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report on business

Beyond promising to study the effects of recent U.S. tax reform, the government has yet to offer any concrete solutions to deal with the country's faltering competitiveness

Finance Minister Bill Morneau, left, and Prime Minister Justin Trudeau leave the Prime Minister’s Office to table the federal budget in the House of Commons in Ottawa on Tuesday, Feb. 27.

Prime Minister Justin Trudeau was still doing a postelection victory lap when he came to Davos, Switzerland, in early 2016 to sell Canada to the world's business and political intelligentsia.

"There has never been a better time to look at Canada," he told those gathered at the World Economic Forum.

With its talented work force and low-carbon economy, Mr. Trudeau predicted the country would be a magnet for "new companies, new growth and new prosperity."

That, of course, was before Donald Trump captured the White House, putting the United States on a path of greater protectionism and deep tax cuts designed to bring corporate investment back to the United States. Two years later, Canada is not the alluring beacon of New Age economic greatness Mr. Trudeau envisioned in Davos. Instead, the country is in the throes of a potentially destructive investment chill as business decision-makers weigh the impact of a lost tax advantage, the possible demise of the North American free-trade agreement, new U.S. tariffs on steel and aluminum, as well as regulatory paralysis gripping major energy projects.

Finance Minister Bill Morneau acknowledged the growing business angst as he delivered the federal government's budget this week. But so far he has offered nothing concrete to deal with the faltering competitive landscape, beyond a promise to study the impact of U.S. tax reform.

"We're not saying we don't need to think about these competitive challenges," Mr. Morneau said in Toronto on Thursday. "We're saying: Let's start with our fortress here at home."

Unfortunately, the fortress is showing stress fractures. Foreign direct investment in Canada declined for a third consecutive year in 2017, plunging 26 per cent, Statistics Canada reported this week. The ratio of non-residential business investment relative to the overall economy has also been shrinking since 2015.

In the United States, the ratio has been going up since the beginning of 2017.

And the prospects for this year are murky. A Statscan survey of business released this week projected that business capital spending will drop 1.1 per cent in 2018, led by a fourth consecutive yearly drop in oil and gas investment. The Bank of Canada's latest quarterly Business Outlook Survey showed a more optimistic view, with more companies saying they intend to boost investment in machinery and equipment this year. And yet many of these same companies say their plans are increasingly clouded by NAFTA uncertainty, tax policy and regulatory hurdles.

Even those figures may not fully capture the broader investment fallout – delayed plant openings, the shelved purchases of new equipment or the quiet shifting of activity out of the country. Corporate decisions are being made now that could hurt this country a decade or more from now.

"People aren't going to wait for the federal government to make up its mind," warns tax expert Jack Mintz of the University of Calgary's School of Public Policy. "We could wind up having a serious productivity problem in this country as the money flows south."

There is a lot Ottawa and the provinces could, and should, be doing. The options range from rethinking the incentives built into the corporate-tax system to offering more predictability for the approval of big infrastructure projects.

Here are six options for Canada in the face of this uncertain economic future:

1. Watch and pray

Canada could choose to do nothing at all, hoping that Mr. Trump will soon quit or be voted out of office in 2020. Canada's relatively healthy fiscal situation and generous social programs would help the country muddle through. Indeed, this may well be an element of the Trudeau government's Plan B, certainly in dealing with trade threats.

Under this scenario, the NAFTA negotiations would drag on beyond this year's U.S. midterm elections, but the U.S. administration would probably back off the more hardline demands championed by Mr. Trump. Meanwhile, other U.S. protectionist measures, including looming U.S. tariffs on steel and aluminum, would eventually be reversed, either through litigation or action by Congress.

Overcoming the fallout from recent U.S. tax changes could prove far trickier. Here again, Ottawa could wait it out, anticipating that the massive tax cuts will push the United States into an unsustainable spiral of deficits and debt. Ultimately, Congress and the next administration would be forced to roll back the massive tax relief.

In the end, the do-nothing option is unlikely to get Canada anywhere. Global investors seem willing to keep lending to the United States, no matter how fiscally irresponsible it is. Besides, the main elements of U.S. reform enjoy bipartisan support and are unlikely to be unwound, says economist William Robson, president of the Toronto-based C.D. Howe Institute.

"This new competitive challenge from the United States is going to be with us for as far ahead as we can see," Mr. Robson says. "It might get slightly less severe, there might be tweaks here and there. … But this is something we're going to have to deal with."

2. Match U.S. tax cuts

This is exactly what many business groups are now demanding. The Business Council of Canada, which represents many of the country's largest companies, has urged Mr. Morneau to cut the federal corporate tax rate and make a longer-term commitment to keep those rates below the average of other developed countries. Seeing nothing in the budget, council president John Manley is getting impatient.

"If you want to go to Silicon Valley or India and encourage investment in Canada, then you are going to have to address our broader competitiveness challenge, especially vis-à-vis the United States," insists Mr. Manley, who is also chairman of Canadian Imperial Bank of Commerce.

The centrepiece of U.S. tax reform is a cut in the U.S. corporate-tax rate to 21 per cent from 35 per cent. But experts say the number that really matters is the broader marginal effective tax rate, which incorporates an average of federal and state taxes on income as well as capital. The bottom line is that U.S. tax reform has moved Canada from a distinct tax advantage to a roughly two percentage-point deficit, according to the University of Calgary's Mr. Mintz. He says the all-in rate is now 18.9 per cent in the United States, compared with 20.9 per cent in Canada.

Companies are highly sensitive to tax rates, particularly when it comes to making major new investments. The tax gap may also affect government revenues. Mr. Mintz says the net effect of the U.S. reforms is that multinational companies will try to shift their costs, including debts and interest expenses, to jurisdictions where taxes are higher, including Canada. And they'll move their profits to the United States. Many already are. Apple Inc., for example, recent announced it's repatriating US$250-billion in profits stashed overseas and will use some of the money to create 20,000 new U.S. jobs at existing company sites and a new campus it intends to open.

Cutting corporate tax rates in Canada would be manageable fiscally because they make up a relatively small share of federal and provincial revenues. But they would be a tougher sell politically. "Most governments ran on platforms that proposed increasing taxes on higher income individuals [and] businesses to pay for improved public services and supports for the middle class," concludes a recent report from credit rating service DBRS Ltd.

And tax relief alone is no guarantee that companies will invest more. Canada has cut the federal corporate tax rate before – nine times from 2000 to 2012. Those cuts, cumulatively, cut the rate almost in half – and yet appear to have done little to encourage businesses to invest.

"There are obviously other reasons why companies decide to invest," points out David Macdonald, senior economist at the Canadian Centre for Policy Alternatives.

3. Faster write off of capital investments

A more targeted approach to the investment conundrum is to give companies greater incentives to invest. Current tax rules limit how fast businesses can expense capital expenditures. The "available-for-use" test, for example, means companies must often wait years before claiming tax breaks on major projects. Canada should follow the United States and allow businesses to expense most capital costs as they are incurred.

In Canada, only manufacturers enjoy accelerated depreciation of capital expenditures. That makes little sense, given the economy's shift to services. Ottawa could allow all companies to immediately write off their investments in new technology and the like, regardless of whether they are a manufacturer or a service company.

Ottawa could offset the higher cost of both a lower overall corporate rate plus accelerated depreciation by phasing out the preferential tax rate for small businesses and capping the amount of capital expenditures eligible for a tax deduction at, say, $200,000 per year.

This would target tax relief directly at businesses that are growing, the C.D. Howe Institute's Mr. Robson says.

4. Find new trade partners

A new-and-improved version of NAFTA would go a long way to relieving protectionist threats facing business in this country. But if Canada can't get trade certainty from the U.S., it must quickly look elsewhere. That means pursuing and inking free-trade deals with China, Japan and other fast-growing Pacific Rim countries.

Opening new markets and selling more to the rest of the world is a critical catalyst for business investment in Canada over the longer term, insists Livio di Matteo, a professor economics at Lakehead University in Thunder Bay. The United Sates has a massive internal market, creating natural economies of scale for homegrown companies. Canada does not, and the antidote is to create a large international market.

"In the end, to have capital investment that boosts productivity, you need a large market," Prof. di Matteo explains. "We've never had that. We never developed into an economy of 50 million or 100 million or 150 million people, so trade has always been crucial."

5. Embrace smarter regulation

Stalled energy pipelines and cancelled liquified natural gas export terminals are all symptomatic of a regulatory system that is stifling investment. That must change, says Mr. Manley of the Business Council of Canada.

"Massive amounts of investment have been put on hold because you just can't get to 'yes' in this country," he complains.

Mr. Morneau's budget hinted at broad regulatory reform. Mr. Manley hopes the government is sincere because improving competitiveness hinges on businesses having more certainty when it comes to getting critical infrastructure projects approved.

6. Change the tone

Beyond concrete proposals for policy reforms, many experts came away from this week's budget convinced that there's something more fundamental that the government could be doing to improve the mood of businesses and give them more confidence to open their wallets: Ottawa needs to change its tone toward corporate Canada.

They argue that while the government might pay lip service to supporting businesses in this country, a range of recent policies at both the federal and provincial level – from the messy small-business tax changes to minimum-wage increases to carbon taxes to stalled pipeline development – sends a signal that government is indifferent to business concerns, even in some areas "openly hostile," according to economist Philip Cross, a senior fellow at the Macdonald-Laurier Institute in Ottawa.

"I don't think you can point at a specific policy of government; I think the business community reacts to an overall tone," Mr. Cross says. "We have had good corporate tax rates in this country, more than competitive with the U.S. up until this year, and yet investment remained weak. Because there was a whole other range of things that governments were doing that the business community doesn't like."

Mr. Robson of the C.D. Howe Institute says a "change in tone" would help.

"The budget reactions that I was hearing had as a common theme – the idea that this government just does not care about competitiveness or the prosperity of the private sector," he says. "This tone leads people to expect no improvement and maybe a deterioration over time."

Several experts believe the budget deficit itself is part of that wrong signal that Ottawa is emitting. The budget projected an $18-billion deficit in 2018-2019, despite an economy that is near its peak of the business cycle; the government has no timetable for returning to balance, preferring instead to focus on slowly reducing the country's debt-to-GDP ratio.

"You have to communicate that you are willing to do something about the fiscal balance. You need at least a plan to get to a balanced budget over the next four or five years," Lakehead's Prof. di Matteo says. "If you don't have a recession, why are you still running large deficits? I think that is of concern to the private sector."

The worry is that perpetuating budgets deficits restricts the government's fiscal capacity to help Canadian business stay competitive. It may even add pressure to the government to eventually raise taxes, when it does finally come to terms with years of deficits.

"It is a big problem, as you look further ahead and think about what Canada can do to be more growth-friendly," Mr. Robson says.