What To Do With The Expected Surplus? — The real question for the 2015 election

In September, the Parliamentary Budget Office (PBO) released its annual Fiscal Sustainability Report. The report provides “a projection of current fiscal policy 75 years into the future to assess the implications of demographic and structural pressures on government financing”. 1

The results closely mirrored those published by the Minister of Finance in November 2012. It is expected that the Minister’s next promised “sustainability” report will not be much different.  Unfortunately, like the last report, it will only look at the federal government’s sustainability position and not that of the total government sector government, notwithstanding that the Minister promise to review the fiscal sustainability of provincial governments in 2007. This is unfortunate because long-term fiscal sustainability reports are needed for not only the federal government but for the components of the total government sector, and his department is best qualified to do so.

The recent PBO sustainability report did not contain any conclusions, which were not included in previous PBO sustainability reports. Nevertheless, the report received considerable print media attention, perhaps because it was the first major report released by the new PBO. What is notable about the release of this report is not so much its content but rather that the new PBO did not appear on the daily political TV shows to expand on the report, something Mr. Page, the former PBO, would have definitely done. This signals that the new PBO will definitely be lower key than his predecessor.

The PBO report makes the following conclusions, which can also be found in previous reports:

First, average annual real GDP growth will decline to 1.7 per cent over the period 2013-2087, down from the average annual growth of 2.6 per cent over the previous 30 years. More importantly, the PBO report concludes that the growth in real GDP per capita (a common measure of improvement in living standards) will decline from 1.5 per cent annually on average since 1983 to only 0.7 per cent annually from 2013 to 2042. In other words notwithstanding everything that is happening, the living standards of Canadians will  improve very slowly over the next half century. Get used to it. An important question is what this means for already widening income inequality?

Second, the federal government’s fiscal structure is sustainable thanks to the unilateral federal decision to hold the growth in the Canadian Health Transfer (CHT) to the growth in nominal GDP. Contrary to the position taken by the federal government, the federal fiscal structure was already sustainable before the decision to increase the age of entitlement for Old Age Security from 65 to 67. In other words the federal government downloaded its fiscal problem onto the provinces. To be fair, the fiscal structure of the provinces and municipalities was already fiscally unsustainable before the federal government downloaded its problems and made it even worse. The federal government is on track to achieve a debt-to-GDP ratio of 25 per cent by 2021 and a net asset position by the mid-2040s.

Third, the provincial, territorial, local and aboriginal (PTLA) government sector is fiscally unsustainable, no matter what assumptions are made. In other words, the debt burden of the PTLA government sector will continue to rise unless action is taken to cut spending AND raise taxes.

Generally speaking, the federal government is in good fiscal shape and the provinces are in terrible fiscal shape, which means that overall Canada is not in good fiscal shape. A growing federal-provincial fiscal divide now exists in Canada and it is likely to get worse.

How did Canada get into this situation? The answer is quite simple. The origin was the fateful decision to reduce the goods and services tax (GST) by two points, costing the federal government about $14 billion annually and growing. This policy action eliminated a $13 billion surplus left by the previous government, created a structural deficit at the federal level, and an unsustainable long-term fiscal situation for the federal government. To put it simply, even without the 2009-10 recession, the debt burden would have started to rise. To stop this from happening meant that the federal government had to cut federal spending and reduce the growth in the CHT escalator in order to restore federal fiscal sustainability. In the absence of the GST cut, none of this would have been necessary

There are two other important messages that emerge from this PBO report.

First, there is no national economic and financial leadership in Canada. Since 2006, the Prime Minister and the Minister of Finance have taken the view that they don’t want to deal with the provinces on economic and financial matters. There is no need for real coordination of federal-provincial policies. The federal government will look after itself and the provinces are on their own. Looking at Canada’s finances, the question has been for years which level of government would have to raise taxes.

The federal government decided back in 2006 that the provinces would have to raise taxes. The federal government would be a government known for lowering taxes and cutting spending. The provinces would have to figure out how they would deal with their fiscal problems without help from the federal government. The federal government wasn’t interested at all in Canada Inc.

Second, the federal deficit doesn’t matter anymore. It is a non-issue. The federal government is committed to eliminating the deficit in 2015-16 and barring some major unforeseen event (e.g., a major slowdown in the U.S.) will likely do so.  The federal government will be forecasting surpluses for the next five years to 2020-21 and hit its 25% debt-to-GDP target in 2021. We will have a better idea of these surpluses when Mr. Flaherty delivers his economic and fiscal update in November assuming he does so. The budgets of 2014 and 2015 will provide updated estimates.

What this means is that the 2015 election will be fought over how each political party proposes to use the surplus the federal government is forecasting. The PBO concludes that “the federal government has fiscal room to increase spending, decrease revenues, or some combination of both” without jeopardizing fiscal sustainability”2. Mr. Harper has already committed to using some of this fiscal room to allow income splitting for families with children under the age of 18; extending the fitness tax credit to adults; and, increasing the tax-free contribution to savings accounts to $10,000. These commitments were made in the 2011 election. Given the problems facing the Canadian economy, these are probably not the best uses of the surplus if the objective is to create jobs and strengthen long-term economic prosperity. The other political parties can wait before presenting their platforms on how they would use the surplus.

Both us were involved in the planning of surplus budgets after 1998. Our experience is that managing a surplus can be just as difficult as managing a deficit. Mr. Chretien made it easy: one-third to new spending; one-third to lower taxes; and, one-third to lower debt. As it turned out, this formula worked out pretty well.

[1] Fiscal Sustainability Report 2013, The Parliamentary Budget officer; September 26 2013.

[2] Ibid.

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