Pressure is mounting on the federal government to require pension funds to increase their investments in Canada.
“Increasing investments in Canada should be a national priority,” said a group of Canadian business executives in an open letter to finance ministers. Given the importance of pension savings, they “would support an effort by the Minister [of] Finance of Canada and the Provincial Ministers of Finance to amend the rules governing pension funds to encourage them to invest in Canada.”
The government is considering options, and we might see some concrete measures in the upcoming federal budget.
Many have rightly noted that mandating pension funds invest more in Canada is a bad idea. Pension fund returns may drop as a result, threatening their sustainability. And there may be broader negative effects on Canada’s economy from allocating capital through non-market means. The risk of capital being misallocated is high.
While such critiques are important, there’s an even simpler argument against such mandates: they will almost surely fail.
At best, increased pension investment would simply “crowd out” other investors. The overall total would be left largely unchanged. At worst, such mandates could actually lower investment in Canada, for reasons I’ll explain. And at the very least, it’s a policy idea that distracts from real reforms that might actually help.
Why would mandating increased domestic investments fail? For the simple reason that Canada is a small and open economy with freely mobile international capital flows.
The supply of investment finance is, to use an economist’s jargon, highly elastic. Assets here and abroad are easily substituted for each other. Investors big and small can seek out the highest returns wherever they happen to be.
This has the effect of pinning down the minimum rate of return that Canadian projects need to offer in order to be financed. If one can earn a ten percent return south of the border, after all, then to secure capital financing, a marginal project here must provide at least that high a return.
In such a world, mandating some investors (in this case, pension funds) increase their holdings of Canadian assets would simply displace other investors from holding the same. Mandates would, all else equal, lower the returns on marginal capital by increasing the overall supply. But lower returns would cause other investors to look elsewhere, offsetting the mandate’s effect. The result would simply be a change in who invests in Canada, without any change in the total amount of investment.
In a sense, it’s not the supply of capital that matters, but demand. Total investment is determined almost entirely by the availability of investment opportunities that pay, after tax, more than the alternatives abroad.
There is a worse possibility, though. By mandating pensions invest more, the government would signal a lack of confidence in Canadian businesses to secure financing on a competitive basis. Other large investors might also worry that their funds could be subject to similar regulations in the future. Policy uncertainty would rise from its already high level, as would risk premiums placed on Canadian investments. Were that to happen, total investment in Canada would fall—precisely the opposite outcome that mandate proponents wish to see.
None of this denies that Canada has an investment challenge. Total capital investment per worker is increasingly lagging behind the United States.
But rather than mandating more investment by some, we should look at where policy itself discourages investment. Taxes are a particular problem. After all, when you tax something, you tend to get less of it. And various governments, federal and provincial alike, tax investment in Canada.
In a future Hub piece, I’ll have more to say on how federal tax reforms—particularly to the corporate income tax system—could help boost Canada’s economic growth and productivity. But a few important points are worth making here.
Today, the effective tax rate on new investments is roughly 14 percent. Some sectors are even higher, with effective tax rates over 20 percent in construction, retail trade, and wholesale trade, and tax rates nearly as high in services.
This matters. Recent work by former University of Calgary economist J.F. Wen, now with the International Monetary Fund, suggests that might have a significant negative effect on investment levels. And other research, this time by current University of Calgary economist Ken McKenzie, finds that such taxes may also lower wages earned by Canadian workers. (Lower investment causes lower labour demand, which causes lower wages.)
Taxes not only shrink the level of investment but also bias its financing.
Since interest payments on debt are tax deductible while dividends are not, businesses face a strong incentive to issue debt (rather than equity) to raise funds. The result: more corporate debt. If one wants to see more equity investments in Canada by large institutional funds, then eliminating debt bias in the tax system would be far better than enacting selective mandates.
In short, the government should reject calls to mandate that pensions invest more domestically. There are many reasons not to, but the simplest one is that they simply wouldn’t work.
