Dear Minister Flaherty:  

You have recently asked Canadians to provide you with their priorities for the 2012 Budget. In this open letter, we are submitting our recommendations for a new strategy to guide your budget planning.

 You have asked for suggestions on how the Government could “better promote job creation and economic growth” and “what should Canada’s priorities be for the short-and long-term to encourage private sector growth and leadership in the economy”. These are the right questions to ask. How you answer them will be critical in determining the future performance of the Canadian economy.  

We believe that the right answers to them will require that the Government adopt a new approach to budget planning. Tinkering with “Canada’s Economic Action Plan” (EAP) will not be enough. The EAP helped provide temporary short-term stimulus to the economy during the recession.  Although there are still uncertainties and risks to short-term growth that will need to be addressed, we believe that the primary focus of your budget planning must now shift to the medium- and longer-term. 

Controlling the accumulation of debt must, of course, continue to be central to your budget planning. But it will not be enough. A sustainable medium-term fiscal structure, one characterized by a stable or declining debt-to-DP ratio, will require a strengthening in the underlying growth potential of the economy. This will necessitate fundamental changes to the Government’s fiscal structure (spending and taxes), so that it can better contribute to supporting savings and investment, creating new technologies, encouraging innovation, and to modernizing Canada’s infrastructure.   

We fully appreciate that the underlying objective of your government is to reduce the size and role of the federal government in the economy. We do not agree with this goal. Nevertheless, we do believe that federal government can do more than it is currently doing to strengthen the underlying growth and job creation capacity of the economy, regardless of the size of the government.  

Our recommendations are aimed at this objective. But our recommendations are not meant just for the 2012 budget. They are meant to guide you in planning a consistent budget strategy to be implemented in the 2012 budget and in the budgets beyond.  

Mr. Flaherty, you have recently referred to the need for politicians in Europe “to show political leadership and courage” to solve the EURO area’s problems.  

Although Canada is not in a fiscal crisis, the federal government, nevertheless, does face policy challenges that will require that you also show political “leadership and courage” to address them. You will need to put ideology aside. You will need to reverse some past budget decisions. You will need to confront entrenched economic interests and do what is right for the economy. You will need to become more transparent and accountable, and you will need to make Canadians part of the policy development process.

 

Your Budget Strategy should be based on a Realistic Assessment of the Economic Prospects for the Global Economy and the Canadian Economy.

 

The global economy is still struggling to recover from the 2009-10 recession and it will likely take years for the recovery to happen. The reality that you must reflect in your budget planning is that the coming decade will be one of slowing and uncertain global economic growth. 

In its September World Economic Outlook, the International Monetary Fund (IMF) provided a somber warning about how fragile global economic prospects are. 

“The global economy is in a dangerous position. Global activity has weakened and become more uneven, confidence has fallen sharply recently, and downside risks are growing.”[1]

 The IMF forecast that advanced economies would grow at an “anemic pace of 1.5 % in 2011 and 2 % in 2012”.[2] But even this depended on three critical assumptions: first, that the EURO crisis could be contained; second, that U.S. policy makers would come to an agreement on how to balance support for the economy in the short run with the need for medium-term fiscal consolidation; and lastly, that there be no worsening in volatility in global financial markets. 

If these assumptions prove to be wrong, and there is a very high probability that they will, the IMF concludes that the EURO area and the U.S. would fall into a recession, and the “damage to other countries could be significant”.[3] Obviously this includes Canada. You have already stated this in public so why not plan your budget strategy on the basis that these assumptions are not valid?  

Failure of the EURO countries to grasp the seriousness and urgency of the problems facing the EURO and complete lack of a coordinated policy response has eliminated any confidence that bond markets might have in EURO leadership. The necessary conditions for a stable common currency still do not exist and it will take years for them to come into existence even under the most favorable conditions. 

The reality is that there is more than a sovereign debt and banking crisis threatening the EURO. There is also a widening gap in internal and external competiveness, which is undermining economic growth and driving a growing wedge between strong and weak countries. Ireland, Greece, Portugal, Italy and Spain need more than simply tough budget actions; they also need renewed economic growth if they are to eventually achieve a sustainable debt framework. 

This is not going to happen soon or without major internal adjustments. Unfortunately, their economies remain stagnant and the prospects for recovery are remote. Domestic demand is weak if not non-existent and these economies are facing current account deficits. The only way to reverse this would be through major domestic deflation to bring prices and wages in labor costs into line with those of stronger economies.  This will be extremely difficult and will no doubt lead to major political, economic, and social disruptions. 

Political dynamics in the EU do not support an early or easy resolution to the EURO crisis. 

In the U.S. the deficit and debt situations are also rather grim. 

The U.S. is now beginning a decade of slowing potential growth. The data now show that there has been little recovery from the “great recession”.  Unemployment remains stubbornly high, homeowners are still under water, income disparities are growing, investment in infrastructure is being postponed, and educational institutions are being starved of funds. 

People are looking for leadership from the Administration and Congress, but neither has been forthcoming. 

The U.S. has both a short-term problem of too little demand and a long-term problem of too much debt.  The U.S. economy is basically stagnant and the recent agreement on the deficit will make it worse in the short term and most likely even in the longer term. 

Economists and financial experts have been warning that the U.S. government’s fiscal situation is out of control and that without major fiscal action, including the raising of taxes, the debt and the debt burden will continue to rise. 

Unfortunately, politics and political institutions in the U.S. have become so paralyzed with divisiveness that the Administration and Congress are incapable of dealing with the country’s economic and financial problems. With the Presidential election in 2012 there will be no major policy decisions until 2013 at best.  

The U.S economy has never recovered from the meltdown of the financial sector and now the average American household is being asked to shoulder the burden of adjustment, through budget cuts, higher unemployment, and the prospect of a decade of lost opportunity. 

Although the prospects of emerging and developing markets remains good with growth of about 6% annually, these prospects would be substantially undermined if the EU and U.S. go into recession. Commodity prices and trade flows would decline abruptly, as would economic growth. 

How will Canada fare in this uncertain and volatile global environment?  Much will depend on what you decide to do. 

It is true, as you have claimed on so many occasions, that the Canadian economy came through the recession better than other G-7 countries. It is also true, however, that Canada did not fare as well as other countries of comparable size to Canada (e.g., Australia, Sweden, and Norway). The G-7 countries provide such a low benchmark that nearly all other advanced countries have done better than the G-7. It is time to stop looking in the rear view mirror especially, if you want to avoid future problems. 

Canada is also facing serious economic challenges, in the short term, the medium term, and the longer term, that will constrain economic growth and the ability of the government to maintain a sustainable fiscal structure.  In the short term, domestic developments will almost certainly impact negatively on the Canadian economy.  Households are overburdened with debt, businesses are not investing, despite record profits, because of the global and domestic uncertainties, and all levels of governments are curtailing their spending and thereby acting as a drag on growth. The private sector has failed to step in to support the recovery as the stimulus has been removed. You will need a very credible budget strategy if you want to get the private sector to start using their growing liquidity balances to strengthen growth. 

Coupled with a slowing export market, it is not surprising that forecasts of Canadian growth have been reduced by International Institutions, such as the OECD and the IMF, and even by the economic forecasters that the Department of Finance consults. There is nothing but significant downside risks on the horizon. 

There will also be a slowing in Canada’s potential economic growth in the coming years, in part because of demographic factors and in part because of Canada’s continuing poor productivity performance.  

This is the international and domestic context in which you must plan your budgets for the next several years. There is great uncertainty and all risks are substantial and on the downside. Your 2011 budget recognized this uncertainty by including a risk adjustment factor. The risks and uncertainties, both globally and domestically, have increased in the past few months. We believe that the risk adjustment factor should be increased, not just in the short term but in the medium term as well. In your current budget framework, the risk adjustment factor declines in the outer years even though the risks to the forecast are much greater. This should be corrected.

 

Your Budget Strategy should introduce Greater Transparency and Accountability.

 

As we have argued on several occasions, it is time for the Government to use its own economic forecast for budget planning and not the average of the private sector economic forecasts. Why do you continue to refuse to accept the fact that the Department of Finance has a better-forecast record than any of the 14 private sector forecasters that you consult? We understand the political attraction of being able to hide behind the private sector forecasters, but wouldn’t it be even better politically to get the forecast right?  

The government should be more transparent in, and accountable for, the economic projections and not hide behind those of private sector forecasters. The latter should be compared to the Department’s projections and major differences should be explained.  Details on the economic projections should be published in the budget papers, rather than just highly aggregate numbers.   

Furthermore, in the past both Conservative and Liberal governments published detailed policy papers outlining the major economic, social and fiscal challenges facing the nation.  These papers formed the basis for public discussions and policy initiatives. Ministers of Finance presented their Economic and Fall Updates to the House of Commons Standing Committee on Finance, explaining the economic and fiscal situations as a basis for pre-budget consultations. Senior Finance officials regularly appeared before the House of Commons and Senate Committees to explain the details of fiscal policy. Economists in the Department of Finance were encouraged to publish their analysis and attend domestic and international conferences to present and debate their work.  

None of this has continued since you became Minister of Finance.  Information previously published is now treated as part of “Cabinet Confidence”.  Your Fall Economic and Fiscal Update is presented outside of Parliament. In a year-end assessment, a highly respected panel of Ottawa watchers could not identify a photograph of the Deputy Minister of Finance.  This is unfortunate and surprising given that your Government was originally elected on a commitment to improve both transparency and accountability. You established the Parliamentary Budget Office (PBO) to provide independent analysis on the budget and spending.  But you have dismissed the analysis coming from this office, refusing to engage in a debate on its studies. Today, the Bank of Canada is the most transparent policy agency within the Government.  It is time that you, as Minister of Finance, and your Department became just as transparent and accountable.

 

The upcoming budget should include a discussion paper on the long-term challenges facing Canada and potential policy prescriptions to deal with the upcoming pressures. The analysis should not be restricted to the challenges facing the federal government, but should also contain an assessment of the fiscal sustainability of the provincial governments.   

In the past, the PBO, the IMF and we have argued that the federal government faced a structural deficit and that this structural deficit would rise rapidly after 2015 due to demographic pressures on potential economic growth and health- and pension-related spending.  

Your recent decision to tie the growth of health transfers to GDP growth after 2016-17 indicates that you now recognize that there is a structural component that needs to be confronted. This unilateral decision, without any prior discussion with the provinces and Canadians, will go along way to eliminating the structural deficit of the federal government.  However, this will be achieved by simply shifting the structural deficit problem to provincial governments. Canada “Incorporated” will be no better off by this decision. Provincial governments will now have to find additional ways to deal with pressures on health spending by further cutting their program spending, raising taxes, or going into debt. As there is only one taxpayer, Canadians should be aware of this. 

There is only one major federal program left, which, over time, will grow faster than the growth in nominal Gross Domestic Product and that is elderly benefits, Old Age Security (OAS) and the Guaranteed Income Supplement. The recent Actuarial Report from the Office of the Superintendent of Financial Institutions clearly indicates that this will be a major pressure on federal finances over the long term.  The impact and possible policy alternatives should be clearly spelled out in this discussion paper.  Any potential changes will need to protect low-income seniors. Previous Conservative and Liberal governments failed in their attempts to reform the OAS.

 

Your Budget Strategy should include a Medium-Term Program Spending Target. This would strengthen the Credibility of your Fiscal Plan

 

In your Fiscal Update, you postponed your target date for deficit elimination to 2015-16. You should have postponed it to 2016-17 or later, since you may have to delay it even longer in the upcoming budget or in the 2012 fiscal update.  Frequent revisions of fiscal targets undermine fiscal credibility. The particular date of deficit elimination is not all that relevant. What is important is that the fiscal plan to get there be seen as credible. 

Since 2006, you have set out a number of fiscal targets. These include the elimination of the total government sector (which includes federal, provincial, local and the Canada and Quebec Pension Plans) net debt; capping growth in program expenses (first total, then just direct program spending); a proposal to allocate higher-than-expected surpluses to the Canada Pension Plan; allowing interest savings from better-than-expected surpluses to reducing personal income taxes; and, reducing the federal debt-to-GDP ratio, etc.  At times, one gets confused as to what your real target is. 

As the OECD has repeatedly pointed out, a credible fiscal anchor is one over which the government has a large element of control.  This excludes deficit and debt type anchors, as governments don’t control the economy and revenues.  However, you do have substantial control over program spending and this should become the focus in your budget planning.  

Such an anchor would allow the automatic stabilizers to work, thereby excluding employment insurance benefits.  It should not be an annual anchor as this would be too disruptive to the effective management of government programs and operations.  It should be a medium-term anchor, whereby over spending in one year can be made up by under spending in subsequent years.   

We would recommend that you commit to a medium-term program-spending target in addition to a deficit elimination target.

 

Your Budget Strategy Should Continue to Review Existing Economic Programs to Ensure that they are Relevant, Cost Effective and Contribute to Economic Growth and Job Creation.

 

It will be important that you show concrete actions to secure the $4 billion in annual expenditure savings. We seriously doubt that this cut in program spending will be enough to achieve your deficit elimination target in 2015-16. We are also concerned by the emphasis that you are placing on finding savings through “efficiency gains”. Serious expenditure savings can no longer be achieved through efficiency gains, although efforts must be made to ensure that programs are managed effectively and efficiently. 

We would suggest the following actions to reduce spending.

 

All spending programs should be subject to the original six Program Review tests on an ongoing basis.  The results of these reviews should be made public and audited independently, by either the Office of the Auditor General or outside experts. If they do not meet the tests, they should be eliminated. 

Regionally extended benefits and the ongoing employment insurance (EI) pilot projects should be eliminated from the EI program – the former may need to be phased out over a period of time. 

The Public Service collective bargaining process needs to be brought into the 21^st century.  Collective bargaining should be comprehensive, including not only wages and salaries, but also pensions and other employee benefits. There should be a more equitable sharing of the pension costs between the government and plan members.  This could be achieved by having members involved in the management and risk sharing of the various plans.  If this is not achievable, defined benefit plans should not be offered to new employees. 

Performance and bilingual bonuses should be eliminated. Employees should not be paid extra for simply doing their job. If they don’t do their job in a fully satisfactory basis, penalties (including termination) should be employed instead.  If bilingualism is part of the job requirement, why should employees be paid extra?

 

Your Budget Strategy should include a Review of Tax Expenditures with the goal of simplifying the Tax System

 

Most importantly, the strategic spending review should be extended to tax expenditures – which are just spending hidden in the tax system.  This would require a major review of the personal and corporate tax systems to eliminate special tax preferences for individuals, sectors and industries that no longer serve any useful purpose. Studies have in fact shown that most of these tax expenditures are not effective. 

The current personal and corporate tax systems have become overly complex and inefficient. The first income tax act was introduced in 1917, as the Income War Tax Act, had only 11 pages. Today, the Income Tax Act has 2800 pages including regulations and commentary. It needs to be simplified. 

A recent study released by the Canadian General Accountants Association concluded that;

 

‘While the Personal Income Tax System has incrementally evolved over the years, its key structural elements and core underlying assumptions have not been reconsidered for at least 20 years and, in some cases, for almost 40 years. During this time there have been significant changes in society and the economy, and no evaluation has been done to confirm whether the basic structure or targeted measures fairly reflect these changing realities.”[4]

 

There have been few attempts at tax simplification and for good reason. They come with significant political risks, because it means eliminating special preferences for groups, individuals, industries, and sectors – preferences that can no longer be justified.  

Interest in reforming and simplifying the personal income tax system has come mainly from economists, economic think tanks, national organizations and special interest groups. 

The pay off of such a review, however, would be substantial in both financial and economic terms. A reasonable estimate would be annual savings of at least $5 billion. These new resources could be used to support tax changes that would strengthen economic growth and job creation. 

The CGA report concludes that:

 

“It would be extremely valuable for the federal government to review the literally hundreds of targeted tax measures in the personal tax system to determine their relevancy and need …”[5]

 

Equally important is the need to reform the Corporate Income Tax (CIT) system, but probably on a more selective basis. The CIT system has undergone significant changes over the past twenty years. Impediments to investment have been removed (e.g., the elimination of capital taxes), corporate tax rates have been reduced, and the capital cost allowance system has been improved.  

Nevertheless, there are areas, (e.g., corporate reorganizations, taxation and repatriation of foreign source income) which need to be reviewed with the objective of simplifying the system and reducing the costs of compliance, which are not shared equally across sector.  

The CGA report concludes:

 

“The benefits of tax simplification are clear. It means increased compliance rates and lower compliance costs for taxpayers. It means less paperwork for business and lower administration costs for government. It means a stronger system with a more secure tax base and predictable revenue.”[6]

 

 

Your Budget Strategy Should Implement a Medium-term Tax Reform Strategy, that Supports Savings, Investment, Job Creation and Economic Growth.

 

We agree with you on the need and importance of lowering personal and corporate income taxes. There is no doubt that your Government has lowered taxes since coming to Office in 2006. Most notable was the lowering of the GST by two points in 2006 and 2007. This reduced government revenues by about $13 billion annually.   

The government has also lowered corporate and personal income taxes. Since 2006, the corporate tax rate has been cut from 21 percent to 16 percent in 2011 and to 15 percent in 2012. These reductions will cost the treasury roughly $10 billion annually. 

In the case of personal income taxes, the government has reduced the lowest tax rate by 1 percentage point, increased the basic personal amount and increased the lowest two tax brackets.  However, it has also chosen to provide special tax “preferences” for specific groups. These include the splitting of pension income for seniors and special preferences to support participation in sports activities, arts and cultural activities, and groups such as volunteer fireman. In the 2011 election, campaign you promised to provide special tax preferences for families with children over eighteen. These cost in the order of $1.5 billion a year. 

On this basis, the government is quite correct to claim that it has provided lower taxes for some Canadians. What the government cannot claim is that this plan constitutes good tax policy that supports growth and job creation. It has tried to pick losers and winners.  In addition, it has not matched the fiscal cost of these tax reductions (about $42 billion by 2012-13) with corresponding spending reductions, such that the Government is now facing a structural deficit, which will only increase over time with the aging of the population. These tax reductions inevitably meant that spending would have to be reduced if the structural deficit were to be eliminated. You made this policy choice by reducing transfers to the provinces for health care. In effect you have downloaded the federal structural deficit problem onto the provinces. 

How could your low tax plan be turned into good tax policy? First, the current plan has only slightly reduced the high effective marginal tax rates imbedded in the personal income tax structure, which seriously inhibit labor force participation. Without getting into detail, what is required is an increase in the tax brackets and a reduction in tax rates. This could be expensive, but getting rid of the many targeted tax credits in the PIT system could help to finance these changes Lower tax rates for everyone, rather than select groups, would provide much needed support for labor force participation. 

Second, the government should restore the two points to the GST bringing back the $13 billion that was lost. You will no doubt reject this out of hand as being politically impossible. We would urge you to reconsider this recommendation in the context of broader tax reform. It would permit you to give an even larger cut in personal income taxes to all Canadians. It would also allow for a larger reduction in the corporate tax rate than is currently planned.  These changes could be revenue neutral. In our view theses reforms to the tax system would be good policy and good politics. Given the number of communications people now working in the government you should be able to sell these reforms to Canadians. 

Third, EI employer/employee premiums should be eliminated. The EI rate is a silent killer of jobs and a very regressive tax.  The lost revenues could be sourced from increasing the GST rate and the corporate income general tax rate. 

With these changes, the tax system would now have substantially lower personal and corporate tax rates and the elimination of EI premiums, offset by higher GST rates and tax simplification. These changes would be revenue neutral, although not neutral in terms of their affect on economic growth. Economic growth and employment growth would be stronger. 

This new tax structure would provide greater support to labor force growth, savings and investment, and productivity growth. This, in turn, would provide stronger revenue growth.  The International Monetary Fund (IMF), in its latest Fiscal Monitor, stated “some of the adverse impact of fiscal consolidation on economic growth can be alleviated through reforms that shift part of the burden of taxation from labor to consumption”.  The House of Commons Standing Committee on Finance recommended a comprehensive review of the tax system by a blue ribbon panel.  As this came from Government members, we would strongly recommend that this proposal be accepted.

 

The Budget Strategy should commit to modernizing the infrastructure of the Economy.

 

Your budget strategy must address the critical need to strengthen the potential growth of the economy. We need to do whatever we can to improve our productivity performance. Tax simplification and tax reform will help. 

There has been much written over the past years about how productivity in Canada has lagged behind that in the U.S. There has been a great deal also written about what might be causing this, and what to do to improve productivity. Nevertheless, despite all of the many policy changes introduced over the past decades to support productivity growth, there has been little improvement.  

Nevertheless, we believe that investments to modernize our human (education, research, patents) infrastructure and our physical infrastructure will be critical. We would recommend that you increase the expenditure savings that you are seeking from $4 billion to $8 billion, and that this additional savings be reallocated to a new Infrastructure Modernization Program. Savings from reforming the tax credit for research and development could also be reallocated to this Program.

 

Your Budget Strategy Should Commit to Supporting Domestic Demand if Economic Growth Weakens Significantly in the Short Term

 

As we said above, there are substantial downside risks to the global economy in 2012 and 2013. Should economic growth weaken significantly in 2012 and 2013, then we believe you have adequate fiscal room to provide a second temporary stimulus program to support domestic demand. Based on the results for the first seven months of the year, we believe that the underlying deficit for 2011-12 could come in around $28 billion and then decline further in 2012-13 to below $19 billion. Even allowing for the automatic stabilizers, an additional $20 billion in temporary stimulus over the two years could easily be accommodated. This could be included in the Infrastructure Modernization Program. 

The credibility of your fiscal plan would not be affected by providing a second round of stimulus provided you have credible fiscal targets, a credible expenditure reduction plan, and a credible date for deficit elimination. 

As we indicated above we believe that the credibility of your budget strategy would be strengthened if you released a paper with the 2012 budget outlining of the directions that you intend to take to strengthen the underlying   growth and job creation performance of the economy.  

Encouraging public debate and discussion can only lead to greater legitimacy and credibility. Previous Ministers of Finance did it and so can you 

 We hope that you will find our suggestions helpful.

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[1] World Economic Outlook: International Monetary Fund, SEPTEMBER 2011; p. xv.

[2] Ibid: p xv.

[3] Ibid: p. xvi.

[4] C. Scott Clark and Len Farber; “the need for tax simplification - a challenge and an opportunity; The Certified General Accountants Association of canada.; 2011

[5] Ibid:  P. 15.

[6] Ibid:  P. 18.