Last January, we speculated on the possibility of a balanced budget “Ottawa’s Got A Growth Problem” (iPolitics January 2014) or even a surplus, in 2014-15. We concluded that a surplus in 2014-15 was not very likely. We believe, in the absence of some creative book keeping, that a surplus is still unlikely.

Nevertheless, the possibility of a surplus in 2014-15 increased when, in Budget 2014, Mr. Flaherty lowered his deficit forecast for 2014-15, from $5.5 billion to $2.9 billion. This generated considerable speculation in the media, as well as among financial commentators, that the federal government could easily achieve a surplus in 2014-15, provided that the “risk adjustment factor” of $3 billion was not needed.  This speculation may have resulted from the fact that the final deficit outcome for 2012-13 was $6.9 billion lower than what Mr. Flaherty had forecast in Budget 2013. According to the media, surpluses in 2014-15 and 2015-16 are already “in the bank”.

What are the chances that there could be a surplus in 2014-15?  This will largely depend the final deficit outcome for 2013-14.  In Budget 2014, the deficit forecast for 2013-14 was lowered from $17.9 billion in the November 2013 Economic and Fiscal Update to $16.6 billion. Most of this decline results from the proposed cost-sharing changes to the Public Service Health Care Plan (PSHCP) in Budget 2014, which is estimated to “save” the government $1.1 billion in 2013-14. 

Mr. Flaherty has a problem. In order to “book” the PSHCP savings in 2013-14, the Government must either come to an agreement with its key stakeholders or introduce legislation prior to March 31, 2013-14 and secure Royal Assent prior to the summer recess.  Otherwise the savings for 2013-14 will not be realized. We expect that the Government will include the required legislative changes in its upcoming Budget Omnibus Bill, which would secure the savings.

Mr. Flaherty also “booked” savings of $600 million in 2013-14 from National Defence under the completely misleading description “responsible management of National Defence capital funding”.  It appears that National Defence was again going to underspend or lapse considerable funds in 2013-14 (and over the next three years - $3.1 billion in total).  In order to avoid the embarrassment of again posting another larger-than-expected lapse in 2013-14, Mr. Flaherty decided to take action and scoop funds from National Defence’s reference levels. This is not the first time he has done this. Mr. Flaherty also scooped funds from National Defence’s reference levels in Budget 2010 – beginning in 2011-12 and amounting to $3.5 billion over seven years.

In order to appease the defence community, he has promised to restore the funding in future years. Not surprisingly, he has been silent on which years.  The scooping of funds, in both the 2010 and 2014 budgets, will constitute a major claim against his future projected surpluses.  We will have to wait and see if these funds will ever be returned to National Defence. However, it will likely be another finance minister’s problem by then.

The revised lower deficit forecast for 2013-14 represents a decline of only $2.3 billion from the final audited outcome for 2012-13.  Financial results for the first eight months of 2013-14, as reported in the monthly Fiscal Monitor, show little change over the same period in 2012-13.  The difficulty is predicting what will happen over the balance of 2013-14, given what happened in 2012-13, when the final deficit outcome turned out to be so much lower than what the monthly Fiscal Monitor was suggesting it would be.

The wild cards, which could significantly affect the final outcome for 2013-14, are corporate income tax revenues and what is referred to as the “end-of-year accrual adjustments”.   Given the remittance requirements for filing corporate income taxes, about forty per cent of total corporate income tax revenues are recorded in the months of December, February, and March and in the “end-of-year” accounting period, which includes final accrual adjustments for tax revenues reflecting assessments of tax returns by the Canada Revenue Agency. 

Chartered banks and other large corporations with taxation years ending on October 31st must file their final taxes owing for their taxation year in December.  For fiscal year 2013-14, these will be reflected in the December 2013 Fiscal Monitor, scheduled for release on February 28th. Other large corporations, with their taxation year ending on December 31st, must file in February/March.  Final accrual adjustments are made in the “end-of-year” accounting period. 

The 2014 Budget assumes a significant pick-up in corporate income tax revenues over the balance of this fiscal year.  If this does not materialize, and there is a good chance it won’t, the deficit outlook for 2013-14 will be at risk.  In addition, valuation adjustments to assets and liabilities outstanding or incurred during the year are usually made in the “end-of-year” accounting period.  In the past, these adjustments have significantly affected the final deficit outcome.  The unfortunate reality for deficit forecasters is that these highly unpredictable developments over the final months of the fiscal year have a disproportionate impact on the final outcome for the year as a whole.

The 2013-14 deficit projection of $16.6 billion includes a “risk adjustment factor” of $1.5 billion.  If not needed, it would lower the deficit outcome accordingly.  However, based on the financial results to date, it is likely that all of the risk adjustment factor will be required to meet the current deficit forecast, especially if the assumed pickup in corporate income tax revenues does not materialize.  

Unless there are some major surprises, it is very likely that the deficit for 2013-14 will not come in lower than currently projected.  The final audited deficit outcome for 2013-14 will not be known until October. Mr. Flaherty would have some explaining to do if the deficit outcome were to be substantially lower than currently forecast.

With a deficit forecast of only $2.9 billion for 2014-15, it seems reasonable to expect that the government might actually record a surplus. It is after all a very small number arrived at by subtracting two very large numbers. “Statistically speaking”, the budget in 2014-15 could easily be in deficit, in balance, or in surplus.  Any of these three outcomes is possible, but not all are equally probable.

Eliminating the deficit in 2014-15 would require a decline of $16.6 billion from 2013-14, all other things remaining equal.  This would be an unusually large year-over-year improvement.  This number, however, is artificially inflated by a number of one-time adjustments.

First, the deficit forecast for 2013-14 includes a “provision” of $2.9 billion for federal liabilities associated with the Alberta floods and the Lac Megantic rail disaster. Excluding this from the deficit forecast would reduce the expected year-over-year decline to $13.7 billion 

Second, the deficit forecast for 2014-15 assumes incremental restraint measures, introduced since Budget 2010, of $5.1 billion.  On balance, if we assume that there will be no further liabilities to be booked in 2014-15 and the expected savings from the restraint measures are fully realized, the underlying decline in the deficit between 2013-14 and 2014-15 to be achieved from economic growth is $8.6 billion.  In other words there would have to be sufficient growth in nominal GDP to generate an increase in government revenues of $8.6 billion.

There are still sizeable downside risks to the economic forecast for 2014. The International Monetary Fund (IMF), in its January 2014 outlook for Canada, forecast economic growth for 2014 lower than the average of the private sector economists.  It also concluded that the “balance of risks remains on the downside” stemming mainly from external sources for 2014, citing protracted economic weakness in the Euro area and lower-than-anticipated growth in emerging markets. In addition, the IMF worries about the potential increase in interest rates and the resulting impact on Canada’s high household debt. 
Since the 2008-2009 financial meltdown, private sector economists have been forecasting a rebound in economic growth, but it is yet to be realized.  Whether 2014 will finally be the year will determine whether the budget will be close to balance in 2014-15.  This is why Mr. Flaherty is right in not declaring victory in 2014-15.  At this time, there is no certainty that the budget will be balanced in 2014-15.

Budget 2014 forecasts a surplus of $6.4 billion for 2015-16. The surplus in 2015-16 is being propped up by a $2.4 billion surplus in the Employment Insurance (EI) Operating Account, by assuming that EI premium rates will be frozen to 2016.  Using surpluses in the EI Operating Account to finance other initiatives was strongly criticized by the Prime Minister and Mr. Flaherty when they were in opposition. Although maintaining the EI premium rates to 2016 is consistent with the current legislation, it is inconsistent with the spirit of the legislation and commitments made by Mr. Flaherty since 2006.  There will be considerable pressure on the Government by the small business community in the fall of 2014 to lower the premium rates for 2015. 

The surplus in 2015-16 also assumes that asset sales of $1.5 billion will be realized.  Previous governments only included the net gain from such sales when they have actually been realized, recognizing the risks involved.  Although the Government still has two fiscal years to realize these sales, this clearly poses a risk to the achievement of the surplus in 2015-16.  The net gain from these asset sales should not have been included in the budget forecast.

Finally, the current fiscal projections assume that the various restraint measures announced in previous budgets will be fully realized.  For 2015-16, the total fiscal impact of these initiatives is estimated at $19.1 billion, of which spending restraint measures amount to $14.5 billion. Most of the spending measures relate to efficiency savings, rather than the elimination of programs.

No one can say with any certainty that this will happen because the Government has refused to provide information about how these savings are being achieved.  The Parliamentary Budget Officer’s requests for such information have largely been ignored.  Without considerably more detail as to how these restraint measures are being implemented, it is impossible to know whether or not they will be realized.  The Government was quite open on the impact of the stimulus phase of Canada’s Economic Action Plan, issuing nine reports boosting of its success in minimizing the impacts of the recession.  However, it has kept Parliament and Canadians in the dark about the impact of the restraint measures.  Unless such information is forthcoming, it will be impossible to know what the impact will be on program expenses and the budgetary balance.

Mr. Flaherty is quite right in not assuming a balanced budget in 2014-15.  The chances of it happening remain low.  Moreover, although though there is likely to be a surplus in 2015-16, it is simply impossible to predict its size with any accuracy. The media and financial commentators are talking as if the projected surpluses in Budget 2014 are “in the bank”. Nothing could be farther from truth. Given the risks that exist and the warnings of the IMF, this is a foolish assumption. We will have a better idea of the likely budget outcomes when the final results for 2013-14 become available. Until then Mr. Flaherty can only hope.   

In our next “Budget Episode” we will examine “The Mystery of the Disappearing Medium-term Surpluses”. Stay tuned!

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