Oh Canada!
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Is the United States the strongest economy in North America? If you are laughing at the suggestion that it may not be, you have not been following recent developments with our neighbor to the North. While hardly a low-tax paradise, Canada is ranked as the “freest economy” in North America for 2010. In fact, it’s one of only a handful of economies in the world to earn the “free” label (the US is classified as “mostly free”). International currency markets also recently expressed their confidence in the Canadian economy by bidding up the value of its currency above par with the US dollar. In April 15 trading, one US dollar would only fetch 0.9985 Canadian dollars.
The “loonie” briefly traded above parity in late 2007 and early 2008, but this was due to aggressive interest rate cuts in the US that made it profitable to move money across the border. Today, money market interest rates in Canada are virtually the same as in the US and the benchmark 10 year Canadian government bond yields 3.71%, or about 0.13% less than the comparable 10 year US note. Corporate bonds also trade at lower spreads in Canada, reinforcing the notion that the loonie’s strength is based on economic fundamentals.
Canada’s economy contracted by 2.5% in 2009 (page 33) and unemployment reached 8.5%. However, the 2009 deficit was only $5.8 billion (or 0.4% of GDP) and the 2010 deficit is forecast to be 3.5% of GDP (page 166) due to a large fiscal stimulus program. Unlike the US, the Canadian budget is expected to return to balance by 2015. Thanks to much lower deficits during the crisis and a credible plan to return to balance, the Canadian debt-to-GDP ratio is expected to rise by just 5.9%. Over the same period, US federal debt is expected to increase by 42% as a share of the economy.
Canada’s fiscal strength is partly due to past policy actions and partly the result of current and future policy trends. While Canada was buffeted by the global financial crisis, its banks did not require taxpayer assistance. The World Economic Forum has ranked the Canadian banking system as the world’s “soundest” both before and after the crisis. The Canadian government has used this experience to express opposition to a new G20 bank tax. Rather than enact a systemic risk fee that could be viewed as seed money for a bailout fund, the Canadians would prefer its banks to continue to face a healthy mix of market (creditor and counterparty) and government regulation.
Part of the Canadian success is the decision to block consolidation of its big banks through the merger review process. Although there is no obvious linkage between size and risk, it’s clear that banks can reach a size where creditors believe that the host government would have no choice but to bail them out in a crisis. By keeping banks from merging to test this presumption and requiring higher capital ratios, the Canadian banking system was well positioned to withstand the financial panic.
The soundness of the Canadian financial system is about more than well-capitalized banks. The International Monetary Fund (IMF) conducted an exhaustive analysis of the Canadian mortgage market and found a number of pro-creditor features that differed markedly from the US: lenders have full-recourse to all the borrower’s other assets and income if the loan goes to foreclosure; all mortgage payments are made via automatic debit from a borrower’s bank account; and prepayment penalties and mortgage insurance provide additional costs to borrowers. In addition, Canada has no mortgage interest deduction or government-sponsored enterprises (the government does provide mortgage insurance but at market rates). Government policy towards homeownership has been to focus on responsible lending rather than the promotion of social goals. Yet, Canada still has the same homeownership rate as the US. See here for an additional interesting exploration of Canada’s banking system and the reasons more stringent rules may not be responsible for increased performance, as many claim.
Beyond these past policies that have protected the Canadian economy from the fallout experienced in the US, the Canadian government is also seeking to reduce the tax burden and improve the country’s economic competitiveness. According to the Organization for Economic Cooperation and Development (OECD), Canada’s total tax burden in 2007 was 33% of GDP, about 5 percentage points greater than the total tax burden in the US. However, Canada is likely to be the lower tax jurisdiction within the next three years as the country cuts taxes as the US raises them.
The top personal income tax rate in Canada is 29%, capital gains income receives a 50% deduction (for a 14.5% effective rate), and dividends are also taxed at special rates. The federal general corporate income tax rate was reduced to 18% on January 1, 2010 and will be further reduced to 16.5% on January 1, 2011 and to 15% on January 1, 2012 (page 67). Measured relative to the US, by 2013 the top federal tax rate will be 11 percentage points lower, the capital gains rate will be 9.3 percentage points lower, and the corporate income tax rate will be 20 percentage points lower in Canada. To be sure, Canada also levies a federal Goods and Services Tax, a flat consumption tax that, as indicated in the chart below, raises as much revenue as the corporate income tax.
As seen in the table above, federal taxes only amount to 14.6% of GDP in Canada and are only expected to rise to 15.2% in 2015 when the budget reaches balance. The remaining taxes are imposed by provincial governments, which enjoy far greater fiscal autonomy than US states. In the 2010 budget, the Canadian federal government takes steps to encourage provinces to reduce their tax rates as well so that the combined corporate tax rate is no higher than 25% – compared to the 39% combined federal-state corporate rate in the US – with an effective combined tax rate on new corporate investment of just 16.7% – less than half the rate of the US (page 76). In total, since 2006 Canada has cut taxes by $220 billion (page 49) – equal to 14% of 2010 GDP.
No analysis of the Canadian economy would be complete without acknowledging that Canada is a large country that benefits from an abundance of natural resources. If undeveloped oil sands are included in the calculation, Canada has the second largest proven oil reserves in the world and 58 trillion cubic feet of natural gas reserves. However, income derived from exporting these resources does not simply reflect good fortune, but also Canadian willingness to develop these assets. The US produces twice as much oil per day as Canada and could have many millions more in undiscovered barrels in Alaska or in the outer continental shelf. US natural gas reserves are more than four times larger than Canada’s and could be much greater depending on additional exploration. While Canada derives a terms-of-trade advantage from rising commodity prices, attributing all of their economic success to natural resources both overlooks the political will necessary to make use of those commodities and ignores other economic developments.
It is funny to think of Canada as a low-tax state. In many quarters of the US it’s derided as basically socialist, and its dysfunctional health care system was routinely pointed to by opponents of President Obama’s health care overhaul. Yet, the Canadian economy is already “freer,” has about half the debt of the US (relative to GDP), and will soon have much lower top tax rates on corporate, personal, and capital gains income. In short, the trajectories of the two North American economies could not be more different.