Publication: C.D. Howe Institute Commentary
Publication Date: 01-FEB-05
Delivery: Immediate Online Access
Author: Poschmann, Finn ; Robson, William B.P.

Article Excerpt
In this issue ...

After more than a decade of sluggish income growth, boosting Canadian's living standards requires more than rhetoric. Restoring a sense of purpose requires tax relief, steady debt reduction, a major review of federal-provincial transfers and discretionary spending targeted on areas where federal programs can deliver meaningful results.

Canada's strong economic performance in 2004 masked continued deterioration in the federal government's capacity to steer resources to key priorities and reduce Canadians' tax burden. Growth in spending has far outpaced improvement in results. This shadow budget shows that we can do better.

This budget focuses squarely on tax relief and program enhancements that will improve Canadian living standards. Personal income taxes are too great a drag on workers' incomes at too-low income levels. Canada taxes investment relatively heavily, limiting the growth in capital stock that creates new products and jobs. Ad hoc changes to federal-provincial transfers have put them on an unsustainable path. Federal subsidies and operating expenditures are rising indiscriminately. This budget launches a new approach: It expands and re-energizes the expenditure-review process to ensure that the federal government has the resources to make needed investments in high-impact areas.

The critical challenge for 2005 and beyond is providing Canadians with a budget that takes on fiscal policy with a serious sense of purpose. This budget does just that.

Fiscal Outlook and Challenges

While the federal government's record of substantial budget surpluses remains intact, the high taxes required to achieve that result in the face of burgeoning spending create concern about the ability to maintain that record in the years ahead.

Economic Developments and Outlook

Strong global growth in 2004 supported Canadian exports, and job gains boosted consumer spending and investment in housing. Final figures for the year will likely show that real gross domestic product (GDP), which started the year at a depressed level as a result of setbacks in 2003, grew at an annual rate of 2.8 percent. Signs of weakness late in the year, as the adjustment to the higher Canadian dollar damped some sectors, point to more subdued quarterly growth rates in the first half of 2005, as well as average real growth for the year of barely 3 percent.

Looking further out, robust consumer and business demand should offset pressure on Canada's external balance as the United States strives to reduce its trade deficit, yielding overall growth at the average 2.9-percent pace consistent with growth in Canada's productive capacity. Combined with 1.9-percent GDP inflation, this outlook indicates an average 4.9-percent annual growth in nominal income through the 2006-to-2009 budget planning period, with interest rates increasing only modestly toward long-term equilibrium levels (Table 1).

Fiscal Outlook

Fiscally, federal finances continue to benefit from rich tax revenues. As many advocates of tax relief predicted, lower rates of personal and business income tax following the 2000 budget fostered healthy growth in taxable incomes. Personal and business tax revenues since then have been growing. With further help from one-time factors, such as the positive impact of the strong Canadian dollar on taxable business income, gross federal revenue in 2004/2005 should be $201 billion. (1)

During 2005, the revenue outlook on unchanged policy is less buoyant. Quarterly growth rates will likely be slower, the stimulus to the tax base from past tax relief is fading, and a less business-friendly climate in Ontario will subdue revenue growth. Over the five-year budget projection period, tax-and-fee revenue is expected to rise at a 4.7 percent average annual rate.

For spending, a bright spot is the result of debt pay-down: Since the advent of surpluses in 1996/1997, the lower stock of debt has reduced annual interest costs by more than $3 billion. Meanwhile, program spending has been growing rapidly--by an average of 4.7 percent since 1996/1997, accelerating to 6.5 percent over the past five years. Recent private-sector projections that include the increases in federal-provincial transfers announced in the fall of 2004 indicate that program spending will grow at an average rate of 4.4 percent over the planning period.

Allowing for the influence of changing interest rates on investment returns and interest costs, and assuming that the 2004/2005 surplus and future contingency reserves are applied against federal debt, the status quo fiscal picture created by these revenue and spending trends produces the pattern shown in Table 2.

On the surface, this overall picture is reassuring. Slower spending growth in the farther-out years appears to ensure that sizeable surpluses will keep federal debt on a steep downward track, even after contingency reserves and a prudence factor to cover possible setbacks. Two facts, however, show there is something wrong with this picture.

One is the rising federal tax burden that Canadians bear as workers, as investors and as consumers. Total annual federal non-interest revenue now averages more than $25,000 per family of four. Adjusted for population growth and inflation, this burden rose by some $2,500 since 1996/1997. These projections envision taxes running well ahead of population growth and inflation over the planning period, pushing the bill up a further $4,000 in real dollars by 2009/2010. Canadians face additional claims on their income, both personal and from other levels of government, which such an increase in taxes does not acknowledge.

A second problem evident from recent experience is that healthy surpluses in budget projections turn out, in fact, to dissipate in new spending. Recent federal budgets have anticipated barely half the increase in program spending that actually happened in the fiscal years for which they were presented. In the seven federal budgets from 1997 to 2003, the spending increases forecast for the upcoming years (which, in some cases, were already under way) amounted, cumulatively, to $22.5 billion

(see Robson and Poschmann 2004). The actual increases over that period amounted to $42.4 billion. Last year was worse: The 2004 Budget projected an increase in spending of $4.5 billion for 2004/2005; on current projections, the actual increase will be $9.9 billion. (3) On average, since 1997, budget-year spending has grown 2.4 percentage points faster than projected. If over-runs on that scale were to persist over the planning period, they would deflate the cushion provided by the contingency reserve and the prudence factor: notwithstanding mounting tax revenues in the projections, the budget would be back in deficit as early as 2006/2007.

Challenges and Priorities

The lesson from those problems is that the status quo fiscal profile does not do enough. The leading edge of the baby boom will begin retiring during the planning period, thinning the ranks of taxpayers, while an aging population intensifies demands for public pensions and health-care. Net demographically driven liabilities add more than $300 billion to recorded government debts in Canada (Robson 2003). This argues for continued declines in the federal debt-to-GDP ratio, as promised in the 2004 Budget, and highlights the need for a sharper approach that will keep fiscal policy on track to achieve it.

Boosting living standards will increasingly require Canada to present workers and savers with attractive opportunities. On both fronts, Canada could do better. Canada's personal income taxes severely crimp the net rewards from working, and the government share of incremental wage earnings rises sharply at low income levels (TD Bank Financial Group 2005). Canada also taxes saving and investment income relatively heavily (Chen and Mintz 2005) and the nation is adding to its capital stock more slowly than competitors (Robson and Goldfarb 2004), reducing potential future growth.

Controlling low-priority spending to ensure that the federal government offers further tax relief and can make meaningful investments in high-impact areas is a critical challenge for the 2005 Budget--a budget that restores serious purpose to fiscal policy.

Getting Serious About Spending

The spending over-runs of the past eight years were no accident. They reflect a lax fiscal...



NOTE: All illustrations and photos have been removed from this article.



More articles from C.D. Howe Institute Commentary
Insuring Canada's exports: the case for reform at export development Canada, 01-DEC-07
Falling poverty rates, rising employment among poor, reflect social policy success: C. D. Howe Institute., 01-OCT-07
Reducing poverty: what has worked, and what should come next, 01-OCT-07

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