A Government on Autopilot

In a recent speech to the Canadian Council of Chief Executives, Mr. Flaherty once again reminded Canadian business leaders that the government had done all it could to support economic growth and job creation, and it was now up to the business sector to do its part.

“Our government continues to create the right conditions to enable Canadians and Canadian businesses to feel confident to invest, to create jobs, to participate in the global market place and to grow our economy. But ultimately, it is up to the private sector to take advantage of all these strengths.” 

This follows earlier statements by Mr. Flaherty and Mark Carney, Governor of the Bank of Canada, exhorting private business to start investing and stop sitting on all that “dead” capital.

Who is in charge and who is responsible for the economy? It would appear that the government has “punted the ball” to the private sector. If economic growth and job creation continue to slow, as they surely will, and the unemployment rate remains stubbornly high, as it surely will, we have only the private sector to blame. The government after all has done all it can. Or has it?

What sectors are expected to support economic growth over the next few years? In the case of the household sector, both Mr. Flaherty and the Governor of the Bank of Canada are warning Canadians about their high debt levels and urging them to curtail their consumption and to reduce their debt.  In the case of the public sector all levels of governments are following restrictive fiscal policies in an attempt to reduce their deficits. By doing so the government sector is withdrawing support for economic growth. In the case of trade, Canada is recording growing trade deficits. Only the business sector is left.

So why is the business sector holding off on new investments? What was the government expecting or hoping to happen? In fact, no one knows and Mr. Flaherty isn’t saying. In the 2012 Budget, there were no details provided on which sectors in the economy would contribute to economic growth.  There was no reference at all in the budget to the outlook for non-residential business investment, so we have no benchmark for judging Mr. Flaherty’s concerns.

The 2012 Budget contained considerable discussion on the economic and political uncertainties in the EURO area and in the U.S. and rightly so, because these uncertainties are not just short-term uncertainties but medium and longer-term uncertainties as well. Perhaps Canada’s CEOs read the budget and decided, if the Minister of Finance is so concerned, they should be also. And they would be right to be concerned. The head of the IMF has publicly stated that the IMF will once again be reducing its forecast of global economic growth. This kind of economic outlook and uncertainty makes investment decisions very difficult.

Surely the recent cuts in the corporate tax rate should stimulate new investments.  But the answer is not that clear cut. First, businesses will have accumulated substantial losses during the recession, which they will apply to reduce their corporate tax liability. Second, very few businesses actually pay the legislated corporate tax rate. Most have special “tax breaks” which significantly lower their tax liabilities. For example, the oil and gas sector has an effective tax rate of about 7 per cent. Only the financial sector comes close to paying the legislated corporate tax rate and no doubt the banks are happy with the tax cuts, but they are not big investors in fixed capital. In the longer term, lower corporate tax rates may have some impact, but we can only wait and see.

Apparently the Mr. Flaherty sees no additional scope for fiscal policy action in these circumstances of slowing economic growth, other than to maintain a commitment to eliminate the deficit over the medium term.   In the 2012 Budget, the government forecast that the deficit would be eliminated in 2015-16, one year earlier than forecast the previous year. This improvement was attributed primarily to the $5.2 billion cut in annual direct program spending. The debt-to-GDP ratio is forecast to fall to 28.5 per cent by 2015-16 slightly below what was forecast a year earlier. The government has included some “prudence “ in the forecast so there is nothing to worry about and nothing to do. In fact this was the case prior to the 2012 budget cuts, according to the government’s own numbers.

We have a few suggestions for Mr. Flaherty, which would require the government to turn off the “policy autopilot”.

First, stop basing policy planning on the hope that the private sector will solve your growth and job creation problems. If significant new private sector investment emerges in the next year or two, this would be great, but you should be prudent and not plan on the happening.

Second, with weak private sector demand, the federal government should step in and provide new support. Additional fiscal action need not violate the government’s commitment to eliminate the deficit over the medium term.  Additional fiscal action would not mean a second stimulus package. The growth problem is a medium-term problem not a short-term problem and additional fiscal action would be medium term not short term.

Third, there is a need in Canada for a new infrastructure program in physical and human capital (research and education). The federal government should take the lead. At a minimum, this would require additional spending of $5 billion annually, perhaps even more.

Fourth, the personal income tax system continues to penalize labor force participation by imposing high marginal tax rates on low and middle income tax payers. These high marginal tax rates need to be reduced. The federal tax mix also continues to penalize savings and investment by relying too much on income tax and too little on the GST. If the government were looking for something to do to promote new investment, economic growth and job creation then initiating a policy review to refocus the tax mix in Canada would be good place to start.

Would these actions make the medium-term fiscal situation worse? The report just released by the PBO shows that because of the cuts to direct program spending introduced in the 2010 and 2012 budgets and the changes to the  Canada Health Transfer (CHT) and the Old Age Security (OAS) system, the government now has a fiscal structure that is sustainable in the long term.

The federal government clearly has a fiscal situation that would  allow new fiscal actions, without jeopardizing fiscal sustainability. They could be partly financed, for example, by using the savings from the 2012 Budget spending cuts. If this were done it would only mean that the deficit would be eliminated one year later (2016-017) than is currently forecast. Financial markets wouldn’t care. Moreover, the government is constantly telling Canadians that Canada has the best fiscal record in the G-7. It still would have after the new program.

Additional sources of funding could also be found by immediately beginning a review of the income tax system (personal and corporate) with the aim of simplifying it by eliminating special tax preferences that no longer serve any useful purpose. There are a lot of them. This could easily raise $5 billion annually, and probably a lot more.

Simply delaying the target for deficit elimination by one year and eliminating unjustified and ineffective tax preferences could free up as much as $10 billion annually, or $50 billion over five years to support economic growth and job creation. Such a program would also have a multiplier effect on private sector investment as well.

Time to turn off the “autopilot” and get back to serious policy work.

There are only five months until the next budget.






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