In August, Mr. Flaherty met with his advisory panel as well as selected business representatives and academics to discuss key issues facing Canada and “to shape the policies and initiatives of the next phase of Canada’s Economic Action Plan”.

Although we don’t know what was discussed, the immediate challenge for Mr. Flaherty is that the Canadian economy could be entering a new recession. And if the economy is not entering a recession, then most certainly it is entering an extended period of slow economic growth, as a result of both external and internal economic developments.

On August 18^th, Mr. Flaherty appeared before the House of Commons Finance Committee to answer questions concerning the worsening international economic situation and what it might mean for Canada. Mr. Flaherty rejected demands for new stimulus in the short term, arguing that “to secure the recovery in an uncertain world” the government should “stay the course” and implement Phase II of the Canada’s Economic Action Plan, as set out in the 2011 Budget. This plan consists of maintaining “a strong fiscal position” and a “low-tax plan for jobs and growth”. He provided few details and had nothing to say about the long term.

He acknowledged, however, that growth in the second quarter would be weaker-than-expected and that if the economy were to enter a period of decline, he would respond in a “pragmatic way as the government had in the past.”

The Prime Minister, however, acted quickly to dampen any expectation that the Minister of Finance would be allowed to act “pragmatically” by introducing another stimulus package. In an interview with the Wall St. Journal, reported in the Globe and Mail of August 26th, the Prime Minister observed that “conditions demand large-scale stimulus are fairly unique’ and a “mere slowing of the economy would not replicate those conditions”.  In an unusual statement for a Prime Minister on independent monetary policy, he stated that the Bank of Canada would keep interest rates low.

The Prime Minister should refrain from making economic forecasts because, as he should know from past experience in 2008, there is a very good chance they will come back to haunt him.  In the same week that the Prime Minister was making his forecast, the Toronto Dominion Bank (TD) released a detailed report concluding, “That the risk of technical recession has undoubtedly risen in Canada. If the US economy contracts, the chances that Canada will follow suit are high”[1].

The TD report also warned that the growth performance of the Canadian economy in 2011 is seriously worsening and there is only likely to be “moderate strengthening in the pace of growth as 2012 progresses”.

As it turned out the TD report was absolutely dead on. The Canadian economy declined by 0.4 percent at an annualized rate in the second quarter, down from a revised rate of 3.6% growth in the first quarter. All of this decline was due to a worsening export performance, but the TD Report also warned “that Canada’s domestic demand is currently more vulnerable to another economic shock compared to the period leading up to the last downturn in 2008-09”. Red lights should be flashing in the Department of Finance and in the Langevin Block.

The government is now confronted with the possibility of a significant weakening in economic growth and job creation not just in the short term, but also in the medium and longer term as well. The US Federal Reserve Board has reduced its forecast for growth in 2011 and 2012, but is has also lowered its projection of potential economic growth. The US is in for a long and disruptive period of slow economic growth, high unemployment and rising debt. The EU and the EURO countries are no better off. Many countries are living on economic life support systems that are not sustainable economically or politically. The very existence of the EURO in its current form is at serious risk.[2]

The economic assumptions underlying the 2011 budget are clearly out of date. We hope that Mr. Flaherty will provide a realistic view of the economic outlook in his fall economic and fiscal update. He will now have to extend his economic forecast to 2016. As we have recommended in the past, Mr. Flaherty should depend on the Department of Finance to provide the forecast since most private sector forecasters only provide forecast for one or two years.

How should Canada respond to this worsening international and domestic environment? The government should begin by stop telling Canadians that Canada is doing better than any other G-7 country and, therefore, we should not  worry. Quite frankly, this has become tiresome and gratuitous. Canadians should worry, especially when economic prospects in our trading partners are rapidly deteriorating. And we will be affected. Canadians want to know what the government is planning.  Building and sustaining confidence in the private sector will need real policy actions, not just words.

The next step is for the government to immediately develop a new “Canada Action Plan” with a fiscal and economic strategy that will support domestic demand in the short term to offset slowing economic growth, and at the same time undertaking new policy actions that will strengthen longer-term economic growth while controlling of the accumulation of debt. The Phase II of Canada’s Economic Action Plan referred to by the Mr. Flaherty at the Finance Committee is out of date and not adequate.

A new and credible strategy will have to address four critical issues.

First, is there fiscal room in the budget  in 2011-12 and 2012-13 that would allow a second round of temporary stimulus should Canada experience declining output? Mr. Flaherty has stated, “The fiscal results to date have been broadly consistent with the conservative 2011-12 projections set out in the Budget 2011”. We believe the government will do better than forecast and that there is fiscal room for a second round of temporary stimulus, although it need not be as large as the first.

Second, is it possible, or even necessary, to eliminate the deficit by 2014-15 in order to maintain fiscal credibility? Last spring, the Parliamentary Budget Office (PB)), and the International Monetary Fund (IMF) forecast that the deficit would not be eliminated in 2015-16, let alone 2014-15 because the deficit includes a structural component.  Would financial markets care if the deficit were not eliminated until 2016-17, as long as it is declining and the debt burden is falling? After, all no other G-7 country will even come close to balancing their budget within the foreseeable future.

Third, what will be the challenges to the economy and the pressures on the government’s deficit and debt after 2015-16?  We believe the underlying growth of the economy will decline significantly and the government will be confronted with a growing structural deficit.

Finally, what policy options are available to the government to deal with these economic and fiscal challenges? What will the government do to restrain the growth of spending? What is the government’s real commitment to provincial transfers for health and social programs? What policies could the government undertake that would not only strengthen economic growth but generate stronger revenue growth- e.g., tax simplification and tax reform; new modernization investments?

Is there Room in the Fiscal Framework for New Temporary Stimulus in the Short Term? Probably yes. 

Although financial results are only available to the end of June and the final results for 2010-11 will not be available until late September/early October, we believe that the deficit for 2011-12 will be lower than the $29.6 billion forecast in the June 2011 Budget.  The main reason for this is that the government has significantly overstated spending in “Other transfers”, just as it did in 2010-11.  This component of direct spending could be $3-$4 billion lower than forecast.  As we noted in an earlier piece  there is a large unusual discrepancy between the Main Estimates and the June 2011 Budget estimate of total expenses for 2011-12, suggesting that the budget estimate is overstated.[3]

In addition, with the rejection of the HST in British Columbia, the federal government is entitled to recover the $1.6 billion it paid the province to harmonize their sales tax with the Goods and Services Tax.  As well, there is still the issue of the potential $2.2 billion payment to Quebec – negotiations for which are to be completed by the end of September. 

There is also $1.5 billion in a contingency reserve that would not be needed because of the above. In total there could be $6 to $8 billion available in 2011-12.

For 2012-13, we believe that “Other transfers” are again overstated by $2-$3 billion. There would also be an additional $1.5 billion from the contingency reserve; however, some of this could be used up by the impact of slower economic growth on revenues and employment insurance benefits. 

Cumulatively for the two years we estimate that there could be $8 to $11 billion available for new stimulus spending without increasing the deficit for those years from that forecast in the June budget.  

Will the Deficit be Eliminated in 2014-15? Probably not but it doesn’t matter. 

We, along with the PBO, have continually questioned the profile of direct program expenses after 2012-13, not just in the June 2011 Budget, but in previous Economic and Fiscal Updates and budgets, as well. The Department of Finance has never provided an explanation for such a low forecast of direct program spending.  Nor has the Department provided any explanation for the profile for “Other revenues” which appears over stated, given the components included.

 We, along with the PBO and the IMF, have consistently forecast larger deficits for the outer years than the Department of Finance. The IMF forecast a deficit of $5.4 billion in 2015-16, the PBO a deficit of $7.3 billion and our forecast was for a deficit of $8 billion. This was before the current financial and economic deterioration  in the EU and the US.  With slowing economic growth over the medium term, there is no doubt in our view that the federal government will not achieve a balanced budget in 2014-15 or in  2015-16, even if the government were successful in achieving all of the expenditure reduction targets announced in the 2011 Budget.   

Given the difficult emerging situation in the world economy, it is very unlikely that bond markets will care if a year or two delays the elimination of the deficit in Canada. Even if there is a delay, the ratio of debt to GDP is unlikely to rise. What matters will be how the government uses this period to prepare for what will come next.

What is going to happen to the Deficit after 2015-16?

The PBO and the IMF both forecast a structural deficit for the federal government in 2015-16.  Much of this comes about from the significant reductions in tax rates (reduction of two-percentage points in the GST, a six-percentage point decline in the general corporate income tax rate, among others), without offsetting reductions to program expenses.  With the aging of the population and its impact on potential economic growth and expenses, this structural deficit will increase in the second half of this decade.  The PBO has projected that the federal government’s fiscal structure is not sustainable over the long term,[4] as increasing deficits beyond 2015-16 will lead to an ever-increasing debt-to-GDP ratio.  Media reports indicate that the Minister of Finance has recently been briefed on the impact of the aging population on the economy and the government’s finances.  In the upcoming fall Economic and Fiscal Statement, the Minister should address these issues.  

In both 2014-15 and 2015-16, annual surpluses in the Employment Insurance Operating Account have reduced the deficits in those years by about $4 billion.  However, under current legislation, once the cumulated deficit in the Account has been eliminated, EI premium rates will need to be reduced by a maximum of 10 cents per year.  This loss in revenue will put significant upward pressure on the deficit post 2015-16.

These problems are not long-term problems that can be ignored for another year or two. These problems are already here and policy action is needed now.

What Policy Options are available to the Government to deal with these Economic and Fiscal Challenges?

A credible new “Canada Economic Action Plan”, or Phase II as the government calls it, must examine options that will control the growth of spending in the coming years, while focusing on the most pressing needs and priorities of Canadians. It must also look at ways to increase revenue growth through strengthening economic growth and through simplifying and reforming the tax system.

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? The biggest issue on the spending side is what to do about health and social transfers to the provinces. 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.

Although the government has indicated that it will extend the current funding arrangements for two years, no one knows what will happen after that. Mr. Flaherty has already indicated that the provinces should not count on these transfers and he has 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. These issues must be resolved quickly.

An important question is whether the provinces have the capacity to deal with the additional financial burden that would result from downloading health and social spending? The provinces are already facing a more serious medium and longer-term financial situation than the federal government.

What must the government do to strengthen economic growth and revenue growth? We would make two recommendations.

First, it is important that the government complete the current Strategic and Operating Review. We believe the $17 billion of cumulative savings would be better spent if it were reallocated to a new Canada Modernization and Innovation Fund aimed at supporting investments in research, innovation, and the modernization of key infrastructure rather than reducing debt. This could be done in partnership with the provinces. Over time, this would help strengthen Canada’s productivity and growth performance, something that will pay off in stronger revenue growth in the coming decade.

Applying the $17 billion to productive investments rather than debt reduction would not in any way affect the government’s fiscal credibility.

Secondly, the government needs to immediately begin a process aimed at simplifying and reforming the income tax system. A report released by the General Accountants Association of Canada observed”There have been very few attempts to simplify the tax system since its creation in 1911. The reason is very clear. Tax simplification comes at a very high political cost, since any reform will involve choices and trade-offs, and have both winners and losers”.[5]

The report also concluded that tax simplification “represents an opportunity because tax simplification can yield substantial savings and thereby contribute to the creation of a sustainable fiscal structure. The benefits coming from a policy of reducing the tax burden on Canadians will be much greater with tax simplification and reform”.

Most importantly the Report emphasised that “Canada – with all its fiscal advantages – cannot afford to fall behind its global neighbours and risk becoming a less attractive place to do business.  Canada needs a 21^st century tax system – a simple, fair, efficient and transparent tax system with low, internationally competitive tax rates”. 

Tax simplification could easily save the government as much as $5 billion annually in revenues. This could be used to reduce income taxes for everyone, rather than a special few, and/or to accelerate even further reductions in corporate taxes. This would provide a major boost to economic growth and job creation.

But tax simplification and reform would require the ultimate in “political leadership and courage” from the Prime Minister and the Minister of Finance. It would mean reversing the decisions of the past five years that have added to the complexity, inefficiency and unfairness that currently defines the income tax system.

Nonetheless, to ignore the absolute need for simplification and reform of the tax system, and the contribution it would make to a strengthening economy and a sustainable fiscal framework would represent a complete lack of “political leadership and courage” by the Minister of Finance and the government.

[1] Economic Update August 24, 2011: TD Economics ww.td.com/economics

[2] see 3dpolicy “what a mess the Euro and Us are in and it won’t get better soon” and “: WANTED ‘political leadership and Courage”.

[3] 3dpolicy “who knowas what the government is spending this year”

[5] CF. Scott Clark and Len Farber “The Need for Tax Simplification: A Challenge and an Opportunity,’ Certified General Accountants Association of Canada, August, 2011.