Asset-based Financing, Investment and Economic Growth in Canada

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1 Assessing past, present and future economic and demographic change in Canada Asset-based Financing, Investment and Economic Growth in Canada Prepared for: Canadian Finance & Leasing Association 15 Toronto Street, Suite 301 Toronto, ON M5C 2E3 Prepared by: 15 Martin Street, Suite 203 Milton, ON L9T 2R1 December 15, 2004

2 Abstract This report examines the linkages between the financial services sector, productivity and economic growth. The authors review the evidence that investment, particularly in machinery and equipment (including vehicles), is a principal driver of long-term productivity gains and economic growth. The research conducted in this report finds that financial services development, including for the first time asset-based financing, raises investment. The research also finds that financial systems support gains in living standards beyond those associated just with the higher investment. Asset-based financing makes a significant positive contribution to increasing national living standards. The authors conclude that government policies should support financial market choice and innovation. The authors go on to note that tax policies that encourage business investment in machinery, equipment and vehicles will boost productivity and help create the economy Canada needs in the 21st Century. About this Report This report was prepared by, a consulting organisation created to improve the quality of spatial economic and demographic research in Canada. The report was sponsored by the Canadian Finance & Leasing Association (CFLA) to examine the links between investment, growth and asset-based financing. The authors wish to thank Dr. Jack M. Mintz, President and Chief Executive Officer, C.D. Howe Institute and the Deloitte & Touche LLP Professor of Taxation, Joseph L. Rotman School of Management and Jim Stanford, Canadian Auto Workers union economist for their many helpful comments on earlier drafts of this report. The authors accept all responsibility for any remaining errors or omissions. The views in this report reflect those of the authors and do not necessarily reflect those of the CFLA or its member companies. Questions or comments about this report can be sent to: Robin Somerville Director, Corporate Research Services rsomerville@c4se.com Robert Fairholm Director, Canadian Forecast Service rfairholm@c4se.com 15 Martin Street, Suite 203 Milton, ON L9T 2R1 telephone: fax: web:

3 Who is the Canadian Finance & Leasing Association (CFLA)? The CFLA is the only organisation advocating the interests of the asset-based financing, vehicle and equipment leasing industry in Canada. The Association's 250-plus members range from large multinationals to national and smaller regional domestic companies, crossing the financial services spectrum from manufacturers' finance companies and independent leasing companies, to banks, insurance companies, and suppliers to the industry. The customers of this industry are Canadian small, medium and large businesses as well as consumers. Funding for this industry comes from commercial markets, notably from pension funds, insurance companies and banks. In addition, well-capitalised manufacturing and servicing companies with substantial earnings have decided to leverage their own equity base and core competencies rather than using third parties. This has led to many manufacturers establishing their own financing arms or partnering with those who manage it for them. Many CFLA members fall into this category. What is Asset-based Financing? After the traditional lenders (banks and credit unions), the members of the asset-based financing industry are the largest providers of debt financing in this country. About 60% of the industry s customers are estimated to be small and medium-sized businesses. According to the 2004 Annual Survey of Asset-Based Financing and Leasing in Canada, the assetbased financing industry s portfolio of assets (owned and managed) was estimated to be worth $116.7 billion in The value of assets under management by equipment finance companies is estimated to be $67 billion. The value of the consumer vehicle leasing portfolio is estimated to be $39.7 billion with an additional $9.9 billion in commercial vehicle leasing. In February 2004, Statistics Canada reported that machinery and equipment investment intentions for 2004 are estimated to be $84.5 billion. Between 20% and 25% of annual new investment in machinery, equipment and commercial vehicles is financed by the asset-based financing industry. Asset-based financing is the financing of equipment, vehicles and related assets by way of specific asset-based priority financing, that is, the financing of particular equipment and vehicles and related items or services, primarily by way of lease, but also by secured loan or conditional sales contract. The specific assets financed secure the borrower's unconditional obligation to make payments over the term of the agreement. In this way, users of equipment and vehicles can use the value of the asset as security to finance its acquisition. This form of financing relies on cash-flow-based credit analysis. Because the financing company retains legal ownership of the asset until lease end, it allows a business or person to qualify on generated cash flow rather than on a net worth lending formula basis as typically offered by traditional lenders. The services of the asset-based financing, equipment and vehicle leasing industry are complementary to traditional banking and other financial lending in providing incremental capital to increase the pool of available credit in Canada and provide a vital competitive alternative in the financial services sector. Authors Note: This report examines the impact of business investment in machinery and equipment on productivity and economic growth. The economic term equipment referred to throughout the report includes vehicles acquired for business use.

4 Table of Contents EXECUTIVE SUMMARY...I ASSET-BASED FINANCING, INVESTMENT AND ECONOMIC GROWTH...1 INVESTMENT AND ECONOMIC GROWTH...3 Neoclassical Model... 5 New Growth Theory...9 Empirical Evidence...12 PRODUCTIVITY AND CANADIAN LIVING STANDARDS...15 Labour Productivity Decomposition Canada in an International Context Productivity and Employment Concluding Remarks on Productivity and Investment FINANCIAL SYSTEM DEVELOPMENT AND ECONOMIC GROWTH...31 Theory Evidence ASSET-BASED FINANCING...34 Current Industry Structure Origins of Asset-based Financing Trends in Financial Innovation Global Asset-based Financing Profile Canadian Leasing Market Small Business and Leasing FINANCIAL SYSTEM DEVELOPMENT, INVESTMENT AND GROWTH: EVIDENCE FROM THE INTERNATIONAL DATA...52 Indicators of Financial Development and Investment Asset-based Financing s Contribution to Living Standards in Canada in the 1990s Concluding Remarks GOVERNMENT POLICY AND ECONOMIC GROWTH...63 Tax Reform Options Productivity and Tax Reform REFERENCES...74 Appendix A: Growth Theory... 81

5 Appendix B: Physical Capital and Long-term Growth: Studies Based on OECD Countries Appendix C: Benefits of Leasing Appendix D: Model Specification Appendix E: Asset-based Financing s Economic Impact Appendix F: The Canadian Multi-Sector Model... 89

6 Asset-based Financing, Investment and Economic Growth in Canada Page i Executive Summary Banks, brokerage houses, insurance companies and various other financial services organisations are a major component of Canada s economy. Countless millions of financial transactions take place every day in Canada. While it is easy to see how important they are in every-day life, it is much harder to measure the benefits they confer in terms of economic growth and prosperity. The Canadian Finance & Leasing Association (CFLA) sponsored this report to examine the relationship between equipment investment, economic growth and asset-based financing. This summary provides some of the highlights from that research; interested readers are encouraged to consult the remainder of the report for more information. Key Findings Investment drives productivity economic research states that machinery and equipment investment directly contributes to labour productivity gains by increasing the amount of productive capital available for workers to use. Research also suggests that machinery and equipment investment is either directly the agent of technological change, or else an important facilitator in the diffusion of new technology. Productivity raises living standards in order to boost living standards either labour productivity needs to rise, or people need to work harder, or more people need to become employed, or more people of working age need to enter society relative to total population. Canadian living standard gains rely primarily on labour productivity growth. Financial system development promotes investment research conducted by the OECD 1 supports the notion that financial system development promotes capital spending and that countries with weaker financial systems are unable to effectively channel domestic or global savings towards new investment opportunities. Asset-based financing adds significantly to the financial system the analysis in this report finds that asset-based financing was responsible for a 2.3% increase in Canada s living standards over the decade 1992 to 2002 (or about 8% of the total increase in Canada s living standards over that decade). Asset-based financing makes a significant positive contribution to increasing national living standards. Policy Implications Financial innovation financial choice and innovation need to be encouraged in order to maintain a healthy and growing financial system. A dynamic financial system is one of the key factors in promoting investment, raising productivity and, therefore, improving our standard of living. Tax policy government policy in Canada does not encourage investment in machinery and equipment to the degree that the economic research suggests would be optimal. Therefore, a strategy of improving the economic climate for machinery and equipment investment should pay significant dividends in terms of stronger economic growth, higher productivity and living standards for Canadians for many years to come. This could be done in a horizontally equitable manner by encouraging all forms of investment spending because of the potential complementary nature of machinery and non-machinery investment in boosting economic growth and productivity. 1 The Organisation for Economic Co-operation and Development (OECD) is an international economic research institute with 30 member countries.

7 Asset-based Financing, Investment and Economic Growth in Canada Page ii Investment and Productivity It is becoming increasingly evident that certain forms of investment matter much more for growth compared with others. In particular, equipment investment has a significantly positive and robust association with growth 2 Over the past 20 years there has been an explosion of theoretical and empirical research that examines the relationship between investment, productivity and economic growth. The major current economic theories agree on the central importance of investment and capital accumulation to economic growth. Some of this research focused on broad measures of physical capital, of which machinery and equipment investment is an important part, while other research examined machinery and equipment investment specifically. In a series of studies, De Long and Summers explored the relationship between machinery and equipment investment, long-term economic growth and productivity to see if there were positive spillovers from machinery and equipment (M&E) investment. They concluded that the return to society of equipment investment is large and exceeds the private return. They found that increasing the M&E investment share by one percentage point could increase long-run productivity growth by 0.2 to 0.3 percentage points. De Long (1991) replicated the analysis for industrialized nations for a period in excess of 100 years 1870 to 1979 and found similar results, with a one percentage point rise in M&E investment share leading to a 0.7 percentage point rise in GDP per capita. Figure 1 shows the relationship he found for advanced countries. Figure 1 Source: De Long (1991) A number of studies use Canadian data as part of their cross country analysis, which generally support the findings of De Long and Summers. Abdi (2004) shows that there is a strong relationship between M&E investment, economic growth and total factor productivity growth 3. He used panel data on 20 Canadian manufacturing industries over the period from 1961 to 1997, 2 Ahn and Hemmings Policy Influences on Economic Growth in OECD Countries: An Evaluation of the Evidence. OECD, Working Papers No p Total factor productivity (TFP) tries to capture the contribution to output of everything except labour and capital, such as technical change, managerial skill, and organisational efficiencies.

8 Asset-based Financing, Investment and Economic Growth in Canada Page iii and time series data from 1961 to 2000 for the entire manufacturing sector in his analysis (See Figure 2). He divided capital into machinery and equipment and non-machinery and equipment investment and found the elasticities of output with respect to M&E capital stock of 0.67, which is above capital s share of national income. Notably, he found that the elasticity of output with respect to non-m&e capital stock was 0.24, which is also well above its share of national income. This suggests that M&E and non-m&e investment could be complements, and not substitutes. It was also found that both M&E and non-m&e investment positively affect TFP levels. A doubling of M&E investment could raise TFP levels by about 20% and doubling non-m&e investment could raise TFP levels by almost 23%. Most other researchers that examined Canada did not differentiate between M&E and non-m&e investment, but their results seem to support the view that there are positive spillovers from investment onto productivity and growth. Li (2002) finds that the aggregate physical capital investment rate is positive, with a 1% rise in the investment rate leading to a 0.2% rise in longterm growth, but the results are not particularly robust. Sargent and James (1997) estimated the effect of physical capital on output growth in Canada over the period from 1947 to They found estimates for the elasticity of output with respect to capital were in the range , which is well above capital s share of national income. Figure 2 Productivity 0.04 M&E Helps to Boost Productivity Share of M&E Source: Abdi (2004) Economic research has found that business investment and the accumulation of physical capital is a significant source of economic and labour productivity growth over the medium term in the neo-classical tradition. And machinery and equipment investment has been found to be directly or indirectly associated with the key drivers of knowledge in the economy as advocated by new growth theories and by the evidence. Productivity and Living Standards For Canadians, the improvement of living standards is of fundamental importance. Productivity is an essential ingredient in fostering improving living standards. This can be seen by considering a traditional measure of living standards, GDP per capita, which can be decomposed into the following: Labour productivity (output per worker hour)

9 Asset-based Financing, Investment and Economic Growth in Canada Page iv Work effort (hours worked per worker) Employment rate (number of people working relative to the working age population) Working age population share (people of working age relative to the total population) Living standards can rise if one, or more, of these measures rise. The combination of the last three measures is referred to as labour utilisation (total hours worked per capita). In Canada, living standards as measured by real GDP per capita grew strongly in the 1960s then slowed appreciably in the mid-1970s. The slowdown in the growth of living standards lasted until the mid-1990s after which there was a significant bounce back in the pace of growth. The same pattern is found in labour productivity growth, which also experienced a strong pace of growth in the 1960s, slowed in the mid-1970s and has started to accelerate again after the mid- 1990s. Notably, labour utilization follows a different pattern: it can be characterized as having significant cyclical variation around a long-term upward trend. The importance of labour productivity to long-term improvements in living standards can also been seen by decomposing the growth of real GDP per capita over long periods of time. In, Figure 3, the average annual growth of labour productivity and utilization are shown by decade averages ( , , and ). Most of the gain in real GDP per capita is because of labour productivity over these long time intervals. Over the whole period, labour productivity was responsible for roughly 80% of the rise in living standards, and has ranged from 56% to over 100% of the increase in GDP per capita over the decades shown. Figure 3 Labour Productivity Boosts Living Standards Contribution to Real GDP per Capita Growth Labour Utilization Labour Productivity Source: Statistics Canada data, calculations by author. Given the importance of labour productivity growth to the overall gains in living standards it is instructive to examine the reasons for labour productivity growth. Three factors combine to generate labour productivity: Total factor productivity or multifactor productivity Capital deepening or intensity (amount of capital services per worker hour) Changes in the quality of labour inputs (improvements in the level of skills)

10 Asset-based Financing, Investment and Economic Growth in Canada Page v Of these three measures, capital deepening was the most important contributor to labour productivity growth over the whole period, and the improvement in labour quality was the second most important factor. Notably, with capital, researchers generally have found that the accumulation of M&E capital to be the more important contributor to labour productivity growth. Changes in Canadian living standards can, therefore, be directly linked to the amount of capital or investment in the economy in general, and machinery and equipment in particular. Financial Systems and Investment The economics profession has spent much of the last few decades trying to understand why economies grow. In particular, the sustained growth of the US economy in the 1980s and 1990s has led to interest in its financial system and the efficiency with which it appears to channel funds to new and productive investment projects. Research has focused on whether financial systems in other countries can and do play similar roles and whether financial structures have an impact on resource allocation and growth. Recent research by the OECD has found evidence suggesting that financial system characteristics are linked to growth patterns in OECD countries and are able to draw the following general conclusions: Legal and regulatory framework conditions for financial systems, particularly their enforcement and transparency, support innovation and investment in new enterprises. Significant relationships between investment and financial development, as measured by indicators of the scale of financial activity, exist among OECD countries. Traditional macro-economic theories consider population growth, technological change and capital accumulation 4 as the driving forces behind sustained economic growth. Financial systems are important because they are integral to the provision of funding for capital accumulation and for the diffusion of new technologies. The micro-economic rationale for financial systems is usually based on the existence of frictions in the trading system. The writing, issuing and enforcing of contracts consumes resources and, in a world in which information is not symmetric and its acquisition is costly, properly functioning financial systems can reduce these information and transactions costs. In the process, savers and investors are brought together more efficiently and, ultimately, economic growth is positively affected. In doing this, financial systems provide four general services: Mobilising savings the pooling of individuals savings through financial intermediaries or securities markets provides a readily accessible source of investment funds. The pooling of the savings of individuals through financial intermediaries or securities markets makes the funding of profitable large-scale investments possible. Diversifying risk financial systems allow individual savers to diversify against the risk that a single investment pays no return and liquidity risk that occurs because savers may need to withdraw investments before returns are available. Allocating savings the cost of acquiring and evaluating information on prospective investments can be very high for individual savers. For a small fee, financial intermediaries that specialize in acquiring and evaluating this information enable small investors to locate higher return investments. 4 Capital in this sense includes both physical and human capital.

11 Asset-based Financing, Investment and Economic Growth in Canada Page vi Monitoring the allocations of managers financial systems also reduce the risk that resources are mismanaged. Financial intermediaries can monitor investments for groups of savers reducing their need to duplicate this activity. Many empirical studies of the determinants of growth in a broad group of countries conclude that financial development makes a significant contribution 5. Recent research by the OECD has focussed on two significant channels. First, financial development appears to be related to economic growth through its relationship with fixed investment. Investment, in turn, plays an important role in the process of economic growth. The OECD research was able to establish a link between financial development and fixed investment. Different indicators of financial development were used with the results appearing strongest for stock market capitalisation and somewhat weaker, though still significant, for private credit of deposit money banks. Second, measures of financial development were significant in growth equations for OECD countries, even after controlling for the level of investment. They conclude that other channels beyond fixed investment appear to link financial system development and economic activity. A link between the development in a country s financial system and long-term growth has been made in both theory and practical evidence. Financial market development contributes to growth. To date most research linking economic growth and financial market development has focused on banking and equity markets. This report breaks new ground by extending the analysis to include leasing a component of asset-based financing. Asset-based Financing Asset-based financing is the financing of equipment (including vehicles for business/commercial use) by way of a secured loan, conditional sales contract, or lease. The largest segment of assetbased financing is leasing. A lease is an agreement between the equipment owner (lessor) and the business that wants to lease the equipment (lessee). Through leasing, the lessee acquires the right to use the equipment for a fee over time, but the lessor retains ownership of the asset. One major advantage of leasing is that the asset secures the borrower's unconditional obligation to make payments over the term of the agreement. As a result, leases typically finance a higher percentage of the capital cost of a needed piece of equipment than bank borrowing, often with little or no initial down payment required. This allows the lessee to preserve its cash or bank facilities to meet working capital needs. Leasing is generally a far more flexible means of financing equipment than traditional lending and can be tailored to the client s specific needs in a number of ways. For instance, payment schedules can be adjusted to accommodate a business cash flow needs. Payments can be low at the beginning and increase throughout the term of the lease, balloon payments, or for seasonal payments where the firm pays more during the time period when the equipment is being used the most. There is also a higher approval rate for leases than for bank loans. Other attractive features of lease financing include: long-term financing, usually at a fixed rate; possibility of upgrading equipment during or at the end of a lease contract; and sales-tax deferral in a capital lease. Unlike traditional banks, lessors offer a variety of services depending on the type of equipment leased. The level of service can range from simply procuring the equipment, to maintenance and agreeing to exchange it periodically for more up-to-date versions. Lessors are frequently responsible for the equipment leased from the time of purchase to disposal. The hands-on day-to- 5 King and Levine (1993) found that financial development was strongly associated with real GDP per capita growth, the rate of capital accumulation and productivity.

12 Asset-based Financing, Investment and Economic Growth in Canada Page vii day management and maintenance of equipment by lessors for their clients is an important customer service. While interest expenses are typically higher in leases than traditional bank lending, transaction costs can be lower. For example, the costs of assigning collateral, legal documentation and slower processing times for traditional bank borrowing can be significant, particularly for small and medium sized enterprises (SMEs) where many of the conventional financing costs are fixed and not based on the size of the loan. These differences in costs and benefits between leasing and bank lending mean that they each serve distinct market niches. In developed economies, asset-based financing is used by every industry to finance some of the equipment it uses. This activity ranges from the office photocopier and printer to airplanes, construction equipment, rail cars and commercial vehicles. Globally, asset-based financing has grown over 10% a year from about $40 billion in 1978 to over $460 in 2002 (see Figure 4). North America is the largest regional market and accounted for nearly 47% of global activity in 2002 followed by Europe with 35% and Asia with 15%. The rest of the world accounted for less than 3% in The leasing statistics presented in this report were generously provided by the London Financial Group and are published regularly in the World Leasing Yearbook. Figure 4 Asset-Based Financing Africa Australia/NZ Billions of US$ South America Asia Europe 100 North America Source: London Financial Group, World Leasing Yearbook While asset-based financing occurs in nearly every country around the world, the global market is currently dominated by the G-7 nations. These seven countries account for over 80% of global leasing activity in In Canada, asset-based financing is used to finance between 20% and 25% of all new capital spending and, as such, has a profound influence on industries throughout the economy. Finance and leasing companies are infrequently included in surveys of major financial institutions and, as such, the industry is often omitted from many discussions on trends in financial services. This omission is telling since the finance and leasing industry has provided some of the most significant innovations in financial services over the last couple of decades. Quite simply, the evolution of financing institutions has outpaced the capacity of tracking systems to understand what is really going on. Government research and regulations are currently trying catch up.

13 Asset-based Financing, Investment and Economic Growth in Canada Page viii Leasing and Economic Growth To date, there has not been a study that has considered leasing as part of the financial system and its potential role in the finance-growth link. Given the innovative nature of the asset-based financing industry in promoting the overall financial system s ability to operate effectively, it seemed natural to contribute to the economic literature by including this sector. Using data provided by the London Financial Group, leasing was added to the group of financial systems measures used by the OECD in their analysis. Our empirical results confirm the OECD s finding of the important role that financial systems play in supporting investment and economic growth. Table 1 provides an estimate of the impact of a 10% increase in Canada s equipment leasing as a share of GDP (1.4% in 2002) or its stock market capitalisation as a share of GDP (101% in 2001) from recent levels 6. Investment is 1.3% higher as a result of the increase in leasing and 3.9% higher with the increase in stock market capitalisation. The resulting increase in investment associated with both leasing and the stock market directly raises living standards 0.2%. Table 1 also shows that the increase in the financial services indicators provides a significant boost to living standards through other channels (beyond the direct investment impact): leasing raises living standards 4.3% and stock market capitalisation by 2.3%. These increases are consistent with new growth theory which contends that TFP can be positively influenced by higher investment. Table 1 Estimated Contribution from a 10% Increase in the share of GDP for: Impact on: Equipment Leasing Stock Market Capitalisation Investment (per cent increase) GDP per capita (per cent increase) from the investment channel from other channels Using this information it is possible to determine the contribution of the growth in asset-based financing to the Canadian economy over the last decade. From 1992 to 2002, asset-based financing of equipment as a share of GDP rose from 0.776% to 1.419% an 82.8% increase and, through the direct impact on investment, raised living standards 2.3%. Over this same period, national living standards rose from $26.6 thousand to $34.3 thousand: a 28.6% increase. The increase in living standards resulting from the rise in asset-based financing was, therefore, responsible for about 8% of the total increase in Canada s living standards experienced from 1992 to In other words, 8% of the 26.8% increase was due to the assetbased financing of equipment. To put this in perspective, asset-based financing s contribution to living standards was larger than many of the better known sectors of the Canadian economy: e.g. residential construction (4.7%), the transportation equipment industry (4.6%), government services (2.1%) and mining (1.8%). The asset-based financing industry provides access to capital outside the banking sector. This incremental capital, and its impact on investment, is one of the principal benefits the asset-based financing industry confers on the economy. The analysis in this report confirms that, in the absence of the asset-based financing industry, capital formation would be adversely affected, growth in equipment investment would be lower and Canadian living standards would suffer. 6 This implies a new level for leasing as a share of GDP of 1.6% and of 111% for market capitalization.

14 Asset-based Financing, Investment and Economic Growth in Canada Page ix Policy Options As discussed, the evidence strongly suggests that machinery and equipment investment is a critical contributor to productivity and economic growth. While this proposition is not without debate, many researchers have gone further in suggesting that this investment is the strategic factor in long-run productivity growth 7 because of its role as either the key driver of economic growth or as a facilitator in the diffusion of knowledge within countries and throughout the world. Economic evidence suggests a positive macro-economic climate of low/stable inflation, sound fiscal policy, as well as a highly educated, well trained workforce are important factors in supporting strong long-term productivity and economic growth. The addition of strong equipment investment is, however, necessary to ensure the other factors deliver stronger productivity gains and economic growth. Furthermore, given the complementary nature of other types of investment in public infrastructure and non-machinery private investment, these investments are also helpful to long-term productivity and economic growth. Given the central role of the financial system in channelling savings to productive investment, and thereby promoting gains in productivity and living standards, the health and competitiveness of the broad range of financial services available to businesses and consumers should be of considerable importance to policy makers. Each segment of the financial services sector provides a set of services that support the activities of different parts of the economy. The breadth of financial services available helps ensure that the needs of all sectors are addressed. Asset-based financing expands the financing options available to businesses in Canada. Without the ability to lease, many businesses would find it more difficult, more risky or even impossible to acquire equipment. Consequently, business choice would be restricted to either buying the equipment and financing the purchase through internal or borrowed funds, or not acquiring the equipment at all. Implications for Government Tax Policy For Canada many of the conditions are in place to ensure success in the world economy. The workforce has a relatively high level of formal education, monetary policy is keeping inflation low and relatively stable, and federal fiscal policy is producing a surplus over the course of the business cycle. Despite these positive attributes, Canada faces many challenges to improve future livings standards because labour utilization is likely to stagnate or decline in the future because of the inevitable aging of society. Consequently, improvements in living standards will increasingly rely on gains in labour productivity. Given the importance of machinery and equipment investment to productivity and economic growth combined with the fact that this type of investment tends to be the most mobile factor of production over the long run and considering the evidence that the world economy is undergoing a significant technological transformation, it is not hard to reach the conclusion that governments should encourage this type of investment. 8 Government policy in Canada, however, is not encouraging investment in machinery and equipment to the degree that the economic research suggests would be best for the economy. For example, positive externalities (spillovers) from machinery and equipment investment as 7 De Long (1991) 8 An external reviewer suggested that government policy should not discriminate between types of investment, but instead foster a tax system that encourages business investment in general. This view is consistent with the empirical evidence that suggests that machinery and non-machinery investment are complementary in boosting productivity and economic growth.

15 Asset-based Financing, Investment and Economic Growth in Canada Page x suggested by new growth theory could mean that private benefits are less than the benefits to society as a whole, therefore, investment will be below what is optimal. A strategy of improving the economic climate for machinery and equipment investment should pay significant dividends in terms of stronger economic growth, higher productivity and living standards for Canadians for many years to come. The analysis conducted in this report illustrates the economic impact of various tax policy options available to Canadian governments. The policies considered were far from exhaustive there exist a huge array of policy options available to governments. The traditional personal and corporate income tax cut options are the least attractive policy options available to governments that we examined. They both yield relatively limited economic benefits while leaving the government that initiates them with a permanent fiscal hole to fill. There are a multitude of possible changes to sales taxes that could be introduced in Canada. This report examined one option in which provincial sales taxes on capital goods are eliminated. This yielded economic benefits but left provincial governments short of revenue. Figure 5 Tax Policy Impacts (after 10 years) Impact on Federal & Provincial Government Revenue (as a share of GDP) Remove provincial sales taxes from business capital Reduce federal corporate income tax rates by 5% Raise capital cost allowance for machinery & equipment by 25% of current levels Reduce federal personal income taxes by 10% Eliminate provincial corporate capital Impact on per capita government revenue, in inflation adjusted terms, is positive for simulations above the dotted red line Impact on Living Standards (% change in real GDP per capita) The more attractive options are to reduce, and ideally to eliminate, corporate capital taxes and to raise capital cost allowances. Both policy options yield significant economic benefits with minimal short term fiscal cost. The long-term impacts of these policy options are summarised in Figure 5. With renewed demands for higher government spending on new social programs coupled with razor thin federal surpluses and provincial deficits, tax reform is low on the political agenda around the country. Building the type of economy that can sustain new spending initiatives will, however, mean that the Canadian economy must produce more than before. It must, in other words, become more productive. Tax reform can help. There is a degree of urgency to the need to construct an appropriate policy environment because evidence suggests the world economy is undergoing a significant technological transformation. This view is held by a number of commentators, for example Sharpe and Gharani (2001) state that Appropriate economic policy is always important to foster growth but it becomes even more crucial at times of rapid technological change. The economic landscape has changed, and thus

16 Asset-based Financing, Investment and Economic Growth in Canada Page xi new policy regimes more consistent with the New Economy must be employed in order to ensure our potential productivity gains are translated into actual gains. A more productive economy is fundamental to government s ability to provide new services. It is also the key to improving opportunities and living standards for all Canadians. Policies that encourage business investment in machinery, equipment and vehicles will boost productivity and help create the economy Canada needs in the 21 st Century.

17 Asset-based Financing, Investment and Economic Growth in Canada Page 1 Introduction Asset-Based Financing, Investment and Economic Growth About twenty years ago, various theoretical and empirical studies trying to establish the link between financial intermediation, investment and economic growth began appearing in academic journals. There is now a growing body of international research supporting the benefits of banking, securities markets and insurance. To date, however, there has not been any work looking at the relationship between asset-based financing and economic performance. This report draws the link from the development of the financial system to include asset-based financing, greater equipment investment, higher productivity, stronger economic growth and improving prosperity for Canadians. Although business investment in machinery and equipment accounts for only about 7% of the Canadian economy, it is a key determinant of productivity growth. While business investment is rising at present, and is expected to continue to do so over the next few years, it is still significantly below that of our major trading partner: the United States. Canadian productivity has, as a result, lagged over the last few years. As a result many experts currently argue that Canada needs to become more productive in order to be competitive it the global economy. But does becoming more productive mean that fewer people must have jobs and those that do have them must work harder? The recent jobless recovery in the United States has raised concerns about the societal impacts of ongoing gains in productivity. This report shows that higher productivity is vital if we are to continue raising the standard of living for all Canadians. Productivity provides opportunities for all Canadians more jobs at higher wages. It is important, therefore, to try and understand why business investment is not higher. It may be that there is no easy answer to that question. Businesses are free to choose the level of investment that best meets their expectations of future needs. Government policy can, however, create an environment in which business believes their future needs will be higher. The first section of this report focuses on the relationship between investment and economic growth. It reviews both the theoretical and empirical economic literature and finds that machinery and equipment investment is a fundamental determinant of economic growth far more so than its relatively small share of national output would indicate. The second section examines productivity and living standards. Productivity growth is an essential ingredient in boosting living standards. Canada, however, lags behind other major economies in terms of labour productivity growth, relying instead on rising utilisation. This is an unsustainable reliance in the future given the aging of society. The report then goes on to review the theoretical reasons and empirical evidence for a positive relationship between financial system development and economic growth. This relationship appears, at least in part, to flow from the role that financial system development plays in supporting investment. The existence of this relationship becomes important when considering the role that investment plays in determining productivity and economic growth. The next section provides a profile of the asset-based financing industry. To date, there has not been a study that has considered leasing as part of the financial system and its potential role in the

18 Asset-based Financing, Investment and Economic Growth in Canada Page 2 finance-growth link. Finance and leasing companies are infrequently included in surveys of major financial institutions and, as such, the industry is often omitted from many discussions on trends in financial services. This omission is telling since finance and leasing industries have provided some of the most significant innovations in financial services over the last couple of decades. This report extends empirical work conducted by the OECD to examine the linkage between financial system measures, investment and economic growth to include asset-based financing. A set of econometric models are constructed to test the hypothesis that the financial services sector, and asset-based financing in particular, support investment and economic growth. The findings from this research provide a key message for the role of public policy in promoting the health and competitiveness of financial services available to businesses and consumers. Each component of the financial services sector provides a set of services that support the activities of different parts of the economy. The breadth of financial services available helps ensure that the needs of all sectors are addressed. Asset-based financing is similar to other parts of the financial services system in that it supports investment and economic growth. It does this by providing services that help match savings with investment opportunities, thereby raising investment and ultimately improving economic growth. Finally, the report reviews some of the policy options available to governments in Canada to encourage higher investment and evaluates them in terms of their impact on economic growth, productivity, investment, employment and personal income as well as their fiscal impact. Tax reform can help stimulate business capital spending. The analysis conducted in this report illustrates the economic impact of various tax policy options available to Canadian governments. The policies considered were far from exhaustive there exist a huge array of policy options available to governments. These range from traditional personal and corporate income tax cut options to sales tax reform or changes in other taxes and tax allowances. A more productive economy is fundamental to government s ability to provide new services. It is also the key to improving opportunities and living standards for all Canadians. Policies that encourage business investment will boost productivity and help create the economy Canada needs in the 21 st Century.

19 Asset-based Financing, Investment and Economic Growth in Canada Page 3 Investment and Economic Growth It is becoming increasingly evident that certain forms of investment matter much more for growth compared with others. In particular, equipment investment has a significantly positive and robust association with growth 9 Investment spending makes a direct contribution to economic activity because investment is one of the components of total expenditure in an economy, GDP equals personal consumption plus investment plus government expenditures plus net exports (i.e.: GDP=C+I+G+(X-M)). These expenditures reflect the total level of demand in the economy. Unlike other expenditures, such as personal expenditure on restaurant meals, capital expenditures are doubly important because capital is one of the factors of production (capital and labour) that directly determine the economy s productive capacity or aggregate supply. While in the short run, fluctuations in demand determine the level of GDP, over the long run, it is the growth in the economy s ability to supply output that determines the speed at which an economy can grow. Consequently, growth theories and the associated empirical work focus on the supply side of the economy. Over the past 20 years there has been an explosion of theoretical and empirical research that examines the relationship between investment, productivity and long-term economic growth. On a theoretical level, this research has two basic schools of thought: the neoclassical model as first described by Solow (1956 and 1957) and new growth theory (also know as endogenous growth theory) articulated by Romer (1986, 1987 and 1990), Lucas (1988) and Grossman and Helpman (1991). The neoclassical model originally focused on investment in tangible assets, and the resulting accumulation of physical assets to help explain economic growth. Recently the concept of investment has been broadened from private investment in tangible assets to include human capital, research and development expenditures and investment in public infrastructure. While emphasising a broader view of investment, this literature remains in the neoclassical tradition where benefits of investment are internal in the form of enhanced productivity or higher wages. New growth theory moves away from the neoclassical model and explores alternate productivity channels through which investment affects growth. This school attaches greater significance to certain types of investment that create externalities and generate an additional productivity boost through production spillovers or the associated diffusion of technology. 10 Both models share similarities concerning the central importance of investment and capital accumulation to economic growth, but differences between these models have important implications for the impact of investment on productivity and economic growth and the role that government policy can and should play. Notably, what these models say about productivity and economic growth depends on the time period and measure of productivity under consideration (see section on productivity for further elaboration). For example, a distinction has to be made between short-and medium-term economic growth and long-term economic growth, when the economy reaches a steady state growth path. 9 Ahn and Hemmings (2000), Policy Influences on Economic Growth in OECD Countries: An Evaluation of the Evidence. OECD. Working Papers No p Stiroh (2000), Investment And Productivity Growth: A Survey From The Neoclassical And New Growth Perspectives. Industry Canada. p. 1.

20 Asset-based Financing, Investment and Economic Growth in Canada Page 4 The neoclassical model suggests that in the long run total factor productivity and labour growth determine economic growth, and that government policies to encourage investment will not influence the steady state growth rate because of diminishing returns to capital investment. Although a higher investment rate will cause a level effect on income per capita in the short-tomedium term. In contrast, new growth theory suggests that a higher investment rate (in the key asset(s)) would boost the steady state growth rate. Furthermore, the positive externalities flowing from investment in the key asset(s) suggest a role for government policy to boost investment toward the socially optimal investment rate, which would be greater than the privately optimal investment rate. The empirical literature also shows this duality. Some researchers have extended the neoclassical model by incorporating a broader concept of investment and hence capital accumulation and by improving the measures of investment and capital accumulation used in the empirical research, for example, Jorgenson and Stiroh (2000), Oliner and Sichel (2000) and Jorgenson (2004) among others. According to recent estimates, asset accumulation and labour growth now explain more than 80% of economic growth, with the accumulation in tangible assets the most important factor. Jorgenson (2004) found that investment in tangible assets is the most important source of economic growth in the G7 nations. The contribution of capital input exceeds that of productivity for all countries for all periods. These recent calculations leave less than 20% in the Solow residual that is thought to represent technological change. This is a significant advance from Solow s first estimate that 90% of the per capita growth in the US economy was unexplained and in the technological change residual. Other researchers have concentrated on elements of new growth theory to try to explain technological progress, productivity and long-term economic growth. There are three branches of new growth theory that emphasise different drivers of long-term productivity and economic growth: machinery and equipment, human capital, and research and development. Some propose hybrid models whereby more than one of these drivers are needed to boost productivity. The empirical research has found a strong link between machinery and equipment investment in particular and economic growth De Long and Summers (1991, 1992, 1993 and 1994), De Long (1991), McGrattan (1998), Sala-i-Martin (1997), Hoover and Perez (2004), and Abdi (2004) among others. These results are suggestive that machinery and equipment investment has a central role to play in long-term economic growth, possibly because technological change is embodied in recent vintages of capital. At this stage, however, given measurement problems in the data it is not clear if the observed linkage between growth and machinery investment supports the neoclassical view, which suggests that a higher investment rate would boost the level of GDP, but not the long-term growth rate, or new growth theory, which supports the view that a rising investment rate could also boost the steady state growth rate. Part of this uncertainty relates to the question of how long is the long run. Several researchers have estimated the speed at which the economy reaches a new steady state growth path. Some have calculated a fairly fast pace of transition, with the rate being in the neighbourhood of 10%, while others have calculated a much slower transition path. Jorgenson (2004) for example using a neoclassical framework and updated measures of capital and labour quality states that The transition path to balanced growth equilibrium after a change in policies that affects investment in tangible assets requires decades, while the transition after a change affecting investment in human capital requires as much as a century. A longer transition path, however, may make the distinction between a series of one time level adjustments to income per capita in the short-to-medium term and a higher long-term growth rate moot to policymakers.