THE 2008 FEDERAL BUDGET

Released on February 26, 2008

HIGHLIGHTS

• FY 07-08 surplus estimated at $10.2 billion, used for debt pay-down
• Surplus projections and planned debt pay-down scaled back for FY08-09 and FY09-10
• Accelerated capital cost allowance (CCA) for manufacturers extended for 3 years, with a phase-down in the rate, at $1 billion cost
• Additional funding for public transit infrastructure, R&D in the auto industry and carbon capture & storage technology
• Creation of a Tax-Free Savings Account (TFSA) in 2009

In the weeks leading up to today’s Budget 2008, Finance Minister Jim Flaherty was busy managing expectations for the fiscal year to come. In light of tax relief measures already announced in October’s Fiscal Update and the expected slowdown in economic activity, the emphasis was on prudence and frugality. Stating on Monday that “people ought not to expect any big spending items”, Mr. Flaherty nonetheless admitted there would be “one or two surprises”. Speculation was that one of these would be the partial fulfilment of an outstanding commitment, made during the 2006 election campaign, to allow investors to shelter their capital gains from taxes if those profits were reinvested within six months. Today’s Budget didn’t go that far, but the government did announce the creation of a new tax-free savings vehicle, the Tax-Free Savings Account (TFSA). Furthermore, along the lines of what was expected, further support for the manufacturing sector and new funding for infrastructure were announced.

$10.2 billion surplus and debt write-down for FY 07-08

The government’s batting average at estimating surpluses might be improving. Indeed, Budget 2008 marks a departure from recent history in that its typical large undershooting of the surplus was more timid this time around. The previous two Budgets had recorded actual surpluses more than double the amounts projected in the fall Fiscal Update. The latest Update, however, had estimated the surplus would come in at $11.6 billion for FY 07-08. Before the impact of new measures announced today, the government’s planning surplus was revised upward relatively modestly from that October estimate, to $12.9 billion. For the same fiscal year, the cost of measures proposed in today’s Budget factor in at $2.7 billion, of which $1 billion will be devoted to supporting communities and traditional industries, $500 million will go towards public transit infrastructure, and $400 million towards a police officer recruitment fund. The remaining $800 million will be split among knowledge & research initiatives, carbon capture & storage technology, and support for more vulnerable Canadians. All told, this leaves a new estimated surplus of $10.2 billion which will be entirely directed towards debt reduction, or $200 million higher than planned in the Fall Update.

The economic outlook has weakened since the Fall Update, mostly in the United States, with its inevitable repercussions into Canada. Real GDP for the U.S. is forecast to grow by only 1.5% this calendar year, in line with TD Economics’ expectations. As a consequence, the Canadian economy, while expected to fare better, should also experience slower growth of about 1.7% in real terms 2008, translating into fairly weak nominal GDP growth of 3.5% or so according to Finance Canada. In turn, the government has therefore had to scale down its projected revenues by $3.7 billion for FY 08-09. On the flip side, spending is now forecast to be lower by about $3.1 billion, mostly due to reduced public debt charges.

The net adjustment for FY 08-09 – when compared to the Fall Update – is therefore a weaker bottom line to the tune of $0.6 billion, bringing the expected surplus (before deducting the impact of new measures) down to $3.8 billion. While economic activity is expected to pick up the pace in 2009, growth forecasts are nonetheless currently more conservative than they were back in October. For FY 09-10, the revenues forecast has been revised down by $3.2 billion, with a $1.7 billion downward adjustment in program expenses only providing a partial offset, The net revision for FY 09-10 implies a “status-quo’ planning surplus of $3 billion, down $1.3 billion from the Fiscal Update.

In light of the limited fiscal room, the government has opted to discontinue its customary strategy of allocating $3 billion to planned debt reduction. Under the former government, this amount was set aside as a contingency reserve along with another buffer for economic prudence, which together provided the budget with significant protection against unforeseen negative revenue surprises. When the Harper government took office, it discontinued the economic prudence cushion, but kept the $3 billion buffer, changing the label to ‘planned debt reduction’. In today’s budget, this amount has been lowered to only $2.8 billion in FY 08-09 and $1.3 billion in FY 09-10 in order to make way for new measures, albeit ones that are still quite limited in scope. In total, the new measures announced for FY 08-09 and 09-10 are expected to cost $1.5 billion and $1.7 billion, respectively.

New measures

While not the most costly in terms of foregone revenue – at least during its start-up phase – the measure that will have the largest impact for most Canadians over the long haul is no doubt the introduction of a new tax-sheltered savings vehicle or Tax-Free Savings Account (TFSA). Unlike an RRSP, contributions to this vehicle are not tax deductible nor are withdrawals subject to tax. But like an RRSP, earnings within the plan don’t attract tax, making it a very useful way to supplement saving for retirement. Details of the proposed TFSA are provided in the accompanying textbox. While economic conditions and fiscal positions differ markedly in the U.S. and Canada, providing Canadians with the added flexibility of an incentive-based savings tool provides a stark and positive contrast to the spending stimulus the U.S. budget will provide. The initial foregone revenue from allowing the tax sheltering of investment income within the TFSA is estimated to be only $5 million in FY 08-09. As the asset base upon which the investment income grows expands, the foregone revenue ramps up significantly over time, to $290 million by 2011 and about $3 billion annually in twenty years.

Within the two-year forecast horizon of the Budget, the only new and significant tax relief measure is, as expected, aimed at manufacturers. In Budget 2007, the federal government announced a 2-year accelerated capital cost allowance (CCA) program for manufacturers for machinery and equipment purchases before 2009. In today’s budget, the government extended the two year write-off (or 50% per year) for an additional year. For the following two years, the accelerated treatment will continue, although at a declining rate. This extended measure is expected to cost $1 billion over the course of the 3-year period.

On the spending side of the ledger, significant initiatives in terms of total expenditures include: