TOUGH BUDGET DECISIONS LIE AHEAD
Public consultations for the 2017 federal Budget, scheduled for before the end of March, are well underway. The House of Commons Standing Committee on Finance began its hearings in September, with its report expected before the House winter break. Finance Minister Bill Morneau has also launched his own consultations, primarily through town hall meetings and on-line submissions. The Finance Minister has also created an Advisory Council on Economic Growth to provide policy recommendations that would strengthen stronger long-term economic growth – the same issues being examined by the Finance Committee.
Both Liberal and Conservative governments have used pre-budget consultations for years. They are seen as good politics, even if they don’t accomplish much. They give the impression that Parliament and the Government are listening to Canadians and give them hope that some of their suggestions may find their way into the budget. Unfortunately, history suggests otherwise. The chances of this happening are very low. Normally budget planning is well underway by September and most major budget decisions have already been made by December.
What are some of the key questions for the Finance Minister as he prepares for his Fall Update and his 2017 budget?
First, have the short- and medium-term economic prospects worsened significantly since last March? The Finance Minister recently met with his private sector economists to review the economic planning assumptions to be used in his upcoming Economic and Fiscal Update (November 1). What we know so far is that many of these economists, along with the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD), have all revised down their economic forecasts for Canada for 2016 and the next five years. Although the main reason for this is a continuing worsening in the global economy, this will be of little consolation to the Finance Minister.
The second key question for the Finance Minister is by how much has the deficit forecast worsened, as a result of this lower expected economic growth? In his 2016 Budget, Mr. Morneau included, what most financial commentators called, excessive economic prudence in his budget forecasts. In the budget, nominal gross domestic product (GDP) was reduced by $40 billion annually throughout the forecast period, implying a fiscal prudence factor of $6 billion per year, twice the normal amount of prudence.
Although private sector economists, the OECD and the IMF have lowered their growth prospects for 2016 from what they were forecasting at the time of the March 2016 Budget, their current forecast for nominal GDP in 2016 is still about $20 to $30 billion higher than the March 2016 Budget planning assumption. As a result, there is a strong possibility that the fiscal prudence of $6 billion included in the 2016-17 deficit forecast will not be needed.
In addition, the recently released Annual Financial Report showed a final deficit outcome for 2015-16 $4.5 billion lower than estimated in the March 2016 Budget, primarily due to higher-than-expected personal and corporate income tax revenues. Some of this better-than-expected revenue outcome will likely be carried forward to 2016-17 and beyond.
On Monday the Parliamentary Budget Officer (PBO) released his latest Economic and Fiscal Outlook. He is now forecasting a deficit of $22.4 billion for 2016-1, $7 billion lower than that forecast in the March 2016 Budget. Thereafter, he is forecasting deficits $4 to $5 billion lower than the Budget forecast for each year to 2020-21. However, the PBO forecast does not include any allowance for prudence, arguing that the risks to PBO’s economic forecast are balanced.
The Budget forecast includes a prudence factor of $6 billion per year, given the uncertainties associated with economic and fiscal forecasting. On a comparable basis (adjusting the PBO forecast to include a $6 billion prudence factor per year), the PBO forecast is only a $1 billion lower in 2016-17 but higher each year thereafter.
It is expected that, in the upcoming Update, the deficit for 2016-17 will be lower than that forecast in the Budget, but that it will be higher in each year thereafter. Most private sector economists have also lowered their growth prospects over the medium term, to below that used in the March 2016 Budget. This will inevitably eat up some, if not most, of the economic prudence and put the deficit targets for 2017-18 and beyond at risk.
The updated economic and fiscal developments raise two important questions for the Finance Minister as he prepares his Update and his 2017 budget. First, should he maintain a six billion dollar prudence reserve in his November Update and his budget forecast? It would appear that the Minister was right to include a larger than normal prudence reserve in his first budget and we would recommend he continue to do so.
The second question for the Finance Minister, is where can he find new sources of funds to finance the government’s election promises, while at the same time maintaining his commitment to a stable or declining debt ratio?
For the first two years, the fiscal cost of the election promises in the March 2016 Budget corresponds closely to what was outlined in the 2015 election campaign. However, budget commitments relating to health care, (specifically the election promise for funding for home care), and for expanding employment insurance benefits and providing employment opportunities for young Canadians fall signicantly short of what was promised in the election. . Fulfilling these election commitments would cost an additional $1.5 billion annually.
In addition, the election platform promised a review of Canada’s international assistance policy framework, but no funding was provided in the budget for the outcome of this review. Finally the Finance Minister has to deliver both a credible growth strategy and a credible innovation strategy in his upcoming budget. Although these strategies could be partially funded through expenditure and tax reallocations (e.g., eliminate the Scientific Research and Development Tax Credit) they are still likely to have some impact on the bottom line.
Mr. Morneau finds himself in the same position as all his predecessors. He is confronted with a worsening economic and fiscal situation, not just for this year, but also for the foreseeable future, and he has a Cabinet that wants to spend more, while he has little in the way of any new sources of funds.
He could raise the GST, but the Prime Minister has ruled that out; he could fulfill an election commitment by undertaking a serious simplification of the income tax system, which could yield substantial revenues (about $3 to $5 billion), but he seems reluctant to do that; or, he could take the easy way out and simply cut his fiscal prudence in half and “miraculously” free up $3billion annually for his cabinet colleagues.
Mr. Morneau has never indicated what the $6 billion fiscal prudence reserve could be used for. Was he simply putting money aside in his first budget for future spending? Previous governments stated that the reserve should not be used to fund new policy initiatives. If not needed to offset the adverse impacts of changes in the economic environment on the deficit outlook and/or translating the economic forecast into the fiscal forecast, the unused prudence reserve would be directed to reduce the federal debt. Mr. Morneau, for his own credibility, should make this same commitment in his November Update.
The Government was able to convince Canadians in the election that making new investments and going into deficit was the right thing to do in an environment of weak economic growth. This was widely accepted in the government’s first budget. However, strong fiscal commitments were also made in the budget and the government might face a backlash if the upcoming budget were to show rising deficits and a growing debt-to-GDP ratio.
In the coming months, the most important pre-budget consultation for Mr. Morneau will be with the Prime Minister and his Cabinet colleagues. This has always been the challenge for Finance Ministers, as they prepare their budgets. Mr. Morneau must convince his colleagues that not only has he no fiscal room to spare, but that they will have to make difficult policy trade-offs in the coming years.