Canada’s economic performance has been among the best in the OECD as a sound policy framework has enabled the country to take advantage of strong global growth and soaring terms of trade.

The economy has adapted well to recent shocks, as labour and capital have shifted rapidly from manufacturing towards the resource and service sectors, with strong net job increases. Overall supply has benefited from rising participation rates. Inflation has been held in check thanks to appropriate monetary policy settings. Budget surpluses have enabled major debt and tax reductions. More recently, though, activity has slowed sharply in response to the combination of the US downturn and stresses from the high Canadian dollar, as declining net exports have nearly offset still strong domestic demand. Significant challenges also lie ahead. Demographic ageing will put a premium on longer working lifetimes and faster productivity gains, which have been relatively weak, to sustain per capita income growth and public finances. Sustainable growth also requires successfully addressing the problem of climate change, notably in the important energy sector.

Monetary policy has room to manoeuvre in dealing with the growth slowdown, and tax relief is providing substantial support to the economy this year, but fiscal policy is constrained by declining surpluses in the short term and ageing liabilities in the longer term. The tightening in domestic credit– fallout from the US credit crisis – and prospects for slower growth have led to substantial monetary policy easing. In addition, the strong currency and easing demand for tradables are helping to neutralise commodity price induced inflation, increasing policy room for manoeuvre. The budget surplus is set to shrink on account of weaker growth and tax cuts. As rising health and other ageing costs are also looming, expenditures need to be controlled for debt to be kept on a downward path. Resolute fiscal policy – in particular through investing abroad more of the public revenue resulting from high oil prices – could help mitigate real exchange rate appreciation.

Tax cuts have been a good use of budget surpluses, but there is plenty of scope left for efficiency enhancing, revenue neutral tax reform. Business tax competitiveness is being enhanced by deep cuts in taxes on corporate income and capital. Labour supply has been boosted by in work tax credits. Yet, attractive opportunities for base broadening and shifting remain to be exploited and could enable still lower income tax rates. Remaining provincial retail sales taxes, penalising business inputs, should be converted to more efficient value added taxes, harmonised with the federal GST. Numerous tax breaks to traditional sectors and small firms should be phased out to unleash supply side dynamism. To further improve capital allocation and build on recent initiatives, personal income should be taxed on a neutral consumption basis, with vertical equity achieved by targeting tax credits on vulnerable groups.

Oil sands exploitation is booming but jeopardises environmental goals. As conventional oil and gas reserves decline, the industry has been switching its attention to extraction from the western oil sands. However, this requires large amounts of gas, land and water and leads to large rises in carbon emissions. Achieving post Kyoto goals, while sustaining energy development, will require putting a price on all sources of carbon, as well as better technology. Market based solutions – such as the planned permit trading – will be critical: by internalising environmental costs they provide stronger incentives for energy efficiency and innovation. At the same time tax preferences to the oil and gas sector should continue to be reduced.

Canada has lost ground in the longer term global trend toward liberalised farm sectors. While the federal government has been appropriately trying to free up marketing of western grains, it continues to coddle some other sectors with supply management. Dairy farmers in particular have enjoyed a quota system that has created enormous rents at the expense of consumers. Meanwhile, other farmers have been supported by a steady stream of federal and provincial budgetary support that is no doubt inducing dependency behaviour. Farmers also need to be given the right incentives to produce in an environmentally friendly manner. Most importantly, government support for bio energy production needs to be reconsidered.