The underlying deficit could fall to $23 billion in 2011-12 and to $17 billion in 2012-13

On Friday March 2nd, Statistics Canada released its first estimate for economic growth for the fourth quarter of 2011 and for the calendar year as a whole. 

Nominal Gross Domestic Product (GDP), a proxy for the federal government’s tax base, increased by 5.8 per cent in 2011 to almost $1.8 trillion. This was $27.7 billion higher than the estimate used in the November 2011 Economic and Fiscal Update.  

All other things remaining equal (an economist’s favorite assumption) and using the average effective tax rate from the November 2011 Update, the higher than expected outcome for GDP in 2011 could result in an additional $4 billion in federal revenues. This would imply that the deficit for 2011-12 of $27.0 billion rather than $31.0 billion forecast in the November update. 

However, in the November Update, the Minister of Finance included an “adjustment for risk to revenues” of $3 billion, implying an underlying deficit of $28 billion.  As a result, the underlying improvement resulting from the stronger outcome for GDP in 2011 is only $1 billion.

However,  the outcome for 2011-12 could be even lower than $27 billion, because the government has been overestimating an important component of its spending.

The Fiscal Monitor for the period April 2011 to December 2011 shows that “other transfer expenses” are nearly $6 billion lower than in the same period in 2010.  Yet the November 2011 Update projected “other transfers” to decline by only $1.1 billion.

Given the ending of most of the Economic Action Plan stimulus spending in 2011-12, one would have expected a significant decline in “other transfer expenses” between 2010-11 and 2011-12, much more than the $1.1 billion forecast by the Department of Finance. 

Unless the Government intends to book some unannounced liabilities at year end, the deficit outcome for 2011-12 could be as low as $23 billion or only about 1.3 % of GDP. This would be the envy of the EU.

What does this imply for the deficit for 2012-13 and beyond?

Normally when the Minister of Finance meets with the private sector economists, the average of their forecasts for GDP for the next five years is released to the public.  However, given that the economists have not had the time to fully assess the impact of the fourth quarter National Accounts and update their forecasts accordingly, no new forecasts were provided.

However, the better-than-expected economic outcome for 2011 would “carry-forward" into 2012 and beyond.  In addition, the economy advanced somewhat faster in the fourth quarter of 2011 than forecast in the November 2011 Update.  This provides a stronger “hand-off” into 2012, suggesting that GDP growth could be somewhat stronger than forecast in the November 2011 Update. 

The November Update  assumed a growth of 4.1 per cent for nominal GDP for 2012, prior to the “adjustment for risk”. Assuming a revised GDP growth of 4.5 per cent for 2012 would generate incremental revenues in 2012-13 of about $6.5 billion, prior to any adjustment for risk.  If Mr. Flaherty followed the same practice as in the November 2011 Update, he would include an “adjustment for risk to revenues” of $3 billion, reducing the impact of the stronger revenue growth to  $3.5 billion - implying a deficit of about  $24 billion rather than the November 2011 Update projection of $27.4 billion.

However, this would imply an increase in the deficit between 2011-12 and 2012-13 – from $23 billion to about $24 billion, which is unrealistic given the sustained growth in the economy and virtually no incremental costs of new policy initiatives between these two years.  The underlying improvement (after removing the “adjustment for risk to revenues) would be $3 billion between 2011-12 and 2012-13, still unexpectedly small, given the economic outlook. 

However as we have argued in the past and demonstrated above for 2011-12, we believe the “other transfer expenses” were overstated in previous budgets and updates for the period 2011-12 to 2013-14.  Thereafter, they appear to be understated.  One can only speculate as to why.  However, we hope that the Minister will present a credible outlook for “other transfer expenses” in his upcoming budget, which would then show a much larger and credible improvement in the deficit outlook between 2011-12 and 2012-13.  Based on some preliminary calculations, we believe that the underlying deficit for 2012-13 could be as low as $17 billion (assuming no “adjustment for risk).