INST Committee Report
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CHAPTER 4: BUDGET PLANNING: SPENDING
PRIORITIES, TAXATION, AND FISCAL BALANCE
Economic Context of the December 2001 Budget
In the aftermath of the tragic events of September 11 and an economic retrenchment that threatens to become a recession, it is hard to believe that just one year ago, when the most recent federal budget was drawn up, the economy was moving at full throttle, with a strong engine and a forecast of nothing but open road ahead. At that time, virtually no one, including the Department of Finance, was predicting an economic downturn. Moreover, that a terrorist attack on the North American continent was imminent was also nowhere to be found on most policy-makers’ radar screen. Consider the Department of Finance’s May 17, 2001, Economic Update. It recognized the slowdown of the U.S. economy (but expected a so-called "soft landing" scenario) that would have a restraining impact on the Canadian economy, but also noted "a number of encouraging developments which have helped to offset this weakness." The Finance Minister then predicted $7.2 billion and $7.6 billion budget surpluses in fiscal years 2001-2002 and 2002-2003, respectively. The Finance Minister went on to assure the Canadian public that:
Clearly, in the wake of the events of September 11 every government in the world, certainly the Government of Canada, has had to pause and had to reflect upon its priorities in both the mid and long terms, but in particular in the short term. First and foremost, the needs of governments everywhere is to ensure security of our citizens, to ensure the security of our borders as well. [The Honourable Brian Tobin, Minister of Industry, 44:8:35]I would encourage the government to see as an urgent priority for taking concrete action … is to establish consumer, investor and business confidence, as well as a secure and trade-efficient border. [Jayson Myers, Manufacturers and Exporters of Canada, 45:15:40]
The aforementioned numbers are derived from the average of the total range of private sector forecasts. Let me now use the average of the most pessimistic of the private sector forecasts. Even here — 1.8 per cent growth in 2001 and 2.9 per cent growth in 2002 — the net impact would result in an adjusted budgetary surplus of $6.2 billion this year and $5.1 billion next year. In other words, … despite the economic slowdown … the $100 billion in tax cuts is protected. And we will not fall back into deficit. [Department of Finance Canada, Economic Update, May 17, 2001, p. 10]
Clearly, the road to prosperity for Canada became both curved and
bumpy. The strong economic fundamentals of a year ago have turned to
weakness, and a recession may be looming. Indeed, Economy.com forecasts a contraction in the Canadian economy of 0.2% (annualized) in the third quarter of 2001 (see Chapter 1) and should this also be the case in the fourth quarter, the Canadian economy will meet the modern-day technical definition of a recession: negative growth in the economy stretching two-quarters. So whether or not the revised forecasts of a weaker economy suggest a deficit, trade-offs in the upcoming budget will have to be made. The Committee now turns to these; rather than providing a detailed budget plan, we will instead make recommendations on the approach to be taken.
Spending Priorities and Taxation
If the slowing Canadian economy did not usher in a new economic context and, therefore, the need to set new budget priorities, the terrorist attacks of September 11 certainly did. On this score, virtual unanimity amongst Canada’s business leaders was obtained over what should be the Government of Canada’s number one priority at this time: national security. Such a shift in priorities now obliges the government to rearrange its budget accordingly.
[T]he Canadian government must now reassess its own fiscal plan to ensure that the fundamental priorities of national and international security are met while continuing to encourage the growth of a healthy Canadian economy and society. [Elizabeth McDonald, Canadian Film and Television Production Association, 47:10:40]
There is hidden wisdom in the suggestion that security and economic growth are complementary, where one objective enhances and reinforces the other. National security is a public good in the traditional sense of the word; it is one manifestation of social capital, which itself is an essential input into the economy. Indeed, increased security can translate into less uncertainty, making commerce and trade more profitable. The business community will readily admit that uncertainty is a condition that it actively seeks to avoid. As the past two months have clearly demonstrated, insecurity brought on by terrorism, real or perceived, can have an adverse impact on the economy through lost consumer and investor confidence; it can also send powerful economies, such as those of the United States and Canada, into a tailspin if left unchecked.
Armed with this knowledge, a number of business leaders were adamant that the Government of Canada should push its new national security agenda forward. They even offered specific actions in pursuit of this objective.
The first priority is that Canada must be inside a North American security perimeter against terrorism and this is for our benefit, not for anybody else’s. I want Canada to be the safest place to be in North America. There’s a side benefit to that, which is that other people in North America will also safe. Secondly, Canada needs better screening at our perimeter. Our screening must be the best. No one must be able to say that we’re playing second fiddle to that. Everyone must be able to say the Canadian screening system is as good or better than anyone else’s and therefore we can rely on the Canadian screening system. [Gerald Fedchun, Automotive Parts Manufacturers Association, 44:10:30]
Clearly, the federal government’s new Anti-terrorism Plan and its decision to compensate selected groups arising from the September 11 terrorist attacks will be costly to the treasury and will eat into the government’s current surplus, or lead to deficit if the economy is much worse than perceived. A deficit is certainly not out of the question anymore.
Above all, we expect that these current essential spending measures will eat up most, if not all, of the current year surplus. In the absence of offsetting cuts and less essential spending, these needs may well push the government into deficit in the next fiscal year. The government may not be able to avoid the deficit for a year or two no matter what it does. [Thomas d’Aquino, Business Council on National Issues, 47:10:40]
Despite national security and economic growth being complements in the longer term, these objectives may be substitutes, or at least be forced to compete with each other for funding, in the budget. Canada’s construction industry explained this in terms of obvious productivity-improving infrastructure investments:
Often the first thing that goes when governments find their fiscal house somewhat restrained or pressured is capital investments in roads, highways, sewage treatment facilities, and water distribution systems. There are many reasons why this often happens, probably because those investments are investments that may not show a yield except for 20 or 25 years, and that’s a very long time. We are concerned that the events of September 11 are causing some governments in Canada to divert their attention away from what is a very ominous threatening problem in this country, and that’s our infrastructure deficit. [Michael Atkinson, Canadian Construction Association, 46:16:55]
However, the short-term budgetary trade-off between national security and productivity-improving investments can be attenuated with sound financial planning, as was expressed by a number of business leaders.
It continues to be the view of the Chamber that government spending priorities must include those areas that can have a direct bearing on our competitiveness as a nation. Resources put into security and building and maintaining critical infrastructure should continue to be a government focus. Evidence also suggests that successful investment in both physical capital, whether it’s machinery and equipment, and human capital, whether it’s education and training, as well as basic research and development, are instrumental in raising productivity and overall economic growth. Our submission further details the Chamber’s recommendation on how spending should be controlled by imposing an annual cap and by reallocating from lower priorities. [Michael N. Murphy, Canadian Chamber of Commerce, 45:15:25]
This opinion was echoed by others, one of whom coupled this advice with issues of reforming federal taxation and regulatory regimes with a view to improving Canadian industrial competitiveness:
This is not a time for massive new spending programs. It is a time to reflect on how we can spend existing resources more effectively. It is a time to look for ways to reshape Canada’s tax structure to make our tax burden more competitive without reducing revenue and it’s also a time to focus on regulatory issues that can have a powerful impact on growth without the need for new spending. [Thomas d’Aquino, Business Council on National Issues, 47:10:40]
Industry representatives, however, were steadfast in their support for the planned tax cuts scheduled over the next five years. Indeed, some suggest that there may be room for their widening and deepening across and within more sectors of the economy over the longer term.
We also think the government should maintain its focus on achieving the $100-billion-tax-cut program that was in that October 2000 Economic Statement. We believe that those tax cuts should be extended to include the resource sectors. [Gordon Peeling, Mining Association of Canada, 45:17:05]
And
We also believe that it is important for the Canadian government to reduce the personal and corporate income tax burden in Canada, building on what has been done by the government over the past few years. This has to be part of a long-term strategy to retain both capital and human talent in Canada. We agree with others in the Canadian business community that the government fiscal course has to be one taken within a framework of fiscal prudence. [Chris Van Houtte, Aluminium Association of Canada, 46:16:45]
For these reasons, the Committee recommends:
10. That the Minister of Finance, in his next budget statement, confirm national security and border trade as the Government of Canada’s number one priority at this time and back this commitment with needed expenditure initiatives.
And
11. That the Minister of Finance, in his next budget statement, confirm the Government of Canada’s commitment to the five-year tax reduction program it set out in Budget 2000.
Fiscal Policy and Debt Management
Review of taxation issues and the government’s spending priorities have become a ritual of winter in Canada. Over the past few years, every February (last year excepted), the Minister of Finance has set out the government’s projected revenues and expenditures — sometimes called fiscal projections — and the resulting surplus or deficit. This statement contains an overview of the government’s economic and fiscal projections, and also sets out fiscal policy for the period ahead. Key to this planning process is that the government’s adjustments in spending and taxation priorities can be made in the light of longer term trends and, thus, a long-term perspective can have a bearing on tendencies to depart abruptly from the projected fiscal course.
Figure 4.1
Source: Finance Canada, The Budget Plan 2000, February 28, 2000, p. 46.
The two charts provided in this section are extracted from last year’s budget statement. They are a graphic representation of the fiscal and debt management course of past and current governments. From Figure 4.1, we observe that, after periods of large deficits lasting through the 1970s, 1980s and early 1990s, the government has returned to fiscal balance. This much-improved performance underscores the soundness of the government’s fiscal strategy of using two-year rolling plans backed by a contingency reserve and, in turn, provides much credibility to the Finance Minister’s commitment that:
The Government is not prepared to risk a return to deficits. The benefits of maintaining sound public finances — sustained economic growth, more jobs and higher incomes for Canadians — will not be put at risk. [Finance Canada, The Budget Plan 2000, February 28, 2000, p. 45]
This chosen fiscal course is not simply the current government’s preference; it enjoys wide support from the business community, large and small.
[T]he Chamber has produced a set of specific recommended proposals in the tax-debt management and program spending areas … They all are couched, in very important terms with respect to fiscal conditions permitting. … The underlying theme of this principle, upon which our proposals are built, is a continued affirmation of the very hard work of all Canadians, in the past several years, to move the country away from deficit financing at the federal level. This achievement is now much too important to abandon, and the members of the Chamber urge the government to avoid a return to deficit financing. We believe this can be accomplished as we set priorities for the country and keep a focus on overall Canadian prosperity. [Michael N. Murphy, Canadian Chamber of Commerce, 45:15:25]
And
[S]tay the course. … Right now the most important thing to do in our current economic environment is maintain business and consumer confidence to the maximum degree possible. All Canadians sacrificed a great deal to get rid of the deficit and indeed start paying down debt. Going back into deficit, I believe, … would not be positive in the least to maintain confidence levels of Canadians generally and not just in the business community. [Catherine Swift, Canadian Federation of Independent Business, 45:15:50]
A commitment to not run a budget deficit, as in the present course, makes debt retirement possible. In fact, the stock of federal public debt has declined by $35.8 billion ($17.1 billion in the past fiscal year alone) from its peak of $583.2 billion in 1996-1997 to $547.4 billion in 2000-2001. This pay down of debt represents an ongoing saving of $2.5 billion each year in the form of lower interest payments to service the debt. Moreover, the federal debt-to-GDP ratio has dropped to 51.8% in 2000-2001 from its post-war peak of 70.7% in 1995-1996 (see Figure 4.2).
Figure 4.2
Source: Finance Canada, The Budget Plan 2000, February 28, 2000, p. 48.
These debt-management developments have also received support from the business sector: "We are very pleased and are very supportive of the government in achieving a pay down of the debt. We indeed think that that should still remain a priority for the government going into the future" [Gordon Peeling, Mining Association of Canada, 45:17:05]. Debt reduction continues to receive favour even under the current trying circumstances.
It must reinforce the plan for debt reduction by clarifying the targets and making stronger commitments to allocate funds for this purpose when surpluses are available. It must limit spending to areas of the highest public priority, particularly those that strengthen the economy and enhance Canada’s long-term international competitiveness. Of course, we do realize that security and defence must be factored into this. [Gordon Peeling, Mining Association of Canada, 45:17:05]
The Committee is convinced that the government’s current fiscal course has provided more flexibility and maneuverability for dealing with unexpected shocks to the economy, such as the September 11 terrorist attacks. The Committee, therefore, recommends:
12. That the Government of Canada continue a fiscal strategy of developing a two-year rolling plan, backed by a contingency reserve, using conservative economic assumptions to deliver a federal budget that does not contemplate a return to a deficit.
And
13. That the Government of Canada continue the practice of retiring its debt by an amount that is not less than the funds available in the contingency reserve at the end of each fiscal year.
Now that the Committee has established what it believes should be the government’s spending and taxation priorities and has further recommended that we continue on the current course of fiscal balance and debt reduction over the next two years, we must address the issue of fiscal actions to be taken should plans go awry. One example would be if the underlying economic assumptions of the budget plan do not materialize or, more succinctly, if our economic fundamentals weaken further than expected. A second example would be if we experience additional external shocks, such as that of September 11, which would require greater-than-anticipated national security spending. In these circumstances, we can take one of three alternative routes: (1) ratchet up government spending to counteract depressed private spending; (2) continue as planned and ride out the economic downturn; or (3) take immediate corrective action by cutting back on budgeted expenditures of low-priority items to stay the course.
Some business advocates argued that additional fiscal stimulus to that which is already planned would be excessive or would risk the credibility of the Finance Minister’s plan, which could possibly further weaken consumer and investor confidence.
In recent weeks we’ve heard a few scattered calls for massive fiscal stimulus as well. At best, we believe this would be counter-productive; at worst, it would [be] disastrous. First, consumers are benefiting already from the major tax cuts announced by Finance Minister Paul Martin last year. Second, American experience with tax rebates suggests that in the current environment most would be saved rather than spent. Third, the new security-related expenditures the government must make will, in themselves, have an overall stimulative effect. [Thomas d’Aquino, Business Council on National Issues, 47:10:40]
Many industry representatives believe that the current monetary policy in Canada and the United States, along with planned U.S. tax cuts and accelerated government spending, are stimulus enough at this time.
On the fiscal front, tax stimulus introduced early this year at the federal and provincial level will continue to work through the economy. Increased government spending for security and defence is pending. South of the border fiscal stimulus coming from the increase in U.S. government spending will also play a role in spurring economic growth, including here in Canada. Thus the stage is set for the start of an economic recovery in Canada, possibly as early as the spring or summer of next year, to start. Our expectation, therefore, is for growth in 2002 to average approximately 1.5%, virtually identical to the growth rate expected for our current year.
It … would be ill-timed to add to these monetary and fiscal initiatives … a direct government stimulus package. Such potentially large government spending initiatives are not needed at this time, and indeed could be counter productive. [Michael N. Murphy, Canadian Chamber of Commerce, 45:15:25]
The Committee agrees and recommends:
14. That the Government of Canada impose spending limits and, if necessary, cutback on low-priority spending in the budget plan should economic fundamentals weaken beyond expectations, or should additional external shocks require greater-than-anticipated national security spending, and begin to threaten the desired fiscal balance.