Bud­get 2018: High Times

Policy - - In This Issue - Dou­glas Porter and Robert Kav­cic

The third bud­get of the Trudeau gov­ern­ment ar­rived with very lit­tle fan­fare and sub­dued ex­pec­ta­tions, and re­in­forces Ot­tawa’s cur­rent pri­or­i­ties. Against a back­drop of ag­gres­sive U.S. tax re­form and NAFTA un­cer­tainty, Fi­nance Min­is­ter Bill Morneau played it safe with a largely stand-pat fis­cal plan, al­low­ing re­cent eco­nomic strength, de­ferred in­fra­struc­ture spend­ing and some tax in­creases (yes, in­clud­ing a pot tax) to fund yet another spend­ing boost. Ot­tawa is again pro­ject­ing a string of dou­ble-digit bud­get deficits as far as the eye can see, nar­row­ing some­what in the com­ing fis­cal year, while the now-key debt/ GDP ra­tio still grad­u­ally drifts lower.

This out­look comes as lit­tle sur­prise, as a fad­ing debt ra­tio has be­come the de facto an­chor for pol­icy. Last year’s firmer-than-ex­pected eco­nomic back­drop has pro­vided a big tail­wind for fi­nances, al­though that favourable trend looks to have largely run its course. Two ma­jor ar­eas of un­cer­tainty head­ing into to­day were: 1) Would there be any sig­nif­i­cant re­sponse to the com­pet­i­tive chal­lenge from U.S. tax re­form; and, 2) Would there be any new spend­ing mea­sures in the year be­fore the next elec­tion? The short an­swers are: No; and, ev­ery last dol­lar sub­ject to keep­ing the deficit path un­changed.

This is set against what could quite pos­si­bly be the high point for eco­nomic and fis­cal con­di­tions in Canada. Con­sider what likely lies ahead: • Eco­nomic growth is bound to slow af­ter a pow­er­ful up­side sur­prise last year, and as we get deep into an al­ready long cy­cle; • Pro­found un­cer­tainty of the NAFTA talks;

• Debt in­ter­est costs are poised to edge higher af­ter years of con­sis­tent pos­i­tive sur­prises, ris­ing as a share of GDP for the first time in decades;

• There is lit­tle fis­cal room to stim­u­late the econ­omy fur­ther, as­sum­ing the fis­cal an­chor holds, and short of a ma­jor re-pro­fil­ing of the in­fra­struc­ture pro­gram; and

• U.S. tax re­form is a tough new com­pet­i­tive chal­lenge, to which the bud­get is nearly silent in re­sponse.

Mean­time, the deficit pro­file closely fol­lows the up­date laid out in the 2017 Fall State­ment, which is hardly a sur­prise, given that the cur­rent eco­nomic out­look is lit­tle changed since that point. Re­call that up­date in­cor­po­rated a much stronger-thanex­pected 2017 eco­nomic growth back­drop into the fis­cal plan, re­duc­ing av­er­age deficits from FY18/19 through FY21/22 by an av­er­age of $6.5 bil­lion per year. Sim­i­larly, the up­dated out­look in this bud­get calls for an $18.1 bil­lion deficit this fis­cal year, be­fore shrink­ing mod­estly to $13.8 bil­lion by FY21/22—there is still no plan to bal­ance the books within the fore­cast hori­zon. Be­low the sur­face, some re-pro­fil­ing of the in­fra­struc­ture pro­gram, lower EI ben­e­fit pay­ments (stronger labour mar­ket), more favourable Crown ex­penses and some tax in­creases have al­lowed chunky new spend­ing mea­sures to go through with­out im­pact­ing the bot­tom line.

A con­tin­gency of $3 bil­lion per year re­mains in place through the fore­cast hori­zon, of­fer­ing some wig­gle room should the econ­omy slow more than we’ve al­ready seen (po­ten­tial risks on the trade front, for ex­am­ple). Also, the debt-to-GDP ra­tio will fade from 30.1 per cent this com­ing fis­cal year, to 28.4 per cent by FY22/23. We’d just re­it­er­ate that we are ob­serv­ing some tell-tale late­cy­cle con­di­tions in North Amer­ica, of­ten a pe­riod that gov­ern­ments should build fis­cal ca­pac­ity—af­ter all, an os­ten­si­bly sta­ble debt-to-GDP ra­tio will de­te­ri­o­rate overnight when the next down­turn hits.

The net fis­cal im­pact of new mea­sures de­tailed in this year’s bud­get is $5.4 bil­lion (or 0.2 per cent of GDP), fad­ing to av­er­age $2.5 bil­lion per year in the sub­se­quent four fis­cal years—not big by any stretch, but not im­ma­te­rial ei­ther. Here’s a re­cap of some of the many new ini­tia­tives: • Pro­gram spend­ing will rise 2.5 per cent in FY18/19 af­ter at 6.1 per cent surge in FY17/18. As a share

of GDP, pro­gram spend­ing will dip slightly to 14 per cent, but that re­mains up from the re­cent low of just un­der 13 per cent in FY14/15. No­tably, pro­gram spend­ing as a share of GDP will drift very mod­estly lower over the fore­cast hori­zon.

• In­fra­struc­ture spend­ing: This bud­get fur­ther re-pro­files the in­fra­struc­ture spend­ing plan, push­ing some in­vest­ment out into fu­ture years. Since the Fall State­ment, Ot­tawa has moved more than $2 bil­lion out of FY18/19, with a mean­ing­ful chunk land­ing in FY19/20—an elec­tion year.

• EI Parental Shar­ing Ben­e­fit: An ad­di­tional 5 weeks of parental leave for a fam­ily where the se­cond par­ent agrees to take a min­i­mum of 5 weeks. This will start in June 2019, and is ex­pected to cost roughly $300 mil­lion per year, funded through the EI ac­count. As such, EI pre­mi­ums will rise by 3 cents in FY18/19, to $1.66

Some re-pro­fil­ing of the in­fra­struc­ture pro­gram, lower EI ben­e­fit pay­ments (stronger labour mar­ket), more favourable Crown ex­penses and some tax in­creases have al­lowed chunky new spend­ing mea­sures to go through with­out im­pact­ing the bot­tom line.

(an­nounced ear­lier). This is one mea­sure aimed at in­creas­ing fe­male work­force par­tic­i­pa­tion, but likely falls short on that front.

• Other mea­sures to pro­mote gen­der equal­ity in­clude pay eq­uity leg­is­la­tion in the fed­eral sec­tor and recog­ni­tion for com­pa­nies with gen­der equal­ity on their board.

• Tax loop­holes: Var­i­ous changes to busi­ness taxes aim to raise $1.2 bil­lion by FY20/21. This in­cludes tax­a­tion of pas­sive in­come in pri­vate cor­po­ra­tions, where the busi­ness limit (amount of in­come that trig­gers a shift to the higher gen­eral cor­po­rate rate) is re­duced from $500,000 as pas­sive in­vest­ment in­come in­creases. In gen­eral, a busi­ness would need at least $50,000 of in­vest­ment in­come to be af­fected. Other ar­eas tar­geted in­clude lim­it­ing re­fund­able taxes larger com­pa­nies can ob­tain on div­i­dend dis­tri­bu­tion; and a few mea­sures tar­get­ing ar­ti­fi­cial losses gen­er­ated by fi­nan­cial in­stru­ments and share buy­backs (mea­sures which the bud­get sug­gests will mostly af­fect banks).

• Pot tax: Ot­tawa out­lines a cannabis tax frame­work and raises to­bacco taxes im­me­di­ately. Com­bined, these will raise more than $400 mil­lion in FY18/19.

• Canada Work­ers Ben­e­fit: This is a re­vamped ver­sion of the prior Work­ing In­come Tax Ben­e­fit, made more gen­er­ous and eas­ier to ac­cess. Fund­ing was al­ready ac­counted for in the Fall State­ment.

• Cre­ation of an ad­vi­sory coun­cil to look at a na­tional phar­ma­care pro­gram. This could be the bigticket item in next year’s bud­get.

With a string of deficits still loom­ing, gov­ern­ment bor­row­ing re­quire­ments will re­main el­e­vated, though down some­what this com­ing fis­cal year. Gross mar­ketable bond is­suance will to­tal $115 bil­lion in FY18/19, down from $138 bil­lion in FY17/18. Af­ter ac­count­ing for ma­tu­ri­ties, buy­backs and other ad­just­ments, the net in­crease in bonds will be $20 bil­lion in FY18/19, ver­sus $43 bil­lion this year. The gov­ern­ment will con­sider issuing bonds with a ma­tu­rity of 50 years “sub­ject to favourable mar­ket con­di­tions”, as has been the norm re­cently. The stock of Trea­sury bills is pro­jected to drift up from $125 bil-

lion to $138 bil­lion, while the av­er­age term to ma­tu­rity of do­mes­tic mar­ket debt is ex­pected to re­main sta­ble around 5.5-to-6.5 years. Ot­tawa con­tin­ues to fo­cus more of its is­suance in the 2-, 3- and 5-year sec­tors, not at the longer end.

Re­flect­ing the above, Ot­tawa is pro­ject­ing net new do­mes­tic bor­row­ing re­quire­ments of $35 bil­lion in the com­ing fis­cal year, with cash bal­ances un­changed. In turn, to­tal fed­eral debt/GDP will fall three ticks, to 30.1% in FY18/19. The debt ra­tio is pro­jected to even­tu­ally grind down to 28.4% by FY22/23—sta­bil­ity (or de­clines) in this mea­sure is the fis­cal an­chor for now.

Ot­tawa’s eco­nomic as­sump­tions were brought up-to-date in the Fall State­ment, and still serve as rea­son­able ba­sis for fis­cal plan­ning. Cana­dian real GDP growth is ex­pected to mod­er­ate to 2.2 per cent this year, down from the heated 3.0 per cent pace ex­pected in 2017, be­fore cool­ing fur­ther to 1.6 per cent in 2019. Our call is 2.2 per cent this year and 1.8 per cent in 2019. The key mes­sage here is that peak growth is well be­hind the Cana­dian econ­omy for now, af­ter grow­ing 3.6 per cent in the four quar­ters through 2017Q2, lim­it­ing any po­ten­tial up­side sur­prises to the bot­tom line like we saw last year. Im­por­tantly for rev­enues, nom­i­nal GDP growth is ex­pected to taper off as well, to 4.0 per cent this year and 3.5 per cent in 2019 (our calls are 4.2 per cent and 3.9 per cent, re­spec­tively). This comes along­side lit­tle en­thu­si­asm over oil prices given the sup­ply-de­mand back­drop—we see WTI av­er­ag­ing $60 by 2019. Three­month in­ter­est rates are ex­pected to av­er­age 1.4 per cent this year and 2.0 per cent next year, sim­i­lar to our call of 1.35 per cent and 2.2 per cent, while 10-year GoC yields are ex­pected to rise from 2.3 per cent on av­er­age this year to 2.8 per cent next (ver­sus our view of 2.5 per cent and 3.0 per cent). It’s note­wor­thy that, aside from a brief pe­riod through 2013, much of this cy­cle has been char­ac­ter­ized by lower in­ter­est rates, lead­ing gov­ern­ments to re­vise down their debt-ser­vice cost es­ti­mates in-year. That tide could be turn­ing. All in, and bar­ring an ex­ter­nal shock (NAFTA, for ex­am­ple), the risks around the fis­cal plan from an eco­nomic per­spec­tive look rel­a­tively balanced.

Cana­dian real GDP growth is ex­pected to mod­er­ate to 2.2 per cent this year, down from the heated 3.0 per cent pace ex­pected in 2017, be­fore cool­ing fur­ther to 1.6 per cent in 2019.

Ta­ble 1: FIS­CAL OUT­LOOK

Chart 1: SPEND­ING STIM­U­LUS FADES

Chart 2: DEBT RA­TIO TRACK­ING LOWER

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