Now that the federal Conservative Government has announced plans to cut the corporate income tax rate to 15% by 2012 from the current 22.5%, the question many are asking is: will lower taxes encourage Canadian companies to invest more in machinery and equipment, thereby increasing productivity and international competitiveness?

On the surface, it seems likely. But recent history isn’t encouraging.

The recent rise in the Canadian dollar against the U.S. dollar to above parity from the low-US60¢ range in 2002 has reduced the cost of machinery and equipment (M&E) made in the U.S. — the source of most of the M&E used in Canada — by more than 40%.

But so far, this has not resulted in a surge in businesses making capital investments, even though corporate profits are high and money is inexpensive because interest rates are low. The outstanding amount of M&E in the business sector has risen by an average of only 0.2% a year in the 2002-06 period from 4.6% in 1992-2001, according to a recent TD Bank Financial Group report.

Other countries have been investing in M&E, however. In 2006, an average of $594 more was spent per worker on investment in M&E and facilities in member countries of the Organization for Economic Co-operation and Development than in Canada. The G-7 countries spent an average of $1,131 more per worker on investment in M&E than Canada did.

The difference between Canada and the U.S. is even more notable. The U.S. spent an average of $2,037 more per worker than Canada last year. In the 1990s, that gap averaged only $1,190.

A number of factors, many of which are related to the smaller size of Canadian firms, can explain — at least, in part — the lower M&E investment in Canada.

Smaller firms do less research and development. As a result, they have less R&D expertise, which may reduce the willingness and/or ability of some firms to use new technologies developed by others.

In addition, smaller firms also may not apply new technologies because they are less likely to benefit from the economies of scale and cost savings that come with the larger production runs that M&E investment can facilitate.

Canadian firms also may be more conservative, resulting in a reluctance to try cutting-edge, unproven technologies. Part of this may be because Canadian managers have less education, on average, than their U.S. counterparts.

In addition, both access to capital and the cost of that capital is generally higher for smaller firms. Furthermore, smaller firms may not want to take on, proportionately, as much debt as larger companies.

The smaller size of Canadian companies isn’t new, but there’s one final factor that is: the rise of the C$, which has hurt the competitiveness of Canadian firms in the U.S. market or against U.S. imports at home.

Companies unsure about whether they will be able to continue to compete may be very reluctant to invest in new M&E — even though that investment may be their only hope for survival.

So, will the lower corporate income taxes help? It’s possible — especially if the C$ comes off its recent highs, as many economists expect.

Royal Bank of Canada expects the loonie to fall to US93.5¢ by the end of 2008, while TD and BMO Nesbitt Burns Inc. expect it to fall to US95¢ and US96.8¢, respectively.

Economists expect the C$ to weaken as oil prices drop as a result of the slowdown in the U.S. and global economies. The C$ generally moves with resources prices — particularly oil.

The result would be increased competitiveness from a lower C$ and lower costs from a drop in oil prices. Combine that with additional after-tax net income from lower corporate tax rates and some Canadian companies may be persuaded to invest more in M&E. IE