The Fis­cal Up­date: Do Mod­est Deficits Mat­ter?

Policy - - Contents - Kevin Page and (Matt) Jian Shi

As piv­otal days in the an­nual pol­icy cal­en­dar of the na­tion’s cap­i­tal go, the fi­nance min­is­ter’s fall fis­cal up­date—of­fi­cially the Up­date of Eco­nomic and Fis­cal Pro­jec­tions—has grad­u­ally be­come al­most as big as bud­get day. In an in­ter­con­nected world that changes faster than at any pre­vi­ous point in hu­man his­tory, fis­cal pol­icy must in­cor­po­rate a rapid re­sponse ca­pac­ity and a global per­spec­tive.

Fi­nance Min­is­ter Bill Morneau tabled his fourth eco­nomic and fis­cal up­date in the House of Com­mons last Novem­ber 21. As far as up­dates go, this Fall Eco­nomic State­ment 2018 (FES) is strate­gi­cally im­por­tant for the gov­ern­ment, and pos­si­bly for the fu­ture fis­cal health of the coun­try.

We are now in an elec­tion year. The Lib­eral gov­ern­ment of Prime Min­is­ter Justin Trudeau will build its 2019 cam­paign case around the pol­icy record and eco­nomic out­look pre­sented in the up­date.

The eco­nomic pic­ture of the coun­try has shifted. The Cana­dian econ­omy is much stronger now than it was in 2015 when the gov­ern­ment took of­fice and laid out its fis­cal strat­egy. In­ter­est rates are ris­ing, re­flect­ing changes to mone­tary pol­icy. Bud­getary deficits and ris­ing in­ter­est rates are a toxic mix for pub­lic fi­nance. If the gov­ern­ment was go­ing to ad­just its fis­cal strat­egy, the 2018 up­date would have been an op­por­tune time.

In this con­text, the fi­nance min­is­ter and the fed­eral gov­ern­ment laid their cards on the ta­ble. The econ­omy is strong. Us­ing the av­er­age pri­vate sec­tor fore­cast, they plan on the econ­omy re­main­ing strong through the 2019 elec­tion and be­yond. With re­spect to bud­getary pol­icy, it will be busi­ness as usual. As long as deficits and debt remain mod­est, they will con­tinue to spend to ad­dress pol­icy pri­or­i­ties. In the Novem­ber state­ment, this meant re­spond­ing to busi­ness con­cerns about the loss of a cor­po­rate tax ad­van­tage with the United States.

There is a lot at stake with the out­look and strat­egy. Get the plan­ning out­look right, and the gov­ern­ment will look smart, and con­fi­dence will build in the gov­ern­ment’s plan. Get the out­look wrong, and the gov­ern­ment could be forced to make ad hoc ad­just­ments and pol­icy re­ver­sals, un­der­min­ing con­fi­dence in the gov­ern­ment. Re­mem­ber the ex­pe­ri­ence of Prime Min­is­ter Stephen Harper and the Con­ser­va­tive gov­ern­ment in the fall of 2008 when the prime min­is­ter was forced to shut down a mi­nor­ity Par­lia­ment soon af­ter an elec­tion? Con­fi­dence can be very fickle.

The eco­nomic record of the Lib­eral gov­ern­ment is strong. In the fall of 2015, when the gov­ern­ment took power, the econ­omy was weak––real GDP was flat, the un­em­ploy­ment rate stood at 7 per cent, and em­ploy­ment was up about 130 thou­sand jobs over the pre­vi­ous year. In Novem­ber of 2018, the Fi­nance Min­is­ter could re­port that real GDP growth was up 2.5 per cent, the un­em­ploy­ment rate was down to 5.6 per cent, the low­est in 40 years and em­ploy­ment growth was up more than 200,000 over the pre­vi­ous year. This is a po­lit­i­cally win­ning eco­nomic record. While bud­getary deficits are higher than pre­dicted, they are mod­est. In a po­lit­i­cal en­vi­ron­ment, many Cana­di­ans will take a strong econ­omy and mod­est deficits rather than the op­po­site.

The eco­nomic out­look un­der­pin­ning the gov­ern­ment’s plan is a Goldilocks sce­nario. It is ef­fec­tively an un­changed out­look from Bud­get 2018 which was tabled Fe­bru­ary 27, 2018. Growth re­mains at po­ten­tial through­out the medium term. There is lit­tle move­ment in many head­line num­bers. It is sta­ble as far as the eye can see with re­spect to in­fla­tion, un­em­ploy­ment, and ex­change rates. In­ter­est rates rise ever so slightly so as not to shock a house­hold sec­tor loaded with debt.

Morneau can safely say that this is the av­er­age pri­vate sec­tor out­look. Blame them if re­al­ity bites. On the other hand, there is not much in the anal­y­sis to sug­gest how the gov­ern­ment’s fis­cal pol­icy and plan would han­dle unan­tic­i­pated events, be­yond a small con­tin­gency re­serve of $3 bil­lion a year (roughly equiv­a­lent to the new mea­sures in­tro­duced in the Up­date to help busi­nesses). This is the usual rule-of-thumb buf­fer for down­side changes to GDP and in­ter­est rates but some anal­y­sis of what more and less op­ti­mistic fore­cast­ers are say­ing would have been help­ful.

In our view, the fed­eral gov­ern­ment’s plan and po­ten­tial po­lit­i­cal for­tunes are vul­ner­a­ble to an unan­tic­i­pated neg­a­tive eco­nomic event. The cur­rent ex­pan­sion is 10 years old. While it is true that ex­pan­sions don’t die of old

age, many ob­servers of eco­nomic and po­lit­i­cal news express grow­ing anx­i­ety about the pos­si­bil­ity of a loss of busi­ness and con­sumer con­fi­dence stem­ming from a trade war be­tween the US and its ma­jor trad­ing part­ners; the build-up of global cor­po­rate debt (as high­lighted by the IMF in its re­cent Global Fi­nan­cial Sta­bil­ity Re­port); and a mis­match be­tween mone­tary and fis­cal pol­icy where ris­ing in­ter­est rates co­in­cide with the end of fis­cal stim­u­lus. Some of these con­cerns have been re­flected in re­cent volatile swings in eq­uity mar­kets. In the next re­ces­sion, Canada is par­tic­u­larly ex­posed due to high house­hold debt. The anal­y­sis un­der­pin­ning the Novem­ber up­date was largely based on “sunny ways”. There is no anal­y­sis of neg­a­tive sce­nar­ios. There is no pre­cau­tion­ary phi­los­o­phy or prin­ci­ples.

Ta­ble 1 pro­vides a bal­ance sheet per­spec­tive of the fis­cal plan pre­sented in the 2018 FES. Fed­eral bud­getary deficits hover in the $18 to $20 bil­lion range over the next few years be­fore they be­gin their grad­ual de­scent. The deficits do not go away de­spite the as­sump­tions of a strong eco­nomic out­look. In this plan­ning en­vi­ron­ment, the debt in­creases by about $80 bil­lion over the next five years (about 11 per cent). In 2019-20, a pro­jected fed­eral deficit of $19.6 bil­lion rep­re­sents less than 1 per cent of GDP. A pro­jected fed­eral debt of $707 bil­lion rep­re­sents 30.5 per cent of GDP. The deficit and debt num­bers are mod­est com­pared to other Or­gan­i­sa­tion for Eco­nomic Co­op­er­a­tion and De­vel­op­ment (OECD) coun­tries and do de­cline over the plan­ning pe­riod. A de­clin­ing fed­eral debt-to-GDP ra­tio is ef­fec­tively the only fis­cal an­chor of the gov­ern­ment. Again, in the con­text of a strong plan­ning out­look, the gov­ern­ment is bet­ting that Cana­di­ans ac­cept the trade­off of higher debt––of which the in­creased in­ter­est costs will be faced by fu­ture gen­er­a­tions––as a nec­es­sary and con­ve­nient trade-off for good eco­nomic num­bers to­day.

In many ways, the fall state­ment was more of a mini bud­get. It weighed in at a hefty 155 pages. There were some 20 mea­sures that re­sulted in ad­just­ments to the fis­cal plan­ning frame­work to­tal­ing about $17.6 bil­lion over six years, only slightly less than the $21.5 bil­lion in new mea­sures an­nounced in Bud­get 2018. In the cur­rent fis­cal en­vi­ron­ment, it is ac­cu­rate to say that all of these mea­sures are deficit-fi­nanced.

Where the gov­ern­ment found the fis­cal room for the $17.6 bil­lion is a lit­tle bit of a mys­tery for the bean coun­ters. The econ­omy, as de­fined by nom­i­nal GDP, is rel­a­tively un­changed, yet it is as­sumed in the FES that bud­getary rev­enues will in­crease close to $25 bil­lion over the next five years. For some ob­servers, this looks like ho­cus pocus, abra­cadabra, voilà! We have a source of funds for a mini bud­get with no pain (ex­cept for the next gen­er­a­tion of tax­pay­ers).

In Novem­ber of 2018, the Fi­nance Min­is­ter could re­port that real GDP growth was up 2.5 per cent, the un­em­ploy­ment rate was down to 5.6 per cent, the low­est in 40 years and em­ploy­ment growth was up more than 200,000 jobs over the pre­vi­ous year. This is a po­lit­i­cally win­ning eco­nomic record.

Em­bed­ded in the fis­cal plan­ning frame­work, as well, is an ad­di­tional

$9.5 bil­lion of “non-an­nounced mea­sures”. While it is not un­usual in the work of gov­ern­ments to set aside some monies for pro­vi­sions against con­tin­gen­cies, this is a rather large num­ber and looks to con­tain fu­ture pol­icy mea­sures. Why not wait to ad­just the fis­cal plan­ning frame­work when these mea­sures are an­nounced, so par­lia­men­tar­i­ans are bet­ter placed to judge the mer­its of a pro­posal in a broader fis­cal con­text?

Vir­tu­ally all the mea­sures pro­posed in the fall state­ment were fo­cused on the busi­ness sec­tor. The sig­na­ture ini­tia­tive (to­tal­ing $14 bil­lion over 6 years) was the im­me­di­ate ex­pens­ing for ma­chin­ery and equip­ment in the man­u­fac­tur­ing and pro­cess­ing of goods, as well as clean en­ergy equip­ment and their sup­port­ing sec­tors.

Strate­gi­cally, this was bold pol­icy and a smart po­lit­i­cal move. One year be­fore a fed­eral elec­tion, the gov­ern­ment moves to level the play­ing field on busi­ness in­vest­ment in the wake of sig­nif­i­cant tax re­duc­tions en­acted by Pres­i­dent Trump and a Repub­li­can Congress. The Lib­eral gov­ern­ment can now plan its po­lit­i­cal cam­paign for 2019 with some ap­pease­ment of the busi­ness sec­tor, and can make the claim that Canada, un­like the US, re­mains largely fis­cally sus­tain­able. How­ever, from a ci­ti­zen per­spec­tive, we also need to be re­minded that we are deficit fi­nanc­ing the cor­po­rate sec­tor.

In as­sess­ing the fis­cal di­rec­tion of a coun­try, it is of­ten help­ful to look at rev­enues and spend­ing as a share of GDP (ac­tual and pro­jected). These num­bers can some­times sep­a­rate sig­nals from the noise. Ta­ble 2 ex­am­ines changes in the fis­cal plan­ning frame­work at three junc­tures: a) 2015-16, when the gov­ern­ment took of­fice; b) 2018-19, ef­fec­tively where we are to­day; and c) 2023-24, the end­point of the medium-term plan­ning pe­riod.

Afew ob­ser­va­tions worth not­ing: 1) the in­crease in the fed­eral deficit over the past few years is re­lated to spend­ing; 2) the planned de­crease in the fed­eral deficit over the medium term is re­lated to spend­ing; and 3) rev­enues as a share of GDP are held con­stant. (Con­ser­va­tives may like to ar­gue oth­er­wise.)

This raises a fun­da­men­tal ques­tion. How much con­fi­dence can Par­lia­ment and Cana­di­ans have in the gov­ern­ment’s fis­cal plan go­ing for­ward––namely a grad­ual re­duc­tion in mod­est deficits––if the plan is based on rein­ing in the growth of spend­ing?

Specif­i­cally, the plan calls for a sig­nif­i­cant re­duc­tion in the growth of some­thing called di­rect pro­gram spend­ing (i.e.: grants and con­tri­bu­tions for pro­grams like in­fra­struc­ture and re­search and de­vel­op­ment, as well as op­er­a­tional spend­ing in­clud­ing wages, salaries, and ben­e­fits for pub­lic ser­vants.)

How­ever, this com­po­nent has contributed the most to the higher deficit in the past few years and, im­plic­itly, is key to bet­ter eco­nomic out­comes for Cana­di­ans. It is also noted that this com­po­nent of planned spend­ing is the least trans­par­ent from a plan­ning per­spec­tive. We sim­ply do not

have the de­tails to as­sess the strength of this spend­ing plan.

Economists like to de­con­struct bud­getary bal­ances to bet­ter un­der­stand the role of the econ­omy in the fis­cal frame­work. A stronger (weaker) econ­omy is more apt to pro­mote stronger (weaker) rev­enue growth and weaker (stronger) spend­ing growth, par­tic­u­larly for pro­grams like em­ploy­ment in­sur­ance. One of the car­di­nal pub­lic fi­nance rules to main­tain­ing healthy lev­els of debt is to en­cour­age gov­ern­ments to use counter-cycli­cal fis­cal poli­cies: pro­vide sup­port for a weaker econ­omy, and with­draw that sup­port when the econ­omy is strong. The lat­ter is some­times re­ferred to as tak­ing the punch bowl away from the party.

Chart 1 pro­vides the fed­eral Depart­ment of Fi­nance num­bers for the bud­getary bal­ance in ac­tual (as re­ported) and cycli­cally ad­justed bases. The Fi­nance Canada anal­y­sis in­di­cates the cur­rent bud­getary deficits are vir­tu­ally 100 per cent struc­tural in na­ture. They will not go away with­out spe­cific mea­sures to raise taxes or re­strict spend­ing.

In his­toric terms, Chart 1 il­lus­trates how the Lib­eral gov­ern­ments un­der Prime Min­is­ters Chré­tien and Martin broke the backs of struc­tural (cycli­cally ad­justed) deficits that ex­isted through­out the 1980s and early 1990s. The Con­ser­va­tive gov­ern­ment un­der Prime Min­is­ter Harper and the cur­rent gov­ern­ment un­der Prime Min­is­ter Trudeau have brought the struc­tural deficits back.

The struc­tural deficits that have ex­isted since 2007-08 are mod­est in his­tor­i­cal terms. It can also be ar­gued that the struc­tural deficits run by Prime Min­is­ter Harper in the wake of the 2008-09 global fi­nan­cial cri­sis were fis­cally pru­dent. They helped sta­bi­lize a weak and un­sta­ble econ­omy. It is more dif­fi­cult to ar­gue that the mod­est struc­tural deficits run by Prime Min­is­ter Trudeau are fis­cally pru­dent un­less you are con­vinced that the gov­ern­ment’s pol­icy agenda will strengthen the po­ten­tial GDP of Canada in a way that re­sults in younger gen­er­a­tions not mind­ing pay­ing a higher pub­lic debt in­ter­est as they get older and have less fis­cal room to ad­dress the chal­lenges of their times.

The last time we had an econ­omy as strong as the cur­rent one was in the mid- 2000s. Un­der Prime Min­is­ters Martin and Harper, the fed­eral gov­ern­ment was gen­er­at­ing bud­getary sur­pluses larger than $10 bil­lion. This com­pares to bud­getary deficits fore­cast by Fi­nance Min­is­ter Morneau of just un­der $20 bil­lion. Notwith­stand­ing the mod­est size of the fed­eral deficit, fis­cal pol­icy is very dif­fer­ent this time around.

Chart 2 pro­vides some his­tor­i­cal and planned con­text around fed­eral debt and pub­lic debt in­ter­est pay­ments. In nom­i­nal terms, it is clear that there has been a sub­stan­tial in­crease in the stock of debt since the mid 2000s, and the slope of the up­ward trend re­mains rel­a­tively steep. In­ter­est on the cost of debt has only re­cently hit an in­flec­tion point and is pro­jected to in­crease at a fast rate in the years ahead, re­flect­ing both the build-up in the stock of debt and the im­pact of ris­ing in­ter­est rates.

Gov­ern­ments will nat­u­rally want par­lia­men­tar­i­ans and cit­i­zens to fo­cus on sig­na­ture pol­icy ini­tia­tives. Chart 3 il­lus­trates the net an­nual in­creases in spend­ing on child ben­e­fits and in­fra­struc­ture. These are sub­stan­tial changes which, the gov­ern­ment ar­gues (likely with merit), will help strengthen the for­tunes of the mid­dle class. Chart 3 also il­lus­trates that the visa bill of the gov­ern­ment will grow by a larger amount. There is a cost to mod­est deficits.

Kevin Page, for­mer Par­lia­men­tary Bud­get Of­fi­cer, is Pres­i­dent and CEO of the In­sti­tute of Fis­cal Stud­ies and Democ­racy at Uni­ver­sity of Ot­tawa. (Matt) Jian Shi is an Eco­nom­ics stu­dent at the Uni­ver­sity of Ot­tawa.

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