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Will the Tories' Budget 2008 Drive Canada Into Deficit?

29 Feb 08

Keeping Canada out of deficit is the finance minister's "fiscal line in the sand." Once crossed, could he re-cover the current fiscal discipline?

Budget 2008 forecasted razor-thin surpluses going forward, in a weak economic environment, clouded with further downside risk. This government has made a high-profile commitment to keeping the country away from deficits, and is strongly supported in this position by opposition parties as well as most Canadians. Have the strong spending increases and tax reductions by this government over the past few years put us in serious risk of going back into deficit? What would it take in terms of an economic downturn to turn the forecasted small surplus into a deficit? What is the risk of such a downturn occurring?

The political risk of this government reporting a deficit is very clear, and potentially embarrassing. Keeping away from a deficit is the finance minister's "fiscal line in the sand." If he were to cross it, would he lose credibility and influence, and ever be able to bring spending back under control?

* Surpluses forecasted in the Budget of year "t" for the fiscal year t/t+1, except for the Budget 2008 forecast for 2009/10

The Scenarios

The economic forecast in Budget 2008 is very reasonable, and is similar to Global Insight's. Global Insight has run several scenarios that are slightly more pessimistic than the base forecast of Budget 2008. From these, we estimate the probability of the small fiscal surpluses forecasted in Budget 2008 turning into deficits. While the calculations of the fiscal implications of various economic scenarios are based on the statistical relationships provided by the Department of Finance, the probabilities attached to these scenarios is judgmental, based on Global Insight's years of experience in economic and fiscal forecasting.

Scenario 1

The economy performs as forecasted, and the federal government's take from each dollar of economic activity is as strong or slightly stronger than forecasted, so no deficit is reported. This is the most likely outcome for both 2008/09 and 2009/10.

Scenario 2

The economy is slightly weaker than forecasted, and the federal government's take from each dollar of economic activity is as forecasted. In this scenario, we assume that nominal GDP, often considered the general tax base, is 1 percentage point less than forecasted, with this shortfall being equally shared between real GDP growth and inflation. Specifically, in 2008, real GDP growth would be 1.2%, relative to the Budget 2008 forecast of 1.7%. We also allow for some modest efforts by the Bank of Canada to thwart this unexpected decline, with interest rate reductions in midyear.

In this scenario, in the closing months of the fiscal year, it appears the government is heading toward a small deficit. Finance and Treasury Board officials are directed to use the maximum amount of imagination and pressure to find roughly $1 billion so the government does not have to report a deficit. They are successful. The impending deficit is headed off, and when the books close, the government reports a very small fiscal surplus.

One of the features of Scenario 2 is that the government may cancel or postpone spending to avoid reporting a deficit. From an economic policy perspective, this would be an inappropriate reaction to an impending deficit, as well as a potentially politically unpopular move. Scenario 2 puts the finance minister in a very tough spot.

Scenario 3

The U.S. economy does not pick up as expected in the final half of 2008, and the Canadian economy performs well below forecast. This scenario is parallel to Scenario 2, except nominal GDP is 2 percentage points below forecast, with real growth at only 0.7% relative to the 1.7% forecasted. GDP inflation is also 1 percentage point below forecast.

In Scenario 3, the impending fiscal deficit is simply too large to be avoided by last-minute heroics. In 2008/09, for the first time since 1996/97, the federal government reports a fiscal deficit. A fiscal deficit in 2009/10 can result from economic weakness in 2008/09 or 2009/10. If either scenario 2 or 3 hits in 2008, the government would probably have to reduce currently planned spending for 2009/10, to avoid reporting a planned deficit for 2009/10 in Budget 2009.

Probabilities of Deficit

 

2008/09

2009/10

Scenario 1: No Deficit

65%

55%

 

 

 

Scenario 2: Impending Deficit Headed Off by Heroic Actions

20%

25%

 

 

 

Scenario 3: Deficit Reported

15%

20%

Political and Economic Repercussions of Reporting a Deficit

Reporting a deficit would clearly be a serious blow to the credibility of the finance minister and the government, unless that deficit was the result of a much weaker U.S. economy than forecasted in Budget 2008. From the economic perspective, however, a small deficit in 2008/09 and/or 2009/10, in itself, would not significantly alter Canada's economic performance or prospects. Canada's debt burden is now at a very reasonable level, both by historical standards and by international comparison. Canada has built up credibility in fiscal performance over the past decade.

From the economic policy perspective, the key concern of reporting a small deficit in 2008 relates to the concept of a deficit as the finance minister's "fiscal line in the sand." After reporting a deficit that cannot be blamed on unexpectedly weak U.S. economic performance or some other clearly exogenous factor, would the finance minister lose his current credibility and authority over his spendthrift cabinet colleagues? Would fears develop that Canada has lost its fiscal discipline? Would economists in Canada and internationally revise upward their forecasts of Canada's debt burden over the medium term? This is a risk we would be well advised to avoid.

Conclusions

After Budget 2008, the risk of a deficit is higher than it has been for a decade. However, the most likely outcome for 2008/09 is that the economy will perform about as miserably as forecasted, and the government's take from the tax base will be slightly greater than forecasted, yielding a small fiscal surplus. There is a smaller probability that reporting a surplus in 2008/09 may require some last-minute changes in plans for spending or some imaginative accounting changes. The probability of the economy turning down, resulting in a deficit of several billion dollars, is about 15% in 2008/09. In 2009/10, things are even tighter. While the most likely outcome is still a fiscal surplus, the probability of the government reporting a deficit is a bit higher in 2009/10, at about 20%.

by Dale Orr

 
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