THE STATUS QUO FEDERAL FISCAL OUTLOOK: NOT MUCH ROOM HERE

While the federal government’s 2006 Budget was only 3 months ago, planning for the 2007 Budget will soon begin with a meeting with private sector economists in late September or early October, followed by release of a Fall Economic & Fiscal Update and then hearings by the House of Commons Standing Committee on Finance. Many unofficial fiscal planning exercises are likely already underway. The Conservative Party may have turned its attention to crafting a new platform. The Liberal Party leadership contenders are no doubt examining the interplay between their positions and fiscal realities. Various interest groups are preparing to engage in the planning processes.

A difficulty all fiscal actors will encounter is that there are no official fiscal projections available beyond 2007-08, the last year covered in the 2006 Budget. As some policy measures take several years to mature and the Government has set a longer-term objective for the debt burden, a much longer time horizon is needed for planning. And as some decisions may be made well before next year’s Budget, such as for transfers to the provinces, there is utility in having a longer-term view fairly soon. However, the last official longer-term projection, extending through 2010-11, was in the Fall 2005 Update by the Liberal Government. But many of the underlying policies have since been altered, undermining the usefulness of that document.

This note takes a stab at a highly unofficial longer-term projection of the federal government’s books. The period extends to 2012-13 to give 5 years following the 2006 Budget’s horizon. The figures for 2006-07 and 2007-08 have been left unchanged from the 2006 Budget. Subsequent data suggest some tweaking of components is in order, but in aggregate the Budget still appears to be a reliable representation of the near-term fiscal situation. The projections for the later years borrow liberally (excuse the pun) from last year’s Fall Update, with appropriate corrections for policy changes. The Conservatives promise of a second point cut to the GST rate has not been incorporated into the status quo outlook.

No adjustments have been made to reflect differences in view between the Budget assumptions and internal projections by TD Economics. In a sense, this exercise could be viewed as an attempt to forecast what the federal government will show in the 2006 Fall Update.

Planning surpluses are modest

Under the key assumptions of continuing sound economic performance and implementation of the policy agenda set out in the 2006 Budget, budget surpluses would continue to accrue. But they would be quite modest. The 2006 Budget projected that on top of paying down $3 billion of debt each year, there would be remaining surpluses of $0.6 billion this year and $1.4 billion next year. These remaining surpluses would not change much over the next 2 years at $1.9 billion and $2.0 billion. The surpluses above and beyond the $3 billion annual debt payments would then grow in the final 3 years.

Over the 5 years 2008-09 to 2012-13 the surpluses on top of the committed debt payments average $6.2 billion per year for a cumulative total of $31.2 billion. On the surface these may appear to be significant figures. But they are not large beside the cost of initiatives in recent budgets. The Liberal’s 2005 Budget had $41.8 billion of initiatives over 5 years and the Conservative’s 2006 Budget had $35.1 billion over 3 years. Further, consider that a single point reduction (or transfer to the provinces) in all 4 personal income tax rates would cost more than $6.5 billion per year by 2010. Of greater relevance for the Conservatives is that by 2010 a point cut in the GST rate will also cost about $6.5 billion per year. The cut could not even be accommodated in this status quo projection by 2010 without compromising the commitment to pay down $3 billion of debt each year. If the 3-year cost of a point GST rate cut is applied to the final years, the 5-year cumulative remaining surplus above debt paydown is only $11 billion or an average of just over $2 billion per year.

A number of conclusions seem evident from this unofficial projection. First, the federal government’s books should remain in a healthy state. In particular, the debt-to-GDP ratio falls below 25 per cent by 2012-13, one of the lowest in the world and just over one-third where it stood in Canada in the mid-1990s. This milestone is reached one year earlier than the objective set in the 2006 Budget. Second, while respecting the commitment to pay down at least $3 billion of debt per year, there isn’t a lot of room for new initiatives short of cutting existing programs and services. This of course has great relevance in the current debate over federal-provincial transfers. It may also serve as a bitter reality check for politicians and advocates alike who may be contemplating schemes with significant costs.

Forecasts can be wrong, policies can be changed

As to forecast accuracy, consider that this exercise assumes a continuation of solid economic performance with modest interest rates for another 6 years. Anyone caring to give a thought to the upside should also ponder that things could be worse. After 2007-08, program expenses rise at an average annual rate of 4.1 per cent. It would certainly be feasible to lower that. But difficult decisions would be required.

The projection for program expenses already implicitly assumes that the internal cost-cutting exercise announced in the 2006 Budget will be successful in meeting its objective and then keeping spending to the lower track. Second, much of the growth in spending comes from programs that in recent times have been considered “untouchable”. For example, driven by indexation to the CPI and the rising growth rate of the population over the age of 65, elderly benefits rise at an annual average rate of 4.9 per cent beyond 2007-08. If the Conservative Government follows the plan legislated by the Liberals for transfers to the provinces for health and other programs then this component will grow at an annual rate of 5.3 per cent. The current equalization scheme is indexed through legislation to 3.5 per cent growth. All the recent proposals for reform would raise the cost above what is contained in this status quo projection. Further, the federal government has said it is considering the provinces’ request to increase transfers with respect to post-secondary education.

Direct program expenses, being the total of all non-major transfers to persons or other levels of government, is projected to grow at an annual rate of 3.9 per cent beyond 2007-08. This is dramatically lower than in recent years, (program expenses averaged 8.2 per cent annual growth from 1999-00 to 2004-05) but could certainly be lowered further. But again there would be real implications. Key factors keeping the growth rate up are the real increases in the budgets to defense and Overseas Development Assistance and rising depreciation charges reflecting the increases in infrastructure spending of recent years. The civil service wage bill, which comprises one-quarter of this spending category, is assumed to grow 3 per cent per year to reflect wage increases slightly higher than inflation (so a small real wage gain) and very modest increases in employment levels.

Budget planning will be more restrained

If the Government’s Fall Update projection bears any resemblance to this unofficial cut, then the days of “easy” budget planning are gone. Recent years have been easy on budget planners because a natural “wedge” had developed between revenues and spending that automatically generated growing planning surpluses. With the growth rate of budgetary revenues above that of total spending, the “wedge” produced larger surpluses as each new budget extended the planning period. But the “wedge” has been flattened. In the projections presented here budgetary revenues grow more slowly than program expenses because tax cuts have slowed revenue growth and new initiatives have ramped up spending growth. Now even with slightly declining public debt charges total spending (program expenses together with public debt charges) only increases modestly less rapidly than revenues. The elimination of the economic prudence factor in the 2006 Budget closed the door on $1 billion of fiscal room that was automatically opened with each new fiscal year. The practice of the Liberals and Conservatives to back-end load the cost of new initiatives has to eventually catch up with policy makers.

The end of “easy” budget planning is not necessarily to be lamented. It did, after all, lessen the need for discipline in all aspects of fiscal management. And we should not lose sight that Canada is in great fiscal shape relative to its own history and the record of almost every other country. Further, the projections contained in this report do not need to spell the end of policy activism. But difficult trade-offs will need to be managed in order to introduce changes with large budget costs. Finally, many of the things that ail the country and economy can be creatively tackled without incurring significant costs. As productivity is enhanced, growth will rise and that will raise revenues and open more choices.