As Deputy Prime Minister and Finance Minister Chrystia Freeland finalizes Budget 2022, she’ll need to look beyond the pandemic to the challenging agenda ahead. Digitization, remote work, baby boomer retirements, and decarbonization could be highly disruptive to the economy, but also a big growth opportunity. She will need to find a balance between public spending and nearer-term fiscal realities, including rising interest rates, low structural revenue growth, and risks of deficit finance. RBC’s Cynthia Leach looks at the elements of the big picture.

Cynthia Leach

The upcoming federal budget will be the first of the post-pandemic era. And for Ottawa, it’s a chance to do more than grapple with the immediate challenges created by the crisis. It’s an opportunity to set an entirely new course, one that will see us accelerate out of a decades-long pattern of slowing growth.

The direct economic impacts of COVID-19 are fading. More people are working in Canada than before the pandemic and real GDP returned to prior levels in late 2021. Even as weakness in high-contact services lingers, travel and hospitality spending is picking up. 

But the economic landscape ahead may be different from anything we’ve encountered before. The structural challenge of labour shortages is intensifying as we move through the baby boomer cohort of retirements. Pandemic-accelerated changes in economic behaviour—increasing digital adoption, remote work, more aging-related services consumption, and decarbonization—will require a shift in spending and investment, new worker skills, and a reallocation of jobs and activity between sectors. 

Households have amassed significant excess savings through the pandemic, in both housing and financial wealth, although it is not evenly distributed. Geopolitical turbulence is threatening trade and energy security, with Russia’s invasion of Ukraine sending global energy prices higher and risking more persistent inflationary pressures.

Big global shifts bring both volatility and opportunity. Changing sources of economic value risk capital obsolescence, loss of competitiveness, displaced workers, and inequality. But a federal policy program that leans into these changes could also help unleash private spending, investment and innovation that brings productivity gains, export opportunities and economic growth. 

The government will need to be careful. There are many potential investment areas: carbon abatement, climate change mitigation, digital and trade infrastructure, advanced technologies, labour mobility, and aging-related pressures on provincial finances. And federal spending is already under pressure from a range of current priorities including national childcare, health, and housing—items with growth dividends that may be long-dated and uncertain. 

The current energy price shock complicates matters. Energy security from hostile regimes increases the case for reduced reliance on fossil fuels, but the added price pressures facing consumers may make it harder to accept paying for climate abatement that will only pay off over time.

Meanwhile, federal revenues are constrained by low trend GDP growth and decisions thus far not to match new structural spending with new sources of revenue. Gradually rising interest rates will erode fiscal capacity further. New spending will probably still be largely deficit-financed.

With plentiful global demand for risk-free assets, structurally low interest rates, and markets that have been sanguine in the face of elevated advanced economy budget deficits, higher public debts may be sustainable. This is particularly likely when they are deployed to fill the climate, infrastructure, or human capital gaps limiting economic potential. But debt is also associated with volatility: deficit-financing for a small open economy carries the threat of inadequate fiscal space in the event of unforeseen crises, rising interest rates, and imported interest rate volatility. 

Canada needs a focused and agile growth-oriented fiscal program to balance these risks. Forward looking federal policy and targeted public investments can be the foundation for increased private investment that accelerates Canada’s growth trajectory.

But to make this happen, we’ll need to mobilize private investment. Many businesses intend to invest more than they did before the pandemic, often in digitization, to address tight labour markets and shifts in consumer behaviour. Given Canada’s lacklustre record on business investment—including longstanding investment gaps with peer economies and relatively low investment in intellectual property as a share of the economy—this is a good news story.

Yet smaller businesses are more likely to struggle with pandemic debt and knowledge gaps that lead to underinvestment. And if the supply of materials critical to green and advanced technologies, like semiconductors or lithium, does not keep pace with expanded global demand, even larger firms may not invest sufficiently. 

What about climate investment? Canadian financial firms with $8 trillion in global assets have committed to reaching net zero emissions by 2050. Yet green investment is much lower than the $60-$80 billion per year we estimate Canada needs to reach Net Zero. Project economics often do not work for private investors given heavy capital requirements, long time horizons, and carbon policy uncertainty. 

The budget needs a proactive regulatory policy that creates more certainty around carbon regulation for key industries, aligns the entire regulatory framework with investment priorities, and promotes general tax efficiency. Public infrastructure like carbon pipelines, EV charging stations, modernized ports, and responsive higher education all make it easier for households and firms to invest. And focused and de-politicized industrial strategies centred on green and advanced technologies within North American supply chains may draw private capital, ensure supply expansion of key inputs, and help grow Canadian firms.

The budget must ensure that increased investment powers innovation and firm scale. Given Canada’s poor business investment record, our lagging innovation performance may be no surprise. But we have trouble translating innovation inputs to outputs despite having other favourable conditions like a skilled workforce and strong venture financing. Canada tends to be underweight in patent activity, business creation, and globally-exporting businesses. Companies earning global incomes can help fund the domestic adjustment to the new economy, yet net exports have been a drag on real GDP growth in Canada for much of the prior two decades.

Lagging innovation could soon present an even greater problem. As technology advances, more economic value will be encapsulated in data, algorithms, digital services and other “intangible assets”. These assets are more scalable compared to tangible inputs like physical capital and labour, and deliver large gains to developers and owners. Services may be the biggest opportunity. Expanded digitization increases data and data-powered insights and a greying population tends to consume more services, priming everything from health care to software to the digital services embedded in the Internet-of-Things, for growth. 

The budget can promote retention of Canadian intellectual property, market access, and firm scale by providing more innovation support for growth-oriented firms such as through government procurement, taxing global platforms at the same level as Canadian intermediaries, and supporting the development of Canadian platforms. Ottawa can also focus on forging trade agreements that enshrine data rights and protect intellectual property. 

Federal policy must recognize that the most powerful driver of innovation is people. The widespread labour shortages across all sectors of the economy are not going away anytime soon. The labour force participation rate is projected to decline further over the next 15 years with retirements of 250,000 per year. Even when immigration recovers, the current targets of about 1 percent of the population would need to double to keep the age structure of the population constant.

Canada has pools of talent that remain untapped or underutilized. Increasing the labour force participation of women and closing the employment and earnings gaps of visible minorities and some immigrant groups could boost both the supply of workers and GDP. Indigenous Canadians are also a significant source of untapped potential, particularly given they are the fastest growing youth population.

The new economy will require the rapid development of new skillsets—current climate plans alone will require the upskilling of 15 percent of today’s workforce over the next decade. And while access to on-the-job training is high amongst OECD countries, Canada’s large training gaps between the high wage, prime age, and larger firm workers who tend to receive training, and others who do not, belie the current broad labour shortages and anticipated skills shifts.

To get it right, the budget needs to recognize that human capital is at the core of the green, digital, and tech transformation and will be a competitive advantage in driving innovation and attracting foreign investment. The government can work with the provinces to adjust immigration and educational programming to reflect emerging job and skill demand, target education and labour market supports to underrepresented groups, and support worker retraining and credentialing to ease movement between jobs and geographies.

The new federal budget can set a course for challenges ahead. No single policy solution exists. Canada needs to confront the policy challenges of a new economy, like climate, data frameworks, and skills strategy. It also needs to realign with longstanding policy frameworks of the old economy, including tax, competition and regulatory policy. 

But by harnessing private investment, promoting innovation and firm scale, and attracting, developing and retaining talent, federal policy can help unleash spending, investment and economic growth. That’s prosperity that can fund both the transition to the new economy and a higher quality of life for Canadians.

Cynthia Leach is Senior Director, Economic Thought Leadership, at RBC.