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3 - Budget Recommendations

"... I share the consensus of my col leagues, namely that 2% of GDP for the following year is a good ob jective."
Clément Gignac, Chief Economist and Strategist, Levesque Beaubien Geoffrion Inc.

The 2% Target

The Minister has recommended that the deficit target for 1997-98 be 2% of GDP, or about $17 billion. The Committee endorses this target as a realistic, responsible and balanced approach to deficit reduction.

Hitting the 2% target for 1997-98 should require only modest new budget measures before then. As a result of Phase I of the government's Program Review, and the measures announced in the 1994 budget and more significantly the 1995 budget, it is expected that program expenditures will fall to $108.6 billion in 1996-97 and to $106.3 billion in 1997-98. The major uncertainties relate to whether our prudent assumptions regarding interest rates and economic growth will hold throughout the next two years.

Prudent Economic Assumptions

The government bases its interest rate and growth assumptions on the average of private sector forecasts modified by a prudence factor to reflect the uncertainties that always accompany economic forecasts.

The private sector forecasts for 1996, prepared between mid-September and mid-October, averaged 6.3% for short-term interest rates and 7.8% on 10-year government bonds.

Adjusted for a prudence factor of about 50 basis points, this results in interest rates for budgetary purposes of 6.8% for short-term rates and 8.3% for 10-year bonds.

Because of the period when the private sector forecasts were made, the average of private sector interest rate forecasts does not reflect the uncertainty that has followed the Quebec referendum. However, other economic developments since then, including credit market conditions, have served to offset some of the negative effects of uncertainty about the unity of the country. The actual budget, in any case, will be based on assumptions updated to reflect conditions closer to the tabling of the budget in the House of Commons.

RECOMMENDATION

However, the Committee believes that the Minister of Finance should be even more prudent in his assumptions, adding not a prudence factor of 50 basis points but of 50 to 100 basis points above the average of the private sector forecasts.

With the prudent interest rates proposed by the Minister, the average of private sector forecasts for nominal growth in gross domestic product would translate into an assumption of 4.1% growth rather than 4.3%. Nominal GDP would be assumed to be $812 billion rather than $814 billion expected in 1996 by private forecasters.

An additional prudence factor as recommended by the Committee would result in higher interest rate and lower growth assumptions than the Department was using in early December.

Future Uncertainties

Attempting to forecast growth and interest rates over the next two years is difficult at best. Past experience tells us that such forecasts are often wrong, leading to errors in budgetary projections. This is why one of the major principles governing our recommendations is that the government must err on the side of caution. Thus we have recommended a prudence factor of between 50 and 100 basis points more than the average of the private sector forecasts. In spite of this prudence factor, the Committee is concerned that forecasting could be overtaken by three possible events. These are an unexpected increase in international interest rates, the possibility of a recession, and future political events in Canada.

A. Interest Rates

Because of the uncertainty of Canada's debt, future budgets are extremely vulnerable to shifts in interest rates. A 100 basis-point increase in rates would increase the deficit by $1.5 billion in the first year alone, with a cumulative impact on the debt of more than $10 billion over four years.

B. Recession

Many experts argued before the Committee that the likelihood of a severe economic downturn or recession before the end of the century is high. They were concerned that the current business cycle, which is by no means robust, could suffer further set backs because of foreign or domestic factors.

C. Political Uncertainty in Canada

So far, the political uncertainty relative to the Quebec issue has cost Canadians dearly. This political uncertainty has increased the risk of investing in Canadian securities, thereby increasing the risk premium on interest rates. In the late stage of the last referendum campaign, financial market concerns resurfaced causing a short-lived spike in interest rates and weakness in the dollar. The spread between Canada and U.S. 3-month Treasury bills increased dramatically one week before referendum day, reaching 177 basis points. On November 1, two days after the referendum, the spread settled at 44 basis points. The Canada-U.S. spread on 10-year government bonds reached 193 basis points on October 23. The volatility of the Canadian dollar was also extreme when it lost almost one cent U.S. in the week preceding the referendum. Even La Caisse de dépôt et de placements du Québec intervened to sustain the dollar. This volatility in interest rates imposed significant cost.

"Short weeks ago, Canada as we know it nearly ran out of time when Quebec came close to determining that it might be better off on its own. This committee cannot, must not, allow those in that province who argue that our federal system is costing them more than the value they receive back to be proven cor rect.
Ross Healy, President & CEO, The 2% Solution Network Solvency Analysis Corporation.
Since the referendum, investors are still worrying about the possibility of Canada breaking up. Because of the extremely slender margin of victory in the referendum and the resulting uncertainty, international investment analyst Barton Biggs eliminated his 3% weighting of Canadian stocks in his global model portfolio. Interest rate differentials on 10-year government bonds remain high, suggesting continuing concerns about not only our debt, but also our political future. The cost of servicing the debt during another referendum would once again be significant.

The Contingency Reserve

Established in last year's budget, the contingency reserve is a financial cushion against unforeseen events. It is there in case already prudent economic assumptions do not prove out. The Minister of Finance has set the amount of the reserve at $2.5 billion for 1996-97 and at $3 billion for 1997-98.

RECOMMENDATIONS

The Committee agrees with the need to maintain the contingency reserve as an additional prudence factor only, and not as a slush fund to be dipped into for new program spending. The Committee believes that the contingency fund has become an important element in maintaining international confidence in Canada's ability to meet its fiscal targets.

The Committee agrees as well that there is greater uncertainty about economic conditions in the second year of each two-year budget planning cycle than in the first and that the differential in the contingency reserve should reflect this added uncertainty. By 1997-98, however, it is possible that Canada will be even closer to the end of the current business cycle and to a referendum. Accordingly, the Committee asks the government to consider whether a contingency reserve of $3 billion for that year will prove adequate.

Finally, the Committee is concerned that one or more of these economic threats to our budgetary targets could have impacts not foreseen in the normal budget process. Accordingly, the Committee recommends that all economic factors not only be monitored on a continuing basis but that the government be prepared to either revise its economic projections or increase the contingency fund as may be required, and take the additional fiscal measures necessary to meet its targets.

"...as an economist - ... I know that we cannot as a group accurate ly forecast the economy at its turn ing point; that is, when we're mov ing into a recession. But as a group, you will find that virtually all Cana dian economists will recognize that there is a considerable risk, a high probability of recession, some time before the end of this decade. Be cause of that, it is important that we get our fiscal house in order so that when economic results come in at less than we anticipate, the finances will be able to adapt to that."
Don McIver, Chair, Economic Policy Committee, Board of Trade of Metropolitan Toronto.

Additional Fiscal Options

In that the government may be required to deal sooner rather than later with extraordinary economic conditions resulting from political uncertainty in Canada or a recession, the tax and expenditure measures outlined below constitute possibilities for additional fiscal action.

A. Possibilities for Tax Increases

Tobacco Taxes

In last year's report, the Committee recommended tax increases on cigarettes as quickly as circumstances related to smuggling would permit. On February 18, 1995 the excise tax on tobacco products was increased in Quebec and Ontario by 60 cents a carton without any apparent increase in smuggling activities.

RECOMMENDATIONS

The Committee recommends such further increases to the excise tax on cigarettes as circumstances related to smuggling will permit. An increase of $1 per carton (0.5 cents per cigarette) across all regions of Canada would increase government revenues by $150 million annually. Such a tax increase would likely reduce tobacco consumption. Recent surveys show that prevalence of smoking has increased in Canada.

In addition, the Committee recommends that the government, subject to smuggling considerations, consider tax measures to equalize federal tobacco taxes as much as possible across all provinces and territories. Under the current regime, the tax level varies from $6.45 per 200 cigarettes to $10.85 per 200 cigarettes, depending upon the province of residence.

Subject again to smuggling considerations, the government should also consider introducing tax increases on ``roll-your-own'' tobacco (fine cut and tobacco sticks for example) to a level closer to the tax on manufactured cigarettes.

Finally, the Committee recommends that the surtax on the tobacco industry and the export tax on tobacco products be maintained.

Lotteries

The Committee recommended last year a tax on lottery and casino winnings. Subsequent representations from border communities indicated that taxing casino winnings would remove a major competitive advantage Canada currently enjoys over the United States where winnings are taxed.

RECOMMENDATION

With regard to government-run lotteries, however, the Committee recommends that winnings of $600 or more be taxed at a flat rate of 15% by way of withholding at source. This tax would not affect lotteries run by charities and is not, in our view, so high as to adversely affect sales of lottery tickets. This measure would raise about $200 million per year.
"I'm a chartered accountant. I have a small public practice and the ma jority of my clients who are corpor ations don't pay taxes, but that is because they haven't made any money in the past few years. Those who have made money recently do have losses coming forward that they offset against the money they've made this year, and there's still more money to carry over to offset against future income."
Cleve Myers, Member, Greater Charlottetown Area Chamber of Commerce.

Gasoline Tax

RECOMMENDATION

In the event it appears that other budgetary measures are failing to lead to success in meeting the 2% target - and only then - an increase in gasoline taxes should be considered. A tax of 1.5 cents per litre would produce $500 million a year in additional revenues. The tax should not apply to other fuels, such as diesel.

Corporate Loss Carryovers

Under the current corporate tax regime, a corporation that suffers a financial loss in any one year can carry that loss forward for seven years and back for three years, deducting the loss from income in a year or years when the corporation was profitable, thereby obtaining a refund of taxes paid for such years. In effect, this is a form of income averaging for corporations that is not available to individuals. In the United States, corporate losses can be carried over for 15 years.

RECOMMENDATION

The Committee recommends that the government give consideration to reducing the number of years for which corporate loss carryovers are now available, recognizing at the same time the need to maintain a competitive investment climate in Canada. This issue should be dealt with as part of a wider study dealing with the taxation of business.

B. Options for Additional Spending Reductions

Defence

RECOMMENDATION

Defence spending is to be cut from $10.7 billion in 1994-95 to $9.2 billion for 1997-98. The Committee heard from many witnesses that further cuts can and should be made. With the Department of Defence having the single largest departmental budget, the Committee recommends that the government consider further cuts in defence spending with the caveat that these not impair the capacity of our armed forces to play their important new roles both at home and abroad.

Retirement Income

The government's largest single program expenditure is for ``elderly benefits,'' including Old Age Security and the Guaranteed Income Supplement. Totalling $20.5 billion in 1994-95, expenditures for elderly benefits will have grown to $22.6 billion by 1997-98. It is the only government program, other than that for Indians and Inuit, which will increase through 1997-98. These figures do not include the Canada Pension Plan (which will not be able to meet its future needs without major changes); ``tax expenditures'' in the amount of almost $15 billion to encourage saving for retirement pension plans; and age and pension income tax credits of $1.6 billion. There are, in addition, various other tax allowances for seniors.

"These old people in the co-ops for seniors lie awake at night. Some times they weep out of absolute fear, frustration and anger because they thought they were working for a fu ture, and now they don't know."
Judy Bayliss, Member, Board of Directors, Cooperative Housing Federation of Canada for Prince Edward Island.

Last year the Committee recommended against changes to programs involving retirement income of Canadians until the future needs of Canada's aging population for a secure and dignified retirement were determined. It was expected that studies to this end would be forthcoming.

RECOMMENDATION

The Committee is disappointed that a comprehensive study of the retirement needs of Canadians has not yet been completed. By 2011, the first of Canada's post war babies will reach retirement age. The Committee is concerned that current programs are not sustainable, and recommends in the strongest possible terms that the government undertake the studies and detailed consultations with Canadians necessary to put its various retirement programs on a sustainable and secure footing for the future.

Business Subsidies

RECOMMENDATION

Subsidies to business in the amount of $3.2 billion in 1994-95 will have been cut to $1 billion by 1997-98. Some business groups appearing before the Committee advocated their complete elimination. The Committee, however, urges the government to look closely at the viability and value of two categories of business subsidy:

RECOMMENDATION

In the past, DIPP was available to assist defence industries to undertake new manufacturing ventures. No new applications are being taken and DIPP is simply honouring past commitments. Canada's aerospace industry was a major user of this program. In a competitive international environment, where foreign governments provide large subsidies, the Committee is concerned that many high level jobs could be lost if our aerospace industry does not have a level playing field. We therefore urge the government to consider ways to maintain this level playing field. Any new program for sharing the risk of new ventures, however, must also envisage full cost recovery by the government.

Regional Development Agencies exist for Atlantic Canada, Quebec, Northern Ontario and Western Canada. The Committee recommended last year that all grants and contributions by such agencies be converted to repayable loans. It is understood, however, that some agencies still make contributions to business at less than commercial rates.

RECOMMENDATION

Spending by Regional Development Agencies will have fallen from $499 million to $254 million by 1997-98. The Committee recognizes the need to assist business to create jobs in Canada's poorer regions. At the same time, however, the Committee has insufficient evidence to determine whether this goal is being achieved, and if so, at what cost. Accordingly, the Committee recommends that the government review each agency with a view both to determining its effectiveness at creating jobs and to how these agencies can recover more costs.

C. Possible Tax Reductions

While the Committee believes that Canada is not yet in a position to consider over-all tax decreases and has recommended against them, it nevertheless wishes to set forth the following limited tax reduction measures for consideration.

Income Averaging for Individuals

An individual whose income fluctuates widely from year to year (an artist or writer for example) will often find one year's income taxed at top marginal rates, even if he or she had no income in a previous year. If the total income had been earned equally in those two years, a lesser rate would have applied. Corporations, under the current rules, can carry losses over for 10 years and set them off against otherwise taxable income.

RECOMMENDATION

The Committee recommends that the government consider an income averaging measure which would reduce the overall tax burden on generally low-income earners such as artists or writers to ensure that they are not unduly taxed because of wide income fluctuations from year to year. The Committee does not recommend income averaging measures for all individual taxpayers.

The Committee is aware that income averaging - available to all Canadians in the early 1970s - was eliminated because of the perception of abuse. While the Committee recognizes the need to control abusive tax avoidance, we believe that other measures since put in place such as the General Anti-Avoidance Rules (GAAR) can control it.

Charitable Donations

The Committee heard evidence that Canadian charities currently face a ``triple whammy'' of reduced funding from governments, of having to serve more Canadians as programs are cut, and having to compete not only against one another but against governments for charitable donations.

The Committee strongly believes that governments have a responsibility, as they cut back on worthwhile spending programs, to assist in helping volunteer and charitable organizations to replace lost public funding with private contributions.

The Committee's pre-budget report of last year recommended that the issue of charitable donations be brought forward for further study. Preliminary reports to the Committee indicated that changes to current tax measures affecting charitable donations would be inappropriate since they were as generous as those in the United States. While this is true with respect to donations of income, further studies provided to the Committee this year by Donald K. Johnson, and Ernst & Young, indicate that Americans enjoy major tax advantages when donating appreciated capital property.

Under Canadian law, a donor of appreciated capital property such as corporate shares, is deemed to have disposed of the property at its fair market value and must pay full capital gains rates on the gain. A donor can deduct only 20% of the fair market value against other income each year.

Under U.S. law, however, a donor of appreciated capital property is not subject to capital gains taxation, and can deduct 50% of the fair market value against income. The authors of the study conclude that these tax provisions are one of the main reasons that many U.S. charities have been so successful in attracting large gifts into endowment funds, thereby gaining both greater financial security and independence from governments.

RECOMMENDATION

The Committee requests the government to consider the following possible measures to give Canadian charities the opportunity to make up for lost public funds with private donations.

Mr. Johnson testified that these measures would enable governments to reduce their direct funding of charities by at least as much as the foregone tax revenue. From the perspective of government revenue therefore, such measures are intended to be, revenue neutral. He informed the Committee as well that charities would welcome such measures, based on the following example:

Some witnesses also complained that those charities which currently enjoy Crown status have an unfair tax advantage, since the 20% limit does not apply to them. The above measures would reduce the inequities between those organizations with Crown status and those without it.

RECOMMENDATION

As well as recommending that the government give consideration to the above measures, the Committee recommends that the government consider enhancing the charitable tax credit for donations to charities currently funded by governments to make it as generous as the current political tax credit for small donations to political parties.

Employer-Provided Medical and Dental Benefits

The Committee heard evidence last year that approximately 20 million Canadians were covered by employer-provided medical and dental benefits. Non-taxation of these benefits constituted an annual tax expenditure of about $1.1 billion.

The Committee recommended that, rather than taxing employees on these benefits, the insurance and health industries should come back to us with proposals to provide benefits for those Canadians not already covered.

Rather than this, the industry returned to the Committee this year with new figures, indicating the number of Canadians who are not covered by supplementary medical and dental plans and suggesting they are far fewer than assumed.

According to industry figures, 1.95 million Canadians could qualify for benefits, but their employers do not provide them. As well, 1.08 million unincorporated self-employed individuals and their dependents do not have supplementary coverage. Unlike incorporated self-employed individuals, workers in this group cannot deduct the cost of their own supplementary coverage as a business expense.

The Committee recommends that the government examine the possibility of allowing self-employed, unincorporated individuals to deduct the premiums of supplementary health and dental coverage. According to the Canadian Life and Health Insurance Association, the cost to the federal government of allowing the deductibility of premiums for unincorporated individuals would be about $35 million.

RECOMMENDATION

Industry figures also show that, in addition to the above 3.03 million individuals not presently covered, 570,000 Canadians have little connection to employment, do not qualify for special government programs and are not covered as dependents under private or government plans. The Committee again asks the industry to seek ways to help those beyond the reach of existing public and private programs.

The Canada Health and Social Transfer

For a number of years, the federal government has provided financial support to the provinces in three main areas of provincial constitutional jurisdiction, namely health care, post-secondary education and social assistance. This support has consisted of both cash payments and the transfer of federal tax points whereby the federal government reduced its taxes to permit the provinces to increase theirs. Transfers for post-secondary education and health care were made pursuant to the Established Programs Financing (EPF) and transfers for social assistance were made under the Canada Assistance Plan (CAP).

The 1995 budget changed this approach. The EPF and CAP transfers become one transfer on April 1, 1996, called the Canada Health and Social Transfer (CHST). Total transfers, including cash and tax points will decline from $29.9 billion in 1994-95 to $25.1 billion for 1997-98. Since the value of the tax points already transferred to the provinces will continue to increase over this period, all of the savings to the federal government will come out of its cash transfers.

"...we've got this thing called the Canada health and social transfer, which is now this merged pot of funds that has managed to set health care, social services, and education against each other. ... It's created a great sense of uneasiness and conflict at the provincial level and possibly at the grassroots level."
Carol Clemenhagen, President, Canadian Health Care Association.
When the Committee considered the CHST under Bill C-76 last spring, a number of witnesses expressed concern that, as the cash component of the CHST diminished, the federal government would lose its leverage on the provinces to adhere to national standards for post-secondary education and welfare and to enforce the provisions of the Canada Health Act. The Committee agreed with these concerns, and passed Bill C-76 with the caveat that there must continue to be a cash component to the CHST sufficient to achieve these ends. The government has pledged to maintain a sustainable level of cash payments under the CHST.

"My only concern with decentraliz ing this type of program is that we know that not all provinces have the same level of wealth or ability to collect taxes. My concern would be that a province like Newfoundland may then end up with a very poor set of social programs compared with, say, another province like British Columbia, which has a lot of extra wealth and could have a very good set of social programs. I'm not sure I would like to see Ca nada divided in that way."
Marvin Painter, Assistant Pro fessor, University of Saskatche- wan.
In its hearings, the Committee heard testimony that the cash transfers under the CHST should be divided into three components, one each for health care, social assistance and post-secondary education. The Committee does not agree with this approach. Creating three separate diminishing cash transfers, each targeted to a specific program, would give far less leverage to the federal government to enforce national objectives. It would mean, for example, far fewer funds with which to enforce compliance with the provisions of the Canada Health Act, as was recently necessary in the case of Alberta, and to enforce the non-residency requirements for social assistance as was the case in British Columbia.

As well, a major purpose of the CHST was to give the provinces flexibility to establish their own priorities within the broad framework of national standards. For the federal government to designate the spending in each sector would negate this effect.

RECOMMENDATION

Provincial governments, however, are free to designate how they will use tax points and cash transferred under the CHST and may well be willing to do so if requested by those groups in each province who are concerned that the funds be earmarked. Earmarking is now a provincial decision to make. Accordingly, while recognizing that cuts in transfers to the provinces are a painful and necessary measure for restoring Canada's fiscal health, the Committee supports the block transfer approach embodied in the CHST and recommends against the federal government splitting the block of funds for each province into smaller, earmarked amounts.

The Goods and Services Tax

"The GST needs to be fixed... The GST is unfair, overly complex and unnecessarily expensive. It is unfair because of its exemptions. Exemp tions force the rate up higher than necessary, create complexity, and facilitate avoidance. This $720 tin of caviar is tax free. ... This child's milk is taxed in our restaurants. Where is the logic here?"
Michael Ferrabee, Vice-President of Government Affairs, Canadian Restaurant and Foodservices As sociation.
In its Report of June 1994, entitled "Replacing the GST: Options for Canada," the Committee recommended that the federal GST and each of the nine provincial sales taxes be replaced by a single National Value Added Tax under one administration.

Since then, the government has undertaken discussions with the provinces in an endeavour to achieve this objective. The new government of Ontario promised to harmonize its sales tax with the GST and consultations are on-going.

"We think the GST needs to be har monized, and the cost recovery pro cess needs to be addressed in a real and serious way. Nobody has any problems with paying fees for ser vice, but what we're asked to do at this point is not pay fees for service but just pay the fees."
Sally Rutherford, Director, Cana dian Federation of Agriculture.
Many witnesses urged the government to renew its efforts to have the GST harmonized. They cited the enormous cost savings to government and the private sector, particularly small business, that would arise from replacing 10 different tax laws and administrations with one. This is one form of federal-provincial duplication that we cannot afford. They cited as well the competitive advantage enjoyed by U.S. businesses that are not taxed on their business inputs. Harmonization would remove this disadvantage for Canadian firms and lead to more jobs.

RECOMMENDATION

The Committee recommends that the government continue its efforts to achieve harmonization of provincial sales taxes with the GST. It is evident that not all provinces will agree to harmonization in the near future, but the government should proceed immediately to harmonize with as many provinces as possible, allowing for others to come on board later.

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