Front Matter Page

©1997 International Monetary Fund

April 1997

IMF Staff Country Report No. 97/20

Canada—Selected Issues

This selected issues report on Canada was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with this member country. As such, the views expressed in this document are those of the staff team and do not necessarily reflect the views of the Government of Canada or the Executive Board of the IMF.

International Monetary Fund

Washington, D.C.

Front Matter Page

INTERNATIONAL MONETARY FUND

CANADA

Selected Issues

Prepared by S. Dunaway, J. Cole, B. González-Hermosillo, T. Ito, C. Kramer, M. Leidy, Y. Li, S. Prowse, R. Salgado, and A. Thomas

Approved by the Western Hemisphere Department

March 26, 1997

Contents

• Executive Summary

• I. Business Taxation in Canada

  • A. Introduction

  • B. Business Taxation and Economic Activity

    • The level and structure of business taxation

    • Tax preferences

    • International tax competition

    • Complexity and specificity

  • C. The Current Tax Environment for Business in Canada

  • D. Estimates of Effective Marginal Tax Rates in Canada

  • E. Concluding Comments

• Text Tables

  • I. 1. Tax Revenues (In percent of GDP)

  • 2. Tax Revenues (In percent of total revenue)

  • 3. Marginal Effective Corporate Tax Rates

  • 4. Marginal Effective Personal Tax Rates on Corporate Source Income

  • 5. Marginal Effective Tax Rates on Corporate Source Income

• Text Boxes

  • I. 1. Tax Preferences and the Allocation of Capital

  • 2. Fundamental Business Tax Concepts

• Charts

  • I. 1. General Government Tax Revenues

  • 2. Federal Government Tax Revenues

  • 3. Provincial, State, and Local Government Tax Revenues

  • 4. Total Payroll Taxes

  • 5. Employers’ Contribution to Payroll Taxes

EXECUTIVE SUMMARY

The papers presented in this report provide more detailed background information and analysis of selected policy and economic issues in Canada.

The first paper, Business Taxation in Canada, reviews Canada’s business tax system, looking at the incentive effects of the country’s business tax regime and their implications for output and employment. It also presents estimates of marginal effective tax rates on corporate-source income in Canada and comparator countries (the United States and United Kingdom) across sectors, asset classes, means of finance, and asset ownership. The paper finds that Canada compares well with the United States and the United Kingdom. The last major reform of Canada’s tax regime in the mid-1980s moved the corporate tax system closer to neutrality by reducing preferences and revising capital consumption allowances more in line with the economic life of assets. Nevertheless, there continues to be scope for improving the neutrality of the system and, thereby, improving resource allocation.

The persistence of unemployment in Canada has been a continuing source of concern, with the country’s unemployment rate ratcheting up over successive business cycles during the past 25 years. The second paper, Labor Markets in Canada, discusses developments over this period. It notes that unemployment rates in Canada have risen across all demographic groups, industries, and regions, although young and less-educated workers and workers in agriculture and primary industries have been most severely affected. The paper also looks at the roles played by modifications to the unemployment insurance system, changes in unionization, demographic effects, and changes in the cost of labor in accounting for the rise in unemployment. The paper concludes with a discussion of the effects of changes in payroll taxes on employment and unemployment. The empirical estimates presented suggest that, while the effects of a payroll tax increase on employment and unemployment may be largely offset over a six year period, successive increases in payroll taxes, especially during the 1980s, appear to have had a sustained impact on employment and unemployment in Canada.

As in other major industrial countries, demographic and economic changes are putting the finances of Canada’s government-sponsored pension system at risk. In response, discussions are underway in Canada on a number of proposals to reform the Canada Pension Plan (CPP). The third paper, Canada Pension Plan Reform: Analytical Considerations, describes the main provisions of the CPP and the major reform options under consideration. The paper also examines some of the economic effects of public pension plans in general and simulates the economic effects of changes in a plan’s provisions using a stylized dynamic general-equilibrium model of life-cycle behavior. The analysis shows that the introduction of a public pension plan can reduce aggregate saving, income, and wages and increase interest rates. It also shows that a significant part of the distortion caused by such a pension plan can result from the fact that benefits are not explicitly linked to contributions, and that creating such a linkage can reduce the distortions associated with the payroll tax that funds the contributions to a public pension plan.

The fourth paper, Developments in Productivity Across Industries in Canada, examines the slowdown in labor productivity and total factor productivity (TFP) growth that has taken place since the mid-1970s. In particular, an assessment is made of the roles in explaining the slowdown of intersectoral shifts of output and labor toward services and other industries with lower productivity growth, a reduction in the benefits from increasing scale in manufacturing, and a slowdown in capital accumulation relative to labor force growth. The paper suggests that intersectoral shifts account for a negligible amount of the slowdown in aggregate labor productivity and TFP growth between 1962–73 and 1974–92, since there has been almost as much of a slowdown in goods-producing industries as in service industries. Reduced benefits from increasing returns to scale and the decline in the growth of the capital/labor ratio account for significant parts of the slowdown; however, a large portion is not explained and may reflect other factors (including relative changes in labor skill levels, in land and natural resource use, and in capital obsolescence) not explicitly considered.

The consumer price index (CPI) is commonly used as a measure of inflation and is often used to adjust tax rates, government spending, and private sector wage contracts for changes in the cost of living. Given its central importance, considerable attention recently has been directed at gauging the accuracy of the CPI in measuring the living costs. The fifth paper, Measurement Bias in the CPI in Canada, reviews research in this area and provides a comparison of potential biases in the CPIs for Canada and the United States. By pricing a fixed-weighted basket of goods and services, the CPI is intended to isolate the impact of price changes. However, the use of fixed weights means that the CPI over time may become less representative of the “true” cost of living as individuals respond to price changes and new product choices. The major sources for differences between the CPI and the cost of living (referred to as measurement biases) are: commodity substitution bias, outlet substitution bias, quality bias, and new goods bias. A survey of the research work done on the subject finds that the overall bias in Canada’s CPI inflation rate is estimated to be in the range of 0.5–1.5 percent per year, comparable to estimates for the United States of 0.4–1.6 percent per year.

In recent years, the Bank of Canada has adopted explicit inflation targets and introduced important changes to its operational framework. The sixth paper, Bank of Canada’s Monetary Policy Operating Framework, discusses these changes and reviews some of the key issues associated with them. In addition, the paper looks at the impact of the changes in the monetary policy operating framework and their implementation on the public’s assessment of the central bank’s credibility. Surveys of medium-term inflation expectations suggest that it is widely anticipated that the Bank of Canada will maintain low inflation over the next three to ten years. However, longer-term credibility, although difficult to assess precisely, appears to have not yet been as firmly established, judging by the steepness of the slope of the yield curve and the spread between yields on nominal and inflation-indexed government bonds.

The final two papers describe recent developments in Canadian trade policy and in official development assistance.

Contents

• II. Labor Markets in Canada

  • A. Introduction

  • B. Labor Market Developments

  • C. Factors Underlying the Rise in the Aggregate Unemployment Rate

  • D. An Empirical Model of the Labor Market

• Text Tables

• II.

  • 1. Determinants of Net Migration Across Canadian Provinces

  • 2. Determinants of Gross Migration Across Canadian Provinces

  • 3. Unit Root Tests

  • 4. Johansen Maximum Likelihood Tests of the System of Equations

  • 5. Criteria for Selecting Lag Length

  • 6. Labor Market Model

• Charts

• II.

  • 1. Components of the Unemployment Rate

  • 2. The Capital-Output Ratio and Relative Cost of Capital

  • 3. Participation and Unemployment Rates by Age and Sex

  • 4. Employment and Unemployment by Industry

  • 5. Provincial Unemployment Rates

  • 6. Population Migration and Unemployment

  • 7. Unemployment Insurance Index and the Unemployment Rate

  • 8. Impulse Responses to Payroll Tax Shock

• Figure

• II.

  • 1. The Labor Market

• III. The Canada Pension Plan Reform: Analytical Considerations

  • A. Introduction

  • B. The Canada Pension Plan: Provisions and Issues

  • C. Options for Reform

  • D. The Economics of Public Pension Systems

  • E. The Simulation Model

  • F. Policy Experiments

  • G. Conclusions

• Text Tables

• III.

  • 1. Details of Policy Experiments

  • 2. Effects of the Introduction of a PAYG Public Pension System

  • 3. Effects of a Permanent Increase in Benefits

  • 4. Effects of a Temporary Increase in Benefits

  • 5. Effects of Introduction of PAYG Pension Scheme with Linkage of Contributions and Benefits

  • 6. Effects of a Permanent Increase in Benefits with Linkage of Contributions and Benefits

  • 7. Effects of a Temporary Increase in Benefits with Linkage of Contributions and Benefits

• Charts

• III.

  • 1. Historical and Projected Elderly Dependency Ratio (Excluding Quebec)

  • 2. Real Wage Rate and Interest Rate

  • 3. Currently Legislated and Benchmark Schedule of Contribution Rates

  • 4. Effects of Different CPP Policies

  • 5. Effects of Different CPP Policies

• Appendix

• III. Description of the Model

• IV. Developments in Productivity Across Industries in Canada

  • A. Introduction

  • B. Measuring Productivity Growth

    • Measurement Issues

    • Methodology

  • C. Productivity at the Aggregate and S Industry Level

  • D. Concluding Remarks

• Text Tables

• IV.

  • 1. Growth in Labor Productivity for S Level Industries and Aggregates

  • 2. Growth in TFP for S Level Industries and Aggregates

  • 3. Testing for Constant Returns to Scale

  • 4. Testing for Constant Returns to Scale, Profit Maximization and Parameter Stability

  • 5. Controlling for Scale and Parameter Instability

• Charts

• IV.

  • 1. GDP, Labor Productivity, and Capital-Labor Ratios

• Appendix

• IV. Data

• V. Measurement Bias in the CPI in Canada

  • A. Commodity Substitution Bias

  • B. Outlet Substitution Bias

  • C. Quality Bias

  • D. New Goods Bias

  • E. Overall Bias

• VI. The Bank of Canada’s Monetary Policy Operating Framework

  • A. Introduction

  • B. Inflation Targets

  • C. The MCI as an Operational Target

  • D. The Operational Implementation of Monetary Policy

  • E. Central Bank Credibility

• Charts

• VI.

  • 1. Inflation Targets

  • 2. Inflation Expectations at Various Horizons

  • 3. Canadian Yield Curve Versus United States Yield Curve

  • 4. Real Return Versus Nominal Government Bond Yields

• VII. Developments in Canadian Trade Policy

  • A. Introduction

  • B. Uruguay Round Agreement and the World Trade Organization

    • Implementation of Uruguay Round

    • Dispute-settlement activity in the WTO

    • Antidumping and countervailing investigations

  • C. The North American Free Trade Agreement and the Free Trade Area of the Americas

    • Trade disputes

  • D. Review of Import Legislation

  • E. Asia-Pacific Economic Cooperation Forum

  • F. Trade Preferences for Developing Countries

  • G. Foreign Investment

  • H. Other Measures and Issues

• VIII. Official Development Assistance