3 STARS OF THE 2006 FEDERAL BUDGET

With 28 tax cuts and a similar number of spending initiatives, there should be no shortage of candidates for star selection from the federal May 2, 2006 Budget. But none of them make this list, although they do deserve honourable mention collectively for passing the transparency test. For the most part they were delivered as advertised in the Conservative’s election platform. The 3 selected stars of the Budget played understated, supporting roles. But they offer considerable promise. They are, therefore, stars and top draft picks simultaneously.

The top 3 stars of the 2006 Federal Budget are:

1. The commitment to “pursue a broad approach over the coming year … to develop a strong, results-oriented agenda to promote a more competitive, productive Canada for the benefit of all Canadians” (Budget Papers, page 92) ;

2. The new approach to budget planning ;

3. The principle-based framework for federal-provincial-territorial fiscal (and economic) relations.

Improving the performance of the Canadian economy for the benefit of all Canadians is not at least directly one of the Conservatives’ 5 priorities. As such, the goal received little attention in the election platform or the Speech from the Throne. But there it is in very concise prose in the Budget. Dare we think of creating a more competitive, productive economy as a sixth priority?

Previous governments also identified raising productivity growth as a priority but did not succeed in convincing Canadians to embrace the challenge. Perhaps Finance Minister Flaherty can succeed where others have failed. The brief discussion of productivity in the Budget may be a thin reed to grasp, but it offers hope. It demonstrates an attempt to put the productivity challenge in terms that shows Canadians why success is in their interests. It doesn’t dummy down the debate by shifting to “softer” words to side step the Canadian public’s wariness of the term productivity. And it doesn’t shy away from taking on some thorny issues where the federal government does not hold the levers like interprovincial trade barriers, provincial capital taxes and multiple-jurisdiction securities regulation.

The productivity challenge needs a national champion that will not only straighten out federal policies, but entice, coerce or bully as required other players in the economy including the provinces, businesses and workers to act in the best interest of improving the performance of the Canadian economy because that is what ultimately serves everyone’s best interests. Let us hope that as he pursues “a broad approach over the coming year…to develop a strong, results-focused agenda to promote a more competitive, productive Canada”, Minister Flaherty, with full support of the Prime Minister and Cabinet, becomes that champion.

The first task will be to find better ways to communicate the productivity challenge. Politicians and economists too often leave Canadians thinking that raising productivity means working harder for less pay (see text box above). The opposite is the case.

The second task is to build consensus on what needs to be done. That might not be difficult because many elements of an agenda already have widespread support, including:

• Promoting macroeconomic stability;

- The Bank of Canada is steadfast in pursuing the objective of low, stable inflation and the pay-off is evident in modest interest rates despite a strong national economy.

- The 2006 Budget commits the federal government to further debt reduction and provincial debt burdens are falling as well.

• Shifting from consumption to investment;

- Government policy should support investment through promotion of education and infrastructure.

- All governments have re-committed to this goal in recent years after a long period of starving investment.

- The 2006 Budget includes a number of investment initiatives.

• Sharpening the incentives to work, save and invest;

- Canadian corporations face among the highest tax rates on capital in the world. The 2006 Budget sliced these rates significantly and much of the remaining problem resides with several of the provinces who heavily tax corporate income and capital and apply their sales taxes to investment. In particular, the 2006 Budget shows leadership in eliminating the federal capital tax effective January 2006. Capital taxes cause the greatest amount of economic damage because they lower the amount of capital Canadians can work with, thus lowering productivity. Unfortunately, many provinces continue to apply capital taxes, either to all industries or to the financial services industry.

- Many Canadians face effective marginal personal income tax rates – once accounting for the loss of income-tested federal and provincial social benefits – exceeding 60 per cent. These too are among the highest rates in the world. The result is there is little incentive left to save or upgrade skills in order to increase earnings. The Budget Papers (pages 70-71) document how taking a job can often leave social assistance recipients financially worse off. In a statement overlooked by virtually all budget commentaries, Finance committed to “identify, in consultation with provinces and territories, potential measures to improve incentives to work for low-income Canadians, including through an earned income tax credit such as a WITB (Working Income Tax Benefit). One was proposed by the Liberal Government in the Fall 2005 Economic and Fiscal Update. TD Economics recommended such a program in a 2005 study on barriers to exiting social assistance (From Welfare to Work in Ontario: Still the Road Less Travelled – September 8, 2005). Lastly, a Task Force recently recommended the creation of a new refundable tax benefit for low-income wage earners (see text box on page 4).

- Unfortunately, lowering the marginal effective personal income tax rates is very expensive. Each percentage point off the 4 federal personal income tax rates costs the federal treasury $5.5 billion per year. Here is where a final shot at the GST rate cut cannot be resisted. Each point reduction to the GST rate has a similar cost, yet that tax cut does nothing to improve sustained economic performance. And there is a commitment to cut a further point, drawing additional resources that could be allocated to improving economic performance.

• Sharpening competition;

- Interprovincial trade barriers and foreign competition restrictions are examples of barriers to competition that lessen the efficiency of the Canadian economy. They have no place in a modern economic structure that has to compete globally.

• Improving immigration;

- Many immigrants of recent years are struggling economically (see accompanying text box on page 5). The 2006 Budget provides funding for settlement and credential recognition and this should ameliorate the situation. But consideration needs to be given to more wholesale change. In particular, immigration could be a more effective answer for growing Canadian labour shortages if it became less of a passive system (merely receiving applications from those choosing Canada) to a pro-active one searching and marketing for certain types of workers. Presently there is not even an electronic register of the qualifications of the applicants in the queue. Further, it can take up to 5 years before an application makes its way to the top of the pile to be considered.

• Businesses need to invest and trade more;

- The Canadian economy’s ratio of machinery and equipment investment to hours worked is only 55 per cent that in the United States. The difference can certainly not all be explained by taxation. Canada’s research and development as a share of GDP was 14th within the OECD countries in 2003 and below the OECD average despite governments support through its R&D spending and the tax credit. And while we think of Canada as a trading nation, almost 50 per cent of our exports comes from 50 companies and about 80 per cent of small and medium-sized businesses do not export at all. A recent Statistics Canada study showed that productivity is much lower in Canadian firms that do not trade relative to those that trade (see text box).

• Reducing the regulatory burden;

- According to the Canadian Federation of Independent Business, Canadian businesses spend $33 billion a year to comply with government red tape. 65 per cent of firms surveyed identify government regulation and paper burden as their greatest concern, second only to the overall tax burden (82 per cent).

- R & D provides an interesting example of how regulatory practices can be as important as policy parameters. On paper, Canada has one of the most generous R & D tax credits. Yet few small and medium size companies use it and when they do, they often go through an intermediary who takes as a fee a good chunk of the value of the credit. Allegedly this is because of the perceived complexity of the program’s regulations and administration.

- As cited in the 2006 Budget, the multiple jurisdictions for securities regulation is another hit to the efficiency of the Canadian economy.

- In recent years federal and provincial governments have been driving down small business income tax rates, claiming small businesses are the backbone of the economy. Yet we do want businesses to grow and larger firms, on average, are more productive and pay higher wages with more benefits. We should be concerned that the jump in tax rates and certain regulatory provisions that kick in as a business grows do not become obstacles to economic growth.

• Promoting a culture of lifelong learning and training;

- Canadian firms do not fare well internationally in the amount of training provided and many workers do not act on the need to update and elevate their skills over time (see text box on page 7). It is no longer sufficient to heavily invest in someone’s education until the age of the early 20s and then let that human capital rundown subsequently. Massive government subsidies should not be required. It is more a matter of demonstrating that training and lifelong learning are in companies’ and workers’ best interests.

- Canada’s shockingly high adult illiteracy rate is an obstacle to lifelong learning that receives inadequate attention. Training cannot be effective if people lack the basic reading, writing and numeracy skills.

The third and final task in a competitiveness-productivity agenda is to ensure action in the most promising areas. Here is where the skills of a champion will be most tested because in many cases the lever required will not be in the federal tool kit. Rather, provinces, companies or individuals will need to be convinced to respond.

The second star: The New Approach to Budget Planning

There are 3 positive aspects to the new approach to budget planning:

It may seem counter-intuitive to pick reduced prudence as a budget star because this is perhaps the aspect of the budget that has been most criticized. The claim is that the new approach raises the risk of running a deficit. Of course that is true. The new Government has stripped out the economic prudence factor which was $1 billion in the first year of a budget plan and $2 billion in the second year. This change was to be expected because the factor was missing in the fiscal plan of the Conservative’s election platform.

Applauding the reduced degree of protection against deficits does not mean that the new approach is superior to the system devised by the Liberals. Conditions have changed and policy needs to adapt. The Liberals introduced the two-tiered system of a contingency reserve and economic prudence after decades of previous governments persistently under-predicting deficits. The deficit at the time exceeded $40 billion and the debt-to-GDP ratio was about 70 per cent. The large buffers played a role in turning those deficits into surpluses and while the debt reduction “by stealth” may not have been as transparent as it could have been, there is no doubt that a greater good was accomplished. The federal government will record its 9th consecutive surplus in 2005-06 and the debt-to-GDP ratio will be 35.5 per cent, about half what it was a decade ago.

The buffers in the budget process had become a liability to good budget planning. As an allergy developed to large debt paydowns, the larger–than–anticipated surpluses were used to finance large end-of-year spending sprees. The Conservative Government’s intention to tap $3.3 billion from the 2005-06 surplus for immediate provincial-territorial pressures suggests they feel the same itch. As the economic prudence was not going to debt repayment, it became an apparatus to keep tax burdens high in order to fund last-minute spending splurges. As such, good riddance to it.

The 2006 Budget also drops the formal label for the $3 billion contingency reserve. However, as the commitment remains to pay down at least $3 billion of debt each year, this change seems to be largely semantic.

What about the charge the Conservatives have raised the odds of slipping into deficit? First, as argued above, the protection they have removed has simply become an artificial way of propping up tax burdens. Second, you cannot simply infer from a fiscal plan whether a deficit will occur. If economic circumstances deteriorate such that significant and persistent deficits appear likely, the Government can change the fiscal plan. Of course, tightening fiscal policy as the economy deteriorates is easier said than done.

Finally, and here comes a thought that will strike many as economic heresy, elevating “thou shall never run deficits” to the status of an eleventh commandment has no ground in economic or fiscal policy. In an economy of over $1 trillion of output annually a small, occasional deficit that is offset over the business cycle is only meaningful in a political sense. And providing ironclad protection against it ever happening does carry a price tag – excessively high tax burdens.

The 2006 Budget commits the President of the Treasury Board to report this fall on a new expenditure management system. In language federal fiscal watchers have come to understand, the new approach amounts to an ongoing Program Review whereby programs are constantly evaluated against purpose, results, value for money and federal responsibilities. Such reviews in the past have been periodic and in the meantime each new program stacked on top of the existing base. Hopefully the new system will also recognize that every time a new spending priority is announced, by definition existing programs slip to a lower rung on the priority ladder and should be trimmed in order to finance the new initiatives.

The announcement by the President of the Treasury Board this fall is to include details of how $1 billion of spending cuts will be achieved in 2006-07 and 2007-08. It is commendable that there is an objective to finance at least a part of the new spending internally, but the amounts targeted are well below the implicit cuts set out in the Conservatives’ election platform ($22.5 billion cumulatively over 5 years). Further, the record of previous governments in delivering on booked, but unspecified cuts is dismal. However, given that the Conservatives have delivered on most of their campaign promises, we should keep the faith until the fall on this promise.

The third star: The Principle-Based Framework for Federal-Provincial-Territorial Relations

Canadians must be highly confused about the so-called “fiscal imbalance” which in its popular form is taken to mean that the federal government has “excess” revenues while the provinces do not have adequate revenues to meet their responsibilities. This year’s round of provincial budgets reveals that only 2 provinces are in deficit – Ontario and Prince Edward Island – and Ontario has a plan to restore balance over their planning horizon (see table below). The 2006 federal budget shows that above the commitment to pay down $3 billion of debt each year, the planning surpluses are a mere $0.6 billion this year and $1.4 billion next year. The planning surpluses could grow in later years, but much of that would be grabbed by the commitment to knock another percentage point off the GST rate. Given the numbers, it is difficult to understand why speculation continues over whether the federal government will transfer tax room to the provinces. How could it in light of the fact mentioned above that a mere 1 percentage point off each of the 4 federal personal income tax rates would cost the federal treasury $5.5 billion per year? The answer is that it couldn’t (that is, unless you consider the GST rate cuts as tax point transfers) unless federal spending was first cut to create the fiscal room. But as cuts to federal spending might shift responsibilities onto provincial-territorial shoulders, such a move would not necessarily be the financial windfall the provinces and territories are looking for.

The 2006 Budget paper “Restoring Fiscal Balance in Canada” goes some way in clarifying the issues. Not that this seems to have had much of an impact on the debate so far. For starters, notice that the term “fiscal imbalance” seems to have morphed into “restoring fiscal balance”. Second, consider the issues the budget document identifies:

We have already discussed the first and fourth points. The second point really cuts to the core of any “fiscal imbalance”. The federal government has been using its spending power, backed by a thick wallet from unanticipated surpluses, to venture into areas that traditionally have been provincial, territorial or municipal responsibility. The result has been blurred accountability and program inefficiency. Consider as an example the Canada Millennium Scholarship Fund, introduced in 1998. The new federal initiative virtually replicated provincial bursary programs so it should not have been a surprise that many provinces withdrew their support for students dollar-for-dollar with the federal injection (they subsequently committed to leaving the money in the PSE field). The “fiscal imbalance” debate typically revolves around revenue sources. But the Budget document shows the issue must start at the other end – defining respective federal, provincial, territorial and municipal responsibilities. The revenue side will only come into play if the federal government exits from provincial-territorial-municipal areas sufficiently to create fiscal room to finance a tax transfer. But as argued above, this would not necessarily be a fiscal windfall for the provinces, territories and municipalities because they might need to spend more money in areas the federal government exits.

The issue of greater predictability in fiscal arrangements is also legitimate. The federal government has a history of increasing spending in areas beyond its jurisdiction but leaving the other levels of government hanging when things get tough. Further, equalization payments have been subject to huge revisions which destroy provincial fiscal planning.

The 2006 Budget promises that a new approach to fiscal arrangements will be set out in the 2007 Budget. This provides less than a year to complete a debate that could fundamentally alter the nature of the federation. It may be decided that some responsibilities should be “up-loaded” to the federal government while others are “down-loaded” to the provinces, territories and municipalities and others are co-managed. Only after the responsibilities have been assigned should the question of transfers of tax points be considered. This does not preclude, however, debate over the allocation of revenues sources. There is some rationale that taxation of the most mobile forms of income, such as corporate income, could be at the national level and a harmonized sales tax system around the GST would be vastly superior to the deeply flawed provincial sales tax regimes.

The 2006 Budget does not allow much time for the debate over fiscal arrangements especially considering that the most interested parties either have profoundly different views on what the subject matter is or are just plain confused. The release within the next few weeks of the federal task force report on equalization and territorial funding will demonstrate again how difficult and divisive this important debate will be (see text box on page 9). That report will undoubtedly prove that equalization has been so damaged in recent years that it will be impossible to repair it without offending some interests, including the federal government’s (for example, the report is unlikely to support the Conservatives election pledge not to include any royalty revenue in equalization).

The 2006 Budget papers subtly, but correctly shift the parameters for the debate on fiscal arrangements. The next step should be more explicit communication of what the federal government intends to consult on and debate. Otherwise the present state of confusion on the subject will become permanent.

The Work Has Just Begun

Some budget commentators noted that it must have been hard work to put together a budget with so many measures in a few months. But this will likely pale against the work that will be required to fulfill 3 key promises in the Budget. For the 2007 Budget, which could be just 9 months away, the Minister of Finance has undertaken to develop an agenda for a more competitive, productive Canadian economy and a new approach to fiscal (and economic) arrangements. The President of the Treasury Board is to unveil by this fall a new system of expenditure management. These undertakings will prove to be far more difficult that the myriad of tax cuts and spending increases in the budget. But if done well, they will also have a much greater impact on the well-being of Canadians.

Don Drummond, SVP & Chief Economist
416-982-2556