OECD weighs in with modified free-market recipe to combat Canada's low productivity

Commercialization gap cited

Uniform R&D tax incentives, a stronger tertiary education sector, differentiation among universities and greater competition within "sheltered sectors" of the economy are among the top policy prescriptions of the latest economic survey of Canada by the Organisation for Economic Co-operation and Development (OECD). The report says low productivity growth and persistently low business R&D spending have been perpetuated by an economy largely driven by natural resource extraction and critical skills shortages — trends that must be reversed if Canada is to succeed long-term in the global economy.

Released last week, the report's overarching theme is "improving the policy framework for innovation" — an activity appropriately described as "an exceedingly complex, lengthy and risky process" requiring efficient resource allocation. But its realization is inhibited by uneven marginal effective tax rates that penalize services, limited capital markets for funding innovation, insufficiently strong competitive pressures in certain sectors and weak "connective tissue" linking research to commercial- ization.

The resulting low business R&D can be addressed by re-examining government policies in support of R&D investment as well as tertiary (post-secondary) education. The report notes that the current government is rebalancing innovation support toward private-sector needs, exemplified by expanded private-public partnerships, a refocusing of the National Research Council towards business-oriented R&D and changes to the scientific research and experimental development (SRED) tax credit program.

more sred changes required

It is the latter change that the OECD report takes exception to. It describes SRED — $3.6 billion in foregone revenue in 2011 plus $1.5 billion in provincial top-ups — as poorly targeted by subsidizing the R&D of large firms that would be performed regardless of the tax credit and directing resources to areas that don't have the highest spillovers.

"Innovation might be encouraged more effectively, and risks better balanced, by reducing the importance of tax expenditures and relying more on grants," states the report, which was prepared for the OECD's Economic and Development Review Committee.

The changes recommended by the Jenkins Panel (and partially adopted in the last federal Budget) went some way towards achieving this rebalance. But the report argues that increasing the gap in the tax credit's value for small and large firms and eliminating capital as an eligible expense was wrong-headed. Instead, it recommends "reducing the differential" between small and large firms and reinstating capital as an eligible expense "to avoid creating distortions in favour of small and/or labour-intensive firms".

"Selective government supports to sectors, firm sizes and ownership structures may have serious impacts on incentives to innovate, succeed and grow. Estimating the economic/social costs and benefits of these selective policies will be needed to overcome the political hurdles to eliminating the least efficient of them. By levelling the playing field and letting market forces run their full course, business innovation in Canada can be unleashed and high productivity growth achieved." — OECD Canada Economic Survey 2012

Changes are also recommended for Canada's small (relative to the US) venture capital sector by reducing the amount of publicly funded VC (currently 50%) and relying more on public-private co-investment funds with the private sector making the investment decisions. It also urges the complete phase out of tax credits for retail investors in labour-sponsored VC funds.

The doubling of the budget for the Industrial Research Assistance Program (IRAP) is viewed as a positive development for rebalancing Canada's system for indirect and direct support for business innovation. But the report recommends introducing user fees "to recover the high cost of expert advice" and subjecting it and other R&D support programs to "rigorous cost-benefit evaluations".

cultural adjustment to reduce risk aversion

The much-discussed commercialization gap is another problem for which the report offers prescriptive advice. But this time it points to the need for a cultural remedy to reverse "an apparently high degree of risk aversion in doing business, rooted in a fear of failure" that characterizes Canadian social attitudes toward commerce. It notes that risk-taking is a "defining characteristic of entrepreneurs" and recommends "enhanced attention to management training and diversity at all educational levels". This includes introducing more entrepreneurship and business-skills training at the college level for those taking science-based programs.

According to the OECD, innovation will also be enhanced through greater competition in sectors that Canada still protects such as telecom and transportation. And sector-specific skills shortages can be addressed by facilitating interprovincial mobility of regulated professions and skilled trades.

In the area of environmental sustainability, the OECD report recommends the adoption of a carbon tax or emissions trading scheme to reduce the "negative externalities of environmental degradation". Considering the government's aversion to taxing carbon, this appears to be the biggest non-starter of all the report's recommendations.

While the value of higher education to multi-factor productivity gains is a given, the report argues that tertiary education is key for innovative growth.

With high attainment levels and a wide range of options ranging from universities to colleges and polytechnics, the Canadian education system appears to be well suited for meeting the challenges of boosting innovation and productivity. But the report notes there are several trends threatening to undermine Canada's post-secondary education system.

For example, it says there must be greater movement between different types of post-secondary institutions as an increasing number of university graduates seek college diplomas to "improve their employability". It also recommends greater diversification among universities that engage in research and those that emphasize teaching "by concentrating institutional resources where comparative advantages exist".

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