=(At • (Ktα • Lt

(1-α)))/H

In Log terms, this representation becomes.

ln GDP/H = ln LP = ln A + α ln K/H + (1- α)ln L/H

So the change in labour productivity can be represented as follows.

∆ln LP = ln A + α ln K/H + (1- α) ln L/H

For the neoclassical model, the first term is total factor productivity. The second term is the amount of capital services per worker hour (scaled by capital’s share of output) and reflects capital deepening, which is sometimes referred to as capital intensity. In instances where the estimate of capital inputs is the same as the capital stock, then the second term would become the capita-labour ratio. The last term captures changes in the quality of labour inputs (scaled by labour’s share of output). For example, a rise in the quantity of engineers to labourers will boost overall labour quality and be reflected in an improvement in the skill level in the economy. In instances where the data for labour input is actual hours worked, then the labour quality expression drops out since the numerator would equal the denominator and the overall relationship would become the expression indicated at the start of this section.

Some researchers have extended their analysis beyond the expression indicated above by subdividing labour or capital inputs into more components. For example, Jorgensen (2004) distinguishes between ITC and non-ITC capital inputs. Armstrong, Harchaoui, Jackson and Tarkhani (2002) in contrast examine the contribution of ITC, other machinery and equipment and structures to labour productivity. Furthermore, there are differences in the sector of the economy and time periods that are examined. Consequently the estimates of contributions to labour productivity growth are not directly comparable between studies. Table 2 shows estimates from some recent studies.

While the results of these studies may not be directly comparable several general observations are evident. First, capital deepening was the most important contributor to labour productivity growth over the whole 1981-2000 period, and the improvement in labour quality was the second most important factor. Notably, in most studies MFP was the least important contributor to labour productivity growth over the whole period. However, most studies also showed that most of the improvement in labour productivity over 1995 to 2000 period was caused by a bounce back in MFP after an exceptionally weak period in the early 1990s.

The studies that differentiated between machinery and equipment from non-machinery and equipment capital found that the accumulation of machinery and equipment capital contributed to overall capital deepening and labour productivity growth more than structures. It also be concluded that machinery and equipment investment was one of the most important contributors to the improvement in Canadians’ living standards over the 1981-2000 period.

Table 2

Business Sector 1981-2000 1981-1988 1988-1995 1995-2000Labour Productivity Growth 1.4 1.3 1.2 1.7Capital Deepening 0.6 0.6 0.9 0.4

ITC 0.4 0.3 0.4 0.4Other M&E 0.1 0.1 0.1 0.1Structures 0.1 0.1 0.3 -0.1

Labour Quality 0.5 0.5 0.6 0.3MFP 0.2 0.2 -0.3 1.0Source: Armstrong, Harchaoui, Jackson and Tarkhani (2002)

Business Sector 1981-2000 1981-1988 1988-1995 1995-2000Labour Productivity Growth 1.4 1.3 1.2 1.8Capital Deepening 0.6 0.6 0.8 0.5

ITC 0.4 0.3 0.4 0.5Other M&E 0.1 0.2 0.1 0.2Structures 0.1 0.1 0.3 -0.2

Labour Quality 0.5 0.5 0.6 0.3MFP 0.3 0.3 -0.2 1.1

Source: Dachraoui, Harchaoui & Tarkhani (2003)

Business Sector* 1984-2000 1984-1988 1988-1995 1995-2000Labour Productivity growth 1.8 1 2 2.3Capital Deepening 0.5 -0.1 1 0.5Labour Composition 0.4 0.3 0.4 0.2MFP 0.9 0.8 0.6 1.6Source: Harchaoui, Jean & Tarkhani (2003)

Aggregate Economy 1981-2001 1981-1989 1989-1995 1995-2001Labour Productivity Growth 1.3 1.2 1.2 1.4Capital Deepening 0.7 0.8 0.6 0.7 IT Capital 0.5 0.4 0.5 0.8 Non-IT Capital 0.2 0.4 0.2 -0.1Labour Quality 0.4 0.4 0.6 0.2MFP 0.2 0.1 0.0 0.6 IT Capital 0.1 0.1 0.1 0.2 Non-IT Capital 0.0 -0.1 -0.1 0.4Source: Jorgenson (2004)

*Harchaoui, Jean & Tarkhani (2003) use a different definition of business sector.

Labour Productivity Growth Decomposition Estimates

Canada in an International Context To understand Canada’s economic performance over the past 20 years it is helpful to compare the nation’s performance with other countries. International comparisons however are fraught with problems because of definitional differences in the data. Jorgensen (2004) has constructed consistent measures of outputs and inputs that permit relatively easy comparisons among G7 nations. The following section uses the data from his study to place Canada’s performance in an international context.

Canada’s living standards as measured by output per capita grew more slowly than any other G7 nation from 1980 to 200133. Canada’s growth was near the bottom of the G7 during 1980-1989 and dropped significantly below that for other G7 nations from 1989 to 1995. However, since 1995 the growth in Canada’s living standards has bounced back to be with the top performers—the US and UK (Figure 13).

Figure 13

Canada Ranks Last In G7 For Living Standard Gains (1980-2001)

U.S. Canada U.K. France Germany Italy Japan

GDP per Capita Growth

1980-1989 1989-1995

1995-2001 1980-2001

Source: Jorgenson (2004), calculations by author.

A decomposition of the output per capita growth performances into labour utilisation and productivity helps to point out why Canada’s performance was worse than that for the other G7 nations since 1980. In terms of labour utilisation, Canada had the second best performance behind the US over the whole period (Figure 14), although there were massive swings in Canada’s labour utilisation over the sub-periods. Canada had a strong improvement in labour utilisation during the 1980s, being second best behind the US during this interval. Canadian labour utilisation dropped sharply during the first half of the 1990s. Most countries experienced a sharp decline during this interval, and many had a larger drop in labour utilisation than Canada. Since 1995, Canada has experienced the largest improvement in labour utilisation. In contrast to the relatively good performance in labour utilisation, Canada consistently has had one of the worst

33 Canadian data starts in 1981.

labour productivity performances of the G7 nations (Source: Jorgenson (2004), calculations by author.

Figure 15). Over the whole 1980 to 2001 period, Canada’s labour productivity was 1.3% compared with an average of 2.1% for all G7 nations This gap was evident in the 1980s and during the early-to-mid 1990s, with Canada’s

Figure 14 Canada Second Best in G7 For Labour Utilisation

US Canada U.K. France Germany Italy Japan

Labour Utilisation Growth

1980-1989 1989-1995

1995-2001 1980-2001

Figure 15

Labour Productivity Lags Behind In Canada

US Canada U.K. France Germany Italy Japan

Labour Productivity Growth

1980-1989 1989-1995

1995-2001 1980-2001

1.2% labour productivity growth consistently being 1% below the G7 average. Since 1995, however, Canada’s productivity performance has improved to average 1.4%, while the G7

average has slowed to 1.6% as many non-North American nations experienced a moderation in labour productivity growth.

An examination of the factors behind Canada’s relatively poor labour productivity growth indicates that Canada lags behind the G7 average in terms of capital deepening and multifactor productivity growth over the whole time period (Figure 16). In contrast, Canada has a slight advantage in terms of labour quality improvements. This basic pattern of underperformance in MFP growth and capital deepening is also evident during most of the sub-periods examined, except during the 1995-2001 period during which Canada experienced a sharper bounce back than the G7 average, but only after experiencing zero MFP growth over 1989-1995.

Figure 16

Canada Relies Less On Capital Deepening & MFP

1980-1989 1989-1995 1995-2001 1980-2001

Contribution to Labour Productivity GrowthG7 Capital Deepening Canada Capital Deepening

G7 Labour Quality Canada Labour Quality

G7 MFP Canada MFP

While the comparison with the other G7 nations is instructive, Canada’s economy is also significantly different to the other G7 nations, being more reliant on raw material exports and less on machinery than other G7 nations. Consequently, it is also helpful to consider Canada’s performance versus nations that share similar economic attributes. This was done by Harchaoui, Jean & Tarkhani (2003) in a comparison of Canada with Australia. Both counties are small, open economies with relatively high levels of income per capita. Moreover natural resources comprise a large share of exports and most of their machinery needs are imported.

Over the 1983-2000 period Australia’s GDP per capita increased at a faster rate than Canada’s (2.4% versus 1.9% on average). Australia held an advantage of 0.5% for labour productivity growth (1.7% versus 1.2%) and 0.2% (0.8% versus 0.6%) for labour utilisation. From 1995 to 2000, however, the pace of growth of real GDP per capita was similar between the two countries, with Australia’s being 3.0% on average compared with Canada’s 2.9%. Notably, Australia held a distinct advantage in terms of labour productivity growth of 2.5% versus Canada’s 1.5%. Canadians almost closed the gap real GDP per capita growth by working harder, with labour utilisation in Canada expanding by 1.5% versus 0.3% for Australia.

From 1984-2000 Australia had an advantage in capital deepening and multifactor productivity growth, while Canada had an advantage in labour quality improvements for the business sector, for which there is comparable data. Notably, during 1995-2000 there was a gain in labour productivity in both nations, with the Canadian business sector34 accelerating from 2.0% in 1989-1995 to 2.3% in 1995-2000. In contrast, Australia’s labour productivity exploded higher from 1.8% to 3.2% in 1995-2000. For Australia, the jump in labour productivity was caused by much stronger MFP growth as it accelerated from 0.7% to 1.9%, and from a slight improvement in capital deepening, which contributed 1% to labour productivity growth in both sub-periods (Figure 17).

Figure 17

Canada Lags Australia in Capital Deepening & MFP

1984-2000 1984-1988 1988-1995 1995-2000

Contribution to Labour ProductivityAus Capital Deepening Can Capital Deepening

Aus Labour Quality Can Labour Quality

Aus MFP Can MFP

Source: Harchaoui, Jean & Tarkhani (2003)

In general it was found in these studies that Canada has relied on labour utilisation more than other nations to boost GDP per capita, while most other countries relied more on labour productivity growth to boost living standards. Clearly Canadians can not use this route to boost living standards indefinitely. Given the aging of the Canadian baby boom generation, over the next couple of decades there will be fewer people of prime working age relative to the total population. And the employment-to-working age population ratio is already at record highs, which gives limited prospect of higher rates ahead given that labour force participation and employment to population ratios tend to drop off after age 55, and particularly after age 65. Furthermore, as incomes rise people tend to increase leisure relative to work, which helps to contribute to a long-term downward trend in hours worked per employee. Consequently, over the long term Canada will need to rely more on labour productivity growth to boost living standards.

Notably, Canada’s area of relative advantage for labour productivity growth tends to rest more on improvements in labour quality. Other nations tend to have higher MFP growth and/or capital

34 The business sector in this examination is different than other studies in order to obtain comparable Canada/Australia data.

deepening as a source of labour productivity growth. To boost living standards in a sustainable manner, Canada therefore needs to boost capital accumulation as well as to continue to improve labour quality. This need is all the more necessary given that new growth theory suggests that machinery and equipment could hold a central role in MFP growth.

Over long periods of time, improvements in Canadian living standards depend primarily on labour productivity growth. Canada’s labour productivity growth, however, tends to lag behind the gains observed in other nations. Canada relies more on gains in labour utilisation instead. This is an unsustainable situation. Improvements in labour utilisation and therefore living standards will inevitably slow as society ages and Canadian living standards will therefore fall behind those for other nations without concrete action to boost investment and labour productivity growth.

Productivity and Employment Many experts argue that Canada needs to become more productive in order to be competitive in the global economy. But does becoming more productive mean that fewer people must have jobs and those that do have them must work harder? The recent “jobless recovery” in the United States has raised concerns about the societal impacts of ongoing gains in productivity. Individuals are working harder and producing more than ever before – but fewer of them are needed because those that are working are so productive. This perspective can be supported by stories found in the media about individual workers or companies dealing with rapid change in markets, technology and production techniques. But is it the whole story? It is relatively easy to identify people that have been negatively affected by change – identifying those that have benefited is far less common.

This analysis will show that those who benefit from rising productivity far outnumber those who suffer. This does not mean that there may not be serious negative consequences for individuals and families as a result of economic change. And there is a very real role for public policy to help minimise these consequences.

Figure 18

Productivity & Consumption Growth

-4 -2 0 2 4 6 8 10

Albania

Canada

Source: World Bank World Development Indicators Database, calculations by author

Productivity, Employment and Income This section reviews current data on productivity, employment and income to develop some stylised facts about the relationship between these concepts in countries around the world over the last decade. The charts in this section are based on data from the World Development Indicators database published by the World Bank and include decade long averages from either 1990-2000 or 1991-2001 depending on data availability for each country.

Figure 18 establishes a clear link between productivity growth and improvements in the standard of living in countries around the world. In this case, the standard of living is represented by real consumption growth. It is, therefore, assumed that the more goods and services people can buy the better off they are – in a material sense.

The technical definitions provided in the previous section showed that increases in labour productivity can be achieved by lowering employment (while maintaining output at the same level). This means that, in a mathematical sense, there is a negative relationship between productivity and employment. Does this, however, mean that in the real world countries that have high productivity growth must provide fewer jobs? Figure 19 shows that the answer to this question is no. And the reverse is also almost always true: countries with positive productivity growth almost always experience positive employment growth.

Figure 19

Productivity & Employment Growth

-4 -2 0 2 4 6 8

Former Soviet Block Countries

Positive Productivity and Employment Growth

Canada

Source: World Bank World Development Indicators Database, calculations by author

The notable exception is the set of countries that made up the Former Soviet Union. For many of these countries, the transition to a more market-based economy has been challenging. In particular, the high levels of employment sustained under the previous state systems have collapsed. Most of these countries have become more productive over the last decade, but that gain has come to some extent from declines in employment. Fortunately, these massive

adjustments should only have to occur once and workers in these countries should be able to look forward to more opportunities as long as their economies continue to become more productive.

The Centre for the Study of Living Standards (CSLS) has extensively reviewed both the causes and implications of higher productivity. In a recent study, they conclude that “There no longer appears to be a belief that productivity increases unemployment in the long-run, and indeed, the improvement to government balances made available by productivity increases can be used to make unemployment insurance programs more generous.”35 Going further, the CSLS finds that “Productivity does not simply enhance our material standard of living; it also expands the range of choices available. Increased productivity gives society the choice through both markets and the political arena of whether our greater economic well-being will manifest itself through greater private consumption goods, more public goods, additional leisure, or greater public transfers to increase equality and economic security. Of course, enhanced productivity will not automatically increase the social well-being, but it will reduce the apparently zero-sum nature of many of the decisions that we face today, and make it easier to achieve the economic and social goals that all citizens of the world have the right to expect to achieve.”36

Labour productivity increases with rising capital accumulation in the short-to-medium term. In the long run, labour productivity could be improved by capital accumulation based on some new growth theories. And the available evidence suggests that stronger labour productivity growth is positively associated with rising employment growth.

Concluding Remarks on Productivity and Investment Machinery and equipment investment is a fundamental contributor to economic growth in the short, medium and long term. In the short run, rising equipment investment directly contributes to growth because investment is a component of gross domestic expenditures. Since equipment investment directly adds to the accumulation of capital, which is one of the factors of production, equipment also contributes to the expansion of aggregate supply, and therefore helps to determine long-term economic growth. From the perspective of the neoclassical model, the contribution of machinery and equipment to long-term growth can be calculated from the accumulation of capital equipment and equipment’s share of total income.

Studies using the neoclassical model to decompose growth over several decades find that the accumulation of physical capital is the most important contributor to growth for Canada and other G7 countries. Notably, capital equipment is found to be more important than non-equipment capital to overall economic growth.

New growth theory suggests that there could be positive externalities (spillovers) from the accumulation of key asset(s). It is often proposed that machinery and equipment investment is either directly the agent of technological change, or else an important facilitator in the diffusion of technological developments that could be the result of human capital development or research and development expenditures.

Machinery and equipment investment is a key determinant of long-term productivity and growth, and current research shows that the long-term output response is greater than equipment’s share 35 Sharpe, A. “Exploring the Linkages Between Productivity and Social Development in Market Economies” Centre for the Study of Living Standards Research Report 2004-02 p.8. 36 Ibid p.67.

of income. These results imply that there are spillovers from machinery and equipment investment that boosts productivity and long-term growth.

Capital deepening helps to boost labour productivity in the short and medium term by providing more capital per worker. Capital deepening has been found to be the most important contributor to labour productivity over several decades. While arithmetically labour productivity benefits directly from a decline in employment, the reality is that countries with strong labour productivity tend to have rising levels of employment. Living standards are also higher in countries with higher levels of labour productivity.

Over long periods of time, improvements in living standards depend primarily on labour productivity growth. Canada, however, tends to lag behind the gains observed in other nations for labour productivity. Canada relies more on gains in labour utilisation instead. This is an unsustainable situation. Improvements in labour utilisation and therefore living standards will inevitably slow as society ages and Canadian living standards will therefore fall behind those for other nations without concrete action to boost investment and labour productivity growth.

Financial System Development and Economic Growth

Banks, brokerage houses, insurance companies and various other financial services organisations are a major component of Canada’s economy. Countless millions of financial transactions take place every day in Canada. While it is easy to see how important this sector is in every-day life, it is much harder to measure the benefits it confers in terms of economic growth and prosperity.

Theoretical and empirical research that tried to establish the link between financial intermediation and economic growth began appearing in academic journals about twenty years ago. There is now a growing body of international evidence supporting the benefits of banking, securities markets and insurance. To date, however, there has not been any work done looking at the relationship between asset-based financing and economic performance.

The economics profession has spent much of the last few decades trying to understand why economies grow. In particular, the sustained growth of the US economy in the 1980s and 1990s has led to interest in its financial system and the efficiency with which it seems to be able to channel funds to new productive investment projects. Research has focused on whether financial systems in other countries can and do play similar roles and whether financial structures have an impact on resource allocation and growth.

Research by the Organisation for Economic Co-operation and Development (OECD)37 has found evidence suggesting that financial system characteristics are linked to growth patterns in OECD countries. While they are unable to state definitively the direction of causation in these relationships, they are able to draw the following general conclusions:

Legal and regulatory framework conditions for financial systems, and particularly their enforcement and transparency, support innovation and investment in new enterprises.

Significant relationships between investment and financial development, as measured by indicators of the scale of financial activity, exist among OECD countries.

The following section discusses some of the theoretical reasons for links between finance and growth.

Theory Traditional macro-economic theories consider population growth, technological change and capital accumulation38 as the driving forces behind sustained economic growth. Financial systems are important because they are integral to the provision of funding for capital accumulation and for the diffusion of new technologies.

The micro-economic rationale for financial systems is usually based on the existence of frictions in the trading system. The writing, issuing and enforcing of contracts consumes resources and, in a world in which information is not symmetric and its acquisition is costly, properly functioning 37 The Organisation for Economic Co-operation and Development is an international economic research institute with 30 member countries. Interested readers are encouraged to visit their website at www.oecd.org for more information. 38 Capital in this sense includes both physical and human capital.

financial systems can reduce these information and transactions costs. In the process, savers and investors are brought together more efficiently and, ultimately, economic growth is affected. In doing this, financial systems provide four general services:

Mobilising savings – the pooling of individuals savings through financial intermediaries or securities markets provides a readily accessible source of investment funds. The pooling of the savings of individuals through financial intermediaries or securities markets makes the funding of profitable large-scale investments possible.

Diversifying risk – financial systems allow individual savers to diversify against the risk that a single investment pays no return and the liquidity risk that arises because savers may need to withdraw investments before returns are available.

Allocating savings – the cost of acquiring and evaluating information on prospective investments can be very high for individual savers. Financial intermediaries that specialise in acquiring and evaluating this information enable small investors, for a small fee, to locate higher return investments.

Monitoring the allocations of managers – financial systems also reduce the risk that resources are mismanaged. Financial intermediaries can monitor investments for groups of savers reducing their need to duplicate this activity.

Evidence Many empirical studies of the determinants of growth in a broad group of countries conclude that financial development provides a significant contribution to growth39. The OECD, however, found it difficult to reproduce these results unless low income countries were included. Several explanations for the failure to find a finance-growth link among OECD countries have been offered.

Close linkages across OECD financial markets makes it difficult to identify the influence of domestic financial development on a country’s growth rate.

OECD countries are at a more advanced stage of development, where financial systems may have a different (and more difficult to measure) impact on growth than in earlier stages of development.

Cross-country econometric methods may not be suited to detect these different channels. If financial development and its effects on growth in OECD countries varies over time as well as across countries, methods that ignore the information provided by the time variation may have difficulty identifying longer-run cross-country relationships.

With these issues in mind, the OECD’s more recent research focussed on two significant channels. 40 First, financial development appears to be related to economic growth through its relationship with fixed investment. Investment, in turn, plays an important role in the process of economic growth. Different indicators of financial development were used with the results appearing strongest for stock market capitalisation and somewhat weaker, though still significant,

39 King and Levine (1993) found that across 80 countries various measures of financial development are strongly associated with real GDP per capita growth. See Levine (1997) for review of literature. 40 Bassanini and Scarpetta (2001) and Leahy et al. (2001).

for private credit of deposit money banks. Second, measures of financial development were significant in growth equations for OECD countries, even after controlling for the level of investment. They conclude that other channels – beyond fixed investment – appear to link financial system development and economic activity.

To date, there has not been a study that has considered asset-based financing as part of the financial system and its potential role in the finance-growth link. Finance and leasing companies are infrequently included in surveys of major financial institutions and, as such, the industry is often omitted from many discussions on trends in financial services. This omission is telling since the finance and leasing industry has provided some of the most significant innovations in financial services over the last couple of decades. Quite simply, the evolution of financing institutions has outpaced the capacity of tracking systems to understand what is really going on. Government research and regulations are currently trying to catch up. The next section reviews this “invisible” part of the financial services sector.

Asset-based Financing In developed economies, asset-based financing is used by every industry to finance some of the equipment it uses. This activity ranges from the office photocopier and printer to airplanes, construction equipment, rail cars and commercial vehicles. This section briefly explains what asset-based financing is and some of the reasons why it is used.

What Is Asset-Based Financing? Asset-based financing is the financing of equipment and vehicles by way of a secured loan, conditional sales contract or lease. Leasing is the dominant form of asset-based financing. There are a number of different definitions and interpretations of a lease. Accounting, tax, legal and financial advisers all have different perspectives on leasing, as do government regulators and the users of leased vehicles and equipment. In its simplest terms, a lease is an agreement where the owner conveys to the user the right to use an asset in return for a number of specified payments over an agreed period of time. The owner of the asset is referred to as the “lessor” and the user as the “lessee”.

Key Distinguishing Features From Traditional Lending Asset-based financing is used to finance equipment, vehicles and related assets. These types of financing agreements are significant and unique as they enable lessors/borrowers to use the value of the specific asset as security to finance its acquisition and are usually the only assets against which the lessor/financier has recourse in the event the lessee/borrower fails to make payments over the term of the agreement or otherwise defaults under the agreement.

Cash-flow-based credit analysis is a primary financial innovation of this industry. Because the financier retains ownership of the asset until the financing agreement ends, a customer may qualify for use of the asset leased based on its generated cash flow rather than its credit history, assets or capital base. Asset-based financiers generally finance 100% of the asset cost.

Leasing Is Not Lending A lease is not the same as a bank loan. A traditional bank loan that is used to acquire an asset is generally secured by security greater than simply the asset itself. While under a lease the equipment or vehicle is generally the only collateral.

Commercial lending and leasing are different products, each with an important role to play in offering alternative forms of financing to Canadian businesses and consumers. Leasing is not simply a form of passive lending. It is a separate, very pro-active commercial discipline. It is an asset management-based business.

Why Do Businesses Lease?41

There are a number of reasons why business lease equipment. One major advantage is that the asset secures the borrower's unconditional obligation to make payments over the term of the agreement. As a result, leases typically finance a higher percentage of the capital cost of a needed piece of equipment or vehicle than bank borrowing, often with little or no initial down payment required. This allows the lessee to preserve its cash or bank facilities to meet working

41 See Appendix C for more information on the benefits of leasing.

capital needs. Furthermore, leasing decisions are often part of a highly-automated process that can be concluded very rapidly, often at the point-of-sale, in part, because the only security required for the lease is the asset itself.

Leasing is generally a far more flexible means of financing equipment than traditional lending and can be tailored to the client’s specific needs in a number of ways. For instance, payment schedules can be adjusted to accommodate a business’ cash flow needs. Payments can be low at the beginning and increase throughout the term of the lease, balloon payments, or for seasonal payments where the firm pays more during the time period when the equipment is being used the most. There is also a higher approval rate for leases than for bank loans. Other attractive features of lease financing include: long-term financing, usually at a fixed rate; possibility of upgrading equipment at or before the end of a lease contract; and sales-tax deferral in a capital lease.

Unlike traditional banks, lessors offer a variety of services depending on the type of equipment or vehicle leased. The level of service can range from simply procuring the equipment or vehicle, to include cost of delivery, installation, training, servicing, insurance, and agreeing to exchange it periodically for more up-to-date versions. Lessors are frequently responsible for the equipment or vehicles leased from the time of purchase to disposal. The hands-on day-to-day management and maintenance of equipment and vehicles by lessors for their clients is an important customer service.

For operating leases, lease payments are considered an expense for the lessee. In contrast, bank financing is capitalised and recorded as a liability on the borrower’s financial statement thereby affecting the debt/equity ratios for the business. This “off-balance sheet” feature can be of considerable benefit to many businesses, particularly to SMEs.

While interest expenses are typically higher in leases than traditional bank lending, transaction costs can be lower. For example, the costs of assigning collateral, legal documentation and slower processing times for traditional bank borrowing can be significant, particularly for SMEs where many of the conventional financing costs are fixed and not based on the size of the loan. And there are typically shorter wait-times to gain approval for a lease. These differences in costs and benefits between leasing and bank lending mean that they each serve distinct market niches.

Leasing and other forms of asset-based financing do not replace traditional bank financing, but instead complement bank lending by providing an alternative method of financing, with its own costs and benefits that appeal to a distinct market segment. The result is an increase in the number of business that have access to financing and an expansion in the pool of credit available for investment.

Current Industry Structure There are several different types of asset-based financing companies.

Manufacturer finance companies, sometimes called “captives”, are an integral part of the production and sales cycle of their manufacturer parent. They are a key part of the relationship linking the manufacturer to the dealer and the distributor to the customer.

Independent financing companies act as financial intermediaries by providing financing for transactions frequently as specialised outsourced financing partners for manufacturers, vendors or distributors. These companies range in size from very small to large multinationals. Some specialise in the financing of particular kinds of equipment and vehicles while others can accommodate a broad range of transactions.

Finally, many traditional financial institutions – i.e. banks and credit unions – also have leasing operations to help provide their customers with a broader range of financing options.

Origins of Asset-based Financing Although the origins of asset-based financing or leasing can be traced back thousands of years, it has evolved considerably over the last half century. Asset-based financing began as a manufacturer selling technique designed to boost sales and started to become an industry with the formation of the first independent leasing company in 1952 in the United States. The industry grew and spread to Europe and Japan in the 1960s before becoming established in Canada. The industry continued to expand in the mid-1970s spreading to developing countries. By 1994, the asset-based financing industry was established in over 80 countries.

The principal innovation that allowed the development of the industry was the matching of sources of large, long-term savings with the need for long-term borrowing. Starting in the 1950s, pension funds and insurance companies with large amounts of money to invest needed to find long-term, predictable rates of return on these funds. The airline industry had a unique need for large amounts of capital to finance the acquisition of new aircraft. Taking on all the debt required to purchase new airplanes would, however, cripple any airline financially. Through leasing, airlines were able to secure the long-term use of their planes without taking on additional debt. In return, the original funders received a stable, long-term return on their funds.

Today asset-based financing is used by nearly every industry to finance a wide variety of assets ranging from computers and photocopiers to construction equipment, farm equipment and aircraft. Asset-based financing is not just used by businesses. Households also take advantage of this type of financing when they lease new vehicles or computer equipment.

Asset-based financing is a specialised financial service. As a product, it does not replace traditional bank financing but it does complement it by offering an alternative financing option and provides incremental capital to the pool of available credit in Canada.

Trends in Financial Innovation It is hard not to have been affected by the financial innovation of the last few decades. The introduction of credit cards in the 1960s, multi-branch banking in the 1970s, banking machines in the 1980s, debit cards and internet banking in the 1990s have all transformed the ways we conduct routine financial transactions. Financial services options for businesses have also changed radically in this period. Capital market expansion, venture capital, and the growth of the asset-based financing industry all provide business with a growing set of financing options.

Various trends, or catalysts, have contributed to the emergence and growth of the asset-based financing industry. These are: disintermediation and disaggregation; globalisation and the proliferation of funding sources; the diversification of funding techniques; and the introduction of new communications and information technologies. It is unlikely that any single catalyst could have succeeded in building this industry; rather the coincidence of all four together propelled the industry forward.

Financial Disintermediation Financial innovation over the last few decades has led to the displacement of classic bank financing by non-traditional financing. The rise of a broad array of non-bank financial providers has been labelled “financial disintermediation”.

In the traditional model, financing was a seamless process comprising five component parts –origination, credit adjudication, funding, administration and collection – all performed through one institution. This, however, is no longer the only model. There are now a growing number of specialised providers dedicated to only one or two of these functions. This “thin-slicing”, unbundling or disaggregation of financial functions works when it is more cost-efficient to share responsibilities.

New as well as existing financial institutions are choosing to concentrate on just a few of the traditional components of financing by joint venturing, out-sourcing or partnering other services out or creating alliances of service companies. The rapid growth in vendor programs is a good example of this phenomenon. The combination of disintermediation or non-traditional bank financing and the disaggregation of financial functions helped open the doors to new financial providers.

Globalisation: proliferation of funding sources The second catalyst is the unprecedented availability of huge pools of private capital seeking global investment opportunities. This phenomenon is a subset of the trend toward globalisation of the marketplace. As these pools of capital have proliferated, this has in turn engendered a dramatic increase in competition in a sector, which, for the last 50 to 100 years, was limited to a small number of participants. This dramatic increase in competition generates a growing choice of new financial products and services, spawning new organisational models for the delivery of those products and services and reducing the cost of financing.

Without these pools of available capital, the non-bank financial service providers would have had great difficulty in funding themselves to compete against traditional bank lenders.

Diversification of Funding Techniques The third trend flows from the proliferation of funding sources, which generates a diversification of funding techniques. Two of these techniques are reviewed here. The first is “securitisation” and the second is the growth in “captive” financing companies.

Rapidly rising levels of corporate debt have been frequently noted in the media over the last few decades. Much of this growth in corporate debt saw the replacement of traditional bank loans with debt securities (securitised assets) because the latter were cheaper and/or because better terms were available. Originally, the demand for securitisation was driven by the longer-term funding needs of certain companies. The traditional bank loan product could not adequately address these financing requirements and securitisation emerged as the solution, matching the financing of long-term assets with long-term investment instruments.

The second funding technique of interest is captive financing companies. While not new, this is another phenomenon generating capital growth of significance: well capitalised manufacturing and servicing companies with substantial earnings deciding to leverage their own equity base and core competencies rather than those of third parties. This has led to many manufacturers establishing their own financing arms or partnering with those who can do it for them.

About 20% of the CFLA membership consists of the so-called “captives” or financial service affiliates that were established by manufacturers to provide customer financing of the parent’s products. Some of these captives are very big: GMAC, GE Capital, Ford Credit, IBM Global Financing, John Deere Credit, Caterpillar Financial, Cisco Systems Capital, and many more. Captives start off offering to finance their parent’s products but once they understand the business, many expand their horizons to finance not only similar products made by other manufacturers but to finance products their parent company does not manufacture at all. GE Capital is a prime example of this phenomenon.

The financial historian Ron Chernow noted that, historically, ...

“banking was a mere by-product of the world of trade [hence the origin of the term “merchant bank”] and it took a long time to evolve into a discrete profession, consecrated by legal authorities with protective charters. Commodity merchants often advanced farmers money against crop deliveries or extended loans against the security of merchandise for safe keeping. ... The natural progression from commerce to finance is worth mentioning for it left open the possibility that clients of merchant banks with surplus lendable funds might someday become rival banks themselves. As we have seen repeatedly in our own day, any successful business that engenders a large surplus is, potentially, an embryonic bank. In the absence of special regulatory restrictions, banking seems to grow spontaneously from other forms of economic activity.”42

This phenomenon can be viewed a natural outgrowth of economic activity and is nothing new. It has happened before. The traditional banking and financial institutions of today were created a century or two ago in this same way and what we are experiencing now is simply part of a continually evolving process.

The growth in vehicle leasing is an excellent example of this phenomenon. This growth is largely attributable to the commitment of corporate funds through the manufacturers’ finance companies to market and at times subsidise consumer leases.

New Technology New communications and information technologies have had a significant impact on the financial services industry. Increasingly in financial services, you are only as good as your technology. Communications technologies are creating new distribution channels for financial services that allow newcomers to leap-frog the traditional, more cumbersome distribution systems at a fraction of the set-up and operating costs.

The speed and reach of new technology to capture information and to rapidly analyse that information has made possible, on an unprecedented scale, the identification and exploitation of many different markets in several time zones at once. And new technology has revolutionised the capacity of a much broader range of professionals to manage risk.

Global Asset-based Financing Profile Asset-based financing has grown over 10% a year from about $40 billion in 1978 to over $460 in 2002. North America is the largest regional market and accounted for nearly 47% of global 42 The Death of the Banker, (The Barbara Frum Lectureship, April 1997), Ron Chernow, Vintage Canada, 1997, pp. 90-91.

activity in 2002 followed by Europe with 35% and Asia with 15%. The rest of the world accounted for less than 3% in 2002. The leasing statistics presented in this report were generously provided by the London Financial Group and are published regularly in the World Leasing Yearbook. The data collected by the London Financial Group differs from that collected by the CFLA: (i) the London Financial Group excludes automotive retail leasing and (ii) they exclude some types of transactions that the CFLA considers part of asset-based financing.

Investment cycles over this period can be clearly seen in Figure 20. The sharp drop in North American investment after 2000 swamped the increase in leasing activity elsewhere in the world. Similarly, the decline in investment in Europe from 1991 to 1993 dominated global activity. Leasing activity in Asia and South America has yet to recover from the crashes in 1997 and 1999 respectively in these regional markets.

While asset-based financing occurs in nearly every country around the world, Figure 21 shows that the global market is currently dominated by the G-7 nations. These seven countries account for over 80% of global leasing activity in 2002.

Figure 20

Asset-Based Financing

North America

Europe

South America

Australia/NZ

Africa

1978 1982 1986 1990 1994 1998 2002

Source: London Financial Group World Leasing Yearbook

Figure 21

Top 10 Asset-based Finance Markets in 2002

0 50 100 150 200 250

Rest of World

Sweden

Switzerland

Canada

United Kingdom

France

Germany

Billions of US$

The following charts (Figure 22 through Figure 24) show the importance of leasing as a form of financing in selected countries. The most useful measure of this is the value of asset-based financing as a share of machinery and equipment investment in the country. This measure is called the penetration ratio and provides a direct indication of the amount of investment financed by the leasing industry.

Financial innovation has been a hallmark of the US economy over the last few decades. The leasing industry is now a major source of funding for equipment purchases in the US. Leasing in Canada has grown rapidly over the last couple of decades. Although Canada’s leasing penetration rate is second highest among the top 10 markets it still accounts for a much smaller share of financing than in the US. In Brazil, South America’s largest economy, leasing has suffered along with the rest of the financial services sector since 1999.

Leasing penetration rates in European countries have all risen over the last couple of decades. Penetration rates have trended down from the highs seen at the end of the 1990s and were between 10% and 15% for most countries in 2002. Although the volume of new leasing business has grown more rapidly over the last two decades, it remains a less common source of finance in Europe than in North America.

The leasing industry in Australia is well established as a source of funding for investment goods with a penetration rate of between 20% and 25% throughout the 1990s. In September of 1999, changes in small business depreciation rules made leasing less competitive thus reducing the penetration ratio in Australia. The penetration rate in Japan has slowly risen, doubling from 5% in 1978 to nearly 10% in 2002 with the increase occurring before Japan entered its decade long recession in the 1990s. Leasing has only maintained its market share in the weak investment environment that has characterised the Japanese economy over the last decade. Leasing in Korea has not recovered from the shock of the Asian crisis. Renewed investment and a more stable financial system should lead to strong growth in the leasing industry in that country.

Figure 2243

Asset-based Finance Penetration Rates for Major Markets in the Americas

1978 1982 1986 1990 1994 1998 2002

United StatesCanadaBrazil

Figure 23

Asset-based Finance Penetration Rates for Major Markets in Europe

1978 1982 1986 1990 1994 1998 2002

GermanyUnited KingdomFranceItalySweden

43 The countries in Figures 22-24 are used in the empirical work later in this report.

Figure 24

Asset-based Finance Penetration Rates for Major Markets in the Pacific Rim

1978 1982 1986 1990 1994 1998 2002

AustraliaJapanKorea

While leasing activity is dominated by a few major markets, it is worth noting that the leasing industry can be of significantly greater importance to countries in need of additional investment in machinery and equipment. Figure 25 shows the top twenty one44 markets in terms of leasing as a share of GDP in 2002. The broader GDP measure is used in place of machinery and equipment investment because the latter is not readily available for all countries. Four Eastern European countries dominate this measure – for them, leasing is a critical source of finance for their investment plans. None of the G-7 countries are in the top 10 using this measure which emphasises the importance of leasing as an alternative – and readily available – source of financing in places and sectors where other parts of the financial services industry are unable to provide all the financing desired by businesses.

44 Canada ranked 21st among the nations surveyed by the London Financial Group in 2002.

Figure 25

Asset-based Finance as a Share of GDP: Top 21 Markets in 2002

1.41.4

1.51.51.6

1.81.8

1.81.9

2.02.0

2.12.1

2.32.3

2.42.7

3.84.0

4.44.8

1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

Canada

Morocco

France

Austria

Denmark

Luxembourg

Germany

Portugal

Romania

Switzerland

Slovenia

Sweden

South Africa

Czech Republic

Hungary

Slovakia

Estonia

Canadian Leasing Market The Canadian Finance and Leasing Association (CFLA) estimates that the industry has a total of over $115 billion in financing in place with businesses and consumers in Canada today. This is a significant increase from the estimated level of assets of about $50 billion in 1996, as reported by the Federal Task Force on the Future of the Financial Services Sector (the MacKay Report)45. In comparison, the total assets of the property & casualty insurance industry at that time were reported to be $53.3 billion.

In Canada, leases are used by consumers and businesses in all industries and regions of the country. Close to 43% of assets are motor vehicle leases, and 57% are equipment. Based on CFLA data, in 2002 the regional distribution of equipment and fleet lease finance was similar to the regional distribution of economic activity (Figure 26). However, there was a heavier concentration of leasing activity in Ontario, Quebec and Manitoba/Saskatchewan than economic activity. In contrast, there was an under representation of leasing activity in Atlantic Canada, Alberta and British Columbia.

The CFLA estimates that around 20-25% of new gross business machinery and equipment investment is financed by leasing, which is a significant advance from 5% or less, just 15 years ago. Furthermore, over 40% of new vehicle sales over the past five years were leased and of that 45 Task Force on the Future of the Canadian Financial Services Sector, Report of the Task Force, September 1998, p.43.

Figure 26

Leasing Used Throughout Canada

Atlantic Quebec Ontario Man/Sask Alberta BC

Regional Distribution Lease Finance and Economic Activity, 2002

Equipment & Fleet Vehicle LeaseFinancing (ABF, FI & MCF)GDP

Source: Statistics Canada and CFLA

number approximately 80% were retail leases (mostly consumers) and around 20% were fleet leases (largely commercial customers).

It is worth noting that the practice of leasing is not confined to the business world. Municipalities, universities, school boards, hospitals and government bodies frequently lease the equipment they need to fulfill their respective missions. Cutbacks in public funding and increasing restraints on capital budgets present obvious difficulties in the acquisition of essential equipment. From computer hardware and software for administrative and educational uses to school buses, garbage trucks, police cars and sophisticated medical equipment, these are the kinds of essential equipment leased by public sector bodies. The federal and provincial governments too are major lessees of a wide range of equipment.

In most cases, lessors are corporations specialising in financial services. They can be privately-owned or publicly-traded companies, manufacturing companies or dealer/distributors, subsidiaries of domestic or foreign banks, trust companies or insurance companies. Independent asset based finance companies (ABF) have the largest share of the business market, while captive automotive finance companies have the dominant share of the retail auto leasing market (Figures 27 and 28).

Different suppliers tend to serve different market niches. This can be seen by distinguishing between the institutions that supply funds based on the dollar amount of the lease authorisation. According to Statistics Canada, finance companies, including the acceptance arms of manufacturers, dominated the market for business leases of less than $50,000, with 52% of amounts outstanding. Domestic banks were the principal providers of leases of $1 million and more, with 48% of amounts outstanding. (Figure 29)

Figure 27

Equipment Financing & Fleet Leasing (2001-03)

Equip. Manuf Captive Finance Comp. 32%

Financial Institutions 17%

Independent ABFs 41%

Independent Vehicle Lessors: Fleet Leasing 9%

Source: CFLA

Figure 28

Retail Automotive Leasing (2001-03)

Independent Vehicle Lessors: Retail Leasing 12%

Automotive Captive Finance Comp. 88%

Source: CFLA

Figure 29 Lease Suppliers Market Shares by Size of Lease

(% Share) Supplier\Financing Authorisation <$50K $50-249K $250-999K $1,000K+Domestic banks 1 24 45 48Finance companies 52 21 27 31Leasing companies 42 46 20 9All other suppliers 5 9 8 12Total 100 100 100 100

Source: Statistics Canada

Small Business and Leasing According to the best estimate of the CFLA, 60% of their customers are small and medium sized enterprises (SME). To understand the importance of leasing to the economy, it is essential to understand the significance of SMEs to the economy and the importance of leasing to SMEs.

There are a variety of ways to define the SME sector. Different surveys use different measures, such as assets, sales or employment46. While the variety of ways to enumerate the SME sector make a consistent statistical description elusive, one thing is clear, the SME sector is important to the economy. Firms with less than 500 hundred employees are responsible for 65% of private sector jobs according to Statistics Canada’s Survey of Employment, Payrolls and Hours (SEPH)47 (Figure 30). And the SME sector was responsible for 63% of the net new private sector jobs created over 1994-2002 on average, although there is significant year-to-year variation (Figure 31). In terms of self-employment, there has been a general upward trend over the past 25 years, based on the labour force survey, with the total number of self-employed reaching a peak in 1999 at 2.5 million jobs. After a setback in 2000-01, self-employment is growing again (Figure 32).

The SME sector, however, tends to have a lower level of wages and value added per employee than large firms. Consequently, its share of economic activity tends to be lower than its share of employment. The OECD estimates that SMEs were responsible for 43% of private sector value added in 1998, while BC Stats calculates that firms with 50 or fewer employees were responsible for 25% of total Canadian GDP in 2002. And BC Stats calculates that these small firms’ share of total Canadian GDP has ranged between 23-26% over 1993-2002, averaging 24.4%.

Figure 30 SME Sector Largest Employer

0-4 5-19 20-49 50-99 <100 100-499 500+

Employment by Firm Size in 2002, %

46 Although employment is not necessarily the best measure of firm size, most studies by Statistics Canada use it because it is readily available. Using employment, SMEs are often defined as firms with less than 500 employees. 47 SEPH excludes self-employed workers not on a payroll, and employees in the following: agriculture, fishing and trapping, private household services, religious organizations and military personnel.

Figure 31

Most Employment Growth In SME Sector

1994 1995 1996 1997 1998 1999 2000 2001 2002

Contribution to Employment Growth, %

Large(500+)Medium (100–499)Small (<100)

Figure 32

Self Employment Increasing In Importance

1976 1980 1984 1988 1992 1996 2000

Self Employment, Thousands of Jobs

With Paid Help

Without Paid Help

The literature on small business development suggests that SMEs can provide unique contributions to the economy via a number of channels: providing a “seedbed” for future industrial growth, source of innovation, development of entrepreneurial talent, adding flexibility

to the industrial structure and thereby promoting greater economic dynamism and speedier and less costly adjustment to economic shocks.48

Clearly, the SME sector in Canada is a “seedbed” for industrial growth, given the importance of SMEs to employment and GDP growth. In terms of innovation, the evidence suggests that most of Canada’s R&D expenditures are made by large companies. Small innovative companies, however, often spend more than large companies relative to revenue (Figure 33). There is also a difference in the kind of R&D spending between large and small companies. Baldwin (1997) found that small innovative manufacturing companies tend to focus on product innovation more than process innovation relative to large companies. Baldwin also found that small firms tend to be more flexible than large companies. The evidence, therefore, supports many of the propositions regarding the importance of the SME sector to the health of the economy.

Canada has a larger SME sector than many countries, including the United States. Given the importance of SME to the economy, factors that prevent this sector from reaching its economic potential will have a significant impact on the overall economy. A considerable amount of research suggests that small business face a financing constraint.49

Small and medium-sized enterprises (SMEs) have difficulty securing either debt or equity funds because they have few assets to offer as collateral for loans from traditional debt-based financial intermediaries such as banks and few equity markets are organised to provide capital to small firms. The financing constraint or credit gap is expected by theory because of asymmetric information between borrowers and lenders, which is particularly acute for new small business.

Figure 33

R&D Expenditures by Firm Size

1–49

50–9

100–

200–

500–

–199

–499

9Total

Scientific R&D Exp., % of Revenues, by Firm Employment, 2001

Source: Industry Canada.(2002),“Financing Small-and Medium-Sized Enterprises”

48 Biggs, T. “Is Small Beautiful and Worthy of Subsidy? Literature Review”. World Bank. 49 Berger and Udell (1998).

Lenders will resort to rationing credit to their borrowers rather than use the interest rate as a market clearing device (i.e., charge the less creditworthy borrowers higher rates of interest to compensate for the credit risk). Hence, information asymmetry could cause credit markets not to clear, and some firms to be credit rationed.50

For the US, Mallick and Chakraborty (2002) found the credit gap, which is the difference between the financing that companies wanted versus what they were able to obtain, for SMEs was 20%. It was even larger for SME manufacturers at 46%. For Canada, the financing gap is likely to be in a similar range as found for the US. This result suggests that Canada could face a serious problem since the Canadian economy is more reliant on SMEs in manufacturing than the US, with about three-quarters of manufacturing jobs in Canada being in SMEs versus two-thirds in the US. Asset-based financing may provide a means to reduce the financing gap.

The economic literature on financing and development suggest that economies grow faster, industries depending heavily on external finance expand at faster rates, new firms form more easily, firms’ access to external financing is easier, and firms grow more rapidly in economies with a higher levels of overall financial sector development.51 Notably, small companies benefit the most from financial development because they can obtain easier access to external financing, while large businesses typically already have access to external financing.

A significant financing problem is said to exist for investment in R&D and new technologies—investments that bolster a firm’s chances for growth and success52. This view is corroborated by the evidence for Canada. One survey found that SME’s that have a higher rate of R&D expenditures had greater problems with obtaining financing. And firms that have a higher R&D investment rate needed financing more than companies that had a lower level of R&D spending relative to revenues.53

Not only does the access to capital help firms to start-up and to grow, but financing can also affect the survival of the firm. Baldwin el al (1997), for example, found that the lack of access to financing was one of the most important factors causing firms to go bankrupt.

Leasing provides small businesses with an additional method of external financing beyond bank loans or equity. Leases have many attributes that are beneficial to small business, such as the ability to finance most or all of the cost of the equipment or vehicle. The preservation of existing lines of credit and the flexibility of lease payments to more closely match the cash flow of the business will help credit constrained small business to purchase equipment that more closely matches their needs.

The literature on “bootstrap financing” suggests that many small businesses prefer to lease rather than use bank loans to buy equipment.54 In one survey, Neeley (2003) found that over 50% of US 50 Mallick and Chakraborty (2002). 51 Beck et al. (2000). 52 Baldwin et al. (2002). 53 Industry Canada. “Financing Small-and Medium-Sized Enterprises: Satisfaction, Access, Knowledge and Needs”. The Research Institute for SMEs, Université du Québec à Trois-Rivières, 2002. 54 Bootstrap financing encompasses the variety of routes that entrepreneurs take to meet businesses’ financial needs without resorting to traditional institutional commitments or market obligations. Neeley, L. “Entrepreneurs and Bootstrap Finance”. Management Department, Northern Illinois University. 2003. p. 1.

small business respondents leased equipment, while Winborg and Landstrom (2001) found that 33% of Swedish small businesses leased instead of buying equipment. In Canada, leasing is an important source of financing for SMEs. Statistics Canada reported that during 2000, 9% of firms in the SME sector requested a lease, while 23% requested a bank loan (Figure 34). In contrast, the approval rate for leasing was 98% versus 82% for loans.

Figure 34

Leasing & Loan Requests2000

Overall 0 1-4 5-19 20-99 100-499Size of Business, Number of Employees

Leases Loans

Source: Statistics Canada, Survey on Financing of Small and Medium-sized Enterprises, 2000

Figure 35

Leasing & Loan Approval Rates

Overall 0 1-4 5-19 20-99 100-499

Approval Rates, %

Leases Loans

Source: Statistics Canada, Survey on Financing of Small and Medium-sized Enterprises, 2000

Notably, in Canada the tendency to request a lease or bank loan rises with the size of the company. In contrast, the approval rate for leases is similar across sizes classes, while there is a distinct rise in approval rates for bank loans by the size of the firm (Figure 35). It is likely that SMEs are relying more on leases over time. For instance, the Canadian Federation of Independent Business (CFIB) found that small business are using bank loans less, which is consistent with other information that suggests that businesses are using leases more.

While the importance of leasing as a source of financing for the small business sector is significant and growing, the importance of the leasing industry’s activities to the small business sector extends beyond the direct financing function. This is because, as mentioned above, many leasing companies have developed expertise in certain asset markets, so that a second tier equipment market has developed. The development of a market increases the availability of used equipment for small firms to purchase.

The literature on bootstrap financing suggests that used equipment purchases have been a mainstay for bootstrappers to realise the most value from each dollar invested in the business. Used equipment normally costs less, and the buying entrepreneur is then able to arrange financing or leasing for the purchase.55 Neeley found that over 75% of small businesses in her sample purchased used equipment, while Winborg and Landstrom found that 78% of small businesses in Sweden utilised used equipment.

By providing relatively easier access to financing and developing a second tier market in equipment, the leasing industry is helping to improve the viability of the SME sector. Given that the SME sector represents around 65% of employment and over 40% of economic activity, the asset-based financing industry is potentially contributing more to the economic viability of the nation than the share of its financing might suggest.

55 Ibid p. 25.

Financial System Development, Investment and Growth: Evidence from the International Data

Theoretical and empirical studies trying to establish the link between financial intermediation and economic growth began appearing in academic journals about twenty years ago. Some of the pioneering work in this field was conducted in Canada by J. Greenwood56 and his colleagues at the University of Western Ontario. There is now a growing body of international research supporting the benefits of banking, securities markets and insurance.

To date, however, there has not been any work done looking at the relationship between asset-based financing and economic performance. Although a recent study released by US Equipment Lessors Association57 conjectured that asset-based financing helps to reduce the cost of capital to business and promotes the use of newer, more productive, capital:

It is plausible to suggest that the unavailability of equipment leasing as an option would result in an overall higher cost of capital, thereby inducing a substitution towards lower cost, used equipment, and in the limit prevent many businesses from acquiring equipment at all. This would have several likely impacts on the economy. First, it would prolong the economic life of capital equipment and, therefore, lower the value of the capital stock ... Therefore, not only would the value of the capital stock fall, but the vintage of the capital stock would age, and with it the diffusion of newer, more innovative equipment.

Finally, a higher cost of capital would likely exclude businesses—presumably smaller, new businesses in particular—from acquiring equipment since the market rates available to them would probably be higher than that of a prospective leasing company. This prospect carries some implications for competitiveness of the economy at large since de novo entry into markets or expansion of firms in existing markets might be diminished.

The US Equipment Lessors Association study tried to determine the impact of the leasing industry by using an economic model of the US economy and assuming the absence of all investment financed by lessors. This approach involves two significant assumptions. The first is that businesses would not use alternate sources of financing for their investment plans. While it is recognised that some investment would not occur without leasing, it is not possible to determine precisely how much would be cancelled. The second assumption is that there is no change in the cost of capital. One of the key benefits of asset-based financing is that it makes financing more accessible (i.e. cheaper) for a large class of businesses. Measuring this benefit is, however, far from simple. These issues are discussed further in Appendix E which also includes a simulation using the C4SE’s model of the Canadian economy in which investment is reduced.

Given the difficulties described above with directly estimating the impact of asset-based financing on the economy, the challenge was to find an alternate approach. The OECD has conducted a number of studies designed to determine the factors – both policies and institutions – that influence economic growth. Two related studies were of particular interest. The first study

56 Greenwood, J. And B. Jovanovic (1990), “Financial development, growth and the distribution of income”, Journal of Political Economy, 98(5), pp. 1076-1107. 57 “The Economic Contribution of the Equipment Leasing Industry to the U.S. Economy”. Global Insight, Advisory Services Group. 2004. p. 12.

by Bassanini and Scarpetta (2001) 58 examined a broad set of factors to try to determine which ones influenced economic growth in OECD countries since the 1970s. The second study by Leahy, Schick, Wehinger, Pelgrin and Thorgeirsson (2001) 59 focused on the contribution of financial systems to growth in OECD countries.

These studies attempt to test the hypothesis that the efficiency with which financial systems in developed economies have channelled funds to new investment projects has fuelled sustained high growth in these economies. And, if it has, whether other countries’ financial systems might play similar roles. Their research found that financial sector activity has a positive influence on growth. The analysis in this report borrows heavily from the approach used in these two OECD studies and extends their measures of financial system development to include the asset-based financing industry.

Indicators of Financial Development and Investment Measuring the services provided by the financial system is difficult. Ideally, a measure should indicate the ease with which companies in need of external funds can access them and the ease with which investors can get adequate returns. This suggests the use of measures related to the efficiency and competitiveness of the financial sector. However, time series data are generally only available for size indicators. As a result none of the available measures is considered ideal.

The standard practice in empirical work is to use indicators that measure components of the financial system relative to GDP. As each measure has certain shortcomings, a set of four indicators is used in this report.

Domestic credit provided by the banking sector, consists of interest bearing assets held by the banking system. These assets include government securities and loan obligations which both private households and firms have with banks. As a measure of the overall size of the financial intermediary system, it has the major shortcoming of not capturing financing through other non-bank institutions or the securities market.

Private credit of deposit money banks provided to the private sector, consisting of the total claims of deposit money banks on the private sector, aims to measure the degree of financial intermediation that occurs in the banking system. It has the advantage that it isolates credit issued to the private sector, as opposed to credit issued to governments, government agencies, and public enterprises. A major shortcoming is that it captures only the financing intermediated by deposit taking banks and not the financing through other institutions or the securities markets.

Stock market capitalisation, consisting of the value of listed shares, attempts to measure the ease with which funds can be raised in the equity market. One limitation is that it does not capture the development of the banking system, the role of debt securities, or other parts of the equity market (non-listed equity). Another possible limitation is that it measures the market value of existing listed companies rather than the amount of funds raised in the equity market in any particular year – though on the other hand, changes in stock market valuations may play an important signalling role concerning expected

58 Bassanini, A. And S. Scarpetta (2001), "The Driving Forces of Economic growth: Panel data evidence for the OECD countries", OECD Economics Studies No. 33, Paris. 59 Leahy, M., S. Schich, G. Wehinger, F. Pelgrin And T. Thorgeirsson (2001), “Contributions of financial systems to growth in OECD countries”, OECD Economics Department Working Papers, No. 280, Paris.

returns on investment. Also, such a size measure does not necessarily indicate the ease and efficiency with which firms can raise funds through issuing equities. Indicators of activity and liquidity would be useful in this context; however, sufficiently long time series of these indicators are not generally available for a large number of OECD countries.

Asset-based financing, measures the availability of asset-based financing. This measure only covers business and public sector financing of equipment. Like the other financial services measures, it gauges the degree to which savings are pooled and channelled into productive investments but is by far the narrowest measure of financial services used in the analysis. It should also be noted that, unlike the other measures which represent the value of assets or liabilities (i.e. stocks), the asset-based financing measures are only available for the value of equipment newly financed each year. The outstanding value of equipment financed this way would be significantly higher. The CFLA estimates new business in 2003, excluding vehicle lessors, of $18 billion on a total financed portfolio of about $77 billion. Applying a similar ratio to the World Leasing Yearbook’s data would imply that over $2 trillion US dollars of equipment is being leased around the world at the present.

Data that differentiate between equipment and non-equipment investment could not be obtained, so total investment was used instead. Gross investment is measured by real private non-residential (or business sector) fixed capital formation. Business-sector fixed investment probably captures the bulk of productive capital accumulation in OECD economies. It excludes other categories of private-sector investment, such as residential construction and stock building, which are generally not driven by the same factors.

Data Sources The data in this report were drawn from two sources. The economic and financial data, excluding the leasing data, were from the World Bank’s World Development Indicators database. This is a comprehensive database on development data covering nearly 600 indicators for over 200 economies. The database includes social, economic, financial, natural resources and environmental indicators for more than forty years.

The leasing data were kindly made available by the London Financial Group and are updated and published annually in the World Leasing Yearbook. These data are collected from a variety of sources, with the most important being the national associations which represent the leasing companies in each country. The figures represent the value of equipment newly financed for business purposes in each year60. Real estate leasing is not considered part of this industry and is excluded from this data. Likewise consumer credit financing is also excluded.

Various types of commercial financing transactions are considered leasing by the World Leasing Yearbook for purposes of this data. Transactions where the financier has no exposure to the residual value of the asset at the end of the “hire period” are, however, excluded. These are considered pure financing transactions, similar to a bank loan, even though they are asset-based in the sense that the finance company retains legal title or security in the financial asset while the debt remains outstanding.

60 Note that this does not strictly denote new equipment; it also includes secondhand equipment and sale-and-leaseback transactions for equipment already in use by the seller/lessee.

The definition above differs in two significant ways from that used by the CFLA and its members. In the first instance, the CFLA’s membership includes the vehicle leasing industry. To account for this, vehicle leasing for private use is removed from the data provided by the CFLA to the World Leasing Yearbook. In the second instance, the CFLA represents the interests of companies involved in asset-based financing. While the majority of asset-based financing transactions are leases, many of these companies also provide other financial services such as conditional sales contracts and secured loans.

The data used in the empirical analysis covers the years 1978 to 2002 for the following countries: Australia, Canada, France, Germany, Italy, Japan, Korea, Sweden, UK and the US.

Estimating the Relationship Between Financial Development and Investment Levels This section describes two approaches to examine the link between financial development and investment. These mirror the approach taken by the OECD in their studies. Both approaches treat investment as a function of one of the financial development indicators and a set of more standard conditioning variables. The financial development indicator serves as a proxy measure of the services provided by the financial system that might influence the financial cost of capital, ease the acquisition of financing, expand the range of financing options or otherwise help to bring savers and investors together more efficiently. The two approaches differ in the set of conditioning variables they employ and the constraints they impose.

Specification for the First Approach The first model is a relatively typical investment equation including measures of output and cost. It takes the log level of gross investment as its dependent variable and the following as its long-run conditioning variables: (i) the log level of output and (ii) a real long-term interest rate, adjusted for relative price changes between capital goods and output. In addition, the approach includes one of the indicators of financial development described earlier.61

In order to focus on the long-run contribution of financial development to investment, a panel error correction approach is adopted for the empirical analysis. Such an approach has the advantage of distinguishing the long-run determination of investment – the primary focus here – from the short-run adjustment.

The OECD experimented with four different specifications to estimate the relationship between financial development and gross investment. These are:

The static fixed effects estimator includes only contemporaneous variables (“static”) and is a special case of an error correction model where the coefficient on the error correction term is constrained to be equal to one.

The dynamic fixed effects estimator, which imposes the constraint that the short and long-run coefficients are equal across countries.

61 An alternate specification, not tried by the OECD or us, would include all or some of the financial development indicators in the regression. The advantage to this approach is that it would allow provide an estimate of the incremental benefit to investment from each of the financial development indicators. This approach would, however, require longer time series than are currently available in order to have sufficient degrees of freedom to estimate the model.

The mean group estimator, which does not impose any restrictions; it is an unweighted average of the coefficients estimated independently for each country.

The pooled mean group estimator, which imposes equality of long-run coefficients but allows short-run coefficients to differ across countries.

These estimators are discussed in more detail in Appendix D. Results for the mean group estimator are not presented here since they failed to provide statistically significant results for any of the financial services measures. This is similar to what the OECD studies found when using this technique. As discussed in Appendix D, this could be the result of the equal weighting of outliers in this approach.

Estimation Results for the First Approach Table 3 summarises the results for each measure of financial development using the three different estimation techniques discussed above (only the long-run coefficient estimates are reported in the table). In all cases the dependent variable is the log change in real gross investment. Under the assumption that the long-run elasticities are identical across countries but allowing the short-run elasticities to vary (i.e. using the pooled mean group estimator), there is support for the hypothesis that financial development is linked to gross investment. This result holds strongly when financial development is measured by stock market capitalisation or by asset based holdings and is only weakly true for domestic credit provided by the banking sector. These results are broadly consistent with the OECD’s analysis. Although the number of countries and estimation interval employed in the two studies differ, the parameter estimates are reasonably close.

Table 3. Long-run coefficient estimates from regressions of the change in gross investment in selected countries

Estimators SFE DFE PMG SFE DFE PMG SFE DFE PMG SFE DFE PMG

Financial development 9.05 9.43 12.48 0.14 0.17 -0.94 0.02 0.19 0.13 0.22 0.61 0.31(0.65)** (2.59)** (1.63)* (0.04)** (0.16) (0.12)** (0.04) (0.15) (0.13) (0.03)** (0.21)** (0.06)**

Gross domestic product 1.05 1.24 1.05 1.10 1.36 1.71 1.13 1.35 1.32 0.79 0.26 1.38(0.02)** (0.06)** (0.04)** (0.02)** (0.08)** (0.08)** (0.02)** (0.08)** (0.07)** (0.05)** (0.34) (0.09)**

Adjusted real interest rate -1.15 -1.45 -1.70 -1.35 -0.41 -0.41 -1.27 -0.40 -0.58 0.29 -3.29 1.54(0.15)** (0.39)** (0.22)** (0.18)** (0.35) (0.14)** (0.17)** (0.36) (0.25)* (0.21)** (2.14) (0.26)**

Memorandum items:Average error correction coefficient -0.16 -0.19 -0.11 -0.17 -0.11 -0.14 -0.09 -0.13

(0.03)** (0.08)* (0.02)** (0.06)** (0.02)** (0.06)* (0.03)** (0.08)*

Asset-based Leasing Domestic Credit to Private Sector

Domestic Credit provided by Banking Sector Stock Market Capitalisation

All techniques are variations of an error correction approach (see Appendix D). SFE is the static fixed effects estimator; the functional form imposes a unit coefficient for the error correction term. DFE is the dynamic fixed effect model and PMG is the pooled mean group estimator.

Financial development is proxied by (i) asset-based financing; (ii) domestic credit to the private sector; (iii) domestic credit provided by the banking sector; or (iv) stock market capitalisation.

Notes: Rounded standard errors are shown in parentheses. * and ** indicate significance at the 5 per cent and 1 per cent levels, respectively.

Data are for 10 countries from 1978 to 2002 (Brazil is excluded from the sample). All variables in logarithms. The real interest rate enters as log(1+r).

Like the OECD analysis, the coefficient estimates for output are positive and strongly significant, but often statistically greater than one. A coefficient estimate that is greater than one may be seen

as being inconsistent with a constant capital-output ratio in the steady state. In the approach used here, however, it is possible that the short-run dynamics of the specification failed to capture all the business cycle effects and that the long-run estimate is picking up the effects of an accelerator-type relationship. It can also be argued that in an environment of steadily declining relative prices for capital such as has been experienced over the last two decades, the real stock of capital, quality adjusted, could grow faster than real output for a long time. In this case, the high coefficient on output may be an indication that the sample period considered here is too short to have captured a true steady-state type relationship. It is also possible that the coefficient estimate on the output variable is picking up additional effects associated with an omitted trending variable that is correlated with output.

The coefficient estimate for the adjusted real interest rate is usually negative and significant in more cases than in the OECD study. This measure is considered, at best, a crude approximation of the user cost of capital and may be collinear with some measures of financial development. Some researchers have even concluded that the cost of capital has little actual impact on investment with quantity variables – output or sales – driving the need to invest.

Finally, again consistent with the OECD research, the error correction term has an estimated coefficient that is negative and significant. This is consistent with the view that there exists a long-run equilibrium relationship between the variables and that the short-run adjustment is driven by the extent of the gap between current and long-run equilibrium values. This is worth noting when reviewing analysis produced by static models (i.e. the SFE columns). Static models assume that the adjustment coefficient is equal to one – a finding rejected by the dynamic models. This indicates that the coefficient estimates from the static models will be biased and should be viewed with caution.

Specification for the Second Approach The second approach takes the ratio of gross investment to output as its dependent variable. This is related to the first approach and differs by imposing the constraint that the long-run coefficient on the output variable in the first approach is equal to one, consistent with a constant investment-output ratio in the steady-state. Another difference between the two approaches lies in the conditioning set, which includes policy and other variables found to be important in the OECD study by Bassanini, Scarpetta and Hemmings (2001). The conditioning set includes varying combinations of: (i) inflation, (ii) the standard deviation of inflation, (iii) government capital formation, (iv) government consumption, (v) government tax receipts and (vi) adjusted trade exposure. The pooled mean group estimator is used to estimate the various specifications.

Estimation Results for the Second Approach The results for the second approach are reported in Table 4. They provide additional support for the view of positive linkages between financial development and investment. Two specifications for each financial development measure are presented. The signs and magnitudes of the estimated coefficients on the financial variables are similar to those derived by the pooled mean group estimator from the first approach. Bassanini, Scarpetta and Hemmings (2001) found that the signs on the other conditioning variables are all negative. The results in Table 4 are consistent with that finding. Finally, the average error correction coefficients are all negative and generally significant.

Table 4. Long-run Coefficient Estimates from Regressions of the Change in Investment Share (Pooled mean group estimators)

Financial development -12.70 9.64 -0.02 -0.05 0.11 0.17 0.67 0.79(5.22)* (2.66)** (0.08) (0.14) (0.09) (0.17) (0.07)** (0.05)**

Inflation 0.20 -1.17 -0.93 -2.90 -0.74 -2.99 -1.97 -0.68(0.8) (0.56)* (0.38)* (0.69)** (0.4) (0.82)** (0.63)** (0.36)

Standard deviation of inflation -14.60 -3.86 -3.87 -4.49 -4.36 -5.26 4.14 -6.53(5.03)** (1.46)** (1.26)** (1.74)* (1.38)** (2.16)* (1.1)** (1.34)**

Government consumption -16.28 -2.86 -3.22 -4.89(3.98)** (0.46)** (0.52)** (0.51)**

Government tax receipts 0.09 -0.65 -0.94 0.68(0.99)** (0.57)* (0.73)* (0.55)**

Government capital formation -15.34 -0.20 -11.38 -1.26 -12.11 -1.43 -12.45 -1.57(8.34)** (0.23) (2.67)** (0.33) (2.75)** (0.4) (1.41)** (0.14)

Adusted trade exposure -1.53 -0.20 -1.00 -1.26 -1.04 -1.43 -2.05 -1.57(0.5)** (0.23) (0.21)** (0.33)** (0.24)** (0.4)** (0.13)** (0.14)**

Memorandum item:Average error correction coefficient -0.13 -0.26 -0.20 -0.20 -0.20 -0.18 -1.66 -0.43

(0.05)* (0.1)* (0.07)** (0.06)** (0.07)* (0.06)** (4.73) (0.1)**

Asset-based Financing Domestic Credit to Private Sector

Domestic Credit Provided by Banking

Sector

Stock Market Capitalisation

Financial development is proxied by (i) asset-based financing; (ii) domestic credit to the private sector; (iii) domestic credit provided by the banking sector; or (iv) stock market capitalisation.

Data are for 7 countries from 1978 to 2002 (Brazil, Italy, Japan, and Korea are excluded from the sample). All variables in logarithms.

Financial Development and Growth The preceding results identify a positive and generally significant relationship between financial development and the level of investment. Coupled with the result that investment contributes directly to economic activity and growth, financial development can be seen to have a role in the growth process.

Our earlier discussion indicated that financial development may also contribute to economic activity through other channels, such as technical innovation or through the improved efficiency of investment. An additional model was developed, relating the long-run level of output per capita to one of the financial development indicators, investment as a share of output and other conditioning variables62. Results from this model can show, even controlling for investment in fixed capital, whether financial development indicators have a positive relationship with output, consistent with the view that channels other than fixed investment may link financial development to economic activity and growth.

62 Bassanini, Scarpetta and Hemmings (2001) develop a human capital index for use in this model. Unfortunately, the World Bank Development Indicators database contained too little data for the relevant concepts for us to develop a set of reasonable human capital indices.

Table 5 shows the results of this analysis. The coefficients for asset-based financing and stock market capitalisation are both positive and significant. The coefficients for the other financial development measures are negative but not significant – in these regressions the investment share term is significant and large. The signs on the other conditioning variables are, again, the same as those found by Bassanini, Scarpetta and Hemmings (2001).

Table 5. Long-run coefficient estimates from regressions of the change in real per capita GDP (Pooled mean group estimators)

Asset-based Financing

Domestic Credit to Private

Sector

Domestic Credit Provided by

Banking Sector

Stock Market Capitalisation

Financial development 30.89 -0.26 -0.63 0.47(6.61)** (0.31) (0.46) (0.02)**

Investment share 0.18 1.38 1.80 0.06(0.24) (0.34)** (0.46)** (0.05)

Change in population -8.58 -28.80 -33.81 -13.42(5.3) (5.15)** (7)** (2.57)**

Standard deviation of inflation -4.37 -6.74 -8.10 -4.36(2.47) (2.04)** (2.63)** (0.62)**

Memorandum item:Average error correction coefficient -0.03 -0.03 -0.02 -0.14

(0.02) (0.01) (0.01) (0.05)** Financial development is proxied by (i) asset-based financing; (ii) domestic credit to the private sector; (iii) domestic credit provided by the banking sector; or (iv) stock market capitalisation.

Data are for 10 countries from 1978 to 2002 (Brazil is excluded from the sample). All variables in logarithms.

The evidence in this report supports the view that economies with deeper and broader financial system development also have higher levels of investment, ceteris paribus, as well as higher levels of per capita GDP, possibly in association with greater efficiency and productivity. We also find that equity market capitalisation is more statistically significant than the bank credit indicator in explaining investment spending and GDP per capita growth. This research also establishes that asset-based financing is an important component of these country’s financial systems along with the banking sector and equity markets.

Asset-based Financing’s Contribution to Living Standards in Canada in the 1990s The results from the previous section provide evidence that asset-based financing along with other parts of the financial services sector contribute to investment and productivity growth. The OECD used the coefficients from their analysis to evaluate the average impact of an increase in financial intermediation taking into account effects on growth arising through the level of fixed investment and through other channels. They note that this type of exercise, while interesting, can be criticised for combining, perhaps inappropriately, the results of different estimations. In

this section, the coefficients estimated in this analysis are used to determine the contribution to Canadian living standards of asset-based financing in the 1990s. The analysis is based on the pooled mean group estimator results so the coefficients reflect the countries in the sample. In order to assess the validity of this assumption, a set of regressions were run dropping one country at a time from the sample. The resulting long-run coefficients on asset-based financing were examined and found to be quite stable across the different samples. Nevertheless, the standard of living impacts presented in this section should be viewed as providing a rough order of magnitude estimate of the contribution of asset-based financing to the economy.

Table 6 uses the coefficients from Table 4 and Table 5 to estimate the impact of a 10% increase in Canada’s equipment leasing as a share of GDP (1.4% in 2002) or its stock market capitalisation as a share of GDP (101% in 2001) from recent levels63. Investment is 1.3% higher as a result of the increase in leasing and 3.9% higher with the increase in stock market capitalisation. The increase in investment associated with more leasing activity directly raises living standards 0.2%. Using the coefficients estimated in Table 5, the rise in investment associated with higher stock market capitalisation also raises living standards by 0.2%. The analysis in Table 5 indicates that the increase in the financial services indicators provides a significant boost to living standards through other channels (beyond the direct investment impact): leasing raises living standards 4.3% and stock market capitalisation by 2.3%. These increases are consistent with new growth theory which contends that TFP can be positively influenced by higher investment.

Table 6 Estimated Contribution from a 10%

Increase in the share of GDP for:Equipment

LeasingStock Market Capitalisation

Impact on:

Investment (per cent increase) 1.3 3.9

GDP per capita (per cent increase) 4.5 2.5 from the investment channel 0.2 0.2 from other channels 4.3 2.3

Given that a 10% increase in the asset-based financing of equipment and commercial vehicles raises investment in Canada by 1.3% and that this results, over time, in a rise in living standards – defined as inflation adjusted GDP per capita – of 0.2%64, it is possible to determine the contribution of the growth in asset-based financing to the Canadian economy over the last decade. From 1992 to 2002, asset-based financing of equipment as a share of GDP rose from 0.776% to 1.419% - an 82.8% increase. Using the results derived above, the increase in asset-based financing raised living standards 2.3% through its direct impact on investment.

Over this same period, national living standards rose from $26.6 thousand to $34.3 thousand: a 28.6% increase. The increase in living standards resulting from the rise in asset-based financing of equipment and commercial vehicles was, therefore, responsible for about 8% of the total

63 This implies a new level for leasing as a share of GDP of 1.6% and of 111% for market capitalization. 64 This impact was replicated using the C4SE’s multi-sector model of the Canadian economy. In a simulation in which investment was raised 1.3%, living standards rose 0.2%. (see Appendix E)

increase in Canada’s living standards experienced from 1992 to 2002. In other words, 8% of the 26.8% increase was due to the asset-based financing of equipment.

This estimate of the contribution of asset-based financing to higher living standards only considers its direct impact in terms of higher investment. It does not include the impact of financial development on economic growth from other channels.

It is interesting to compare these impacts with those of other, more established, components of the financial system. Using data for the decade 1991-200165 and the estimated coefficients in Table 4 and 5, the stock market66 helped raise living standards 9.2%, or 36% of the total national increase; while the more mature banking system67 raised living standards only 0.3% accounting for just 1% of the national increase. Over this period, asset-based financing’s impacts were slightly larger: a 2.6% increase in living standards accounting for 11% of the national total.

Looking outside the financial system, asset-based financing’s contribution to gains in living standards over the decade 1992-2002 is larger than the contribution of many of the other sectors that drive the Canadian economy: e.g. residential construction (4.7%), spending on motor vehicles (6.3%), the transportation equipment industry (4.6%), government services (2.1%) and mining (1.8%).

The asset-based financing industry provides access to capital outside the banking sector. This incremental capital, and its impact on investment, is one of the principal benefits the asset-based financing industry confers on the economy. The analysis in this report confirms that, in the absence of the asset-based financing industry, capital formation would be adversely affected, growth in equipment investment would be lower – and living standards in Canada would suffer.

Concluding Remarks On a theoretical and empirical level, the evidence strongly suggests that machinery and equipment investment (including commercial vehicles) is a critical contributor to productivity and economic growth. While this proposition is not without debate, many researchers have gone further in suggesting that machinery investment is the strategic factor in long-run productivity growth68 because of its role as either the key driver of economic growth or as a facilitator in the diffusion of knowledge within countries and throughout the world.

While strong equipment investment is probably a necessary condition for strong long-term productivity and economic growth it is likely not sufficient to ensure a successful outcome. The economic evidence suggests a positive macro-economic climate of low/stable inflation, sound fiscal policy, as well as a well educated, well trained workforce are also needed. Furthermore, given the complementary nature of other types of investment in public infrastructure and non-

65 Stock market capitalization data was not available for 2002 in the database used for this study 66 The stock market measure is stock market capitalisation as a share of GDP and rose from 45.3% to 100.9% - a 123% increase over the period. 67 The banking system measure is domestic credit provided by the banking sector as a share of GDP and it only rose from 87.6% to 91.0% - a 1.3% increase over the period. 68 De Long (1991)

machinery private investment, these investments are also helpful to long-term productivity and economic growth.

Recent economic research has examined the proposition that financial systems can, in principle, enhance growth through the provision of key services that mobilise savings, diversify risks and reduce monitoring costs associated with allocating savings and overseeing firms. Empirical research by the OECD found that financial systems play an important role in encouraging investment and economic growth in member countries.

The OECD studies were, however, only able to review the impact of selected segments of the financial services sector on investment. Given the innovative nature of the asset-based financing industry in promoting the overall financial system’s ability to operate effectively, it seemed natural to extend their analysis to include this sector. The empirical results presented in this report support the OECD’s finding of the role that financial systems play in supporting investment and economic growth. The findings also confirm the role that asset-based financing plays in supporting investment and boosting living standards. In particular, the rise in asset-based financing from 1992 to 2002 improved living standards in Canada by 2.3% (or about 8% of the 26.8% increase in Canada’s living standards over that period).

The health and competitiveness of the broad range of financial services available to businesses and consumers should, therefore, be of considerable importance to policy makers. Each component of the financial services sector provides a set of services that support the activities of different parts of the economy. The breadth of financial services available helps ensure that the needs of all sectors are addressed. Asset-based financing is similar to other parts of the financial services system in that it supports investment and economic growth. It does this by providing services that help match savings with investment opportunities, thereby raising investment and ultimately improving economic growth.

Government Policy and Economic Growth As was discussed earlier, there are different schools of thought regarding the role that government policy can and should play in promoting growth. In the neoclassical model, long-run per capita growth is determined by the rate of total factor productivity (TFP) growth. Since TFP is exogenously determined in this model, there is nothing that government policy can do to boost long-term growth. A rise in the investment rate will boost income per capita on a one time level basis, but will not influence the long-term steady state growth rate.

In contrast, new growth theory suggests that there can be a role for government policy since the positive externalities (spillovers) from the accumulation of the key economic driver will boost the overall economic steady state growth rate. The reason for the ongoing effect is that, according to the new growth theory, more output not only raises living standards but also leads to more human capital formation and innovation, which boosts productivity and output, which increase human capital and innovation again, and so on in a virtuous circle.69

The distinction between the short-to-medium term and long term, when the economy reaches a steady state growth rate, raises the question as to how long it takes for an economy to achieve its steady state. Estimates of the speed of convergence to steady-state output vary in the literature: most studies estimated values around 2-3 per cent per year (Mankiw, et al. (1992), Barro and Sala-i-Martin (1995)) – which implies that an economy spends about 20-30 years to cover half of the distance between its initial conditions and its steady state. A few studies have found values of 10 per cent or more for the OECD countries (Caselli et al. (1996) and Bassanini and Scarpetta (2001)), which imply less than nine years to cover half of the distance.70 Jorgenson (2004) estimates that after policy changes that affect investment in tangible assets, it will take decades for the economy to return to its steady state path, while after policy changes that affect human capital it could take as much as a century.

For most practical purposes, the distinction between a series of one-off level adjustments to living standards that takes decades to unfold, and a permanent rise in the steady state growth rate is indistinguishable to policymakers. Given the uncertainties inherent in any economic model the most sensible approach would be to have policies that encourage the likely sources of improvements in living standards—R&D expenditure, human capital and capital goods. This suggest that government policy should be bias in favour of physical capital accumulation, since capital deepening has been found to be a significant source of economic and labour productivity growth over the medium term in the neoclassical tradition. And machinery and equipment investment has been found to be directly or indirectly associated with the key drivers of knowledge in the economy by new growth theories and by the evidence.

De Long and Summers (1992), for example, concluded that policies that tilt the playing field against equipment are likely to be disastrous, and there is a strong case for at least modest bias in favour of equipment. Growth is likely to be increased by investment-promoting policies that are market conforming: policies that alter the marginal incentives of producers and investors and induce them to undertake machinery investment projects that had previously just failed to meet hurdle rates.

69 Rodriguez and Sargent (2000) p. 9. 70 Bassanini and Scarpetta (2001) p. 45.

Ab Iorwerth (2004) concurs with the general thrust of De Long and Summer’s policy prescription. He suggests that a policy compatible with new growth theory should “have low prices for machinery and equipment, particularly those that embody or lead to new technologies. A high tax burden on innovative equipment would exacerbate the negative implication of the pre-existing distortion: that prices already exceed marginal cost. A policy to mitigate this distortion tackles directly the source of the market failure.”

The need for a positive environment for equipment investment is made all the more necessary by the fact that equipment is one of the most mobile factors of production in the long run. And if equipment is uniquely valuable as a driver of long-term economic growth, then government must make sure that investors in equipment see that country as a hospitable environment. This does not just mean a low tax rate on equipment investment, but given the complementary nature of other factors, it is necessary to ensure that there is a positive climate for non-equipment investment, an ample provision of infrastructure, a skilled, trained, and motivated workforce, as well as a stable macro economic environment that would foster a low cost of capital. Furthermore, given the evidence that the diffusion of knowledge crosses international borders, it is also important for a government to have a policy of openness to the flow of goods, services and capital is needed to encourage long-term growth.

There is a degree of urgency to the need to construct an appropriate policy environment because of the evidence suggests the world economy is undergoing a significant technological transformation71. This view is held by a number of commentators, for example Sharpe and Gharani (2001) state that “Appropriate economic policy is always important to foster growth but it becomes even more crucial at times of rapid technological change. The economic landscape has changed, and thus new policy regimes more consistent with the New Economy must be employed in order to ensure our potential productivity gains are translated into actual gains.”

For Canada, many of the conditions are in place to ensure success in the world economy. The workforce has a relatively high level of formal education, monetary policy is keeping inflation low and relatively stable, and federal fiscal policy is producing a surplus over the course of the business cycle. Given the importance of machinery and equipment investment to productivity, economic growth and living standards combined with the fact that Canada is lagging behind other countries in these key metrics, then it is not hard to reach the conclusion that governments should encourage this type of investment.

Government policy in Canada, however, is not encouraging investment in machinery and equipment to the degree that the economic research suggests would be best for the economy. Therefore, a strategy of improving the economic climate for machinery and equipment investment could pay significant dividends in terms of stronger economic growth, higher productivity and living standards for Canadians for many years to come. 72 Tax reform can help

71 See Lipsey (1996) for a general discussion. 72 An external reviewer suggested that tax policy should not discriminate in favour of equipment investment and against non-equipment investment. But rather a policy regime of encouraging business investment in general combined with public infrastructure investment would be more beneficial. In his view technological advance is also embodied within non-equipment investment, which is complementary to equipment investment in promoting productivity and economic growth. One benefit of such a regime is that it gets around the problem of governments picking “winning” investment assets and allows business to determine the best combination of capital assets for their investment needs.

stimulate business capital spending. The analysis conducted in this report illustrates the economic impact of various tax policy options available to Canadian governments: personal and corporate tax cuts, capital cost allowance enhancement, provincial capital tax removal and elimination of provincial sales taxes on capital inputs.

Tax Reform Options Public policy determines the conditions in which businesses operate. Policy can either encourage or discourage certain kinds of behaviour. While it is possible for policy makers to prohibit or even mandate some activity, government cannot directly dictate how much businesses choose to spend on capital goods. Ultimately business is responsible for this decision. Economic theory and research indicates, however, that businesses will respond to changes in public policy. Changes in tax rates or regulations will lead to changes in behaviour. When businesses chose to respond, and by how much, is uncertain.

The estimates provided in this report are based upon analysis from the C4SE’s multi-sector model of the Canadian economy (see Appendix F for a description of the model and the simulation assumptions). This is a neoclassical model of the economy and as such a policy change causes a level adjustment in output over the long term in part because of a change in the level of capital, but does not include a higher rate of long-term growth that new growth theories suggest. While different models of this genre will produce different results, the differences should be relatively minor and largely reflect differences in the assumptions used.

The Scenarios A set of five simulations were conducted using the C4SE’s model that examine the possible economic consequences of various tax policy changes. Some of the policy changes fall under federal jurisdiction while others are provincial.

The five tax policy simulations are:

Personal Income Tax Cut – the average federal personal income tax rate was reduced by 10% of baseline levels.

Corporate Income Tax Cut – the federal corporate income tax rate was lowered by 5% from baseline levels.

Corporate Capital Tax Elimination – provincial corporate capital taxes are eliminated.

Capital Cost Allowance – the capital cost allowance for machinery and equipment is raised by 25% of baseline levels.

Sales Tax Reform – provincial sales taxes are removed from business spending on new capital.

The policy change in each simulation was introduced in 2004 and assumed to be permanent. The model was then solved for the 30 year period from 2004 to 2034.

Tax Policy Impacts The results are reported in tables for each simulation which show the impacts of the policy change for selected years over the three decade simulation interval. The C4SE’s model includes over two thousand measures of the economy that can be affected by these policy changes.

Displaying all that information would probably overwhelm most readers (and the authors), so a small number of the more critical concepts are displayed in each table.

Gross Domestic Product – measures, in inflation adjusted terms, the goods and services produced by the Canadian economy. This is a broad measure typically used to indicate overall level of income in the country.

Per Capita Gross Domestic Product – measures, in inflation adjusted terms, the value of goods and services produced per person in Canada. It is an indicator of the average standard of living in the nation and in the impact analysis will differ from the previous concept when the number of people in Canada is affected by the policy change.

Personal Disposable Income – measures, in inflation adjusted terms, the value of income received by households from all sources less all direct taxes paid to governments. Direct taxes include all income taxes and payroll deductions such as CPP/QPP contributions and employment insurance.

Employment – measures the number of people with paid work in the economy.

Labour Productivity – is a simple measure of productivity and represents, in inflation adjusted terms, the value of goods and services produced per employee in Canada.

M&E Capital Stock – measures, in inflation adjusted terms, the value of the business sector’s stock of machinery and equipment. Many of the tax policies studied in this report are intended to raise business investment and, therefore, the capital stock.

Consumer Price Index – measures the price of a standard set of goods purchased by a typical urban household.

Average Annual Wage – measures the average annual wage for a paid employee.

Three Month T-Bill Rate – is the yield on the Government of Canada’s three month treasury bills.

Exchange Rate – is the value of the Canadian dollar expressed in terms of the number of U.S. dollars needed to buy one Canadian dollar. An increase in this represents an appreciation of the Canadian dollar against the U.S. dollar.

Federal Government Revenue as % of GDP – measures federal government revenue as a proportion of nominal gross domestic product. This measure provides an indication of the federal government’s ability to raise revenue. It is more useful than a simple measure of the change in federal government revenue as a result of the policy change because prices can be (and are) affected significantly by some of the policy changes. An increase in prices would, for example, make it appear that tax revenues had risen. Expressing government revenue as a share of nominal GDP – which rises with higher prices – removes the impact of changing prices on government revenue.

Provincial Government Revenue as % of GDP – provides the same measure for provincial governments in Canada.

The impacts in the table reported as the “% Difference from Baseline” compare the level of the concept after the introduction of the tax policy with its level before the shock (the baseline) and calculates the percentage difference between the levels. A positive value indicates that the variable is higher after the change in policy than it was before. If the value keeps rising over time then it means that the concept continues to grow faster after the change in policy than it did

before. If the value gets smaller then the concept is actually growing slower than it was in the baseline simulation but remains above its original value as long as it is above zero.

The calculation described above is altered slightly for three of the measures in the table: the three- month T-bill rate and the two government revenue measures as shares of GDP. For these three, the value of the measure before the introduction of the tax policy is subtracted from its value after the shock. For interest rates, this indicates the change in the level of the interest rate as a result of the tax policy. For the government revenue terms, this indicates the change in the overall proportion of government revenue as a share of GDP collected by that level of government. For purposes of comparison, the C4SE estimates that in 2004 the federal government revenue as a share of GDP will be 16.3% and the provincial governments share will be 20.2%. The C4SE also estimates the three month T-bill yield in 2004 to be 2.3%.

Personal Income Tax Cut The first tax policy change reviewed is the politically popular cut in personal income tax rates. It is often argued that lower personal taxes leave more money in the hands of consumers whose higher spending then helps fuel business spending on new capital and more people – thus sparking a cycle of higher economic activity. This simulation reduces federal personal income tax rates by an average of 10% of baseline levels73.

Table 7: Personal Income Tax Cut Difference from Baseline: # of years 0 5 10 15 20 25 30

% Difference in Real Gross Domestic Product 0.5 0.2 0.2 0.1 0.0 0.0 -0.1% Difference in Real Per Capita Gross Domestic Product 0.5 0.3 0.2 0.2 0.1 0.1 0.0% Difference in Real Personal Disposable Income 1.6 1.2 1.0 0.7 0.5 0.3 0.2% Difference in Employment 0.4 0.3 0.2 0.1 0.1 0.0 0.0% Difference in Labour Productivity (GDP per worker) 0.0 0.0 0.0 0.0 -0.1 -0.1 -0.1% Difference in Real M&E Capital Stock 0.2 0.1 0.2 0.1 0.1 0.0 0.1

% Difference in Consumer Price Index 0.1 0.3 0.3 0.3 0.1 0.0 -0.2% Difference in Average Annual Wage 0.2 0.2 0.3 0.2 0.1 -0.1 -0.3Difference in 3 Month T-Bill Rate 0.2 0.0 0.0 0.0 -0.1 -0.1 -0.1% Difference in Exchange Rate (USD per CAD) 0.2 -0.2 -0.3 -0.3 -0.2 -0.1 0.1

Difference in Federal Government Revenue as % of GDP -0.7 -0.7 -0.7 -0.6 -0.5 -0.5 -0.4Difference in Provincial Government Revenue as % of GDP 0.0 0.0 0.0 0.0 0.0 0.0 0.0 In the C4SE’s model this policy has some short-term positive impacts in terms of output and employment although these effects tend to fade over time. Real personal disposable income does rise as a result of the tax cut. Although consumption rises, the benefits of higher income to the rest of the economy are muted because of (i) a rise in household savings and (ii) the large proportion of imported goods consumed by households.

Wages and prices rise with the stronger economy and, not surprisingly, the Bank of Canada quickly raises interest rates to help reduce inflationary pressures. The near-term appreciation of the Canadian dollar in response to the stronger economic activity fades over time as higher prices force the dollar to depreciate. Canada’s net exports decline sharply. Imports rise with higher

73 Provincial personal income taxes are assumed to be independent of federal taxes so a federal tax cut has no direct impact on provincial tax revenues.

consumer spending and the initial appreciation of the Canadian dollar. Exports, however, fall as both higher prices and an appreciation of the dollar make Canadian exports less competitive in world markets.

Cutting personal income tax rates does little to encourage business investment or to raise productivity both of which remain near baseline values throughout the simulation. The most lasting impact from this policy is to the federal government, which sees its revenue permanently impaired. This policy effectively does little more than to transfer revenue from the government sector back to households.

Corporate Income Tax Cut The second tax policy option considered is also one that is frequently called for in the business section of the newspaper. Lower corporate income taxes, it is argued, will leave more money in the hands of businesses which will then be used to invest in new capital or to hire more workers. Federal corporate income taxes were lowered by 5% from baseline levels in this simulation.

Table 8: Corporate Income Tax Cut Difference from Baseline: # of years 0 5 10 15 20 25 30

% Difference in Real Gross Domestic Product 0.0 0.2 0.3 0.3 0.3 0.4 0.4% Difference in Real Per Capita Gross Domestic Product 0.0 0.1 0.2 0.2 0.2 0.2 0.2% Difference in Real Personal Disposable Income 0.1 0.2 0.2 0.2 0.2 0.2 0.3% Difference in Employment 0.1 0.1 0.2 0.2 0.2 0.2 0.2% Difference in Labour Productivity (GDP per worker) -0.1 0.1 0.2 0.1 0.1 0.1 0.2% Difference in Real M&E Capital Stock 0.4 1.7 1.4 1.1 1.0 1.1 1.1

% Difference in Consumer Price Index 0.0 -0.1 -0.4 -0.7 -1.0 -1.2 -1.4% Difference in Average Annual Wage 0.1 0.1 -0.2 -0.5 -0.8 -0.9 -1.1Difference in 3 Month T-Bill Rate 0.1 -0.1 -0.1 -0.1 -0.1 -0.1 -0.1% Difference in Exchange Rate (USD per CAD) 0.0 -0.1 0.1 0.4 0.7 1.0 1.1

Difference in Federal Government Revenue as % of GDP -0.2 -0.2 -0.3 -0.3 -0.4 -0.4 -0.5Difference in Provincial Government Revenue as % of GDP 0.0 0.0 0.0 0.0 0.0 0.0 0.0 The lower corporate income tax rate reduces businesses cost of acquiring new capital. The reduction is, however, partially offset for companies that borrow money to finance new capital acquisitions. This is because the interest expense on borrowing by business is tax deductible so a reduction in tax rates reduces the benefit of this tax deduction.

As expected, the machinery and equipment capital stock rises and remains at least 1% above baseline levels throughout most of the simulation period. Over time as new capital accumulates, productivity rises and remains above baseline levels. Output, employment and output per capita all rise over the duration of the simulation. Canada’s population rises as a result of this policy change because fewer people emigrate and Canada attracts more immigrants, so output per capita rises by less than GDP.

Wages and prices are lower in spite of the stronger economy. This is a result of lower production costs arising from the increase in capital and labour, which boosts the productive capacity of the economy. Workers are, however, better off because wages fall by less than the CPI so the real wage – the ability of a worker’s wages to buy goods and services – actually rises relative to the baseline. Nominal interest rates also fall as a result of lower inflation. And lower prices in Canada eventually force the Canadian dollar to appreciate.

Similar to the personal income tax cut scenario, the federal government’s revenue is permanently reduced as a result of this policy change74.

Corporate Capital Tax Elimination The third tax policy option is less frequently discussed in the popular media. This scenario involves the elimination of the network of capital taxes collected by provincial governments. The capital taxes are levied on corporations based upon complicated formulas regarding the value of their capital assets. These taxes are invariant to corporate profitability. They provide governments with a stable source of revenue but shift the risks to businesses which have to pay regardless of their income. In 2003, $3.3 billion were collected by provincial governments in corporate capital taxes. In the same year the provincial governments collected $15.2 billion in corporate income taxes and the federal government collected $29.4 billion.

Table 9: Corporate Capital Tax Elimination Difference from Baseline: # of years 0 5 10 15 20 25 30

% Difference in Consumer Price Index 0.0 0.0 -1.5 -3.3 -4.7 -6.1 -7.4% Difference in Average Annual Wage 0.3 0.9 -0.4 -2.2 -3.6 -4.8 -5.9Difference in 3 Month T-Bill Rate 0.4 -0.4 -0.7 -0.7 -0.6 -0.5 -0.6% Difference in Exchange Rate (USD per CAD) 0.3 -0.4 0.2 1.9 3.6 5.0 6.3

Difference in Federal Government Revenue as % of GDP 0.1 0.0 0.0 0.0 0.1 0.1 0.1Difference in Provincial Government Revenue as % of GDP -0.2 -0.2 -0.2 -0.1 -0.1 -0.1 0.0 Eliminating corporate capital taxes also reduces businesses cost of acquiring new capital. This time the reduction is not offset for companies that borrow money to finance new capital acquisitions. This is because the capital is already in place and no new borrowing is required to finance it.

As before, the machinery and equipment capital stock rises and remains above baseline levels throughout the simulation period. The increase is, however, significantly larger in this case than for the reduction in corporate income tax rates seen in the previous simulation. Once the new capital becomes productive, productivity rises and remains above baseline levels. Output, employment and output per capita all rise over the duration of the simulation. Canada’s population rises as a result of this policy change so output per capita rises by less than GDP.

Again, wages and prices end up lower in spite of the stronger economy as the rise in capital and labour reduces production costs. Workers are, however, better off because wages fall by less than the CPI so the real wage – the ability of a worker’s wages to buy goods and services – actually rises relative to the baseline. Nominal interest rates also fall as a result of lower inflation. And lower prices in Canada eventually force the Canadian dollar to appreciate. 74 The reduction in corporate income tax revenue is partially offset by changes in tax planning as corporations chose to report more of their revenue in Canada than elsewhere. Research by Jack Mintz suggests that the corporate income tax base should rise by about 4% for each 1% reduction in the tax rate.

In this scenario, provincial governments’ revenue is affected. The impact on their revenue is, however, significantly smaller as a result of this policy than the impact of the previous policy options was on the federal government.

Capital Cost Allowance Increase The fourth tax policy option has been credited by some as being partially responsible for the massive boom in capital spending in the United States over the last few years. In the U.S., the federal government allowed accelerated depreciation for a limited period.75 This scenario involves raising machinery and equipment capital cost allowance rates (CCA) by a quarter of their baseline value.

Raising CCA rates also reduces businesses cost of acquiring new capital. The higher CCA rates initially reduce the level of business taxable income. It is interesting to note that – when keeping investment at its baseline levels – the stock of undepreciated capital falls more rapidly over time than in the baseline. So the CCA deduction from taxable income falls over time and, after about 15 years becomes smaller than in the baseline – so corporate tax revenue actually rises above its baseline level.

Table 10: Capital Cost Allowance Increase Difference from Baseline: # of years 0 5 10 15 20 25 30

Difference in Federal Government Revenue as % of GDP -0.5 -0.2 -0.1 0.0 0.0 0.0 0.0Difference in Provincial Government Revenue as % of GDP -0.2 -0.1 0.0 0.0 0.0 0.0 0.1 As in the previous two simulations, the machinery and equipment capital stock rises and remains above baseline levels throughout the simulation period. The increase lies between the capital tax and corporate income tax simulations. Once the new capital becomes productive, productivity rises and remains above baseline levels. Output, employment and output per capita all rise over the duration of the simulation. Canada’s population rises as a result of this policy change so output per capita rises by less than GDP.

Again, wages and prices end up lower in spite of the stronger economy as the new capital and more labour reduce production costs. Workers are, however, better off because wages fall by less than the CPI so the real wage – the ability of a worker’s wages to buy goods and services – actually rises relative to the baseline. Nominal interest rates also fall as a result of lower inflation. And lower prices in Canada eventually force the Canadian dollar to appreciate.

75 Ritholtz (2004).

In this scenario, the federal and provincial governments’ revenue is negatively affected. The impact on their revenue beyond the first few years is, however, very minor.

Sales Tax Reform The final tax policy considered in this report is that of sales tax reform. The federal Goods and Services Tax (GST) provides businesses with input tax credits for both capital and non-capital spending. One proposal is for the provinces that currently tax capital spending to eliminate this tax. This change would directly lower the cost of new capital equipment for businesses.

Eliminating the provincial sales tax from capital spending reduces businesses’ cost of acquiring new capital. As in the previous three simulations, the machinery and equipment capital stock rises and remains above baseline levels throughout the simulation period. The increase is similar to that observed in the capital consumption allowance scenario. Once the new capital becomes productive, productivity rises and remains above baseline levels. Output, employment and output per capita all rise over the duration of the simulation. Canada’s population rises as a result of this policy change so output per capita rises by less than GDP.

Table 11: Sales Tax Reform Difference from Baseline: # of years 0 5 10 15 20 25 30

% Difference in Real Gross Domestic Product 0.0 0.2 0.3 0.4 0.4 0.5 0.6% Difference in Real Per Capita Gross Domestic Product 0.0 0.0 0.1 0.1 0.1 0.2 0.2% Difference in Real Personal Disposable Income -0.1 0.2 0.2 0.2 0.2 0.3 0.4% Difference in Employment 0.0 0.2 0.2 0.3 0.3 0.4 0.4% Difference in Labour Productivity (GDP per worker) -0.1 0.0 0.1 0.1 0.1 0.1 0.2% Difference in Real M&E Capital Stock 0.5 2.1 1.9 1.6 1.7 1.9 2.1

Difference in Federal Government Revenue as % of GDP 0.0 0.0 0.1 0.1 0.1 0.1 0.1Difference in Provincial Government Revenue as % of GDP -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 Again, wages and prices end up lower in spite of the stronger economy. The initial decline in prices arises from the removal of provincial sales taxes on new business capital and then continues to fall as the rise in capital and labour reduce production costs. Workers are, however, better off because wages fall by less than the CPI so the real wage – the ability of a worker’s wages to buy goods and services – actually rises relative to the baseline. Nominal interest rates also fall as a result of lower inflation. And lower prices in Canada eventually force the Canadian dollar to appreciate.

In this scenario, provincial governments’ revenue is permanently affected although by less than the personal and corporate income tax reduction scenarios.

Productivity and Tax Reform This report has argued that business investment is the key determinant of labour productivity growth. Although business investment is rising, it is still significantly below that of our major trading partner: the United States and is far lower than would be suggested by corporate profits – which are currently at record levels as a share of the economy. Canadian productivity has, as a result, lagged over the last few years.

This matters because higher labour productivity leads to a higher standard of living for all Canadians. Productivity also provides opportunities for more Canadians – more jobs at higher wages. Policy makers must ask the question: why is business investment not higher? It may be that there is no easy answer to that question. Businesses are free to choose the level of investment that best meets their expectations of future needs. Government policy can, however, create an environment in which business believes their future needs will be greater.

With renewed demands for higher government spending on new social programs coupled with razor thin federal surpluses and provincial deficits, tax reform is low on the political agenda around the country. Building the type of economy that can sustain new spending initiatives will, however, mean that the Canadian economy must produce more than before. It must, in other words, become more productive. Tax reform can help.

Figure 36

Tax Policy Impacts(after 10 years)

0.0 0.2 0.4 0.6 0.8Impact on Living Standards(% change in real GDP per capita)

Eliminate provincial corporate capital

Raise capital cost allowance for machinery & equipment by 25% of current levels

Remove provincial sales taxes from business capital

Reduce federal personal income taxes by 10%

Reduce federal corporate income tax rates by 5%

Impact on per capita government revenue, in inflation adjusted terms, is positive for simulations above the dotted red line

The analysis conducted in this report illustrates the economic impact of various tax policy options available to Canadian governments. The policies considered were far from exhaustive – there exist a huge array of policy options available to governments. The long-term impacts of these policy options are summarised in Figure 36. This figure shows the increase in living standards for each simulation after twenty five years mapped against the change in federal and provincial government revenues as a share of GDP. The dotted red line in the figure is the “revenue neutrality line”. Simulations above and to the right of this line yield higher per capita, inflation adjusted, government revenues than in the baseline simulation. While those below and to the left of the line yield lower real per capita government revenues. Note that government revenue measured as a share of GDP can fall but still be higher than they were in the baseline simulation – this result occurs when the economy grows faster than tax revenues.

The traditional personal and corporate income tax cut options are among the least attractive policy options available to governments today. They both yield relatively limited economic benefits while leaving the government that initiates them with a permanent fiscal hole to fill.

There are a multitude of possible changes to sales taxes that could be introduced in Canada. This report examined one option in which provincial sales taxes on capital goods are eliminated. This policy raised living standards and also raised government revenues – but by less than the increase in economic activity.

The more attractive options are to reduce, and ideally to eliminate, corporate capital taxes and to raise capital cost allowances. Both policy options yield significant economic benefits with minimal short-term fiscal cost.

The results in this study are consistent with recent analysis produced by the Department of Finance Canada. Using a general equilibrium model, their simulations suggest that “taxes on savings and investment impose the highest costs, followed by wage and then consumption taxes.”76 The Department of Finance concluded that changes in the structure of taxation could improve economic performance with measures targeting new investment – such as reducing corporate capital taxes, eliminating sales taxes on capital and raising capital cost allowances – being particularly potent.

A more productive economy is fundamental to government’s ability to provide new services. It is also the key to improving opportunities and living standards for all Canadians. Policies that encourage business investment will boost productivity and help create the economy Canada needs in the 21st Century.

76 Department of Finance Canada (2004) p. 75.

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Appendix A: Growth Theory This discussion is from Ahn and Hemmings (2000) pages 7 and 8.

The Solow model centres on a production function ),( ALKFY = where Y is output, K is capital and AL is the labour force measured in efficiency units, which incorporates both the amount of labour and the productivity of labour as determined by the available technology. It is assumed that there are constant returns to scale in production that allows the function to be expressed more simply as )(kfy = where y and k are both expressed per efficiency unit of labour. Using this production function in a dynamic setting and introducing an exogenous rate of saving (s), population growth (n), technological change (g) and depreciation (δ) shows that

)()( δ++−=•

gnksfk k. Hence, in the steady state where capital is constant over time, *)(*)( kgnksf δ++= where the * serves to distinguish from non-steady states. See Mankiw

(1995) and Barro and Sala-i-Martin (1995) for further details.

Manipulation of the Solow model shows the importance of the factor shares in determining outcomes with regard to output; the speed of convergence and the rate of return to capital (see, for example, Mankiw (1995) for further details). Thus total differentiation of the model in the steady state show that changes in output relate to the exogenous variables via the ratio of the share of capital (α) to the share of labour in output (1-α):

))/()(/))(1/((*/* δδαα ++++−−= gngndsdsydy The rate of convergence (λ) is determined by the product of the labour share and exogenous variables, ))(1( δαλ ++−= gn The rate of return to output (dR/R) can be shown to relate to the level of output via the factor shares and the elasticity of substitution (σ) in the following way:

ydyRdR /)/)1((/ ασα−−=

Appendix B: Physical Capital and Long-term Growth: Studies Based on OECD Countries

Explanatory Variable Reference Finding Share investment in GDP Alexander (1997) +* Share investment in GDP Cornwall (1976) +* Share investment in GDP Dowrick and Nguyen (1989) +* Share investment in GDP Englander and Gurney (3) (1994) + Share investment in GDP Fagerberg (1987) +* Share investment in GDP Helliwell and Chung (1991) +* Share investment in GDP Hjerppe (1991) +* Share investment in GDP Kneller et al. (1998) - Share investment in GDP Lee (1995) +* Share investment in GDP Mankiw et al. (1992) + Share investment in GDP Miller and Russek (1997) +* Share investment in GDP Skonhoft (1989) +* Share investment in GDP Woff and Gittleman (1993) +* Share investment in GDP Bassanini and Scarpetta (2001) +* Share investment in GDP Li (2002) +* 14 of 24 Share investment in GDP Li (2002) +* 4 of 5 Equipment investment share De Long (1991) +* Equipment investment share Englander and Gurney (2) (1994) +* Structure and transport equipment share Englander and Gurney (2) (1994) - Capital to labour ratio Englander and Gurney (1) (1994) +* Growth in fixed public capital Nourzad and Vrieze (1995) +* Growth in private-sector capital Nourzad and Vrieze (1995) +* Capital per work-hour, physical Park (1995) +* Capital per work-hour, R&D private Park (1995) +* Capital per work-hour, R&D public Park (1995) + Relative price level of investment goods Knack and Keefer (1997) -* Net stock of M&E capital Abdi (2004) +* Adjusted net stock of M&E capital Abdi (2004) +* M&E Investment on TFP Abdi (2004) +* Net stock of Structures capital Abdi (2004) +* Adjusted net stock of Structures capital Abdi (2004) +* Structures Investment of TFP Abdi (2004) +* Gross capital Sargent and James (1997) +* Net capital Sargent and James (1997) +*

Source: Ahn and Hemmings (2000) Updated by authors to include more recent studies “*” means the findings are statistically significant "+" means variable had a positive sign "-" means variable had a negative sign

Appendix C: Benefits of Leasing Efficient use of capital

Many businesses consider leasing to be the most efficient and effective use of available capital. One thing is certain. There is a far greater understanding today that most businesses make money by using equipment or vehicles not by owning them. Cash tied up in fixed assets are no longer available to finance inventory and the profit producing activities of production, distribution and marketing.

Equipment and vehicles generally do not normally increase in value over time. Owning depreciating equipment is not always the logical answer. With the increasing speed of technology obsolescence, there may be little equity potential in owning equipment.

Fixed-rate financing

Leasing typically offers long term financing at a fixed rate over the financing term. In this way the customer is insulated from spikes in interest rates.

While SME loans are often tied to the prime rate, most leases are written as fixed rate transactions. The "prime rate" is an irrelevant measurement in leasing. Generally, the "prime rate" is a short-term floating rate that is adjusted as market conditions dictate. At best, "prime" is a short-term, variable corporate loan rate.

The advantage of fixed rate transactions is that they are not subject to any fluctuations in rate during the term, which provides greater certainty for both lessor and lessee (particularly SMEs). Leases typically have service terms of 24, 36, or 48 months. Funds are not borrowed for such periods at prime. It is therefore essential to match these lease terms with fixed interest rates. For bench-marking purposes, government bond rates for similar periods (i.e. a two-year Government of Canada bond rate is more relevant to set a fixed cost for financing a 24-month lease). Government bond rate are generally recognised as a more accurate bench-marking of longer-term borrowing costs.

Expertise An asset management-based business requires specialised industry and equipment/vehicle expertise. With operating leases in particular, lessors must be able to accurately estimate residual values several years hence at lease-end when the equipment or vehicle must be re-leased or sold on the secondary market.

Because of this critical requirement, leasing companies frequently specialise in a limited range of equipment or vehicles. This is another important difference between bank lending and leasing. The expertise developed by lessors of the lessee's industry and on specific equipment or vehicles allows lessors a greater advisory role to lessees on appropriate equipment or vehicles to use in a specific business.

Similarly, on the disposal side, unlike traditional lenders, leasing companies are experts in the re-marketing of equipment and vehicles and the optimisation of their values. The growing after market in second tier equipment is a by-product of this management expertise.

Customer service

Lessors offer a variety of levels of service depending on the type of equipment or vehicle leased. This level of service can range from simply procuring the equipment or vehicle, to maintenance and agreeing to exchange it periodically for more up-to-date versions.

Lessors are frequently responsible for the equipment or vehicles leased from the time of purchase to disposal. The hands-on day-to-day management and maintenance of equipment and vehicles by CFLA members for their clients is an important customer service.

Unlike with a loan, the leasing company continues to have a stake in the actual product purchased throughout the lease.

Speed Speed is an essential ingredient of asset-based financing. Critical to the recent strong competitive emergence of leasing, most evident in vendor programs, is the speed with which leasing decisions can now be made. New technology is key to this phenomenon. Increasingly in financial services, you are only as good as your technology. The speed and reach of new technology to capture information and to rapidly analyse that information has revolutionised the management of risk. Leasing decisions, among others, are now made in minutes, often at the point-of-sale.

The essence of the formula for success with vendor program financings: a high volume, low touch, quick turnaround business.

Flexibility Flexibility is an innovative hallmark of asset-based financing and is particularly true in the small ticket leasing market, the market comprised primarily of SMEs.

Leasing is generally a far more flexible means of using equipment or vehicles than traditional lending. This flexibility is a significant operational advantage in a number of situations where, the

lease payments can be tailored to a customer's revenue streams and offers a level of flexibility in timing and payment schedules unmatched in the traditional lending sector. (For example, ski lift operators using equipment 6 months a year can make seasonal payments on its equipment. Similarly, other seasonal businesses such as school bus operators can take advantage of the unique flexibility that leases offer.)

Equipment/ vehicle upgrading

If, during the term of the lease, a lessee decides that a new model or different type of equipment or vehicle would be to the advantage of the business, the lessor will generally negotiate the replacement of the old technology with the new one, rolling the costs into a new lease with a new payment schedule. Leasing provides a flexible means for businesses to respond on a timely basis to the productivity and competitive challenges of technological obsolescence and product innovation.

Off-balance sheet financing

Under Canadian Generally Accepted Accounting Principles (GAAP), an operating lease is not capitalised on the financial statements of the lessee, whether public or private sector lessee. Lease payments are considered an expense for the lessee. In contrast, typical bank financing or finance leases are capitalised and recorded as a debt liability of the borrower/lessee on its financial statement thereby affecting the debt/equity ratios impacting the business. This "off-balance" sheet feature -- obtaining the use of needed equipment or vehicles by way of an operating lease -- can be a real advantage, particularly to SMEs.

Simpler security arrangements

Because the lessor retains ownership of the equipment or vehicle leased and because the asset leased is generally the collateral for the transaction, leasing involves simpler legal security arrangements. Less strict requirements for historical balance sheets means that lessees can access financing more easily than conventional bank loans.

Lower transaction costs

Lease transaction costs are generally lower. The costs of assigning collateral, of legal documentation and of slower processing times for traditional bank borrowing can be significant, particularly for SMEs where many of the conventional financing costs are fixed and not based on the size of the loan.

Little cash required

Leasing can typically finance a higher percentage of the capital cost of a piece of equipment or of a vehicle than bank borrowing, often with little or no initial down payment required. This allows the lessee to preserve its cash or bank facilities to meet working capital needs.

Sales tax deferral

For non-production equipment, that is, equipment or vehicles not considered as part of the core production of a business --- for example, photocopiers in an office (rather than in a photocopy shop) or trucks --- if acquired by way of a loan, the total of the Federal Goods and Services Tax and harmonised taxes (GST) and of the Provincial Sales Tax (PST) must be paid upfront by the customer (although the GST will be refunded eventually). The total sales tax plus the down payment can be a significant upfront amount.

In obtaining the use of non-production equipment or vehicles by way of lease, the sales taxes are levied generally on each monthly lease payment over the full term of the lease rather than as a single lump sum, upfront payment. In this way, under a lease, the payment of sales taxes is more effectively tied to the revenue-producing use of the leased equipment or vehicle.

Appendix D: Model Specification Three versions of error correction approaches are used in this report, the pooled mean group estimator suggested by Pesaran, Shin and Smith (1998), the mean group estimators and the dynamic fixed effects estimator. The first two approaches are designed for samples in which T, the number of time series observations, and N, the number of countries, are relatively large (about 20 to 30 countries according to Pesaran et al.) and of roughly the same order of magnitude.

For easier comparison of the different approaches, an ARDL(1,1,1,1) is used as a benchmark specification, where the numbers in parentheses stand for the lag length of the lagged dependent and the three explanatory variables. The unrestricted specification is as follows:

ibvi,t=µi+δ10igdpi,t+δ11igdpi,t-1+δ20iirli,t+δ21iirli,t-1+δ30ifini,t+δ31ifini,t-1+λiibvi,t-1+εi,t (1)

where irli,t gdpi,t ibvi,t, , and fini,t, are respectively real gross investment, real gross domestic product, adjusted real long-term interest rate and a financial development indicator (liquid liabilities, stock market capitalisation, private credit, and leasing). This equation (1) can be written in the form of an error correction model (ECM):

∆ibvi,t=µi+φi(ibvi,t-1-θ1igdpi,t-1-θ2iirli,t-1-θ3ifini,t-1)-δ11i∆gdpi,t-δ21i-∆irli,t-δ31i∆fini,t+εi,t (2)

where the long-run coefficients are:

θ1i=(δ10i+δ11i)/(1-λi)

θ2i=(δ20i+δ21i)/(1-λi)

θ3i=(δ30i+δ31i)/(1-λi)

and the adjustment coefficients is:

φi=1- λi

On the basis of equation (2) the three approaches can be distinguished according to the restrictions imposed by each of them.

Estimator

Type of parameter restrictions

Number of restrictions

Mean group estimator No restriction 0

Pooled mean group estimator θ1i= θ1, θ2i= θ2, θ3i= θ3 for all i= 1,...N 3*(N-1)

Dynamic fixed effects estimator θ1i= θ1, θ2i= θ2, θ3i= θ3 for all i= 1,...N

σi2=σ2

δ11i= δ11, δ21i= δ21, δ31i= δ31 for all i= 1,...N

only µi differ freely across countries

7*(N-1)

Note: µi is the country specific intercept, θ = (θ1, θ2, θ3)’ is the vector of long-run coefficients, σi2 is the

standard error of the estimate of country i and δ = (δ11, δ21, δ31)’ is the vector of short-run coefficients and N is the number of countries.

Mean group estimator The mean group estimator consists of estimating N separate regressions and calculating the coefficients as unweighted means of the estimated coefficients for the individual countries. This

does not impose any restrictions on the short-run and long-run coefficients or the error variances. In this respect, this method is less restrictive than the pooled mean group estimator or dynamic fixed effects estimator. However, even if it is consistent, it will tend to be sensitive to the outliers for finite samples, because the outlier is given the same weight as other observations. Its specification is as follows:

∆ibvi,t=µi+φi(ibvi,t-1-θ1igdpi,t-1-θ2iirli,t-1-θ3ifini,t-1)-δ11i∆gdpi,t-δ21i-∆irli,t-δ31i∆fini,t+εi,t

The results obtained from this estimator yielded inconclusive results for all of the financial services measures employed in this report. The influence of outliers in a comparatively small sample appeared to strongly influence the results. None of the results obtained from this estimator are reported in this report.

Dynamic fixed effects estimator At the other extreme is the dynamic fixed effects estimator which imposes equality of all slope coefficients and error variances, allowing only the intercepts to differ across countries. The parameters are treated as fixed because we are not using samples but almost the whole population of countries in a particular category: members of the OECD (see Pesaran, Shin and Smith (1998)). The dynamic fixed effects estimator is more restrictive than both the pooled mean group and mean group estimators. One has to justify the homogeneity of short-run coefficients across countries. Therefore, when homogeneity is imposed incorrectly it can lead to heterogeneity biases in the pooled estimators. This bias is likely to be smaller in the case of the pooled mean group estimator and does not exist when using the mean group estimator. The specification of the dynamic fixed effects estimator is as follows:

∆ibvi,t=µi+φi(ibvi,t-1-θ1gdpi,t-1-θ2irli,t-1-θ3fini,t-1)-δ11∆gdpi,t-δ21-∆irli,t-δ31∆fini,t+εi,t

A special case of the dynamic fixed effects estimator is the static fixed effects estimator:

ibvi,t=µi+θ1gdpi,t-1+θ2irli,t-1+θ3fini,t-1+εi,t

It can be written similar to an error correction model in the following form:

∆ibvi,t=µi-(ibvi,t-1-θ1gdpi,t-1-θ2irli,t-1-θ3fini,t-1)+εi,t

Pooled mean group estimator The pooled mean group estimator can be interpreted as an intermediate procedure between these extreme approaches because it involves both pooling and averaging. This estimator allows short-run coefficients, including the adjustment coefficient, and error variances to differ across countries, while the long-run coefficients are constrained to be the same. This has two aspects. First, imposing equality restrictions, if they are valid, will increase the efficiency of the estimates. Second, because the short-run slope coefficients are allowed to differ, the dynamic specification (lag length) can also differ across countries. The pooled mean group estimator is chosen here because the constraining of long-run coefficients permits us to focus on the long-run effects of financial development on investment, while allowing the short-run adjustment to the long-run equilibrium values to differ country by country. There are good reasons to expect the long-run equilibrium relationships between variables to be similar across OECD countries or, at least, a sub-set of OECD countries, due to similar levels of financial development and financial structures, common technologies, and the openness of the economies with a tendency toward convergence. Its specification is as follows:

∆ibvi,t=µi+φi(ibvi,t-1-θ1gdpi,t-1-θ2irli,t-1-θ3fini,t-1)-δ11i∆gdpi,t-δ21i-∆irli,t-δ31i∆fini,t+εi,t

Appendix E: Asset-based Financing’s Economic Impact

Research in this report has examined the central role of the financial system in channelling savings to productive investment, and thereby promoting gains in productivity and living standards. The health and competitiveness of the broad range of financial services available to businesses and consumers should, therefore, be of considerable importance to policy makers. Each component of the financial services sector provides a set of services that support the activities of different parts of the economy. The breadth of financial services available helps ensure that the needs of all sectors are addressed. Asset-based financing expands the financing options available to businesses in Canada. Without the ability to lease, many businesses would find it more difficult, more risky or even impossible to acquire equipment. Consequently, business choice would be restricted to either buying the equipment and financing the purchase through internal or borrowed funds, or not acquiring the equipment at all.

The research conducted for this report established, for the first time, that asset-based financing has a statistically significant, positive impact on investment. With this information it is possible to generate an estimate of the impact of an increase in asset-based financing activity on the economy using the C4SE’s model of the Canadian economy (see Appendix F for a description of the model and the simulation assumptions).

This analysis answers the question: what would happen to the Canadian economy if the amount of assets financed by asset-based financing were 10% higher. In 2002, leasing as a share of the economy was 1.4% in Canada. The empirical analysis conducted in this report found that investment will rise by 1.3% for a 10% increase in that value. A simulation was then designed in which machinery and equipment investment was raised 1.3% above baseline levels for the duration of the simulation.

Table 12: Asset-based Financing’s Economic Impact Difference from Baseline: # of years 0 5 10 15 20 25 30

% Difference in Real Gross Domestic Product 0.0 0.1 0.2 0.2 0.3 0.3 0.3% Difference in Real Per Capita Gross Domestic Product 0.0 0.1 0.1 0.1 0.1 0.1 0.2% Difference in Real Personal Disposable Income 0.0 0.1 0.1 0.1 0.1 0.1 0.2% Difference in Employment 0.0 0.1 0.1 0.1 0.1 0.2 0.2% Difference in Labour Productivity (GDP per worker) 0.0 0.0 0.1 0.1 0.1 0.1 0.1% Difference in Real M&E Capital Stock 0.3 1.0 1.2 1.2 1.2 1.2 1.2

% Difference in Consumer Price Index 0.0 -0.1 -0.2 -0.4 -0.7 -0.9 -1.1% Difference in Average Annual Wage 0.0 0.0 -0.1 -0.3 -0.5 -0.7 -0.9Difference in 3 Month T-Bill Rate 0.0 0.0 -0.1 -0.1 -0.1 -0.1 -0.1% Difference in Exchange Rate (USD per CAD) 0.0 0.0 0.1 0.3 0.5 0.7 0.9

Difference in Federal Government Revenue as % of GDP 0.0 0.0 0.0 0.0 0.0 0.0 0.0Difference in Provincial Government Revenue as % of GDP 0.0 0.0 0.0 0.0 0.0 0.0 0.0 This estimate just considers the impact of the increase in investment on living standards. It does not include the possible impact that could arise from other channels. Current research, including this report, shows that the financial services sector – including asset-based financing – raises productivity by more than just the rise in investment would suggest. This can happen in a variety of ways – for example, new technology making existing processes more efficient. These effects

are considered by the new growth theory models. The macroeconomic model used by the C4SE is a traditional neoclassical model and does not include this feature.

The increase in machinery and equipment investment raises the stock of capital, in the long-run, by 1.2%. Once the new capital becomes productive, productivity rises and remains above baseline levels. Output, employment and output per capita all rise over the duration of the simulation. Canada’s population rises as a result of this policy change so output per capita rises by less than GDP.

Wages and prices end up lower in spite of the stronger economy as the new capital reduces production costs. Workers are, however, better off because wages fall by less than the CPI so the real wage – the ability of a worker’s wages to buy goods and services – actually rises relative to the baseline. Nominal interest rates also fall as a result of lower inflation. And lower prices in Canada eventually force the Canadian dollar to appreciate.

The increase in economic activity leads to both federal and provincial government revenues rising by the same amount as the overall economy.

This analysis is similar t o a study conducted for the Equipment Lessors Association (ELA) by Global Insight. In that study it was assumed that the absence of asset-based financing would lead to a $1 for $1 decline in investment spending. While some investment spending would not be feasible without the innovative features leasing offers, it is far from clear that all investment plans would be cancelled. The approach taken in this report uses the estimated impact on investment of a 10% increase in leasing industry activity. This has the advantage of providing an estimate of the impact of businesses financing plans on investment decisions as a result of changes in the availability of asset-based financing. The results obtained from this analysis are, accounting for differences in scale, key assumptions, and the structure of the US and Canadian economies, quite similar. This is because both models are neoclassical in structure which limits the impact of investment on productivity in the long-run.

Using the results from this simulation, the reader could multiply the results by ten to estimate the impact of the asset-based financing industry in Canada. As discussed previously, this would assume that no alternative financing is available – it also ignores the impact on the cost of capital for certain types of businesses. Multiplying the long-run impact on living standards by ten yields an impact of 1.6%. This impact would be augmented by any increase in the cost of capital and reduced by the use of alternate financing arrangements. There is, however, no way of estimating the magnitude of these offsetting effects.

Appendix F: The Canadian Multi-Sector Model The Canadian Multi-Sector Model, CMSM, is a multi-industry sector macroeconomic model of the Canadian economy. The purpose of the model is to produce medium to long-term projections of the Canadian economy and conduct simulation studies that require significant industry and demographic detail.

The model is similar in nature to a general equilibrium model, but full product and factor substitution is not implemented. At present, substitution is restricted to the energy products and value-added. For purposes of manageability the model does not consider the impacts of changes in relative labour and capital costs across industry categories. There is only one wage rate and one set of cost of capital measures – construction and equipment – in the model. Changes in these measures of labour and capital costs cause labour and capital intensities to change across all sectors of the economy.

The model's economy is organised into four broad sectors. Firms employ capital and labour to produce a profit-maximising output under a Cobb-Douglas constant-returns-to-scale technology, and supply financial instruments. Households consume the domestic and foreign products, supply labour and demand financial assets under the assumption of utility maximisation. Governments collect taxes, purchase the domestic and foreign products, produce output and supply financial instruments. Foreigners purchase the domestic product, supply the foreign product, and demand and supply financial instruments.

There are three main markets in the model. These markets correspond to the domestic and foreign products, the labour market, and financial markets. Each of these markets is concerned with the determination of demands, supplies, and prices. The markets and their operations are described below.

Product Market There are two sets of products in the model: domestic products and foreign products. These products are assumed in many cases to be imperfect substitutes. For such products as oil and gas, nevertheless, the law of one price is implemented. The products are put to a number of different uses in the model. They can be consumed, used for investment in residential and non-residential forms, held as inventories, or purchased by governments. The demand for the products comes from these uses. The supply of products originates from domestic production, imports, and inventory change. The foreign products are supplied with a perfect price elasticity of supply. Market clearing in the model comes via both quantity and price adjustments. In the short run, nevertheless, quantity adjustment plays the more important role.

Demand Consumer demand is derived from the life-cycle model. Desired consumption is dependent on real wealth, real labour and transfer income, and the real interest rate.

Residential investment demand is derived from the stock-flow model of the housing market. Two types of demand are considered: new housing expenditures and other expenditures. The latter expenditures include real estates commissions and alterations, conversions, and some household durables.

New housing expenditures are based on the number of housing starts. Housing starts are determined from a reduced-form supply function for starts. The supply function depends on housing prices and costs. Prices are determined through the interaction of stock demand and supply.

The desired stock of housing is dependent on those factors that determine the consumption of housing services, which are essentially the same as those discussed for consumption above. Housing supply is essentially fixed in the short run. An expression for prices determined through the interaction of stock demand and supply is substituted for the price in the housing starts equation.

Other expenditures are assumed to be determined by variables similar to those affecting consumer expenditures.

Non-residential investment demand is based on firms' factor demands. The demand for capital and thus investment is derived from profit maximisation. The long-run desired capital stock is dependent on expected output, the expected price of the product, and the expected user-cost of capital. The expected level of these variables is determined by past levels. Investment is determined through an adjustment process of the actual to desired stock of capital.

Government demand is essentially exogenous. For certain types of expenditures, it is dependent on population growth.

Exports are demand-determined. As foreign demand and the relative cost of the domestic and foreign products change, exports change. Foreign demand is represented by real GDP or other final demand measures for Canada's major trading partners. The exchange rate plays an important role in the performance of exports through its impact on relative production costs when measured in a common currency.

The demand for the domestic products is based on the above demands and that for imports. The demand for imports is a function of domestic economic activity and the relative cost of the domestic and foreign products.

Supply The supply side of the model integrates output, factor demands, output prices, and factor prices. The production function behind factor demand and costs is a constant-returns-to-scale Cobb Douglas function. The factor demand and cost functions are derived under the assumption of profit-maximising behaviour on the part of firms. Factor demands respond to output and factor prices. Output prices are driven by factor costs through a unit cost function.

A key assumption regarding the supply side of the model is that factors of production are quasi-fixed in nature due to adjustment costs - as a result of such things as career markets for labour - and the passage of time. Firms are assumed to maximise profits subject to the production function. This production structure is expected to hold on average and not on a period-to-period basis. In addition, the marginal conditions associated with profit maximisation are expected to hold on average and not in each period.

With quasi-fixed factors of production, firms are assumed to design their production process to enable them to operate over a range of feasible operating rates. They will then choose factor demands and operating rates so as to maximise profits over the expected pattern of operating rates.

The supply of the domestic products is determined through variations by firms in their capacity utilisation. They vary these rates to meet expected sales and changes in inventory stocks.

The demand for employment and capital stock are derived from profit-maximising behaviour on the part of firms given the production technology. Employment and capital adjust to desired demand levels in a partial adjustment framework. The determinants of capital stock were described above. Desired employment is dependent on the expected level of output and the product wage.

Price adjustment in the product market varies in response to factor costs and changes in capacity utilisation. Factor costs influence price determination through a Cobb-Douglas short run unit cost function. A stage-of-processing price model is employed to determine the various final demand price deflators in the model, the key driver of which is the unit cost function. Other key drivers of final demand prices in this framework include commodity prices and indirect taxes.

Changes in demand in the model are met by changes in inventories, output, and prices, with almost all of the adjustment coming through quantities rather than prices in the short run.

Labour Market The determinants of the supply of labour in the model include population, real wages, government policy, and other exogenous socio-economic factors. The demand for labour comes from firms producing the domestic products. As mentioned above, this demand is based on the profit-maximisation decisions.

The labour force, which is the measure of labour supply in the model, is determined from source population and the participation rate. Population is determined as a function of fertility and mortality rates and international migration. The participation rate is derived from an equation relating this rate to the real after-tax wage rate, the employment/population ratio and a time trend that reflects changing socio-economic factors.

Wages are determined from a Phillips curve. This curve includes expected consumer price inflation and the difference between the actual and natural unemployment rates. A constant term is included in the equation that incorporates the influence of trend productivity growth and other factors.

Unemployment is determined as a residual from labour force and employment.

Financial Markets The interaction of the supply and demand for the financial assets for the various groups of economic agents including the Bank of Canada in the model serves to determine the yields for these assets including the price of foreign exchange.

The key short-term interest rate in the model is determined through a Bank of Canada reaction function. The function adopted is a “Taylor Rule” that incorporates the target rate of inflation and the difference between the actual and natural rates of unemployment.

The demand for narrowly defined money is determined through a conventional money demand equation that incorporates real GDP, the GDP deflator and the key short-term interest rate.

The market for government bonds plays two important roles in the model. The first role is that of determining the supply of government bonds. The second is that of determining the exchange rate. The supply of government bonds is determined from government financing requirements,

which are based on the size of government deficits. Equilibrium is assumed in the market for government bonds and reflects the imposition of nominal interest parity.

Under this assumption, the yield on short-term government bonds must be equal to that in the United States, adjusted for the expected depreciation of the Canada-U.S. exchange rate and a normal risk premium. Since the yield on government bonds is determined through the Bank of Canada reaction function, the interest parity condition associated with the market for government bonds is imposed by making the exchange rate the residual in this condition.

The exchange rate is thus determined by the differential between Canadian and U.S. short-term interest rates, a risk premium and the expected value of the exchange rate. The latter is measured by a purchasing power parity equation.

The major function of the market regarding the net claims on foreigners is to determine net capital inflows. The demand for net foreign savings is determined by the balance of payments, which includes net exports of goods and services and net investment income flows. Equilibrium between the demand and supply of net foreign savings is assumed and thus net capital inflows are determined as a residual from the balance of payments identity.

Net capital flows determine Canada's net international investment position. The latter, together with interest rates and the exchange rate, is used to compute the net investment income payments on this position.

Government The government sector attempts to incorporate the impact of governments on the economy. The major categories of revenues and expenditures are modelled for three levels of government and pensions. The levels of government are the federal government, the provincial government, and local-hospital governments.

The model considers three major sources of government revenues: sales of goods and services, direct taxes, contributions to social insurance plans, indirect taxes and other revenues. The latter revenues refer largely to investment income. Direct taxes are further separated into those for persons, business and non-residents.

Direct and indirect taxes are modelled using a synthetic tax base and an implicitly calculated tax rate for each type of tax. Almost all of these rates are exogenous. Other revenues are computed using equations relating such revenues to economic variables.

Expenditures are divided into those for goods and services and capital formation, transfers to persons, transfers to non-residents, transfers to business, transfers to other governments, and interest on the public debt.

Many of the expenditures in the model are determined in real per capita terms through an exogenous growth rate. Interest on the public debt is determined from an equation that includes the stock of government bonds and the average yield on these bonds.

Assumptions All models include a variety of assumptions about the behaviour of the economy. This section will focus on some of the major assumptions that can have a significant impact on the results.

Monetary Policy Monetary policy is assumed to respond to changes in the economy caused by the new policy. Short-term domestic interest rates are set based upon the “Taylor Rule” used by the Bank of Canada.77 This implies that the central bank attempts to set interest rates so as to keep inflation near its target rate (assumed to be 2%) without creating too much unemployment. The other key monetary policy variable is the exchange rate. This is also assumed to respond to changes in the economy as discussed in the previous section.

These assumptions allow the key intertemporal and international prices in the economy to vary as a result of the policy changes. In some research, analysts assume that these variables remain invariant to changes in economic conditions. This tends to introduce some significant distortions in their analysis. These arise from a number of sources. One source is the impact of the real interest rate which is defined as the nominal or market interest rate less the rate of inflation. Since prices are allowed to adjust, higher inflation reduces the real interest rate and stimulates certain types of activity (such as business and household investment). In this analysis, higher inflation would lead to an increase in market interest rates (via the Bank of Canada’s Taylor Rule) which would reduce the change in real interest rates and, therefore, the change in investment. Failing to let the nominal exchange rate adjust means that an increase in domestic prices will make Canadian goods less attractive to foreigners (and vice-versa) so exports will fall and imports will rise. An increase in domestic prices will, based upon the theory of purchasing power parity, lead to a depreciation of the Canadian dollar versus other currencies. This will help make Canadian goods and services cheaper and reduce the negative impact on exports and the positive impact on imports.

On balance, allowing interest rates and exchange rates to adjust in response to changes in economic conditions tends to reduce the overall impact of a given policy change relative to keeping them fixed. The results for the policy changes reported in this research are, therefore, likely to be lower than those found using the alternate assumption of no change in monetary policy.

Fiscal Policy All tax rates, other than those directly changed for the simulation, are assumed to remain unchanged. This does not, however, mean that government tax revenue is unaffected. The tax rate is applied to a tax base which varies with economic conditions. Stronger economic growth, therefore, leads to higher tax revenue. The tax base is also affected by inflation – higher prices raise the value of the tax base and lead to more tax revenue.

Government spending is not directly altered in these simulations. It does, however, adjust based upon certain changes in the economy. Some government spending is assumed to change based upon the number of people in the country. Social assistance is based on the number of unemployed people. Government spending is also affected by inflation with higher prices raising the level of spending. Finally, government spending is affected by changes in debt service payments.

77 Cote, D., J.P. Lam, L. Ying and P. St. Amant. “The Role of Simple Rules in the Conduct of Canadian Monetary Policy”, Bank of Canada Review, Summer 2002. p. 33.

The changes in tax policy considered in this analysis have an impact on both the amount of revenue collected by governments and their spending. As a result, government deficits and their borrowing requirements will change and interest payments on the public debt will be affected by both the level of debt and changes in interest rates.

Demographics The C4SE’s model allows net migration – and therefore the total population – to adjust over time to reflect changes in economic conditions. If the economy and employment is growing, then the demand for labour rises and net migration rises. This is clearly an important consideration if you are interested in examining the possible impact of policy changes over several decades.

Many similar models do not have this feature, so population does not change with changes in policy. This has several important consequences for the analysis. Imagine a policy that encourages the economy to grow. This raises the demand for labour and helps to reduce unemployment. But once the unemployed have jobs, higher demand for labour will result in raising the cost of labour – higher wages. The higher cost of labour leads firms to buy labour saving machines. As a result, models that ignore the possibility of changes in population will tend to overstate the impact on investment and wages relative to the model used in this analysis.

It is worth considering for a moment what this assumption implies for immigration. Historically, the government has encouraged immigration during periods of high economic growth it is, however, under no obligation to do in the future. Emigration can be linked to the perception of better opportunities elsewhere in the world. Stronger domestic growth reduces the need for Canadians to leave the country for economic reasons. Another effect of significant concern both in the media and for policy makers is the incidence of failed immigration. While the reason for this phenomenon appears to be primarily linked to regulatory issues, stronger economic growth could provide alternative new opportunities for Canada’s under-employed recent immigrants.

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