This paper explores the factors that have led to a Canada-U.S. productivity gap using a sectoral growth accounting approach. Both fiscal and monetary policies have had significant effects on the saving rate. The Canadian dollar’s appreciation was followed by a protracted period of exchange rate weakness. This paper reviews the institutional aspects of Canada’s real return bond program. The Canadian system provides a successful model for pension reform. Free trade has helped promote the integration of U.S. and Canadian economies, but significant differences remain.

Abstract

This paper explores the factors that have led to a Canada-U.S. productivity gap using a sectoral growth accounting approach. Both fiscal and monetary policies have had significant effects on the saving rate. The Canadian dollar’s appreciation was followed by a protracted period of exchange rate weakness. This paper reviews the institutional aspects of Canada’s real return bond program. The Canadian system provides a successful model for pension reform. Free trade has helped promote the integration of U.S. and Canadian economies, but significant differences remain.

I. The Canada – United States Productivity Gap: Evidence from Industry Data1

1. Despite the close integration between the Canada and U.S. economies, the labor productivity gap between the two countries has widened over the last two decades (Figure 1). While a greater utilization of labor resources has allowed Canada to narrow the gap with the United States in terms of per capita income from the mid 1990s, convergence has been held back by the more modest pace of Canadian labor productivity growth.

Figure 1
Figure 1

United States and Canada: Income and Productivity Indicators

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A001

Source: OECD. Labor Productivity: GDP in millions of 1999 US$ (converted at EKS PPPs) per hour worked. Labor Utilization: hours worked per person.

2. This chapter explores the factors that have led to the Canada-U.S. productivity gap using a sectoral growth-accounting approach. Building on the approach of Faruqui, et al. (2002), this chapter constructs a sectoral database with comparable data on value added, labor, and capital inputs for 23 industries over the 1981–2000 period, in order to assess the extent to which this gap reflects differences in the industrial structure of the two countries.2

3. The chapter’s main results are that

  • The post-1995 labor productivity growth gap largely reflects the performance of two key service sectors, trade and “finance, insurance, and real estate” (FIRE). The manufacturing sector, in particular the information and communication technologies (ICT)-producing industries, also continued to contribute to the gap, but no more than in the previous period.

  • Differences in industrial structure explain the majority of the productivity growth gap over the second half of the 1990s. The United States appears to have been more successful in shifting resources toward high-productivity sectors, compared to Canada.

  • The lower contribution from ICT capital accumulation to productivity growth in Canada may also reflect differences in realizing the productivity benefits of ICT investments. In particular, Canadian productivity growth may have been held up by the delays in introducing organizational changes necessary to complement ICT capital.

  • The increased economic integration with the United States has allowed Canadian firms to benefit from economies of scale and technology transfers, something that appears to have positively contributed to their productivity performance over the last two decades.

A. Review of the Literature

4. A copious number of studies have sought to analyze the factors behind the productivity gap between Canada and the United States (for a survey, see Crawford, 2002, and Macklem, 2003). Among the explanations offered are the following:

  • Different size of the ICT-producing sector: Some studies have attributed most of the post-1995 acceleration of labor productivity in the United States to the exceptional total factor productivity performance of the ICT-producing sector (e.g., Gordon, 2003, and Harchaoui and Tarkhani, 2002). Given its smaller ICT-producing sector, these studies suggest that Canada is at a relative disadvantage in reaping the benefit of the ICT productivity wave.3

  • Different contribution from ICT capital accumulation: The widespread adoption of ICT capital assets has been regarded as a key factor behind the strong labor productivity growth in the United States.4 Harchaoui and Tarkhani (2002) show that Canada’s business sector also experienced solid growth in ICT capital services over the 1981–2000 period, at levels comparable if not higher than the United States (Table 1).5 Nonetheless, the contribution from ICT capital deepening to labor productivity growth is generally estimated to be lower in Canada than in the United States, mainly reflecting the lower estimated marginal productivity of ICT capital and the lower ICT capital intensity in Canada.6

  • Differences in the share and productivity performance of small and medium size enterprises (SMEs): In the Canadian manufacturing sector, SMEs (i.e., firms with less than 500 employees) accounted for 75 percent of total manufacturing employment, compared to around 60 percent in the United States in 1997. Not only has the weight of SMEs in the Canadian economy increased over the last two decades, but some studies have found these firms to be less productive relative to their U.S. counterparts.7

  • Differences in the share and income of self-employed: The difference in labor-productivity growth between Canada and the United States in the 1990s has also been attributed to the faster growth of self-employment in Canada and the poorer income performance of this group compared with the United States (Baldwin and Chowhan, 2002).

5. Less relevant factors include:

  • Differences in national accounts statistics: While differences still remain, the methodology used by national statistical agencies to measure labor and total factor productivity has been converging. In particular, both U.S. Bureau of Labor Statistics and Statistics Canada now use hedonic prices and include purchase of computer software in the national account measures of investment.

  • Differences in the regulatory burden in labor and product markets: Gust and Marquez (2004) find that countries with a more burdensome regulatory framework tend to have lower total factor productivity growth. However, notwithstanding the difficulties in building comparable indexes of regulatory burden across countries, empirical evidence does not reveal a large difference between Canada and the United States in terms of labor and product market legislation and institutions.8

Table 1

Canada and the United States: ICT Capital Accumulation

(In percent)

article image

Source: Haver Analytics.

Sources: Armstrong et al. (2002) for Canada and BEA for the United States. Values are for 1981 and 2000.

6. Few studies have examined the contribution of different industries to the business sector labor productivity gap between Canada and the United States. The majority of the literature has focused either on the labor productivity gap in the manufacturing sector, or used the growth accounting framework at an aggregate level. This chapter examines the extent to which productivity differences between the two countries reflect differences in their industrial structure and the performance of specific industries.

B. Results from Sectoral Growth Accounting

7. The analysis below uses a traditional growth accounting framework. This approach attributes labor productivity growth (value added per hours worked, yt) to the contribution of three factors: the improvement in labor quality (Ht), weighted by the labor income share of value added t); capital deepening (proxied by the flow of capital services per hours worked, kt), weighted by the capital income share of value added t); and total factor productivity (TFP, denoted by At)9

yt˙=αtkt˙+βtH˙t+A˙t(1)

8. Labor and capital inputs for both Canada and the United States are adjusted for quality changes using the same methodology. In particular, labor quality (Ht) is the difference between the growth of hours worked and the growth of labor input, obtained by weighting the hours of different types of labor (in terms of educational attainment, age, and gender) by their marginal productivity (proxied by their relative compensation). Similarly, capital services are obtained by weighting the growth rates of different capital assets, using their estimated marginal productivity (proxied by rental prices) as weights. Within this framework, the estimates of labor and capital inputs capture the effect of substituting toward inputs with a higher marginal productivity (e.g., ICT capital and higher educated labor). In turn, this allows the estimates of TFP to better proxy the impact of technical and organizational changes on productivity.10

9. Appendix II shows Canadian and U.S. industries’ average labor productivity growth, and the contribution from the three proximate causes. The results are shown separately for the period 1981–2000, as well as the pre- and post-1995 period. The appendix also shows average labor productivity growth for the entire business sector, aggregated over the 23 sectors considered.11 The main results may be summarized as follows:

  • Canadian aggregate labor productivity grew by an average annual 0.3 percentage points less than in the United States over the whole period, but the gap in growth rates widened to an average 0.8 percentage points in the post-1995 period. These estimates are broadly consistent with the estimates obtained by conducting growth accounting at an aggregate level (see Macklem, 2003).12

  • In the post-1995 period, the labor productivity gap between the two countries widened not only in the ICT-producing sector, but also in sectors that intensively used ICT capital.13 Canada’s non-ICT producing manufacturing industries appear to have performed as well, if not better, than their U.S. counterparts. However, a gap emerged in sectors that have been most intensively using new technologies, like the trade and FIRE sectors. In particular, labor productivity growth in Canada’s trade sector was well below that in the United States, reflecting shortfalls in both TFP and capital deepening. A gap also opened in the FIRE sector, reflecting a smaller contribution of capital deepening than in the United States.

The impact of industrial structure on the aggregate labor productivity growth gap

10. Conducting growth accounting at a sectoral level allows to decompose the aggregate labor productivity growth gap between Canada and the Unites States into three components, which correspond to the three terms on the right hand side of equation (2):

  • a “direct” effect, which reflects the contribution from industry i’s different labor productivity growth performance, weighted by its average value-added share (vai);

  • a “structural” effect, which reflects the contribution from the industry i’s different relative size across the two countries, weighted by its average labor productivity growth;

  • and a “reallocation factor”, that reflects the different ability of the two economies to direct labor resources (hours worked, hi) toward sectors with a value-added share that exceeds the labor compensation share (lsi) (that is, toward sectors with higher-than-average labor productivity level):14

y˙Cany˙US=Σi(vai,Can+vai,US2)(y˙i,Cany˙i,US)+Σi(y˙i,Can+y˙i,US2)(vai,Canvai,US)+[Σi(vai,Canlsi,Can)h˙i,CanΣi(vai,USlsi,US)h˙i,US](2)

11. This decomposition shows that a significant part of the widening labor productivity gap between Canada and the United States over the post-1995 period is explained by structural differences between the two economies. Table 2 shows that the negative contribution from the “direct” effect has remained relatively constant over the two periods, whereas the other two effects have become a negative contributor in the post-1995 period. This seems to suggest that the widening of the Canada-U.S. labor productivity gap over the second half of the 1990s was mostly due to a shift in the relative pattern of industry specialization. In other words, rather than having become less productive than the United States, Canada has tended to be less successful in directing resources toward high-productivity sectors.

Table 2

Canada - U.S. Labor Productivity Growth Gap

(In percent)

article image
Source: Fund staff estimates.

12. The widening of the aggregate labor productivity gap between Canada and the United State over the second half of the 1990s has been mainly driven by two major service sectors, trade and FIRE. Figure 2 shows the industries’ contribution to the aggregate labor productivity growth gap in the two sub periods, 1981–1995 and 1995–2000. Each industry’s contribution is given by the sum of its contribution to the “direct,” “structure,” and “reallocation” effects. While the negative contribution from the ICT-producing sector increased only slightly in the second half of the 1990s, the negative contribution from the trade and FIRE sectors rose significantly. The negative contribution from the ICT-producing manufacturing and trade sectors mainly reflected lower labor productivity growth, whereas the negative contribution from the FIRE sector was largely the result of the lower relative size of the sector in Canada.15

Figure 2
Figure 2

Sectoral Contributions to the Canada - U.S. Aggregate Labor Productivity Growth Gap

(In percent)

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A001

Source: Fund staff calculations.

Why has the contribution from ICT capital accumulation in Canada been more muted?

13. The more muted contribution of ICT capital accumulation to productivity growth in Canada may reflect the different timing of Canadian and U.S. ICT investments. ICT investments affect labor productivity not only through capital deepening. They also affect TFP growth by inducing additional investments in intangible assets, such as organizational changes and the accumulation of knowledge. However, the payoff of these investments in terms of measured output can be delayed considerably, given the time and resources required to reorganize production after investing in ICT capital. Basu, et al. (2003) find that the post-1995 TFP acceleration in the United States is correlated with ICT investments in the 1980s and early 1990s, and negatively correlated with ICT investments in the same period.

14. Empirical evidence is supportive of the existence of relatively long lags between ICT capital accumulation and TFP growth in Canada. Following Basu, et al. (2003), a simple OLS regression is run to relate TFP average growth in the post-1995 period to ICT capital service growth in the 1980s, the mid-1990s and the late 1990s, taking each industry as a cross-sectional observation. Table 3 shows that Canadian TFP growth in the late 1990s is negatively correlated to ICT capital investments in both halves of the 1990s, but is positively correlated to ICT investment in the 1980s.16 For the United States, the results are qualitatively similar to Basu, et al. (2003), with post-1995 TFP growth negatively correlated to ICT capital accumulation over the same period, but positively correlated to ICT capital accumulation in the 1980s and early 1990s. This result suggests that Canada’s slower TFP acceleration in the post-1995 period may reflect the fact that Canadian firms invested in complementary capital later than U.S. firms and/or that this process has taken a longer period of time for Canadian firms. It also suggests, however, that Canadian firms might benefit from faster TFP growth in the near future.17

Table 3

Canada and United States: TFP Growth Regression with Current and Lagged ICT Capital Services Growth 1/

article image
Source: Fund staff estimates.

Dependent Variable: Average annual TFP growth in 1995-2000. White Heteroskedasticity-Consistent standard errors in parenthesis.

C. Productivity Growth and Trade

15. The labor productivity gap between Canada and the United States widened despite the marked deepening of trade linkages between the two countries. Some authors have argued that this reflected Canada’s increased specialization in the natural resource and resource-based manufacturing sectors, where Canada has had a comparative advantage (see, for example, Jackson, 2003). This reallocation of resources could have dampened the aggregate growth of Canadian productivity.

16. However, the labor productivity gap is unlikely to be related to increased economic integration. First, the results shown above attribute nearly the entire structural labor productivity gap to the service (i.e., nontradable) sector. Second, over the second half of the 1990s, Canada’s tradable sector seems to have evolved rapidly in the direction of high-tech productions. In particular, while it remains lower than in the United States, Canada’s ICT-producing sector has increased its share of aggregate GDP over this period (Table 4). Finally, several studies have shown that, over the last decade, Canadian trade has increased mainly in two-way trade in similar products, rather than among different industries.18

Table 4

Canada and the United States: Value-Added, Shares of Total

(In percent)

article image
Source: Fund staff estimates.

17. On the contrary, Canadian TFP growth is positively correlated with trade. Plotting average TFP growth against (1) the degree of vertical specialization and (2) the degree of trade exposure of Canadian sectors over the 1981-2000 period shows that TFP growth is positively correlated with openness to trade (Figure 3).19 In particular, the ICT-producing and transportation equipment sectors seem to have most benefited from exposure to trade and inter-industry specialization over this period. Moreover, the extent of the correlation has increased since the inception of the free trade agreement with the United States.

Figure 3
Figure 3

Canada: Sectoral TFP Growth and Openness to Trade

Citation: IMF Staff Country Reports 2004, 060; 10.5089/9781451806908.002.A001

Source: Fund staff calculations.

APPENDIX I Data Sources

Data for Canada

Real (chain Fisher weighted) value added, hours worked, labor input, and capital services data were obtained from Statistics Canada and were based on a SIC-80 industry classification.

For the manufacturing sectors, however, the data ended in 1997. They were extrapolated to 2000 using the growth rates from the KLEMS input and output database which follows a NAICS industry classification (starting from 1997).

Comparing the 1997 industries’ value added based on the two industry classifications shows that the difference is generally around 15 percent, except for “other manufacturing sector” and “furniture and fixture”, for which the difference is around 30 percent. The results for these sectors should then be interpreted with greater caution than others.

Data for the United States

Industry data for the United States follows the US SIC 87 industry classification.

Real (chain Fisher weighted) value added industry data for the United States were obtained from Bureau of Economic Analysis’s “gross product originating” by industry (GPO). As these figures are on a market-price basis, value-added data at basic prices were obtained by subtracting the indirect business tax and nontax liability from GPO.

GDP by industry is obtained from industries components of domestic income which, as it is well known, tend to falls short of GDP measured on an expenditure basis. The difference is named “statistical discrepancy”, and is attributed to the industries based on their share of total GDP.

Hours worked, labor input and capital services were obtained from Jorgenson, Ho, and Stiroh (2002), and are based on methodologies that are largely comparable with those adopted by Statistics Canada.

Industry classification

To obtain the same level of industry classification for the two countries a number of subsectors were aggregated into larger sectors. As an example, a “mining” sector was obtained for the Unites States by aggregating four subsectors (namely, metal mining, coal mining petroleum and gas and nonmetallic mining).

The aggregation was needed also to obtain comparable sectors for the two countries. For example, US SIC 87 classification places computers and office equipment in Industrial Machinery, while Canada SIC 80 classification places it in the Electrical and Electronic equipment. For the sake of comparison, the two sectors were aggregated into one large sector, which is taken as a proxy for the ICT-producing sector in the chapter.

The following aggregation criteria were utilized: sub-industries value-added were aggregated using value-added shares as weights; labor and capital inputs were aggregated using relative shares in aggregate labor compensation and capital income, respectively, as weights; and hours worked were aggregated through the unweighted sum.

Despite following these aggregation procedures allows to obtain reasonably comparable sectors for the two countries, some minor differences still persist, particularly in the service sectors. In addition to the different treatment of eating and drinking places (see footnote 14 in the text), another difference which is worth mentioning regards postal services, which are placed in the Communication sector for Canada but in the Transportation sector for the United States.

APPENDIX II Canada and the United States: Productivity Growth, 1982-2000

(In percent)

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Canada and the United States: Productivity Growth, 1982-1995

(In percent)

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Canada and the United States: Productivity Growth, 1995-2000

(In percent)

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Source: Fund staff estimates.

References

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1

Prepared by Roberto Cardarelli.

2

Data for Canada are from Statistics Canada, while data for United States are from several industry data sources, including the database used by Jorgenson, Ho, and Stiroh (2002) in their latest study on the U.S. productivity performance. See appendix I for a description of the database.

3

Harchaoui and Tarkhani (2002) show that the size of Canada ICT-producing sector increased from around 2½ percent of GDP in 1981 to around 4 percent of GDP on average over the second half of the 1990s, but remained below the U.S. share, which was around 6 percent of GDP over this period.

5

The faster growth in ICT capital services in Canada might be partly explained by differences in the capital asset depreciation rates used by Statistics Canada and the BLS. In particular, Statistics Canada uses higher depreciation rates for ICT assets, something that might lead to a faster growth of their capital services (see Ho, Rao, and Tang, 2003).

6

See Khan and Santos (2002), Harchaoui and Tarkhani (2002), Armstrong, et al. (2002), and Ho, Rao, and Tang (2003). Both Armstrong, et al. and Harchaoui and Tarkhani find that ICT-capital deepening has contributed around ¼ percent to the average annual labor productivity growth in Canada over the 1995-2000 period, up only slightly compared to the 1981-2000 period. The equivalent figure for the United States is estimated between ½ percent (Oliner and Sichel, 2002) and ⅔ percent (Jorgenson, Ho, and Stiroh, 2002).

7

Baldwin and Tang (2003) show that around ¼ percentage point of the labor productivity gap in the manufacturing sector in 1997 was due to the larger share of SMEs in Canada compared to the United States, and ½ percentage point to the lower productivity of SMEs in Canada.

8

Based on the regulatory variables they use, Canada is lagging the United States according to the OECD employment protection legislation index, but is leading the United States according to the World Economic Forum’s regulatory burden index.

9

The dot over the variables denotes percentage growth rates. For a more detailed discussion of the methodology see Jorgenson, Ho, and Stiroh (2002).

10

Industry value-added measures of TFP reflect technological changes only assuming that the production function is separable in primary (capital and labor) and intermediate inputs. Loosely speaking, this amounts to assuming that firms’ decisions on the capital-labor mix are not affected by decisions regarding intermediate inputs. If this is not the case, industry value-added TFP would capture not only technical changes, but also the productivity improvements that derive from more efficiently produced intermediate inputs. Hence, while TFP would still reflect technological changes at an aggregate level, its breakdown across industries would be affected. The OECD (2001) suggests interpreting more widely the industry value-added measure of TFP as an indication of the industry’s ability to translate technical changes into overall income.

11

Consistently with the OECD (2001), total labor productivity growth is obtained as the weighted average of labor productivities across industries using value-added shares as weights, plus a reallocation term that reflects the economy’s ability to move labor resources to those sectors with a higher-than-average level of labor productivity (see equation 2 below). Given that aggregate TFP and contributions from labor quality and capital deepening are obtained as weighted average of industries figures using value-added shares as weights, their sum is different than total labor productivity, the difference being the reallocation factor.

12

Recent data revisions by Statistics Canada suggest that the aggregate labor productivity growth gap between Canada and the United States in the 1995-2000 period has been smaller, about ½ percent, than the data used in this chapter.

13

The ICT-producing sector is proxied by the industrial machinery and electrical and electronic product sectors.

14

See Faruqui, et al. (2002) for a similar decomposition formula. Their conclusion is that most of the business sector labor productivity growth gap between Canada and the United States in the 1987-2000 period is explained by the direct effect. Moreover, the manufacturing sector is the main contributor to the aggregate gap in the post-1996 period, while the service sector is more relevant in the period 1987-1996. However, these results are obtained at a rather coarse level of disaggregation (4 large sectors are identified, namely, primary, manufacturing, construction and services), something that (as admitted by the same authors) might conceal the contribution from the structural and reallocation effects.

15

The comparison between the trade sectors in the two countries may be blurred by the fact that eating and drinking places are included in the U.S. trade sector, while they are part of the “other service” sector for Canada (as they are in the “accommodation, food, and beverage” sector). However, the results do not change substantially when the Canadian trade sector is adjusted to include that fraction of the “accommodation, food, and beverage” sector that can be attributed to eating and drinking places.

16

As stressed by Basu, et al. (2003), the OLS regression and the simple specification used do not allow to infer causation from the results, but only whether a correlation exists between lagged ICT capital and TFP growth. The results in Table 3 are robust to the exclusion of key sectors, such as the ICT-producing, trade, and FIRE sectors.

17

Leung (2004) finds that investments in new technologies in Canada have their strongest impact on TFP growth only after three years. Robidoux (2003) also suggests that the contribution of ICT capital to the acceleration of TFP growth in the service sector in late 1990s reflects the successful incorporation of ICT in the production and management processes in the 1980s and early 1990s.

19

Both indexes of openness to trade are from Dion (2000) (the data, originally up to 1996, have been extrapolated to 2000). The degree of vertical specialization measures the extent to which an industry’s trade is accounted for by inputs that are imported and embodied in exports. The degree of trade exposure is the algebraic sum of three different indicators: the share of an industry’s exports in its gross output (capturing its degree of export orientation); the share of an industry’s imported intermediate inputs in its gross output (capturing the exposure of an industry on the cost side); and the share of an industry’s competing imports in the domestic markets for its core products (measuring the exposure to foreign penetration of the domestic market).

Canada: Selected Issues
Author: International Monetary Fund