By now the Finance Minister should be close to putting the “finishing touches” on his 2018 budget.

He recently presented his updated economic and fiscal outlook to the Cabinet in London, Ontario  and he has finalized his own budget consultations and received the budget recommendations of the House Finance Committee.  Putting “finishing touches” on a budget, however, can take a long time, as they require considerable consultation with individual ministers. It might take longer than usual given the importance of the 2018 budget. Nevertheless, it would be smart for the Finance Minister to deliver a late February budget rather than a late March budget, as it would show that he is actually in charge of budget planning. 

The last 8 months have not been kind to the Finance Minister. His attempt to change the tax laws for Canadian Controlled Private Corporations (CCPC) was an unmitigated disaster, not just for him, but for the Finance Department as well. In addition his complete failure to appreciate the political consequences of not putting his financial assets in a blind trust raised questions as to whether he should be in politics at all. There was talk that he should resign, or be replaced, something that rarely happens to a finance minister, given his Cabinet seniority.

To put it mildly the Finance Minister and the government have a lot of credibility riding on the 2018 budget, perhaps even more than the 2019 budget. If the 2018 budget fails basic credibility tests then the Finance Minister’s future will continue to be at risk.
The starting point for 2018 budget planning is the Fall Economic Statement (FES) presented by the Finance Minister last October. In the FES, the deficit for the current fiscal year, 2017-18, was estimated at $19.9 billion.  This includes a Contingency Reserve of $1.5 billion. Financial results to date, suggest that the Contingency Reserve will not be required. This would mean that the deficit for 2017-18 could be relatively unchanged from that reported in 2016-17 at $17.8 billion.

The FES forecasts a deficit of $18.6 billion for 2018-19, falling gradually to $12.5 billion in 2022-23.  This forecast includes a $3 billion Contingency Reserve. In the FES forecast the deficit-to-GDP ratio declines from 0.9% in 2018-19 to 0.5% in 2022-23 with a steadily falling debt-to-GDP ratio reaching 28.5%, the lowest level in over 35 years, and two percentage lower than in 2017-18.
Shortly after the release of the FES, the Parliamentary Budget Office (PBO) released its economic and fiscal update. Its deficit forecast closely mirrored that of the FES, excluding the Contingency Reserve. In addition, the Department of Finance and the PBO recently released their long-term economic and fiscal projections. Both studies concluded that the federal finances were sustainable, with the budget in surplus in or before 2045, not a bad starting point for planning the 2018 budget.

Recently, however, the University of Ottawa’s Institute of Fiscal Studies and Democracy (IFSD), released a report  “Federal Fiscal Forecast: Can the Federal Government Really Slow Its Pace of Spending”, that concluded that the federal government’s FES significantly understated the medium-term budgetary balance. 

The IFSD forecast showed a rising deficit reaching $31.5 billion in 2022-23, $19 billion higher than the Fall Update’s forecast of $12.5 billion and $22.1 billion. In deriving their program expense forecast, however, IFSD did not include the costs of the Home Care and Mental Health initiative beginning in 2018-19.  As result, their forecast of the deficit should be $1.2 billion higher in 2022-23, reaching $32.7 billion. The debt-to-GDP is expected to remain relatively stable at about 30.5% rather than to decline as forecast in the FES. This would imply that the government’s fiscal target of a declining debt-to-GDP is at risk.
If this were the case, then the Finance Minister should take strong action in his 2018 budget to cut program spending. How could IFSD, run by the former head of the PBO, release a report that completely contradicted, not only the Finance Department, but also his own previous Agency?

So what accounts for these very different budget forecasts? The IFSD forecast is based on two false assumptions. First, the IFSD study forecasts lower budgetary revenues, amounting to $6.1 billion in 2022-23.  However, more than all of the difference is attributable to personal income tax revenues (PIT), which are $8.3 billion lower (most other revenue components are either the same or slightly higher). The lower PIT forecast is questionable, as it appears that PIT revenue is growing at the same as nominal GDP. However, personal income tax revenues traditionally grow faster than nominal GDP, as higher incomes push workers into higher tax brackets.

Second, IFSD forecasts a much higher level of direct program expenses (total expenses excluding major transfers to persons and other levels of government).  The IFSD forecast assumes that direct program expenses “should” at a minimum grow in line with inflation – about 2% per year.  As a result their forecast of direct program expenses is $6.3 billion higher than that forecast in the FES in 2022-23.

It is difficult to understand why the Finance Department (and the PBO) would deliberately understate their direct program expense forecast. Subsequent upward revisions would undermine the creditability of the government’s budget planning.

Furthermore, in our experience we know that the Department of Finance spends a considerable amount of effort in developing their direct program expense forecast, taking into consideration potential wage increases, the profile of various transfers and subsidies, provisions for valuation, the sun setting of various programs, etc. In addition, the FES forecast includes a spending “lapse” assumption - the amount actually spent compared to that authorized by Parliament.  Based on current financial results, it appears that the lapse will again be higher than expected. Finally, because of the higher primary deficits (budgetary revenues less program expenses) and somewhat higher interest rates, public debt charges in the IFSD forecast are $8.8 billion higher in 2022-23 than in the FES forecast.

As a result, the IFSD deficit forecast appears to be grossly overstated, given its assumptions with respect to PIT revenues and direct program expenses and the resulting impact on public debt charges.

In the coming weeks, there will no doubt be considerable pressure on the Finance Minister to commit to a fixed date for deficit elimination; notwithstanding the fact the government faces a “sustainable” fiscal situation for the foreseeable future. He should be firm and clear on why he is   rejecting these demands.

In the current fiscal circumstances, there is absolutely no economic rationale for a balanced budget. The media demand for deficit elimination is an unfortunate “hangover” from the Harper government’s sole fixation on deficit elimination as the only objective of fiscal policy. But this should not be the case. Given historically low long-term interest rates, the government has considerable fiscal flexibility to undertake key public investments, while maintaining a falling debt to GDP ratio. This could include, for example, new investments in early childhood education and day care facilities.

Although there is no economic rationale for a fixed date to eliminate the deficit, there may be a cabinet management rationale. It could be argued, with some justification, that a commitment to deficit elimination gives the Finance Minister a firm constraint to better control government spending. In reality however, the success of the Finance Minister to control the spending habits of his cabinet colleagues depends ultimately on the support he gets from the Prime Minister for spending constraint.

The Finance Minister has already said that his 2018 budget will reaffirm the government’s commitment to strengthening potential economic growth. The government has already taken important policy actions to achieve this goal.

But more needs to be done.  If the Finance Minister is really serious about an economic growth strategy, then he will have to address the need for comprehensive tax reform in his 2018 budget. He must do this in part because of recent tax changes in the U.S.; in part, because the current income tax system is an impediment to growth; and in part, because he needs to show that he understands the importance of comprehensive tax reform, and remains committed to it despite last year’s mistakes. A growth strategy without comprehensive tax reform is simply inadequate. There is no doubt that comprehensive tax reform would be challenging and politically difficult, but this should not be used as an excuse not to do it.

The Finance Minister should, for both political and policy reasons, establish a new process involving an independent “commission of tax and policy experts” to address not only income tax reform, but also, equally important, the structure (income taxes and GST) of the tax system itself.  The review would focus not just on fairness, but also on efficiency and economic growth.

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