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Chapter 3: innovation and economic performance.

Innovation plays a key role in economic progress and lifting living standards. The most critical factor in encouraging innovation is getting the framework conditions right so that businesses can flourish. This chapter concentrates on the more specific aspects of innovation in Canada to identify where policies could be improved. It first reviews Canada's performance on innovation, which is relatively good on product innovation but weaker on processes. The country's innovation strategy focuses on knowledge, skills, the innovation environment and community-based innovation. Public R&D needs to be governed by an integrated strategy, while generous tax credits for business R&D should be re-examined. More attention is being paid to commercialisation of R&D. A skilled and talented workforce helps to diffuse innovation through the economy, but while Canada has enough scientists to meet current demand, it lacks people with management, marketing and other business skills. Diffusion would also be aided by lifting general literacy and life skill levels. Well-designed co-financing arrangements would encourage participation in adult education and training. Lastly, the venture capital market would perform better if the tax advantage provided to Labour-Sponsored Venture Capital corporations were removed.


Lifting the economy's rate of innovation is a key component in meeting the challenge of raising productivity growth (see Chapter 1). In fact, innovation has been responsible for most of the rise in material living standards since the industrial revolution (OECD, 2006). It makes it possible for countries to produce an increased amount of economic output from a given set of inputs such as capital and labour. Indeed, Canadian firms that innovate have higher productivity levels than firms that do not, and those that make world-first innovations perform best of all (1) (Cozzarin, 2003). At the industry level, innovation is also closely linked to productivity for Canadian manufacturers (Gu and Tang, 2003).

Innovation can spring from within the firm itself, but it can also involve applying knowledge and technology acquired from other firms or institutions. Adoption of ideas from outside the firm is the channel through which innovation gradually diffuses throughout the economy. This can emerge from formal and informal linkages between different players or through investment in machinery and equipment that embodies new technology. Innovation also flows across borders through various channels, such as international alliances, joint ventures, licensing, foreign direct investment and migration of skilled workers.

Innovation is not a separate add-on from other aspects of business, but instead an integral part of it. Thus, establishing a favourable environment for firms is a vital factor in encouraging innovation (Jaumotte and Pain, 2005a). Until shortcomings in the overall Canadian business environment are addressed (see Chapter 2), direct efforts to boost innovation may yield only mediocre results. Furthermore, diffusion of innovation can happen only if individual firms and, by extension, the economy as a whole, are capable of picking up and applying technology. A responsive labour market well endowed with skilled workers plays an important role here.

Governments often endeavour to design policies to boost innovation directly, and Canada is no exception. These efforts generally rely on the broadly accepted argument that innovation generates spillovers to the rest of the economy, so that net social returns are higher than private returns. Thus, without public financial support through a range of channels, the private sector would not carry out the socially optimal amount of innovation. However, it is difficult to identify the size of likely spillovers from firm-level innovation with any degree of confidence. (2)

This chapter begins by looking at the characteristics of innovation in Canada before summarising the current strategy to boost innovation. It then considers in turn several aspects of policies that directly or indirectly support innovation: first in optimising the knowledge base, and second in transforming knowledge into innovation. The chapter concludes with some policy recommendations.

The state of innovation

Four separate types of innovation have been identified and are now defined in the Oslo Manual (OECD, 2005a). Product innovation introduces a good or service that is new or significantly improved with respect to its characteristics or intended uses; process innovation implements a new or significantly improved production or delivery method; organisational innovation incorporates a new organisation method in the firm's business practices, workplace organisation or external relations; and marketing innovation involves significant changes in product design, packaging, placement, promotion or pricing. In each case, innovation may be incremental or disruptive. (3) From the firm's point of view, innovation always involves some novelty, whether the firm produces world-first innovation or is the last firm on the block to adopt technology or practices that everyone else has already put in place.

Statistics Canada has been surveying innovation activities of different sectors of the economy since 1993, although surveys to date cover only product and process innovation. But whereas most innovation surveys (including the European Commission's Community Innovation Survey, which covers EU members, Iceland and Norway) take a snapshot of the entire business sector, Canadian surveys have covered only selected sectors in any given period of time. Unfortunately, this makes international comparisons difficult.

The overall picture for Canada is somewhat mixed:

* Innovation density, i.e. the share of firms undertaking innovation, is reasonably high compared with other countries. But although Canadian manufacturing firms were more likely to be innovating, innovating firms had a lower share of their sales coming from innovative products than in four European countries (Mohnen and Therrien, 2003). Around 60% of Canadian product innovators gained, at most, 15% of their sales from new or significantly improved products. In contrast, innovating European firms were significantly more successful at transforming their innovation into revenue streams.

* Innovation performance is reasonably good for products, but relatively weak for processes. This trend is also observed in a range of other countries, although many innovative firms undertake both types of innovation, even though each type has a somewhat different motivation.

* To the extent that different sectors have naturally different rates of innovation, sectoral composition may account for some of the differences observed in innovation rates in different countries. In particular, Canada has an unusually important resource-based sector, and in extraction (i.e. mining and logging) process innovation is more important than product innovation.

An examination of the key characteristics of innovating firms can provide some deeper insights into the innovation story and suggest where policy issues might arise.

Firm size matters for innovation. As in other countries, large Canadian firms on average undertake more innovation than small ones. They are more likely to have dedicated R&D teams that are not only able to generate ideas themselves but also to be more capable of absorbing ideas from outside the firm (Sharpe, 2003). Small firms are less likely to use innovation inputs (4) more generally, but when they do, their success in converting these inputs into innovation outputs is similar to large firms (Le and Tang, 2003). But Canada has relatively few large firms: in 2003 only 7.9% of enterprises had 20 employees or more and 1.3% had 100 staff or more. In contrast, in the United States, 12.3% of firms had at least 20 employees and 2.0% had 100 or more. (5) Thus, the obstacles that inhibit the development of larger firms in Canada (see Chapter 2) may impact on Canadian productivity growth by impeding innovation activity.

Innovation is a key factor for success among new entrants. Only 20% of start-ups in Canada survive more than a decade. They generally face strong competitive pressures (6), and successful entrants are more likely to have developed market niches and to stress quality and customer service (Baldwin and Gellatly, 2003). Furthermore, across industries, faster-growing firms put more emphasis on innovation-related strategies. They also focus more intensely on a range of business competencies (7), such as training, marketing, and technology, business and financial management than do slower-growing businesses (Baldwin and Gellatly, 2003).

The link between competitive pressures and innovation is complex. Manufacturers face different types of competition (Table 3.1) and econometric analysis has shown that the link between competition and innovation activities (8) varies depends on how they perceive the competitive threat (Tang, 2003). Indeed, the possibility of competing products arriving on the market spurred innovation activities and especially encouraged the invention of new technology. However, if purchasers can easily switch between suppliers producing easily substitutable products then firms are less likely to innovate. On the process side, firms in sectors where production technologies change rapidly were more likely to innovate through both technology invention and adoption. Altogether, these results suggest that well designed competition policy contributes to innovation by facilitating the arrival of competing products while ensuring that new technologies can easily establish themselves.

Rapid change of production and office technologies both appear to be important for innovation, with ICT increasingly playing an integrating role. ICT investment generally boosts firms' productivity growth, especially when it is accompanied by organisational change and human capital investment as an integrated package (Gu and Gera, 2004). But Canada has invested less in ICT per worker than a number of OECD countries and significantly less than the United States over a long period of time (9) (Sharpe, 2005) (Figure 3.1). There are also striking differences in the gap across industries, especially for software investment (Figure 3.2). Furthermore, the gap in ICT investment per worker has grown wider over time, especially for communication and software investment. Given that Canadian firms are able to access the same production and office technologies as their US counterparts, it is not clear why Canadian firms are investing less in new technologies. Possible explanations include: smaller firm size; depreciation and other taxation rules; different relative costs of labour versus capital; and managers who do not recognise the economic importance of such investment. Indeed, Canadian managers use computers less intensively than their American counterparts (OECD, 2005c).


Owners and managers of Canadian firms set the pace of innovation within their companies, and if they pursue an explicit or implicit business strategy that does not require innovation, then it simply will not happen (Martin, 2002). Management skills are linked to overall business performance (Dorgan et al., 2006, Baldwin and Gellatly, 2003). It is impossible to get a direct measure of Canada's business management capital. Canada's overall levels of educational attainment comfortably exceed the OECD average (OECD, 2005b). But Canadian firms have a lower share of highly-educated managers than the United States (Figure 3.3) and less than 10% of Canadian managers have degrees in commerce, management or business administration (Table 3.2). A survey of CEOs of growing R&D-intensive firms identified a dearth of sales, marketing and management skills as a major weakness for their firms and the Canadian economy as a whole (Barber and Crelinsten, 2005). k has also been suggested that insufficient attention to the role of customers' needs (or wants) in driving innovation may explain why Canada's innovation performance has not been stronger (Crelinsten, 2005; McDougall, 2005).


Innovation flows across borders in a number of different ways. The technology balance of payments measures international technology transfers: license fees, patents, purchases and royalties, know-how, research and technical assistance. Canada's incoming flows of these production-ready technologies relative to GDP are significantly lower than for other countries (Figure 3.4). It is not clear why this would be: it might reflect some unwillingness to look offshore for ideas; biases in public policies to support innovation (including the Scientific Research and Experimental Development (SR&ED) tax credit which provides more generous treatment for Canadian-controlled Private Corporations than for other Canadian or foreign-owned businesses) that tip the balance in favour of home-produced rather than imported technology; or weakness in absorption capacity more generally.


Canada's inward foreign direct investment relative to GDP is close to the OECD average (Figure 3.5), and foreign-controlled manufacturing firms are more productive, make greater use of technology and do more innovation (Baldwin and Gu, 2005). They also use more skilled workers and pay higher wages. Furthermore the presence of foreign-controlled firms generates spillover benefits to the domestic sector, both by enhancing competition and by stimulating more intense use of advanced technologies amongst their competitors. Although empirical analysis is not available for services, it would seem reasonable to expect that similar patterns would be observed. Thus, dismantling Canada's remaining barriers to foreign direct investment (see Chapter 2) could also play a role in lifting innovation more widely. But international orientation more generally is correlated with innovation- domestic manufacturers with foreign operations perform as much, if not more, R&D and undertake as much innovation as do foreign-controlled firms in Canada. In any case, increased outward foreign direct investment observed in recent years is a positive development, not least because it allows Canadian firms to maximise their competitive advantages in international markets (Conference Board of Canada, 2006).


Canada's innovation strategy

The previous government laid out an innovation strategy for Canada in 2002 (Box 3.1) and embarked on a wide-ranging consultation process with the aim of building a national agenda for change involving all stakeholders. This culminated in a national summit that produced 18 priority recommendations for action (Government of Canada, 2002a).
Box 3.1. Canada's Innovation Strategy

Canada's innovation strategy has been organised into four key areas
each with goals and specific targets. These are set out below, along
with the first assessment, in 2004, of progress towards meeting them,
which was commissioned from the Conference Board of Canada.

Knowledge performance

Goals: Vastly increase public and private investments in knowledge
infrastructure to improve R&D performance and ensure that a growing
number of firms benefit from the commercial application of knowledge.

Targets: By 2010, rank among the top five countries in the world in
terms of R&D performance, at least double the government's current
investment in R&D, rank among world leaders in the share of
private-sector sales attributable to new innovations, and raise
venture capital investments per capita to prevailing US levels.

Assessment 2004: Moving from 15th to 5th position in R&D investment
will be challenging. Leading countries are continuing to increase
their R&D investments, and Canada's rank has remained relatively
constant over the past 10 years. Preliminary research suggests
Canada is also lagging in commercialisation. A balance must be struck
between the level of investments Canada is prepared to make and the
ability to reap the benefits of those investments through the sale of
innovative goods and services.

Skills performance

Goals: Develop the most skilled and talented labour force in the
world, and ensure that Canada receives the skilled immigrants it
needs and helps immigrants to achieve their full
potential in the labour market and society.

Targets: Over the next five years, increase the number of adults
pursuing learning opportunities by one million. Increase admission
of Masters and PhD students at Canadian universities by an average
of 5% per year at least until 2010. By 2002, implement the new
Immigration and Refugee Protection Act and regulations, and, by
2004, significantly improve performance in the recruitment of
foreign talent, including foreign students, by means of both
the permanent immigrant and the temporary foreign workers programmes.

Assessment 2004: Canada has one of the most highly qualified labour
forces in the world but lags in employment in science and technology
occupations, improvements need to be made to build on the capabilities
of skilled immigrants. Canada has relatively fewer adults pursuing
continuing education and training, but when they do, they invest
considerable time. Yet what comprises essential "innovation skills"
is not yet entirely understood.

Innovation environment

Goals: Address potential public and business confidence challenges
before they develop, ensure that stewardship regimes and marketplace
framework policies are world-class, improve incentives for innovation,
and ensure that Canada is recognised as a leading innovative country.

Targets: By 2010, complete systematic expert reviews of the most
important business and regulatory regimes. Ensure the business
taxation regime continues to be competitive with those of other G7
countries. By 2005, substantially improve Canada's profile with
international investors, and, by 2004, fully implement the Council
of Science and Technology Advisors' guidelines to ensure the
effective use of science and technology in government decision-making.

Assessment 2004: Canada still has room for improvement in corporate
taxation and, while the tax treatment of R&D is attractive by
international standards, that advantage is waning. Continued focus
on the development of smart regulations will contribute to a favourable
innovation environment; indicators suggest that confidence in Canada's
innovation potential is beginning to slip. Canada ranks highly for the
volume of venture capital investment, but a more complete understanding
of risk capital is required to make true comparisons.

Community-based innovation

Goals: Governments at all levels work together to stimulate the
creation of more clusters of innovation at the community level.
Federal, provincial/territorial and municipal governments co-operate
and supplement their current efforts to unleash the full innovation
potential of communities across Canada, guided by community-based
assessments of local strengths, weaknesses and opportunities.

Targets: By 2010, develop at least 10 internationally recognised
technology clusters, and significantly improve the innovation
performance of communities across Canada. By 2005, ensure that
high-speed broadband access is widely available to communities.

Assessment 2004: Measuring Canada's innovation performance at the
community level will require more research. Nonetheless, momentum
appears to be growing in the development and understanding of
clusters. Canada's communications infrastructure, particularly
broadband penetration, is among the best in the world.

Source: Government of Canada (2002b) and Conference Board of Canada

One outcome of the strategy exercise was the development of a set of indicators to monitor Canada's innovation performance in the four key areas, and the government commissioned a benchmarking report from the Conference Board of Canada (Conference Board of Canada, 2004). This compared Canada's performance on 17 indicators against 10 other countries, although with considerable caution, noting both the value and the shortcomings of benchmarking when applied to innovation. (10,11) Overall, the Board concluded that Canada has a number of strengths that could underpin an improvement in its innovation performance, but it also pointed out several areas where new indicators and/or a better understanding (12) are needed:

* In Knowledge Performance, a better measure of the intensity of innovation, such as the change in value-added (or revenues) attributable to innovation, more regional and sectoral indicators of innovation, and more sophisticated indicators of tangible outputs resulting from research activities.

* In Skills, a clearer understanding of the relationship between skills and innovation, improved knowledge of cross-country labour mobility and improved indicators for comparing intellectual property rights systems across countries.

* In Innovation Environment, more sophisticated comparisons of tax treatment of early-stage investments and broader assessments of the availability and cost of risk capital.

* In Community-based Innovation, indicators related to economic and social value at the community level, commonly-accepted definitions of clusters, and research and data assessing the full range of benefits flowing from broadband internet connections. More broadly, the benchmarking assessment pointed out that the strategy puts more emphasis on the creation of knowledge, in particular through research, than the transformation of that knowledge into innovation. Indeed, it suggests that Canada's ambition to be among the top five countries for total spending on R&D as a share of GDP by 2010 is not only clearly unrealistic but may represent misplaced effort. Instead, it proposed that the strategy should be revised to place greater emphasis on commercialisation of R&D. (13)

Nonetheless, many commentators still point to Canada's relatively low ranking for the share of aggregate business investment in R&D compared with the rest of the OECD and argue that stronger measures to boost it should be incorporated into the innovation strategy. But this conclusion overstretches the available evidence, for several reasons:

* The aggregate business R&D measure masks some important industry differences, with Canada's low R&D intensity being mainly evident in the auto industry and wholesale and retail trade (Ab Iorwerth, 2005). It also reflects the relatively small share of research-intensive industries, except for motor vehicles, in the Canadian economy as a whole.

* Although there is widespread consensus that, left alone, firms would undertake too little R&D investment because of externalities, empirical estimates of the shortfall vary considerably, and it is debatable whether results for the United States, for example, could be assumed to apply to Canada (Gera et al., 2006).

* It is difficult to assess whether the current level of government support to business-sector R&D is too much, too little or just enough to ensure that social costs and benefits are equalised at the margin (Jaumotte and Pain, 2005b).

* The balance between research and development may not be optimal, especially given the growing importance of services, where innovation is somewhat less reliant on scientific discovery and exploitation and may depend more heavily on process enhancements (OECD, 2006).

These uncertainties point to the importance of further research into the innovation process itself, in order to provide a more robust underpinning for the strategy. In any case, it would make more sense to focus policy efforts on establishing a coherent and rational incentive structure that would bring forward the optimal amount of R&D, rather than trying to target a particular R&D level.

Optimising investments in the knowledge base

Innovation involves the transformation of knowledge into new or improved products and processes. Thus, increases in the stock of knowledge are generally considered important precursors of innovation. R&D is one important way in which it can be created, although the importance of other ways of developing it should not be under-estimated. Indeed, building up knowledge in processes, management and marketing areas may be just as important for innovation, especially in services where the traditional R&D model may not apply (OECD, 2006). In any case, Canada spends almost 2% of GDP on R&D, with a larger share of public R&D than many countries (Figure 3.6). The government has articulated three main reasons for funding R&D (Industry Canada, 2005):


* To improve Canada's performance in commercialising technologies.

* To strengthen Canada's social foundations by bringing new economic and social opportunities to Canadians across the country and in all fields of national endeavour.

* To help ensure Canada's place of pride and influence in the world, by bringing forward new Canadian ideas and technologies to address global issues and challenges.

Public-sector R&D

The government increased its spending on science and technology activities (14) by almost 40% in real terms over the past decade, and in 2004 allocated CAD 9 billion (around 0.7% of GDP) to it (Statistics Canada, 2005). OECD member governments now attach greater importance to research priority setting and are developing and using mechanisms to set priorities and allocate funds (OECD, 2003b). A number of countries either operate a predominantly top-down approach or integrate top-down and bottom-up exercises. But Canada's priority setting is essentially a bottom-up, decentralised approach: the government advisory bodies on research each operate separately and interact with different government agencies. On the basis of spending shares, public health emerges as the highest priority, followed by social structures and relationships: spending is channelled through many different agencies.

A groundswell of support has emerged within the research community for a more co-ordinated and strategic framework for major science projects, as recommended by the Auditor General in 2001. The government's National Science Advisor proposed a framework for evaluating and prioritising proposals for major science investments and overseeing the management of those projects once approved and sought comments on it during the course of 2005. This process emphasised the need to adopt a clearly articulated, integrated national science and technology policy. This strategic step, which would bring Canada into line with OECD best practice, remains to be taken.

Business-sector R&D

Knowledge creation in the form of R&D also involves the business sector. Indeed, the business sector both funds and performs around half of all R&D (Table 3.3) although the top 10 companies have carried out one third of all intramural R&D on average over the past 20 years (Statistics Canada, 2006). Some of private sector's activity is financed indirectly by federal and provincial SR&ED tax credits, although this contribution is not attributed to the government as funding sector. Overall business R&D intensity remains relatively low, even with both federal and provincial/territorial tax incentives (15) and subsidies designed to encourage business R&D expenditures (Figure 3.7). Indeed, cross-country analysis suggests that changes in public spending on R&D (including, but not only, grants and tax incentives) have generally played a smaller role in boosting business-sector R&D intensity than have changes in regulation and changes in framework and innovation conditions (Figure 3.8).


Across the OECD, the use of direct grants to individual institutions and firms has generally diminished, (16) and tax measures targeted at business R&D have become more important over time (Jaumotte and Pain, 2005b). In part, this trend reflects the practical difficulties associated with grants, including correctly identifying projects offering the highest marginal social returns as well as deciding who is best placed to carry them out. Evaluating the outcomes has also proved difficult. The weight of international empirical analysis is that public subsidies as typically operated are not generally effective in boosting R&D expenditures. But it is an open question whether this is an intrinsic result or reflects shortcomings in the design of specific grants programmes and the inclusion in the data of some R&D contracts awarded to the private sector for carrying out non-commercial research, for example in defence, health and other public services.

In contrast, there is some evidence that tax-based measures can lift business R&D intensity, at least in some circumstances (Jaumotte and Pain, 2005a). But the net social benefits, especially taking account the cost of foregone tax revenues and possible deadweight losses, remain difficult to estimate. Tax incentives may also distort choices over project details or even lead firms to engage in significant tax planning efforts so as to maximise their tax credits. Empirical evidence for Canada is mixed. (17) One study found the SR&ED credits have been cost-effective by generating around CAD 1.30 additional R&D spending for each dollar of tax revenue foregone (Klassen et al., 2004). A separate study goes further and finds that Canada's tax credits have not only led to additional R&D engagement among firms but also in turn generated additional innovation output (Czamitzki et al., 2004). But an earlier estimation suggested that the tax credit generated only 97 cents for each dollar of tax expenditure (Dagenais et al., 1997). Another analysis fails to find consistently statistically significant relationships between tax incentives and business R&D intensity, whereas government R&D grants did make a positive difference (Ghosh et al., 2004). In fact, less than half of innovating manufacturers actually used the tax credits, although almost 60% used government support programmes.

There has been considerable policy debate about whether, and what, changes might be needed to the present government support arrangements. Broadly speaking, three different options have been put forward. The first would be to redesign the present SR&ED tax credit rules (Box 3.2) to make them more efficient and effective; the second would be to shift the mix away from tax credits towards more direct grants; and the third would be to scale back specific tax credits and implement corporate tax cuts that would lower the very high marginal effective tax rates on investment (see Chapter 2).
Box 3.2. SR&ED tax credits for business R&D expenditures

The federal government provides the Scientific Research and
Experimental Development (SR&ED) Investment Tax Credit,
which has the objective of encouraging the private sector to
undertake scientific research and experimental development
in Canada and, in particular, to assist small businesses in
doing R&D. Newfoundland and Labrador, Nova Scotia, New
Brunswick, Quebec, Ontario, Manitoba, Saskatchewan, British
Columbia, and the Yukon also offer tax incentives for R&D.

The federal tax credit is earned on eligible current and
capital expenditures performed by, or on behalf of, a
taxpayer and related to the taxpayer's business. Eligible
expenditure is generally based on the OECD's Frascati
definition of R&D and consists of:

* Experimental development done to achieve technological
advancement to create, or improve, new materials, devices,
products, or processes. (Most SR&ED claims involve
experimental development.)

* Applied research done to advance scientific knowledge with
a specific practical application in view.

* Basic research done to advance scientific knowledge without
a specific practical application in view.

* Support work that directly supports and is commensurate with
the needs of experimental development, applied research, and
basic research. This includes only the following specific
types of work: engineering; design; operations research;
mathematical analysis; computer programming; data collection;
testing; and psychological research.

Three criteria must be met for the expenditure to qualify:

* Scientific or technological advancement: the work must generate
information that advances the understanding of scientific relations
or technologies.

* Scientific or technological uncertainty: whether a given result or
objective can be achieved, or how to achieve it, is unknown or cannot
be determined based on generally available scientific or technological
knowledge or experience.

* Scientific and technical content: there must be evidence that
qualified personnel with relevant experience in science, technology,
or engineering have conducted a systematic investigation through
experiment or analysis.

The tax credit rates and refundability rates are set out below.

In any case, the present arrangements have two features that may dilute their effectiveness and merit reconsideration. The first is the special treatment for small firms. The tax structure more generally imparts a bias towards small firms that translates into a less-favourable treatment for larger firms (see Chapter 2) and the refundable element of the SR&ED tax credits for smaller enterprises adds to that distortion. Canada is not alone in providing more generous R&D tax credits to small firms, although a twist in the rules is that the more generous provisions only apply to the subset of private corporations that are defined as Canadian-controlled Private Corporations (18) (CCPCs). A better approach might be to target new firms rather than all small firms, especially as they are most likely both to be finance-constrained and to have no taxable income against which to claim the credit. The costs and benefits of such a shift would merit further investigation.

The second element is the application of tax credits to the level of R&D expenditure rather than to incremental expenditures. Although incremental tax credits are more complex to design, they can do a better job of encouraging research at the margin as long as the base period is carefully defined (OECD, 2003a). Indeed, some ways of defining base periods (e.g. the rolling average base) can actually discourage firms from undertaking R&D (Bloom et al., 2001). In contrast, a fixed-base system or using a firm's all-time maximum R&D expenditure can minimise these perverse incentives. An incremental approach could reduce the fiscal cost of the incentives programme and also reduce deadweight losses, and could be explored further. But concerns that it would lead to sub-optimal R&D spending relative to spillovers also need to be examined carefully. Perhaps unsurpfisingly, established firms that already carry out a large quantity of R&D tend to prefer the level approach (OECD, 2003a).

Transforming knowledge into innovation

Greater attention is now being given to ways to commercialise Canada's knowledge and transform it into innovation. The previous government set up an Expert Panel on Commercialization in May 2005 to advise it on how to ensure more new technologies and products reach the Canadian marketplace. The panel recommended the establishment of a business-led Commercialization Partnership Board to advise the Minister of Industry and ensure the private sector has a strong voice in the design of public policies to improve commercialisation (Expert Panel on Commercialization, 2006). The group also recommended the federal government take early action in three areas:

* Talent: develop a new Canada Commercialization Fellowships Program; spur private sector hiring of highly qualified personnel with commercialisation talents; and develop and retain talent for success in the global marketplace.

* Research: create a Commercialization Superfund; expand federal programmes that support seed and start-up firms in proving their business ideas; and create a Canadian SME Partnerships Initiative.

* Capital: improve access to early-stage angel financing and expertise; identify improvements in the expansion-stage venture capital market; and remove barriers to investment for foreign venture capital investors.

Commercialising publicly-funded R&D

One element of these commercialisation efforts is developing and bringing to market new products and processes based on publicly-funded R&D. It is assumed that universities, in particular, provide large "untapped reservoirs" of potentially commercialisable knowledge that just needs encouragement and incentives to be brought to market (Wolfe, 2005). This thinking has underpinned three shifts in policy across most countries: closer linking of government funding for academic research to economic objectives; fostering more long-term relationships between firms and academic researchers; and encouraging universities to more actively seek to commercialise their research (Etzkowitz and Webster, 1998).

Canada has seen a rise in the number of inventions by researchers in universities and hospitals, with some 3000 domestic patents held by the end of 2003 (Read, 2005). Some 45% of patents were commercialised, (19) generating CAD 56 million to date in intellectual property revenue. Higher education institutions also reported 876 spin-off companies, with more than two-thirds in health, information, or engineering and applied sciences. Around three-quarters of all higher education institutions are now actively managing their intellectual property, in part reflecting significant increases in government funding for technology transfer offices. Rules governing the assignment of intellectual property fights and constraints on commercialisation are established by each institution (see, for example, University of Toronto, 2005).

However, increasing the emphasis on commercialisation of R&D undertaken in public research institutions also carries risks. First, it may crowd out some basic science activity that is, by nature, effectively non-commercialisable but still valuable to society. Second, it may encourage academics and/or their institutions to assert proprietary rights over their research to such an extent that it interferes with the socially optimal flow of knowledge (Aghion et al., 2005). Third, it may be based on an incorrect model of how universities most effectively contribute to innovation. Although the standard model underpinning commercialisation policy assumes a linear progression from basic science through applied research to commercialisation (20), this model may not capture the feedback cycles within business that drive innovation (Figure 3.9). In the cycle approach, the critical contribution of universities is the flow of university-trained graduates out to the business sector (21) (Wolfe, 2005). The Canadian company Research in Motion provides a practical illustration of this. Notwithstanding its close association with the University of Waterloo, it has licensed only two technologies from universities since it started more than 20 years ago, whereas it has hired over 5000 students over the same period (Lazaridis, 2004). If the linear model of innovation does not capture the contribution of universities to innovation correctly, then pressure to commercialise university research itself could lead to wasted effort and divert resources from where they could make a stronger contribution to innovation in the longer run, via basic research and training people (22) (Crelinsten, 2005).


Innovation through skilled and talented people

People with skills and talents are clearly key players in the innovation process, although it is not clear exactly what skills and talents are needed. (23) Canada, like many countries has endeavoured to increase its supply of highly-skilled researchers. However, the marginal net rate of return for a masters degree (compared with a bachelors degree) in science is barely positive and significantly smaller than for non-science fields (Stark, 2006). The overall net rate of return for any doctorate compared to a master's degree is even smaller. This suggests that there is no excess demand for such qualifications. If so, increasing the supply of graduates may simply lead to increased migration of highly-skilled workers to the United States, in particular, where the returns are significantly larger. (24,25)

In contrast, master's degrees in commerce and business generate the highest rate of return in Canada, indicating that the labour market values these qualifications more highly and is willing to pay more for them. As noted above, a range of studies have highlighted the importance of strategic and management capabilities in the innovation process. Indeed, raising the stock of management skills available to the business sector by increasing university places in MBA and other business programmes may make a stronger contribution to innovation performance over the longer term than training more scientists, at least until Canadian demand for scientists and the rates of return to such human capital investment rise.

The capacity to diffuse innovation rapidly and efficiently throughout the economy also depends on the general skill level of the entire working-age population. Canada has one of the highest rates of post-secondary education in the OECD overall and the share of 25 to 34 year-olds with university degrees has almost caught up to the share in the United States and is well ahead of the OECD average (OECD, 2005b). But the more relevant test may be whether Canadians have the general skills and competencies needed to function effectively in a knowledge-based economy. The Adult Literacy and Life Skills Survey (ALL) attempts to assess this through a range of literacy, numeracy and problem-solving tasks of increasing difficulty (OECD, 2005c). On these criteria, some 9 million working-age Canadians (42%) appear to have inadequate literacy skills (below level 3). Fifty per cent of working-age Canadians appear to fall short on numeracy, and 68% have insufficient problem-solving skills. In contrast, Norway, the country with the best results, had only 34% achieving sub-standard levels for literacy, 40% for numeracy and 60% for problem-solving skills.

Skill levels tend to be lower for older people and are linked to level of educational attainment across all age-groups. Literacy competencies are also closely correlated with the intensity of ICT use. Innovation involving new ICT technology and associated organisational change may be more difficult to implement if the workforce has difficulty mastering the transition. But Canadians are less likely to participate in adult education and training than in some other OECD countries (Figure 3.10). And adult education and training, in Canada and elsewhere, tends to be disproportionately taken by younger, already well-educated workers (OECD, 2005c).


This suggests that greater attention should be paid to designing effective adult learning policies to raise these core skills. OECD countries have generally found this a challenging task, although a cross-country

review of adult learning points to some best practices (OECD, 2005d). These include campaigns to help people understand the return they could get from investing in upgrading their skills, well designed co-financing arrangements and providing quality assurance of courses offered. Indeed, as noted in the previous Survey, there are a number of reasons why Canadians do not undertake more training, including inconvenient times, conflicts with work schedules and high workloads. Nonetheless, financing remains the single most important reason (Peters, 2004). For those who do participate in adult education and training, employers and individuals shoulder a higher share of the cost than they do in several other countries including the United States (Figure 3.11). This is the case even for those at the two lowest levels of literacy. This suggests that Canada could look for more effective co-financing arrangements to boost life-long learning, especially for the low-skilled, which would in turn facilitate the diffusion of innovation through the economy. Assisting low-skilled adults to upgrade their skills would also contribute to social objectives (see Chapter 5).


Financing innovation

Availability of finance for innovation, especially for start-up ventures, has been raised as an issue, although Canada actually has one of the highest flows of venture capital investment among OECD countries (Figure 3.12). Indeed, it has typically been difficult to establish a robust link between venture capital and innovation inputs such as R&D spending (Jaumotte and Pain, 2005c). In any case, quality is an issue. In Canada, a large share of venture capital funds has been channelled through a unique arrangement, known as Labour-Sponsored (26) Venture Capital Corporations (LSVCCs--also commonly known as labour-sponsored investment funds or LSIFs). These currently account for around 40% of all venture capital raised. These funds may invest up to CAD 15 million in Canadian businesses that have less than 500 employees and less than CAD 50 million in assets. Individuals using these funds as a savings instrument obtain income tax credits as long as the investment is held for eight years. (27) However, investors in other venture capital funds do not benefit from similar tax advantages.


The LSVCCs have distorted the market for venture capital, lowering the average quality of deals and limiting the supply of equity to non-traditional industries and newer companies (Baygan, 2003). To some extent this is because the LSVCCs have objectives relating to social development as well as profit maximisation. Indeed, net internal rates of return for the market as a whole are remarkably weak and often negative (Table 3.5). Low returns and the seasonal pattern of inflows from individual investors suggest that they largely function as tax shelters. At the same time, other VC funds are crowded out as LSVCCs can scoop up investment opportunities with lower required internal rate of returns. However, the governance structure of LSVCCs leads to less-skilled fund managers and poorer fund performance (Cumming and MacIntosh, 2003).

As well as the adverse impacts on the venture capital market's performance, Finance Canada estimates that the annual federal tax expenditures amount to around CAD 200 million per year. Indeed, cross-country evidence on factors affecting venture capital suggests that a well designed overall business taxation environment produces better results than targeted tax measures (Baygan, 2004; Romain and van Pottelsberghe de la Potterie, 2003). Overall, the damaging effects of the LSVCC tax credits on the financing of innovation along with their fiscal costs present a clear argument for their elimination.

Another complaint is that there are insufficient "investment-ready" companies becoming available to venture capital funds due to a shortage of angel investors (National Angel Organization, 2005). It is not clear how this claim could be substantiated. In a survey of early-stage venture capital investors, the most important issue identified was the scarcity of the very specific professional skills needed for successfully managing early-stage ventures (Macdonald & Associates Limited, 2005). It is also well established that the biggest contribution of angel investors is their business and management acumen, rather than the financial support that they contribute. Careful assessment of projects can also predict future commercial success quite well, as demonstrated by the Inventors Assistance Programme run by the non-profit Canadian Innovation Centre. In a sample of 1 091 inventions they evaluated, 65% of those that they predicted would be successful (28) generated positive internal rates of return (IRR), and the median IRR was 26%. In contrast, half of those that they rated doubtful were nonetheless continued and only 23% generated a positive IRR and the median IRR was -28% (Asterbro, 2003). This suggests that weaknesses were inherent in these projects themselves rather than in their "investment-readiness" or access to finance. In sum, further careful research into the true nature of any policy gap would be required before allocating public resources to new financing initiatives. (29)

Conclusions and policy recommendations

Overall, there is considerable scope for lifting the rate of innovation in Canada. Federal, provincial and territorial governments can all contribute to this process both by ensuring that the overall business environment is conducive to innovation and by designing innovation-specific policies that support and enhance the process. Recommendations that emerge from the analysis presented in this chapter are summarised in Box 3.3.
Box 3.3. Policy recommendations for innovation

The highest priority for enhancing Canada's innovation performance is
to improve the overall business environment in line with the
recommendations set out in Chapter 2. Those measures should be
complemented by the following actions:

* Undertaking research into those aspects of the innovation process
that remain poorly understood or contested, so as to provide a
stronger analytical and empirical underpinning for the Innovation
Strategy. Such work should be carried out before adding new policy
initiatives to the strategy that would involve significant direct or
indirect commitments of taxpayers' funds, It should also be used to
critically reassess the net economic benefits flowing from existing
programmes and policies.

* Developing a clearly articulated and integrated national science and
technology policy and a priority-setting exercise for Canadian
science, within which individual project proposals can then be

* Examining whether the efficiency of the SR&ED tax credits might be
improved. This should include exploring the option of carefully
redesigning them to target R&D in new firms and to encourage
incremental spending on R&D.

* Putting more emphasis on business management programmes (including
those designed for mid-career executives) and removing obstacles to
expanding such courses in response to demand.

* Encouraging less-skilled working-age Canadians (including
immigrants) to upgrade their literacy, numeracy and problem-solving
skills by promoting better understanding among target groups about the
rewards in the form of higher future wages and ensuring well-designed
co-financing arrangements are available.

* Eliminating the federal and provincial tax credits for investments
in Labour-Sponsored Venture Capital Corporations so that they are
required to compete on the same basis as other venture capital funds.


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(1.) Performance in this context is assessed according to profitability, employment, labour productivity and wages.

(2.) Work on estimating spillovers has essentially concentrated on business R&D, rather than the broader concept of innovation itself(see, for example, Wieser, 2005).

(3.) Innovation involves both existing firms making incremental enhancements to technologies and independent inventors and entrepreneurs who produce disruptive technologies (Banmol, 2006).

(4.) Innovation inputs include such activities as R&D, intellectual property protection and human capital development that can be transformed into subsequent innovation when the results of these activities are implemented.

(5.) These data exclude enterprises with no paid employees. US data are taken from the US Census bureau's Statistics of US Businesses: 2003 database and Canadian data are provided by Statistics Canada's Longitudinal Employment Analysis Program database.

(6.) Most of these successful new entrants in Canada were serving mature markets, and only a quarter of them considered that their industry's products quickly become obsolete, whereas almost half believed that production technology changed rapidly (Baldwin and Gellatly, 2003).

(7.) Entrepreneurial values were also cited as an important factor in explaining the success of small Canadian companies (Baldwin and Gellatly, 2003).

(8.) Six variables were used from the 1999 Innovation Survey as indicators of technology invention and adoptions namely: patent applications; acquisition of technologies; trademarks; copyrights; R&D; and industrial design. These are innovation activities or inputs and do not necessarily correspond to innovation outputs within the Survey time frame.

(9.) ICT investment as a share of GDP for the business sector was 2.1% in 1987 and 2.5% in 2004 in Canada, compared with 2.8% in 1987 and 4.1% in 2004 in the United States. Only a relatively small proportion of the gap with the United States can be explained by adjusting for differences in industry composition and firm-size distribution.

(10.) The caveats can be summarised as follows: benchmarking methodologies do not involve any information about optimal levels; they often include indicators that do not have a firm empirical link to the desired outcome; there may be few valid and reliable indicators, and proxy indicators may be misleading; they do not account for underlying differences, such as economic size and structure, in the entities being compared; and there is a tendency to measure the quantifiable and neglect qualitative aspects (Conference Board of Canada, 2004).

(11.) This exercise can be compared with the European Innovation Scoreboard, which covers the 25 EU member states, six other European countries, the United States and Japan. The 26 indicators are grouped into innovation drivers, knowledge creation, innovation and entrepreneurship, application and intellectual property (

(12.) Some of these issues were canvassed in a workshop hosted by Statistics Canada at the end of 2003 (Earl and Gault, 2004).

(13.) The Board also argued that the strategy could be fine-tuned to focus knowledge performance on particular niches and strengths where Canada can most effectively develop world-class capabilities, rather than striving to excel on all fronts. A further conclusion was that business should play a more prominent role in the strategy, since Canadian companies appear to under-invest in precursors to innovation such as R&D, training and new machinery and equipment.

(14.) Around 63% of spending was allocated directly to R&D, and the remainder comprised related scientific activities (RSA) such as data collection, information services and special studies. These data do not include the Scientific Research and Experimental Development (SR&ED) tax credits provided to business.

(15.) In fact, the marginal effective tax rates for R&D have been estimated to vary across provinces from about minus 40% in Alberta to over minus 200% in Quebec (McKenzie, 2005). These variations reflect not only differential federal tax treatment across provinces but also heterogeneous provincial taxes.

(16.) This may also reflect scaling back of military-related R&D carried out by the private sector under contract arrangements. Such expenditures are not intended to stimulate business R&D overall, but to deliver defined projects. But such arrangements are difficult to identify and exclude from the data.

(17.) Two often cited studies in support of the effectiveness of the SR&ED tax credit are not discussed further here as they have limited empirical value. The first proceeded by asking recipients of the tax credit how much they would reduce their R&D expenditures if the tax credit was eliminated (Finance Canada, 1997). The second was based on a small sample of only 27 firms (Bernstein, 1986).

(18.) A CCPC must not only be a private corporation (i.e. without shares listed on a public stock exchange) but may not be controlled directly or indirectly by a public corporation or by non-Canadian residents or a combination of the two.

(19.) This ratio concerns only the subset of patents where commercialisation information was reported.

(20.) An interesting corollary of this model is that a country such as Canada would not need to do basic science itself as it could buy it in from elsewhere and insert it in at the appropriate point on the innovation production line.

(21.) These people bring to industry not only the knowledge and research skills honed in a university environment but also a network of academic contacts and a stock of tacit knowledge. (Tacit knowledge cannot easily be codified and transmitted electronically, in contrast to codified knowledge that can be disseminated through standard academic publication channels.) It is argued that it is these researchers' ability to "learn through interacting" within the firm to connect knowledge with market opportunities that generates innovation.

(22.) It remains an empirical question whether greater emphasis on applied research might undermine the training benefits that come from the greater opportunity for unplanned discoveries associated with basic research.

(23.) Another challenge for the education system at all levels is that an education system designed to produce graduates who are good at incremental innovation may, at the same time, stifle the creativity and imagination needed for major breakthroughs (Baumol, 2004). However, since both types of innovation are important and complement each other, the education system at all levels faces the challenge of encouraging originality and creativity as well as developing knowledgeable, rigorous and well trained thinkers.

(24.) For example, on average Canadians with tertiary-type A and advanced research programme qualifications earned 61% more than those with only a high school diploma (OECD, 2005b). In contrast, those in the United States with the equivalent level of qualifications earned 91% more than those with only the diploma. These data do not distinguish between higher levels such as masters and PhDs and lower levels within the broad category.

(25.) Among established scientists listed in "American Men and Women of Science", the probability that Canadian scientists will be working in the United States has steadily increased since 1967 when the probability reached its lowest point (Easton, 2005).

(26.) Although the funds are generally run by a management or marketing company, a labour union must agree to act as the fund's sponsor. The union is required to appoint the majority of fund board members and thereby exercise control. But it usually has no economic stake in maximising the fund's returns, instead receiving a fixed fee or a small percentage of the net asset value of the fund.

(27. Individuals investing up to CAD 5 000 per year can obtain a 15% federal tax credit and a further 15 to 20% provincial tax credit.

(28.) This group does not include proposals that were recommended to go forward but where modest returns were likely. 80% of these were carried through to commercialisation but only 38% of them generated a positive IRR and the median IRR was--13%.

(29.) If the critical constraint is capable people, then increasing financial incentives through tax breaks such as the proposed innovation and productivity tax credit being actively promoted by the National Angel Organization will do little to increase the supply of angels. Indeed, it appears to be largely a rent-seeking exercise.
Table 3.1. Motivating factors for innovation in manufacturing firms

                                      disagree    Disagree

A. Perceptions of competition faced
by innovators

My clients can easily substitute my
  products for the products of my
  competitors                            5.7        14.7
Arrival of competing products is a
  constant threat                        4.8        15.2
My products quickly become obsolete     35.3        34.7
Production technologies change
  rapidly                                5.2        20.3
Office technologies change rapidly       1.8         7.6

                                        Low         low

B. Importance of objectives for

Extend product range                     3.4         5.3
Improve product quality                  1.4         2.7
Increase speed of delivering
 products to the market                  5.6         7.9
Replace products being phased out       16.8        16.7
Reduce labour costs                      9.9         9.6
Increase production capacity             4.2         6.0
Reduce production time                   6.1         7.3
Improve production flexibility           4.6         7.6
Reduce materials consumption            18.3        17.3
Reduce environmental damage             24.8        19.5
Reduce energy consumption               24.3        21.4
Deal with/respond to new government
  regulations                           31.3        20.6

                                      Neutral      Agree       agree

A. Perceptions of competition faced
by innovators

My clients can easily substitute my
  products for the products of my
  competitors                           20.7        28.3        30.6
Arrival of competing products is a
  constant threat                       22.9        30.8        26.3
My products quickly become obsolete     17.5         7.7         4.8
Production technologies change
  rapidly                               30.7        27.6        16.1
Office technologies change rapidly      24.3        38.4        27.9

                                       Medium       high        High

B. Importance of objectives for

Extend product range                    15.2        29.4        46.8
Improve product quality                 10.2        31.6        54.1
Increase speed of delivering
 products to the market                 18.5        25.6        42.4
Replace products being phased out       22.0        21.6        23.0
Reduce labour costs                     17.9        25.4        37.3
Increase production capacity            11.0        29.3        49.5
Reduce production time                  15.4        30.1        41.1
Improve production flexibility          18.3        32.9        36.6
Reduce materials consumption            21.7        21.5        21.2
Reduce environmental damage             22.5        17.2        16.0
Reduce energy consumption               25.6        16.7        12.0
Deal with/respond to new government
  regulations                           23.0        13.1        12.1

Source: Statistics Canada, Survey of Innovation 1999.

Table 3.2. Managers' educational attainment by field of study

Per cent of managers aged 25-64 years, 2001

                                                  and        Bachelor
                                              diplomas (1)   degrees

Fine and applied arts                              1.7          0.4
Agricultural, biological, nutritional, and
  food sciences                                    1.3          0.8
Health professions and related technologies        1.5          0.5
Mathematics, computer and physical sciences        0.5          1.7
Humanities and related fields                      1.2          2.1
Engineering and applied sciences                   0.5          2.7
Educational, recreational and counselling
  services                                         1.5          1.5
Social sciences and related fields                 1.6          4.0
Applied science, technologies and trades          10.7          0.0
Commerce, management and business
  administration                                  12.0          5.8
No post-secondary qualifications                   0.0          0.0
Total--all fields of study                        32.6         19.6

                                                Advanced      Total
                                              degrees (2)    employed

Fine and applied arts                              0.1          2.2
Agricultural, biological, nutritional, and
  food sciences                                    0.3          2.4
Health professions and related technologies        0.4          2.4
Mathematics, computer and physical sciences        0.7          3.0
Humanities and related fields                      0.8          4.1
Engineering and applied sciences                   1.2          4.4
Educational, recreational and counselling
  services                                         1.7          4.7
Social sciences and related fields                 1.5          7.1
Applied science, technologies and trades           0.0         10.8
Commerce, management and business
  administration                                   3.7         21.5
No post-secondary qualifications                   0.0         37.2
Total--all fields of study                        10.6        100.0

(1.) Trades certificate, college diploma and university sub-degree.

(2.) Graduate university certificates, medical degrees, masters
and doctorates.

Source: Statistics Canada, Census 2001.

Table 3.3. Gross domestic expenditure on R&D

Percentage shares by performing and funding sectors, 2004

                                      Performing sector

                          Federal        Provincial       Business
Funding sector           government    government (1)    enterprises

Federal government          8.9             0.0              1.1
Provincial government       0.0             1.2              0.2
Business enterprises        0.2             0.2             42.5
Higher education            0.0             0.0              0.0
Pnvate non-profit           0.0             0.0              0.0
Foreign                     0.0             0.0              7.4
Total                       9.1             1.3             51.2

                                      Performing sector

                           Higher         Private
Funding sector           education       non-profit         Total

Federal government           9.3            0.0              19.3
Provincial government        4.2            0.1               5.8
Business enterprises         3.3            0.0              46.2
Higher education            17.6            0.0              17.6
Pnvate non-profit            3.1            0.1               3.2
Foreign                      0.5            0.0               7.9
Total                       38.1            0.3             100.0

(1.) Including provincial research organisations.

Source: Statistics Canada (2005), Federal Scientific
Activities 2004-2005, Statistics Canada, Ottawa.

Table 3.4. Federal SR&ED tax credit rates and rates of refundability

Per cent

                                               Refundability rates

                                  Credit     Current        Capital
Business type                     rates    expenditures   expenditures

Unincorporated businesses           20          40             40

CCPCs with prior-year taxable
  income of CAD 300 000 or
  less (1)

  Expenditure up to expenditure
    limit (2)                       35         100             40
  Expenditure over expenditure
    limit                           20          40             40

CCPCs with prior-year taxable
  income of CAD 300 000 and
  CAD 500 000 (1)

  Expenditure up to expenditure
    limit (3)                       35         100             40
  Expenditure over expenditure
    limit                           20           0              0

CCPCs with prior-year capital
  employed in Canada between
  CAD 10 million and CAD
  15 million

  Expenditure up to expenditure
    limit (4)                       35         100             40
  Expenditure over expenditure
    limit                           20           0              0

All other corporations              20           0              0

(1.) Taxable income thresholds of CAD 300 000 and CAD 500 000 will
be raised to CAD 400 000 and CAD 600 000 respectively in 2007.

(2.) Expenditures limit is generally CAD 2 million per annum.

(3.) Expenditures limit for CCPCs is phased out for prior-year taxable
income between CAD 300 000 and CAD 500 000.

(4.) Expenditures limit far CCPCs is phased out for prior-year taxable
capital employed in Canada between CAD 10 million and CAD 15 million.

Tax expenditures associated with the SR&BD programme were estimated
at CAD 2.5 billion in 2005 and delivery of the programme employs more
than 500 staff in the Canada Revenue Agency.

Source: Canada Revenue Agency and Finance Canada.

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Publication:OECD Economic Surveys - Canada
Geographic Code:1CANA
Date:Jan 1, 2006
Previous Article:Chapter 2: improving the business environment.
Next Article:Chapter 4: adapting fiscal policy and financial arrangements in the federation.

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