Main Message

The federal government is not confronted with a short-term fiscal crisis but it is facing a stubborn medium-term structural deficit that will prevent you from balancing the budget by 2015-16, without new expenditure cuts and/or tax increases.

The structural deficit will subsequently grow larger as a result of slowing potential economic growth and pressures on program expenses resulting from an ageing population. It is not just the Parliamentary Budget Office (PBO) who believes there is a growing structural deficit, but the International Monetary Fund (IMF) also forecasts a structural deficit for Canada.

You may choose to put off new fiscal initiatives in the 2011 budget but you will not be able to avoid them in the 2012 budget. The current legislation with respect to federal support under the Canada Health Transfer (CHT) and Canada Social Transfer (CST) expires on March 31, 2014. New legislation will be required to authorize any payments after that date.

The decision your government, or any government, makes with respect to the Health and Social transfers to the Provinces/Territories will seriously impact the future size and policy role of the federal government.

We would, therefore, urge you to support the conclusion of the IMF to provide greater transparency and communication on the demographic challenges and to increase public awareness and debate on policy solutions. Having the Department of Finance issue a discussion paper, with the 2011 budget, updating its own analysis of demographic trends and structural deficits could do this.

BACKGROUND ANALYSIS

As you have pointed out numerous occasions, the Canadian economy has come through the recent recession in fairly good shape, especially when compared to other G-7 countries. The short-term prospects for the deficit also look good; probably better than you forecast last October in your Economic and Fiscal Update. Medium-term deficit prospects are, however, more problematic.

In your Fall Update, you set out a medium-term fiscal track in which you assumed the deficit would be eliminated in 2015-16. No doubt the 2011 budget will include a new deficit track with a small surplus still emerging in 2015-16. Most importantly, both you and the Prime Minister have said that this will be achieved without further major restraint measures.

In fact, both you and the Prime Minister have said that departmental spending will be spared major program cuts; that major transfers to the provinces/territories and individuals will be protected, as will be spending on research and health; and that taxes will not be increased. In other words, any major budget decisions will be postponed or put "on-hold" until after an election. You might do a few small initiatives, but for the most part, you will continue to rely on favorable economic assumptions and "unexplained adjustments" to balance the budget.

This complacency and your repetitive self-congratulations are misplaced.

Instead of putting budget planning "on-hold", the government should be taking stock of future economic and fiscal challenges and developing an appropriate policy response. The future is unlikely to turn out the way you would like and major policy challenges are rapidly approaching. It doesn't take long for the medium term to become the short term.

In the fall of 2006, you released Advantage Canada: Building a Strong Economy for Canadians. However, this document failed to address, or even acknowledge, the long-term problems associated with the ageing of the population. It has also been overtaken by international developments. It needs to be updated.It was replaced by Canada's Economic Action Plan in 2009, but the "Plan" is basically a two-year stimulus program aimed at mitigating the adverse impacts of the recession on economic growth and employment.

The Prime Minster has said that the upcoming budget will focus on the next phase of Canada's Economic Action Plan. What does this mean? Does it mean a medium-term strategy or just another two years of short-term planning? Are there particular economic and fiscal challenges that you and the Prime Minister believe the next Phase of the Economic Action Plan will have to deal with? How will Canadians be impacted by decisions the government will take? How will the provinces be affected?

The economy is slowly emerging from a recession, but potential economic growth is slowing and there is a structural imbalance between program expenses and revenues. This would be a good time for your government to advise Canadians on what it sees as the economic and fiscal challenges facing the country.

Canada's Medium-term Fiscal Prospects

In your October 2010 Update, you forecast a significant decline in the deficit in both 2010-11 and 2011-12, primarily due to ending of the two-year stimulus funding and the booking of a number of one-time accrual liabilities in 2009-10, which inflated the deficit in that year (Table 1). The deficit continues in decline after 2011-12, primarily due to the expectation of sustained economic growth, growing surpluses in the Employment Insurance Account ($4 billion in 2014-15 and $5.0 billion in 2015-16), as current legislation requires that premium rates be kept high to compensate for previous years' deficits in the Account, and the impact of the Budget 2010 expenditure reductions. This is dampened somewhat by the legislated reductions in the general corporate income tax rate. By 2015-16, you are forecasting a small surplus.

How realistic is this deficit track? As argued in an earlier piece (Deficit Outcome for 2010-11 will be $7 billion lower than forecast in October 2010 Update – December 2010: www.3dpolicy.ca), we expect that the deficit in 2010-11 will be at least $7 billion lower than forecast in the October 2010 Update, based on the financial results to the end of October 2010 and an analysis of the impact of one-time accrual liabilities which inflated the 2009-10 deficit outcome. Whether this actually materializes will largely depend upon what liabilities you may be planning to book in 2010-11. There is speculation that the government is considering paying $2.2 billion to compensate Quebec for harmonizing its sales tax with the Goods and Services Tax or introducing a heating rebate, which would be "booked" in 2010-11...

In the absence of such bookings, we would expect that the deficit for 2010-11 would be around $38.5 billion. At this time, it is unclear whether some of this would be carried forward.

There are also a number of other adjustments that we feel are necessary to make your October 2010 forecast credible. First, we previously questioned your calculation of the fiscal impact of the reductions to the employment insurance premium rates and feel that they were overstated (How Credible is the October 2010 Fall Economic and Fiscal Update? October 2010: www.3dpolicy.ca). Your forecast for "other revenues" also appears optimistic. This component can be very volatile from year-to-year due to special transactions (asset sales, royalty payments to Newfoundland and Labrador and Nova Scotia, exchange fluctuations, etc.), which are extremely difficult to forecast. The Office of the Parliamentary Budget Officer (PBO) raised the same concern in its update[1].

Second, the October 2010 Update reduced "direct program expenses" in 2012-13 and beyond from that forecast in the March 2010 Budget, without providing any explanation. This results in what we believe is an unrealistic profile for "direct program expenses" in those years. The PBO also questioned your profile for direct program expenses.

Third, in the March 2010 Budget, you announced a number of measures to reduce administrative costs. However, ask the Chief Financial Officer in any department/agency and they will tell you that they are always looking for administrative savings to reallocate to meet other priorities, such that additional savings will be difficult to achieve. In addition, as departments are not permitted to exceed their Parliamentary appropriations, they usually spend less than what they are appropriated. With departments required to find these administrative savings, they will now be forced to operate closer to their appropriations.

However, in setting the expenditure track for a budget, the Department of Finance would take into account that departments will not be spending all of their appropriations, through what is known as the "lapse" adjustment. The required administrative savings will, therefore, result in an offsetting reduction in the lapse adjustment, which the Department of Finance did not take into account in Budget 2010. We have reduced the lapse accordingly. We do not believe that these administrative savings will result in any significant net savings for the deficit, as claimed in the 2010 Budget.

Finally, we have adjusted public debt charges to account for the net impact of these changes.

As a result, we expect a higher deficit profile over the 2012-13 to 2015-16 period than in your October forecast. Rather than a small surplus in 2015-16, we expect a deficit of $8.0 billion.

How realistic are our deficit projections? Both the PBO and the International Monetary Fund (IMF)[2] forecast that the federal government would still be in deficit in 2015-16, by $11.0 billion and $5.4 billion, respectively.

What conclusions can we draw from these projections?

First, under current policies, and in the absence of more favorable economic assumptions, it is highly unlikely that the deficit will be eliminated by 2015-16. Nevertheless, the government is not confronted with an immediate fiscal crisis as in the early 1990s.

The deficit this year will likely be less than 3 % of GDP and by 2015-16 less than 1 % of GDP (Table 2). In addition, the federal debt-to-GDP ratio declines steadily after 2011-12 to just over 30 %. By both historical and international standards, these are very low numbers. Your colleagues in the G-7 will be extremely envious of the fiscal situation that you are confronted with.

Second, the deficits posted over the 2008-09 to 2015-16 period will add about $200 billion to the federal government's debt, nearly doubling the reduction recorded over the 1997-98 to 2007-08 period ($104.7 billion). In absolute terms, the deficit will be at an all time record high, thereby exposing the federal government to interest rate fluctuations. Your goal of reducing the debt-to-GDP ratio to 25% has been pushed off into the future.

In the last two budgets, you have presented five-year economic and fiscal projections. We recommend that you continue that practice rather than reverting back to two-year budget plans. As we have argued before (Time to Make the Budget Planning Process More Accountable, Transparent and Prudent – November 2010 www.3dpolicy.ca), we would strongly recommend that you use the Department of Finance's economic forecast rather than average of private sector forecasts, arguing that the Department's economic forecasts provide the most accurate basis for budget forecasting. Even you implicitly acknowledge this by lowering the average private sector forecast for nominal domestic income growth, presumably on the advice of your Department.

You would be much better served by relying on your Department's analysis and forecasts. This would not preclude you from asking private sector economists for advice and justifying the Department's projections with those of the private sector economists. In addition, as recommended by the PBO, the Department should be much more transparent and publish the details of its economic projections so that a proper assessment can be undertaken.

The Bank of Canada updates and explains its economic forecasts on a quarterly basis. It is high time that you took responsibility for your forecasts rather than hiding behind private sector forecasts.

In addition, we would recommend that you set an additional fiscal target over which you have control. As clearly demonstrated by developments of the last two years, you do not have control over budgetary revenues, cyclically sensitive spending, such as unemployment insurance benefits, and public debt charges. Therefore, you have little control over fiscal targets such as the annual budgetary balance and debt. Your anchor of eliminating total government sector net debt relied heavily on growing surpluses in the Canada and Quebec Pension Plans (which will not continue as the baby-boomers retire). You might want to consider setting upper limits on program spending, as the Mulroney government did in 1991.

The Organization for Economic Cooperation and Development (OECD) argues that, although not without its problems, expenditure rules are less sensitive to economic cycles and more transparent[3]. It also strongly argues for an independent fiscal council to provide independent short-term and long-term economic and fiscal projections and to identify underlying and more ephemeral elements of the budget position.

Should the Government be Concerned about a Structural Deficit?

An important question that emerges from a review of the medium-term projections is why does it take so long for the deficit to be eliminated? It is hard to find empirical evidence that shows that economic growth by itself has eliminated deficits. Deficits normally have a structural component, sometimes small, sometimes large. In fact, the deficits throughout the period from the late 1970s to early 1990s were largely the result of structural imbalances between revenues and expenses. Expenditure cuts and tax increases were required to restore the fiscal balance. Structural reforms by the Mulroney government and primarily spending cuts by the Chretien government eventually eliminated the structural deficit.

Unfortunately, a structural deficit has re-emerged because the tax cuts of the last ten years were not matched by restraining the growth in program expenses.

We raised the issue of a structural deficit in our budget submission to you last year. The medium-term deficit projections of both the Office of the Parliamentary Budget Officer (PBO) and the International Monetary Fund (IMF) include a structural deficit component. You have rejected the PBO analysis of a structural deficit and criticized the PBO projections as lacking credibility. But you have not applied the same criticism to the IMF.

The calculation of structural deficits is extremely sensitive to the methodology and assumptions used. Nevertheless, both the PBO and the IMF deficit projections contain fairly sizeable structural components, of about 1 % of GDP, until about 2014-15. About 70-80% of the deficit in 2013-14 is structural. The reason it is taking so long to eliminate the deficit is that economic growth is not strong enough to offset a rather large and constant structural deficit. It is important to understand that the elimination of the deficit does not mean there is no structural deficit. It simply means that the economy must generate a sufficiently large cyclical surplus to offset the structural deficit and still reduce the overall deficit.

Departments have spent the past year trying to find ways to meet the 2010 Budget commitment to savings without cutting programs. We hope that you will announce some credible actions to meet your 2010 budget commitments. An analysis of Departmental Strategic Reviews in the last budget demonstrated that the savings identified were clearly not credible. Your budget should include detailed plans for each of the Departments reviewed. However, we are not optimistic that this will happen given the latest report of the PBO. Nor do we expect that your restraint measures will lead to the net savings that you included in the 2010 budget, for the reasons given above.

In the absence of tax increases, the government will not be able to achieve its goal of a balanced budget by 2015-16 without major cuts in direct program expenses and the elimination of "boutique" tax expenditures in the order of $8 to $11 billion by 2015-16. Some might argue that a deficit of this size is small and inconsequential. However, Canadians want a balanced budget and you have staked your government's "conservative credibility" on achieving one.

Protecting major transfers to persons, spending on health and education and other spending such as that for Aboriginal programs, research and development, and assuming you won't revisit defense and international assistance, then to find an additional $8 to $11 billion by 2015-16 would require major cuts in labor market programs, spending on the homeless, infrastructure programs, and last, but certainly not least, government personnel costs. Changing economic assumptions to eliminate the deficit would not be justified based on both domestic and international developments.

No one would be surprised if you didn't make additional spending cuts. The fact is your government has not made any tough budget decisions since being first elected. Instead, program expenses have increased significantly and taxes have been cut significantly.

You might be persuaded to avoid tough decisions by the fact that both the PBO and IMF projections show the structural deficit declining. Maybe it will continue to decline after 2015-16 and just go away on its own. Or will demographic pressures exert upward pressures on federal program expenses, while at the same time exerting downward pressures on potential economic growth and tax revenues?

We have attempted to answer this question by extrapolating the fiscal projections for 2015-16 to 2025-26, based on projections of potential economic growth, consistent with IMF/OECD projections, historical relationships and expected trends (Table 5). The OECD[4] calculates that for Canada, potential economic growth is forecast to decelerate from an annual growth of 2.9 per cent over the 2000-2007 period, to 1.6 per cent over the 2015-2025 period. The resulting budget calculations can be used to provide a reasonable indicator of the trend in the structural balance and a "rough estimate" of its size.

Budgetary revenues as a share of GDP are projected to decline from 14.8 per cent in 2015-16 to 14.4 per cent in 2025-26, as higher personal income taxes, resulting from the progressivity of the tax system, are more than offset by stability or declines in the other taxes.

Total program expenses as a share of GDP, however, are projected to decline from 13.3 per cent in 2015-16, to 13.0 percent in 2020-21, before barely increasing over the next 5 years. Major transfers to persons, as a share of GDP, are projected to increase, reflecting the ageing of the population.

Major transfers to other levels of government are also projected to increase as a share of GDP, assuming that the current financing arrangements (CHT growing at 6% per year and the CST growing at 3% per year) remain in place. In contrast, direct program expenses are expected to decline assuming, that the government is successful in restraining the growth to less than the growth in nominal GDP. The public debt charges ratio is expected to increase, attributable to the impact of higher interest rates and an increase in the stock of debt.

This trend analysis of the budget reveals three important facts about the government's long-term finances. First, the structural deficit will continue after 2015-16, increasing slowly from $8 billion (0.4 per cent of GDP) to $11.0 billion in 2020-21 (0.4 per cent of GDP), and then doubling to $22.0 billion in 2025-26 (0.8 per cent of GDP). In other words, abstracting from cyclical downturns, the structural deficit, although initially small, should increase steadily over the longer term.

Second, the debt burden of the government will continue to decline over the coming decade, barring any unforeseen economic disruptions. We are sure you realize that without a significant cut to expenses, it would not be possible to stabilize the debt/GDP ratio at your target of 25 %.

Third, the influence of the federal government on the economy will continue to decline, relative to the size of the economy, notwithstanding the continuing growth in transfers to the provinces. As a share of GDP, program expenses declined from 18.7% in 1984-85 to a low of 12.1% in 1999-2000. It increased to 16.0% in 2009-10, primarily due to the impact of the stimulus measures in the Economic Action Plan and the booking of one-time liabilities. If these are excluded the ratio would be 14.3%. It is projected to decline after that to just over 13% in 2015-16, over 5-percentage points lower than in 1984-85, provided you are successful in restraining the growth in government operations. It remains at that level for the next five years. Reducing the size of the federal government has been part of your government's mandate since coming into office. You may, therefore, find these trends encouraging.

Budgetary revenues increased from 16.0% of GDP in 1984-85 to 18.0% in 1999-2000 but since then have fallen almost continuously to 14.3% in 2009-10. Thereafter, they are expected to remain relatively stable. Public debt charges have fall by more than half since 1984-85.

Trend analysis, such as this, needs to be interpreted very carefully. But the analysis can provide a reasonable guide to the underlying direction of key variables, although specific estimates can be sensitive to different assumptions. We doubt, however, that our general conclusions would change.

Not all structural deficits are bad. Structural deficits that result from public investments that yield future benefits can be justified. However, there is little evidence to suggest that this is the case currently. We believe that action should be taken to eliminate this structural deficit, not only because it is unfair to future generations, but also because it would reduce the exposure of the budget to interest rate shocks and provide greater short-term policy flexibility. This is consistent with the views of the IMF, an institution you strongly support, which "noted the significant risks to long-term fiscal sustainability from the budgetary impact of the population ageing and health-care inflation."[5]

We agree with the IMF that it would be best to take action earlier rather than later in view of "the impending long-term costs of aging and healthcare costs."[6] Unfortunately, and somewhat surprisingly for a "fiscal conservative", you have been reluctant in the past to take tough budget decisions. Fortunately, there is one policy decision you will not be able to postpone beyond 2013-14.

What to Do About Major Transfer to the Provinces/Territories in 2013-14?

The current legislation with respect to federal support under the Canada Health Transfer (CHT) and Canada Social Transfer (CST) expires on March 31, 2014. New legislation will be required to authorize any payments after that date.

What are the options available to the federal government, especially when the government is confronted with a structural deficit that not only refuses to go away, but also is likely to get larger?

You have already indicated that the provinces should not count on these transfers and you have highlighted the need to clarify the roles and responsibilities between federal and provincial governments. What does this mean for these transfers, and what are the implications for Equalization, and for federal and provincial taxes. It will be impossible to escape these questions when reaching new agreements on CHT and CST transfers to the provinces.

Your statements suggest that your preferred option would be to cut the growth of CHT and CST transfers by an amount that would reduce federal program expenses enough to reduce or even eliminate any structural imbalance. This "downloading" onto the provinces would be justified since health is a provincial responsibility. But it does raise some very difficult policy questions that you need to consider.

First, how much would the federal government save by cutting transfers? Reducing the growth rates of these programs by one percentage (from 6% to 5% for the CHT and 3% to 2% for the CST would save the federal government an incremental $425 million per year. In 2025-26, you would save over $8.5 billion, but this would eliminate only about a third of the structural deficit. To eliminate the structural deficit would require that the CHT be cut to 4% and that CST be frozen at it 2014-15 level

Second, do the provinces have the capacity to deal with the additional financial burden that would result from downloading? The provinces are already facing a more serious medium and longer-term financial situation than the federal government. Why would you want to make it worse?

Earlier analytical studies[7] by the Department of Finance indicated that the ageing of the population would have a much more adverse impact on the provinces than the federal government. We would strongly recommend that these studies be updated and made public.

A recent TD study[8] concluded that a major challenge for all governments would be to constrain program expense growth to 2.5% per year or less over the medium term. Given the proportion of total provincial spending directed towards health care, this will be a major challenge for all the provinces, not only over the medium term, but also especially over the long term, with the ageing of the population.

Third, even though you cut the GST by two points, the provinces will demand more tax room. Would you agree, given it would mean loosing revenues thereby leaving the federal government with continuing structural deficit problem?

If you were to agree with the provinces demands, how would you provide the tax room? What taxes would you reduce that the provinces could increase? How would the impact vary among provinces? How would individual Canadians be impacted by lower federal taxes offset by higher provincial taxes?

Fourth, transfers are paid to the provinces on a per capita basis but the ability of a province to replace the transfer income varies considerably depending on their economic capacity to raise offsetting revenues. This may not be a problem for the "Have" provinces, but it will be a problem for the "Have-nots. This would mean reopening the Equalization formula or by providing special provincial offsets.

Finally, would the federal government be able to provide any leadership in how health care is delivered in Canada? What moral authority would you have?

Perhaps there is a simpler way, which could avoid most of these difficult issues? Why not continue to allow transfers to increase as before and eliminate the structural deficit by increasing the GST by 2 points? This would raise $14 billion by 2020-21 and completely eliminate the structural deficit. It would almost completely offset the structural deficit by 2025-26. In other words, why not have the government raise the GST to cover its contribution to health and social spending, and let the provinces deal with the serious budget problems they already have.

Your answer would probably include some of the following;

• You don't agree with any of the above argumentation; there is no structural deficit problem;
• Our analysis, and that of many other economists, is nonsense, which is the typically response you have given in response to PBO's research even though it is supported by other reputable organizations;
• Your government is committed to reducing the size and role of the federal government in the economy; and, that means
• Your government will only cut program expenses and never raise taxes, no matter what the consequences.

The Need for Greater Transparency, Communication and Public Discussion

The decision you, or any government, will take with respect to the CHT and CST will set the course of the federal government and federal/provincial relations for many years to follow. Is it not possible to engage Canadians in this debate before a final decision is taken? In the past you have supported the analysis and recommendations of the IMF, and quite rightly so. We would strongly recommend that you support the IMF conclusion in its recent report on " the importance of increasing transparency and communication about these challenges (demographic) and their long-run implications, (and) to increase public awareness and contribute to a debate about possible solutions"[9].

[1] "Economic and Fiscal assessment, 2010",Office of the Parliamentary Budget Officer, November 3, 2010.

[2] International monetary Fund: Canada Staff Report for 2010 Article IV Consultations – Supplementary Information. December 2010

[3] "Fiscal Consolidation: Requirements, Timing, Instruments and Institutional Arrangements: OECD Economic Outlook Volume 2010/2.

[4] Ibid

[5] International Monetary Fund; Canada Staff Report for 2010 Article IV Consultation, December, 2010

[6] Ibid.

[7] "Public Implications of Aging Population" Department of Finance Working Papers – P King and H. Jackson 2000-08

[8] Snapshot of Federal and Provincial Fiscal Positions: TD Economics December 17, 2010.

[9] International Monetary Fund; Canada Staff Report for the 2010 Article IV Consultations".