Setting a Deficit Target Isn’t Easy. Mr. Flaherty should take a lesson from Paul Martin.


Mr. Flaherty has just announced that the government will not be able to meet its target of eliminating the deficit by 2014-15. He is now planning to eliminate the deficit in 2015-16, provided the government can find $4 billion in annual expenditure savings; the U.S starts to grow at potential; the EURO zone solves its problems; and, international imbalances begin to diminish. Very few people expect the latter three conditions to happen. Just recently, the head of the IMF expressed her concern over the possibility of a “lost decade” of world economic growth.

In these circumstances, how should Mr. Flaherty set his “deficit target”? Overall he wants the target to be believable or credible, and to be achievable. The fact is Mr. Flaherty has very little control over the deficit. He can undertake policy actions in the form of expenditure cuts and/or tax increases, but for the most part he is at the mercy of unforeseeable and uncontrollable events, both domestically and internationally.

Mr. Martin’s lesson was simple. Once you have chosen the policy actions you believe are required, and given the economic assumptions, choose “risk adjustments” or “allowance for prudence” that will virtually guarantee you will not miss the target. Such a situation is “win-win” for the government. If the economy turns out better then you get credit. If the economy performs as bad as assumed you also get credit for your “prudent planning”.

Mr. Flaherty, like Mr. Martin, wants to use economic assumptions based on the “average” of private sector forecasts. This is a mistake statistically and politically. Taking an average when all the risks are on the downside makes no sense at all. Mr. Flaherty understands this because he now includes a “risk adjustment” factor. The problem is his adjustment for risk is simply far to small. For Mr. Martin the risks were on the upside. The surplus was always larger than forecast.

Mr. Flaherty wants to now claim that he will eliminate the deficit in 2015-16. This is a mistake because the risks and evidence are stacked against this happening. It is virtually certain that he will have to revise his budget planning assumptions before, or in, the 2012 budget. It will be even more embarrassing if he has to revise it immediately after the budget.

It would have been better for Mr. Flaherty to base his planning framework on less optimistic, but more realistic, economic assumptions and a much larger allowance for risk adjustment. Right now he has a risk adjustment of only $10 billion in nominal GDP in 2016-17, which amounts to only $1.5 billion in tax revenue. Given the adjustments that have been made since June, this is completely inadequate. If Mr. Flaherty wanted to avoid announcing another delay in his deficit target, then the “adjustment for risk” should have been ten-fold larger, if not more.This would have meant simply delaying the target date for deficit elimination to 2016 or 2017. 

Given that Canadians are prepared now to accept a delay in the deficit elimination target does not mean that they will accept continuing revisions. Continuing revisions suggests that the government does not understand what is happening. Mr. Flaherty should have been prudent and gone for a longer delay (2016-17 or 2017-18) now rather than a succession of delays in the coming months. 

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