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CHAPTER 3: A PRUDENT
BUDGET-MAKING PROCESS

A. A SUCCESSFUL BUDGET MODEL

1. Prudent Budgeting

The federal government has developed a budgetary model that has proven to be extremely successful in turning around our fiscal situation. This model was vital to achieving the recent reductions in the federal deficit. Enhanced credibility of the government in the eyes of financial markets, the business sector and individual Canadians is important in enabling the government to signal its intentions to the private sector. More importantly, a credible and prudent fiscal policy helps to keep interest rates in check, which in turn helps the government pay down the debt and reduce taxes. It also helps Canadian families directly because it reduces the costs of home ownership and lowers financing costs associated with the purchase of other consumer durables.

The prudent economic assumptions used in past budgets were established in the following manner: Prior to the publication of the budget and the preparation of the Economic and Fiscal Update, private sector forecasters were surveyed with respect to their expectations regarding future economic conditions. In recent years, this sample has comprised 15 to 21 respondents. The prudent assumptions used by the government added 80 basis points to the private sector average forecast for short-term interest rates and 50 basis points to the private sector average for long-term interest rates. This Committee recommended in its first consultation report that the prudence factor be between 50 and 100 basis points. In the past, the government has used a prudence factor of as low as 50 basis points for short-term rates.

This practice had two significant effects. The government's calculation of its debt servicing costs were raised as a result, and along with it, estimates of the size of the budget deficit - for example, a 100-basis-point increase in interest rates reduces the budget surplus by $1 billion in the first year. The assumption of higher interest rates also reduced the government's estimates of economic growth, leading to estimates of lower revenue and higher spending. The 1998 budget contained prudent assumptions about nominal GDP growth that were 60 basis points lower than the private sector average for 1998 (4.1% vs. 4.7%) and 100 basis points lower for 1999 (3.9% vs. 4.9%). Sensitivity analysis contained in that budget indicated that a one percentage point decrease in the nominal growth rate would reduce a surplus by $1.3 billion. For the second year of the government's planning horizon, these prudent assumptions would reduce the government's estimate of the surplus by about $1.5 billion.

1.1 Contingency Reserve

The second component of prudent budgeting was the explicit inclusion of a Contingency Reserve. Initially, the government used a $2.5 billion Contingency Reserve for year one in its two-year planning horizon and a $3 billion reserve for year two. The higher reserve was justified because of the greater uncertainties that exist when planning further into the future. Now a $3 billion Contingency Reserve is used for both years of the planning period.

A $3 billion Contingency Reserve protects against the first year effects of a 300-basis-point increase in interest rates or a 2.3 percentage point decrease in nominal GDP growth. Prudent economic assumptions and the Contingency Reserve, combined, provide a $4 billion deficit cushion in year one of the budget horizon and a $4.7 billion cushion in year two.

The government does not allow the Contingency Reserve to be used to finance program spending. If it is not needed, it will be used to reduce the Government of Canada's net debt. All of the Contingency Reserve for 1997-98 went to debt reduction.

The Committee believes that the practice of prudent budgeting should continue - it is as vital in a world of debt reduction as in a world of deficit reduction. Moreover, many of the economic, financial and political risks that existed a few years ago will still be present in the future. The economic and financial turmoil in much of the world are examples of such risks. They originate outside Canada and are beyond our control.

In the few short years that this Committee has been holding pre-budget consultations, we have been told repeatedly that governments must use prudence when drafting budgets. Of course, prudence is always appropriate. Inflation remains under control in most nations, reducing the chances of a recession triggered by monetary policy. But the near-term outlook for the Canadian economy has been downgraded this year and economic forecasts became more pessimistic as the year progressed. And, of course, political uncertainty is always a factor to be considered.

The elimination of the deficit does not lessen the importance of prudence. While federal deficits contributed to economic risks in the past, they were only part of the equation. We still have highly indebted governments, and until that indebtedness declines substantially, the government sector will continue to be a source of potential financial risk. Even though the federal government has made its debt structure more manageable, the sheer size of the debt and the heavy debt-servicing burden means that a very large portion of government spending continues to be beyond its direct control.

The risks involved in budget making have not disappeared, or even declined substantially. Recent practice has served Canadians well and it should be continued. As the government has increased the term-to-maturity of its average debt outstanding, we believed last year that it should be able to increase the prudence factor with respect to longer-term interest rates when circumstances warrant, as it had with short-term interest rates. The Committee is pleased that the government took our advice.

Thus, the Committee makes the following recommendations:

The Committee recommends that the Government of Canada continue to use prudent economic assumptions in the formulation of the budget.

The Committee recommends that assumptions about both short- and long-term interest rates continue to be set 50 to 100 basis points higher than the private sector average. The Minister should alter the prudence factor as circumstances warrant.

The Committee recommends that the government continue to employ a Contingency Reserve, which should be set at $3 billion per year. As at present, the Contingency Reserve should not be used to fund either increased program spending or tax cuts.

2. Budget Targets

Another of the government's budgeting innovations was the replacement of the traditional five-year projections with two-year rolling targets. The five-year forecasts were abandoned because of the inability of the government to accurately project that far into the future. The results frequently proved to be so inaccurate that the entire process of longer-term projections lost all credibility. On the other hand, two-year rolling targets are sufficiently immediate that the economic data upon which they are based is much more accurate, so only extraordinary events would excuse any failure to meet them. This practice also prevents the government from delaying required action until later in the planning period. As the Minister of Finance has stated on numerous occasions, these targets help to provide a standard to which the public can hold the government accountable.

Recent events demonstrate clearly the benefit of a two-year planning horizon. Over the course of nine months, private sector forecasters have revised downwards by 60 and 70 basis points respectively, their growth estimates for 1998 and 1999. As a result of the Minister's prudence, he is proving to be a more accurate economic forecaster than the private sector.

The Committee believes this practice has served Canadians well and should be continued.

Thus, the Committee makes the following recommendation:

The Committee recommends that the government continue to use two-year planning horizons for the conduct of fiscal policy.

The government has done more than make budgetary projections over a two-year period. However, it set targets to which it was committed and these targets became the benchmark against which the government's fiscal policy was judged. This practice brought transparency to government policy and imposed accountability on its actions. The fact that deficit targets were bettered every year earned the government a degree of credibility that had been lacking in the past.

Having witnessed the value of deficit targets in restoring fiscal balance, the Committee favours their continued use in the new fiscal environment. What, however, should these new targets be?

Last year the Committee recommended that the government target a balanced budget for 1998-99 and all subsequent years, based upon prudent economic assumptions and a $3 billion Contingency Reserve. We also recommended that the unneeded portion of the reserve be committed to debt reduction.

The Committee believes that this should define the minimum path of debt stabilization. According to the Economic and Fiscal Update 1998, the 2002-2003 debt-to-GDP ratio would fall to 55% if we enjoy a 4% annual growth in nominal GDP and balance the budget every year. With 3.5% annual growth, the ratio would fall to 57%. These growth rates are not unreasonable, even with today's lower growth forecasts. The debt-to-GDP ratio would be about 1.5 percentage points lower if the government could pay down the debt every year by $3 billion. This strategy would put the debt-to-GDP ratio in the middle of the Committee's target range, as recommended last year.

The Committee recommends that the government take steps to accelerate the downward trend in the net debt-to-GDP ratio and not rely solely upon growth in the economy. The unneeded portion of the Contingency Reserve should be applied to debt reduction.

These recommendations would help ensure that the government need not run a deficit in future years. With the continued use of a Contingency Reserve, it means that the government must plan for an underlying surplus of $3 billion per year. In the absence of unforeseen events, the net debt would decline by at least $3 billion per year.

Deficit reduction and balanced budgets are goals that lend themselves to short-term targets. A debt-to-GDP target is a longer-term goal.

We note that in 1985-86 the net debt amounted to about 50% of GDP and grew steadily for 10 years, peaking at 72% of GDP. It was during this period that the damaging effects of fiscal excesses had the greatest impact.

The Committee recommends that the federal government establish a long-term target for a sustainable debt-to-GDP ratio.

The Committee recommends that the federal government establish an interim debt-to-GDP target range of 50% to 60%, to be achieved in this mandate.

B. Prudent Stewardship and the Promotion of Productivity

The federal government will soon be in a fiscal position to address the vital concerns of Canadians regarding taxation, health care, education and competitiveness.

The Committee wishes to make clear that while we expect the government to have resources to spend in the near future, these should be spent with care, with a view to achieving measurable results and within a framework of accountability. We should not use the existence of budgetary surplus as an excuse for spending more money. New resources, whether they are invested through new programs or significant changes to existing programs, should be subject to some form of performance guidelines. These guidelines would spell out what the program intends to do and how its results will be measured. If it fails and cannot be improved, the program should be terminated.

Safeguards should be implemented before a new program is initiated. Program Review provides such safeguards and the Committee believes that all new initiatives must be rigorously put to the test of Program Review.

Thus, any new initiative must demonstrate that it is in the public interest by addressing an evident problem. If there is a problem, is it one that can best be resolved by government or would the private or voluntary sectors be more appropriate? If it is a problem for government, is the federal government the appropriate level to deal with the problem? And if so, what is the most effective and efficient way to deliver the program? Of course any new program must meet the test of affordability. While affordability is a necessary requirement, we must not presume that it is a sufficient basis for a new program.

The Committee wishes to stress that this review would not be an exercise in empire building but rather the implementation of a new set of checks and balances to ensure Canadian taxpayers get real value for their tax dollar when it comes to new programs.

The Committee wishes to take the concept of Program Review one step further. We want to put it within the context of an overall strategy of enhanced productivity growth in the Canadian economy. This Productivity Covenant would apply to all government activities and initiatives, taxes, spending and regulation.

The Committee recommends that any new spending initiatives be subject to the rigorous and detailed test of the principles of Program Review and that the results of that review be published at the time any new program is announced.

The Committee recommends that a comprehensive strategy for productivity enhancement be undertaken by the government and that a Productivity Covenant be established against which all federal initiatives would be judged.