April 1998 Vol 4, No. 1

April 1998 Vol 4, No. 1


Paul Martin's Balanced Budget versus the Alternative
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Austerity Continues Despite the Elimination of Deficits

Paul Martin triumphantly announced in February that the federal budget was balanced for the first time in almost three decades. Despite the hype, the balanced bottom line came as no surprise to financial analysts—who have known for years that Martin was poised to eliminate the deficit far ahead of even his own strict timetable. But Martin was not the only one to table a balanced budget in Ottawa this spring. Two weeks before official budget night, the fourth annual Alternative Federal Budget was presented to reporters and parliamentarians—and it, too, featured a zero deficit.

With deficit hysteria now a thing of the past, the true issue is finally visible: it is not whether deficits will be eliminated (they can and should be). Rather, the issue is who will pay for deficit elimination, and what kind of Canada will exist once budgets are finally balanced. Incredibly, despite having balanced the budget two years ahead of schedule and already starting to generate large fiscal surpluses, the Liberals cut total funding for public programs (like health care and education) by another $1.5 billion in the current budget. This proves that—deficit or no deficit—the Liberals are committed to radically downsizing the public sector and further cutting programs.

In contrast, the Alternative Federal Budget (AFB) found $12 billion for rebuilding health care, education, and other public programs, while still balancing the budget. The AFB provides a more optimistic vision of how fiscal responsibility can be combined with social responsibility. Here are the grades that we might give to Paul Martin’s historic balanced budget, with corresponding comparisons to the AFB’s rather different approach.

The Issue: What to do with the "Fiscal Dividend"

With balanced budgets and continued economic growth, Canada’s public debt is now shrinking rapidly in relation to the size of our economy. Interest costs are thus poised to decline, producing a growing surplus—the so-called "fiscal dividend."

Contrary to the views of Canadians, and in opposition to their own election promises, the Chrétien government is allocating the whole fiscal dividend to the repayment of accumulated debt (instead of repairing social programs or cutting taxes). The financial community loves this strategy—it generates profits for bondholders, and ensures a continued passive role for government in our economy.

A better approach: use the fiscal dividend to start repairing important public services like health care and education, so damaged by the cutbacks of the 1990s. The Alternative Federal Budget shows how these programs can be rebuilt while still balancing the budget—and reducing the debt burden even faster than Paul Martin.

Grades are assigned to Paul Martin’s official budget in the following categories:

Allocating the Fiscal Dividend: D

A great debate has occurred in Canada since economists first concluded that the federal deficit was poised for quick extinction. With years of red ink soon to be replaced by large and growing annual surpluses, how should the government spend the money? Three broad options were presented: repay some of the accumulated debt, cut taxes, or rebuild the public programs (such as education and health care) that have been so damaged by spending cuts at the federal and lower levels of government.

Being good Liberals, the federal government positioned itself near the middle of this "triangle" of options: they would spend one-half on social programs, one-quarter on tax cuts, and one-quarter on debt repayment. Not surprisingly, this formula was similar to the preferences that Canadians themselves were expressing to pollsters. For example, the most recent national survey (conducted for the federal Liberal party) suggested that Canadians would spend $100 of fiscal dividend as follows: $44 for social programs, $33 for debt repayment, and $23 for tax cuts. Other polls have indicated that Canadians quite consistently put top priority on repairing public programs.

In practice, however, Martin’s budget has strayed far from both public opinion and his own formula (see Figure 1). He cut taxes by $1.5 billion in the 1998-99 fiscal year. But he paid for this generosity by cutting program spending by the same amount. The full fiscal surplus —which in practice will likely exceed $8 billion—is thus devoted to debt repayment.

In contrast, the AFB allocates all of the surplus to the reconstruction of public programs. While the AFB includes a major "tax relief" package for low- and middle-income households, these targeted tax cuts are financed by higher taxes on banks, high-income households, and the business sector. This makes the tax system fairer, without undermining the revenue base for public programs.

Debt Reduction:B-

By slashing programs, Paul Martin eliminated the deficit far faster than even his own supporters expected. Now he plans to use the bulk of coming surpluses to reduce the outstanding accumulated debt. This is winning him high marks for fiscal prudence from Bay Street.

In practice, however, Martin is not achieving as rapid a pace of debt reduction as is possible. Indeed, his own debt reduction timetable falls behind what is projected for the AFB—even though the AFB sets aside no funds for actual debt repayment.

How is this? The debt burden is most appropriately measured as a share of GDP (see page 6). The real burden of any debt (whether a public debt or a household mortgage) depends on the income of the borrower. By growing nominal GDP at a faster pace (thanks to lower interest rates, rebuilt public programs, and a tolerance for moderately higher inflation) the AFB actually reduces the debt fasterdollar value of the debt is unchanged.

The 1998 AFB assumes a 6% expansion of nominal GDP—one-third faster than Martin’s own conservative assumption. This is achieved partly through new real growth (driven by low interest rates and federal spending), and partly thanks to slightly higher inflation. By historical standards, 6% nominal growth is actually quite moderate —but we will eventually need to consider measures such as controls over foreign investment flows and regulations on private banks in order to support low interest rates and faster growth within Canada.

In contrast, by continuing to endorse the slow-growth, low-inflation economic strategy of the Bank of Canada, Paul Martin ensures that nominal GDP will continue to expand quite slowly. This makes the task of debt reduction all the more difficult. Financiers love Martin not because they genuinely worry about government default and big debt. Rather, they love his fiscal strategy because it ensures small government, low inflation, and big capital gains for existing bondholders (since bond prices tend to rise as the stock of outstanding debt is reduced).

Support for Public Programs: D

Incredibly, despite the attainment of a balanced budget two years ahead of schedule and the imminent appearance of a large federal surplus, Paul Martin actually cut federal program spending for 1998 by another $1.5 billion. Program spending will thus fall to just over 11% of Canada’s GDP—its lowest level since the conclusion of World War II, and notably smaller than federal programs in the U.S. Federal spending has thus retreated dramatically to levels not seen since before the introduction of the big-ticket social policy items (public pensions, medicare, modern UI, and so on) that defined Canada as a supposedly "kinder, gentler" place. In the wake of this dramatic and ongoing downsizing of public programs, for how long can we continue to accept the myth that our society is still a "generous" one?

Even if Paul Martin followed his own 50:25:25 surplus allocation rule (which he is ignoring), federal program spending would at best stabilize at a much smaller share of our economy (between 11 and 12 percent of GDP; see Figure 2). One can almost feel sympathy for the efforts of Preston Manning to portray the Liberals as "big spenders": this has become an impossible task for even the nimblest spin-doctor, so tight-fisted have the Liberals become.

In contrast, the AFB would start to gradually rebuild federal program spending—to some 13% of GDP in the current fiscal year, and more thereafter. The spending programs contained in the AFB look large by current Ottawa standards (providing major funding for pharmacare, student grants, job-creation, and revamped transfers to the provinces, totaling over $12 billion in new spending for fiscal 1998). But in reality the AFB would only partially offset the historic cuts that have been overseen by Martin.

Design of Tax Cuts: B+

In one respect, Paul Martin still differs from his even-more-conservative critics in the Reform Party and elsewhere: the relatively progressive orientation of his tax policy. The bulk of the $1.5 billion in tax relief offered up by his budget is targeted nicely at lower and middle-income households—additional funding for the Child Tax Benefit, an increase in the basic personal exemption, and a targeted elimination of the 3% federal surtax. This contrasts sharply with the general income tax cuts recently implemented by several provinces (including Ontario, Alberta, B.C., and Saskatchewan). These general income tax cuts concentrate the benefits of a tax cut among high-income earners—thus worsening the already-growing inequality of income distribution in Canada.

Despite his relatively progressive approach, some of Martin’s tax cuts are quite regressive (and hence drag down his overall grade in this category). For example, he reduced the capital tax on large banks (hardly the neediest constituency in Canadian society today) and expanded RESP credits—a program which overwhelmingly benefits high-income families. The level of funding provided to the child tax benefit has been sharply criticized as inadequate. And the fact that Martin financed his tax cuts with further spending cuts greatly undermines what would otherwise have been progressive measures.

Nevertheless, the AFB’s own tax relief proposals were not entirely dissimilar from Martin’s. The crucial difference is that the AFB’s tax relief was financed with new taxes on well-off households and businesses, rather than through further spending cutbacks. Indeed, the AFB provided close to $10 billion in targeted tax relief, concentrated in the child tax benefit (increased by $4.4 billion in 1998), the complete elimination of the 3% surtax, and lower basic tax rates for low-income taxpayers. The AFB showed that tax relief can be provided to working-class and low-income Canadians, but without undermining the revenue base of the public programs which are just as important to those same households.

Sustaining Economic Growth: C-

Nothing impacts on the state of federal finances more than the state of Canada’s economy. Strong growth means more revenue and less spending on EI and other programs. Stagnation and recession mean lost revenues and more social costs. And when the economy is slowed deliberately with the use of high interest rates (which simultaneously increase the government’s own debt service costs), then the negative fiscal effect is amplified.

The Liberals deserve some credit for encouraging the Bank of Canada to relax the hysterical anti-inflation policy it pursued under former governor John Crow. Since 1993, the Bank of Canada has taken a distinctly more moderate approach—cutting interest rates deeply in response to Martin’s huge spending cutbacks. This, more than any other factor, explains Canada’s stronger growth over the past two years. And it has been strong growth and lower interest rates, even more than the deep spending cuts, that brought about the very fast elimination of the deficit.

Now, however, the Bank of Canada is reversing course. It has boosted interest rates by almost two points over the last year, both to defend the Canadian dollar and to keep unemployment from falling "too low." Further government cutbacks will continue to undermine job market conditions. And the fallout from the Asian crisis and slowing growth in the U.S. could bite deeply into continued Canadian expansion in the next year or two.

This was the time for Martin to guarantee the continuation of our badly-needed recovery—by loosening the federal purse strings, and pushing the Bank of Canada to reverse its rate hikes. Instead, this budget did the opposite: it endorsed the Bank’s ultra-low inflation targets for two more years, and cut public spending even further.

Honesty in Budgeting: F

One of the most worrying legacies of Paul Martin has been the deliberate and manipulative design of federal budgets for ideological purposes. Of course, every budget is a political document. But it should still provide an accurate description of the state of government finances.

This is no longer the case for our federal government. Its budgets have been so distorted with "contingency funds," deliberately conservative assumptions, program spending that isn’t actually spent, and other accounting gimmicks that they now completely fail to reflect the government’s true fiscal situation.

Under Paul Martin, federal budgets are written in code. They portray one message to Canadians—first that historic spending cutbacks were inevitable, and now that future surpluses will be small so don’t expect much in the way of new social spending. But they portray another, more accurate message to the Bay Street analysts and anyone else who is handy with a computer spreadsheet—in short, to those who can look behind the misleading assumptions of the official budget to see the true picture. That’s why Martin has become such a hero on Bay Street: even his historically conservative budgets have in fact been far more conservative than they appeared to be.

Martin’s 1997 budget overachieved its deficit target by an incredible $17 billion. His first five budgets will have outperformed their targets by a cumulative total of close to $50 billion (see Table 2). This has come as no surprise to the financial community. But in retrospect it casts great doubt on the claim that the government "had no choice" but to cut annual program spending by $14 billion over the previous four years (for a total cumulative cut also equaling almost $50 billion). Indeed, the cuts could have been completely avoided (with program spending maintained at its 1994 levels), simply by correcting Martin’s bogus, "conservative" accounting methods.

If any corporation missed its own revenue and profit forecasts by such a large margin—even in a positive direction—it would face sharp criticism from the financial analysts and traders who demand accurate and timely information. But in the case of government, despite its supposed "corporate" mode of functioning, this deliberate duplicity is applauded.

The 1998 budget continues this unfortunate tradition. In theory, it is a "balanced" budget. The only surplus will arise if the $3 billion contingency fund is not needed. But in practice, the government will certainly run a huge surplus—of $8 billion or more.

He has assumed slower growth and higher interest rates than economists expect for 1998. And his forecasts of revenue and debt service charges are still conservative —even after adjusting for "prudent" macroeconomic assumptions. Once again Martin plans for rising EI payouts, even though both unemployment and average EI coverage continue to slide. We can only hope that Canadians will learn from past experience: when Martin says no funds are available to finance health care, education, child poverty initiatives, or other services, he is quite simply lying.

Overall Grade: D+

This was supposed to be Paul Martin’s "good news" budget. After 30 years, the red ink had finally stopped. The tough medicine had been swallowed. It was time for Canadians to stand up and accept their reward.

But Martin’s first post-deficit budget portends a still-grim future for most Canadians. It downsizes the real functions of government and the public sector even further. It leaves most Canadians more at the mercy of a lean, mean, business-dominated economy. It accepts sluggish, tightly-constrained, unbalanced economic growth—the result of high interest rates and Bay Street’s phobia of inflation—as a given. And the only rewards are those being handed out to the financial community: debt repayment, rising bond yields, and a growing confidence that activist government is indeed a thing of the past (deficit or no deficit).

The deficit was a phony excuse, but a powerful excuse, for the attack on public programs and services that has dominated Canadian politics in the 1990s. Now the charade of "fiscal necessity" has been removed from the budget-cutting process once and for all. When governments fail to act on the pressing social and economic issues of our time—health care, job-creation, poverty, access to education—it is because they are choosing not to act. And Canadians must hold them accountable for those choices.

Debt Reduction: Why Not?

Debt reduction—for now at least—has grabbed the whole pie in terms of how the fiscal dividend will be spent. For attacking the accumulated debt so aggressively, Martin has won high marks from financial analysts. The fact that a shrinking supply of government bonds is driving up yields and producing capital gains for financial investors might also have something to do with Bay Street’s enthusiasm.

What is questionable is whether this single-minded pursuit of debt reduction will have any measurable benefits for the rest of us. In reality, the debt burden is poised to fall rapidly, even if the federal government generates not a looney of fiscal surplus. With balanced budgets and continued moderate economic growth (the consensus forecast is for nominal growth of about 4.5% per year), the federal debt will decline from 67% to 54% of GDP in five years. Interest costs will decline correspondingly as a share of government revenues, opening up more room for tax cuts or new spending.

On the other hand, if the federal government sets aside $5 billion per year for debt repayment (equal to Martin’s contingency fund and then some), the debt burden would decline to 52% over the same period—a difference of 2 whole percentage points (see Figure 3). To attain a debt ratio of 52% rather than 54%, Canadians would forego significant opportunities for social reinvestment. For example, $5 billion per year could buy a pharmacare program, a national system of grants for university students, and a doubling of the child tax benefit that has been so widely criticized as inadequate.

Financial markets, on the other hand, would be hard pressed to even notice the difference between a 54% debt burden and a 52% burden. So the possibility that we will be rewarded for our prudence with lower interest rates and financial stability is remote indeed. The arithmetic of the debt burden ensures that nominal debt repayment can play at most a symbolic role in the coming decline of the debt-to-GDP ratio: important not because it reduces debt in any meaningful way, but only because it signals to financiers the continued tight-fistedness of this government.

Martin not only ignores this basic arithmetic with his planned surpluses, he also ignores Canada’s historical experience. The federal government experienced another instance of high indebtedness at the conclusion of World War II—when debt reached 110% of GDP. How did we successfully cut that burden to just 14% of GDP by 1975?

In reality, debt repayment played virtually no role in postwar debt reduction. Over 11 years (from 1946 to 1957) the government repaid a grand total of $2 billion of its accumulated debt. This accounted for no more than 15% of the decline in the debt burden during that decade (which fell to 32% of GDP by 1957); 85% of the decline was due to economic growth (about evenly divided between real growth and inflation). Thus the ChrŽtien government has already paid off more debt in the last 3 months than occurred in an entire decade after World War II.

More strikingly, the federal debt then actually began to grow—more than doubling between 1957 and 1975, even as the debt ratio was falling to reach its postwar minimum. Debt repayment thus did not contribute to the postwar reduction of the debt burden; it was driven solely by economic growth.

If governments of the time had been as obsessed with paying off the dollar debt as they are now, Canadians would have foregone many of the spending initiatives which both improved the quality of life in this country and helped fuel the long postwar economic boom. Our own history shows it is more effective for a country to work down its debts than to attempt to actually pay them off.

To truly reduce our debt burden as fast as possible, we must put greater emphasis on sustaining faster economic growth, especially through lower interest rates— tolerating slightly faster inflation in the process. This would reduce the debt ratio faster than even an aggressive debt repayment program. Yet it is the financial community, despite its crocodile tears about the debt, that aggressively supports higher interest rates and slower growth for the sake of maintaining ultra-low inflation. Like our earlier battles over the deficit, the debate over debt reduction is less about repairing public finances than about preserving the dominance of financial wealth.

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