Man Standing on Cliff Searching Through Spyglass In The Fog

There is growing evidence that the steady 10-year decline in business investment and related withering in “animal spirits” of corporate investors is deeply embedded in the economy and will likely continue in 2023 and beyond.

Business capital spending fell in 2022 after a modest uptick the previous year reflecting some pent-up post-Covid spending. Similarly, venture capital spending (venture funds and private equity) declined sharply last year after a promising post-pandemic lift in 2021. The latest StatsCan business survey confirmed the weakness in spending plans, citing ongoing slow economic growth, continued post-Covid supply chain complications and labour supply problems.

The continued low levels of capital spending will again fail to provide momentum for economic growth and job creation to support recovery, and will not begin the urgent task of restoring productivity and increasing innovation. The steady decline in capital formation in both the large and small business sectors has eroded the competitive footing of the Canadian economy.

But it is even worse.

The reluctance to invest in new business startup and expansion extends to existing operating businesses, at a time when many successful businesses — an estimated 300,000 firms — are looking for buyers and investors as baby-boomer owners retire. The shrinking pool of potential buyers and investors, through direct purchase or through financing arrangements in public and private markets, is alarming, as it threatens the future of many existing businesses, leaving the inevitable option of business windup and closure, and the damaging economic consequences of reduced growth and employment.

Many negative factors weigh on business investment. Some relate to the current economic environment. Recessionary fears, continued high interest rates in the past year or so, and weakened business sentiment have discouraged capital expansion, especially for the vulnerable business models of small and mid-sized firms. Further, the heavy indebtedness of many small and mid-sized businesses, mainly from the pandemic, has squeezed cash flows and working capital, and limited scope for external financing, constraining capital spending.

Perhaps one of the more serious factors restraining business spending is the prevailing malaise and negative sentiment in the corporate sector, and greater reluctance to take risks. This malaise is caused by an unprecedented, prolonged period of weak economic growth, averaging in the range of an inflation-adjusted 2%, punctuated by several successive economic and financial crises. These include the 2008–09 financial crash, the recessionary conditions of 2009–2011 and collapse in commodities markets, the recent Covid pandemic and emerging high inflation rates, and numerous macro policy missteps. The continued sluggish growth and economic challenges over the past 10 years, in contrast to the more predictable post-war business cycle, have increased the uncertainty and pessimism in the economic outlook.

The recent federal budget did little to invigorate broadly based investment spending and investor confidence. Indeed, confidence has been further weakened by the abandonment of a fiscal anchor, removing the discipline for spending. The specific budget measures for investment will likely be insufficient to restore needed investment spending, given limited incentives solely focused on green investment and reliance on discretionary government programs, like the Canada Growth Fund, to pick winners from losers.

The budget could have introduced several incremental tax measures across the corporate sector to improve the investment climate in Canada. Instead, amid difficult economic conditions, the government has again neglected to review and renovate the tax system for more competitive corporate and personal tax rates, and for targeted personal tax incentives in the form of tax credits and reduced capital gains tax rates on the purchase of eligible small business shares. These measures and the related capital flows would have inevitably financed many green projects, given attractive returns.

To mitigate investment risk, investors can find qualifying successful business franchises with the guidance of registered advisors and with their knowledge of local business. The successful Enterprise Investment Scheme in the United Kingdom is the blueprint for a successful policy vehicle to promote capital-raising in the small business sector and encourage needed investment in the regions of the country.

A proactive and cooperative effort by the federal and provincial governments to implement broad tax reform could act as the needed catalyst to spark greater confidence and optimism in the economic outlook, and spur investment in the corporate sector. For better investment outcomes, the government should also place a greater priority on fiscal restraint, giving confidence of lower tax rates in the future, and supporting monetary policy for lower inflation and interest rates.

Without broad tax reform and effective incentives to encourage capital spending and instil greater confidence and optimism, the economy will not break from its alarming downward trajectory in capital spending, mired in sluggish growth. As a result, the economy will be left acutely vulnerable to the next shock.

Ian Russell is a partner with Russell Deacon & Company and past president of the Investment Industry Association of Canada.