The 1998 Alternative Federal Budget - What Could Have Happened?


Introduction

What Happened?

What Could Have Happened?

What Might Happen Now?

Conclusion

Appendix

Canadian Centre for Policy Alternatives

CHO!CES: A Social Justice Coalition

by Jim StanfordEconomist, Canadian Auto Workers and Co-Chair, Macro Policy Committee, Alternative Federal Budget

Suite 804, 251 Laurier West, Ottawa, Ontario, K1P 5J6

Phone (613) 563-1341; fax (613) 233-1458; e-mail ccpa@policyalternatives.ca


The 1998 Alternative Federal Budget: Technical Paper #1

OVER THE RAINBOW: The Balanced Budget, How We Got It, And How to Hang Onto It

III. WhatHave Happened?

Cowardly Lion: "I’ll go in there for Dorothy, wicked witch or no wicked witch.

Guards or no guards—I’ll tear them apart.

I may not come out alive, but I’m going in there.

There’s only one thing I want you fellows to do."

Tin Man: "What’s that?"

Cowardly Lion: "Talk me out of it."

In light of the fundamental contribution that has been made to the federal deficit-reduction exercise by low interest rates and accelerating economic growth, the question might be asked whether the historic program spending cutbacks implemented over the past two years were even necessary. The cutbacks have not been the dominant force behind the government’s deficit reduction, which has run two years ahead of Martin’s own timetable. What path would the federal deficit have followed if Martin had been persuaded not to cut program spending?

To consider this issue, we perform the following counterfactual simulation exercise. Assume that Martin had only frozen nominal spending at its fiscal 1994-95 level: $118.7 billion. In the absence of the fiscal drag associated with the spending cutbacks, Canada’s overall GDP growth would have been stronger than was actually the case. To capture this effect, we cautiously assume a fiscal "multiplier effect" of 1.5: in other words, each dollar of withdrawn federal program spending reduces final aggregate demand by $1.50 (the initial dollar, and then 50 cents of additional GDP assumed to have been created by the subsequent spending and partial re-spending of the original dollar). This higher level of GDP in turn translates into higher federal tax revenues than otherwise was the case; in fact, in light of prevailing tax-to-GDP ratios, about 25% of the cost of each dollar of foregone spending cutback is subsequently returned to the government due to the increased tax revenue associated with more vibrant macroeconomic conditions. A third impact on the federal deficit must also be considered by the counterfactual simulation: since the deficit would have fallen less quickly than was actually the case, the federal debt burden would have been higher, and hence debt financing expenses higher.

These three different impacts on the federal deficit can be estimated in an integrated fashion, as illustrated in Table 2. As a result of forgoing the program spending cutbacks, GDP growth in the counterfactual scenario is notably faster than was experienced in the first years of the actual cutbacks; in subsequent years, however, growth is actually slower in the counterfactual scenario (since by that point a given volume of new GDP generated by continuing growth in the private sector must now be measured against a larger base). Program spending is higher, but this is partially offset by higher tax revenues captured from the higher levels of GDP. Higher debt servicing costs add further to the federal deficit. Not surprisingly, the estimated federal deficits in the counterfactual scenario are significantly higher than has occured (or are expected to occur) in reality—by as much as $12 billion in fiscal 1997. Nevertheless, the deficit declines steadily from its 1994 level, on the strength of the program spending freeze, continued economic growth, and lower interest rates, and a balanced budget is attained by fiscal 1999. What is especially surprising is that the deficit reduction path in the counterfactual simulation actually exceeds the original deficit targets that Paul Martin set out in his 1995 and subsequent budgets: falling to significantly less than 3% of GDP in fiscal 1996, and by a further percentage point of GDP each year until achieving balance in fiscal 1999 (see Figure 1). And the debt-to-GDP ratio falls steadily in the counterfactual simulation, beginning in fiscal 1996.

In other words, Paul Martin could have beaten his professed deficit-reduction timetable simply by freezing nominal program spending, and waiting for the benefits of continued economic growth and lower interest rates to work their magic on the government’s fiscal balance. Not only have the program spending cutbacks that subsequently ensued been extremely damaging to the social and economic fabric of the country, they were not even necessary—even by the measuring stick of Martin’s own timetable (which, remember, would still have reduced Canada’s deficit to the lowest among the major industrialized economies). It has been the fiscal benefits of economic growth and lower interest rates that have propelled the federal budget into its present balanced position, not the spending cuts. Those more fundamental and constructive forces would have balanced the federal budget on their own, with just a freeze on nominal spending, without requiring the spending cuts that have been implemented in practice (and without requiring any tax increases other than the modest "bracket creep" which Martin himself has overseen). Of course, Martin has vastly outperformed his own deficit-reduction timetable, and it is this (together with the spending cutbacks) which has so endeared his government to business and financial interests —those who would prefer to see a smaller role for government in our society anyway, quite independently of any concerns regarding deficits and debt. But if Martin’s initial professed timetable held any credibility in and of itself, then this timetable could have been matched simply on the strength of lower interest rates and their beneficial impact on economic growth. One obvious objection that could be raised to the forgoing simulation is the argument that the lower interest rates that have prevailed since 1995 were themselves a consequence of the government’s spending cuts. There are two versions of this story: the first suggests that lower rates were automatically bestowed on Canada by financial markets as a reward for our fiscal discipline, while the second suggests that lower rates were engineered by the Bank of Canada in response to the persistent economic sluggishness that accompanied the dramatic public sector spending cuts. The former is contradicted by empirical evidence on historical patterns in interest rates, and is further undermined by the recent upward trend in shorter-term interest rates: if lower interest rates resulted from improved "investor confidence," then why are interest rates now rising when investors should be more confident than ever? It is the latter view which is now more commonly accepted in policy circles. In either case, it could be argued that it cannot be assumed that lower interest rates would have prevailed in the absence of the spending cuts.

Table 2

Federal Deficit With and Without the Cutbacks

Counterfactual Simulation, 1994-2000

All data in $billions unless noted.

Fiscal Years

1994

1995

1996

Program Spending Actual1

Counterfactual

Difference

118.7

112.0

118.7

6.7

104.8

118.7

13.9

Nominal GDP Actual

Counterfactual

Difference

757

780

790

10.1

807

828

20.9

Nom.GDP Growth(%) Actual

Counterfactual

4.8

3.0

4.3

3.4

4.8

Total Revenue Actual

Counterfactual

Difference

123.3

130.3

132.0

1.7

140.9

144.5

3.6

Debt Service Charges Actual

Counterfactual

42.0

46.9

47.1

45.0

45.8

Deficit Actual

Counterfactual

37.4

28.6

33.8

8.9

20.0

Closing Debt Actual

Counterfactual

545.7

574.3

579.5

583.2

599.5

Deficit / GDP (%) Actual

Counterfactual

Martin Timetable

4.9

3.7

4.3

1.1

2.4

3

Debt / GDP (%) Actual

Counterfactual

72.1

73.6

73.4

72.3

72.4

1. Actual includes forecast to 1998 based on federal Budget Plan and consensus economic forecasts; for 1999 and 2000, forecast assumes freeze on program spending at 1998 levels, 4.5% nominal GDP growth, average effective interest rate on federal debt of 7.75%, and constant tax-to-GDP ratio.


Table 2

Federal Deficit With and Without the Cutbacks

Counterfactual Simulation, 1994-2000

All data in $billions unless noted.

Fiscal Years

1997

1998

1999

2000

Program Spending Actual1

Counterfactual

Difference

105.8

118.7

12.9

103.5

118.7

15.2

103.5

118.7

15.2

103.5

118.7

15.2

Nominal GDP Actual

Counterfactual

Difference

849

868

19.4

897

920

22.8

938

960

22.8

980

1003

22.8

Nom.GDP Growth(%) Actual

Counterfactual

5.2

4.9

5.7

6.0

4.5

4.4

4.5

4.4

Total Revenue Actual

Counterfactual

Difference

148.2

151.6

3.4

156.7

160.7

4.0

163.7

167.7

4.0

171.1

175.1

4.0

Debt Service Charges Actual

Counterfactual

43.8

45.4

45.1

47.7

44.4

47.8

43.1

47.4

Deficit Actual

Counterfactual

1.4

12.5

-5.1

5.7

-12.8

-1.2

-21.5

-8.9

Closing Debt Actual

Counterfactual

584.6

612.1

579.5

617.8

566.7

616.7

545.2

607.7

Deficit / GDP (%) Actual

Counterfactual

Martin Timetable

0.2

1.4

2

-0.6

0.6

1

-1.4

-0.1

0

-2.2

-0.9

Debt / GDP (%) Actual

Counterfactual

68.9

70.5

64.6

67.2

60.4

64.2

55.6

60.6

1. Actual includes forecast to 1998 based on federal Budget Plan and consensus economic forecasts; for 1999 and 2000, forecast assumes freeze on program spending at 1998 levels, 4.5% nominal GDP growth, average effective interest rate on federal debt of 7.75%, and constant tax-to-GDP ratio.


But if lower rates are seen to have resulted from the pro-active preferences of the Bank of Canada, then the Bank could still have engineered those lower rates even if nominal program spending had only been frozen (instead of being reduced). The counterfactual simulation thus presumes a different set of policy priorities on the part of the Bank of Canada—just as it presumes a different set of priorities on the part of the Finance Minister. While the existing Bank of Canada leadership is unlikely to have acted in the manner assumed by the counterfactual simulation, this is not to imply that it would have been impossible for the Bank of Canada to act in this fashion. In other words, if the Finance Minister had placed more emphasis on preserving public programs, and if the Bank of Canada had placed more emphasis on sustaining growth and job-creation (rather than reducing inflation), then the counterfactual simulation described above would be quite within the realm of possible fiscal outcomes. The fact that both of these "ifs" are far-fetched reflects only the deep extent to which conservative economic priorities are embedded in the word-views of our top policy-makers, rather than any lack of economic "realism."

In summary, it has been the beneficial effects of lower interest rates and economic growth that have fueled the rapid improvement in federal finances. These forces could have been harnessed quite separately from the painful spending cuts which have been the professed centrepiece of the Finance Minister’s strategy. Indeed, the macroeconomic factors alone would have been sufficient to approximately achieve Martin’s originally stated timetable—with no spending cuts and no additional tax increases. We note in concluding that previous editions of the Alternative Federal Budget (dating back to 1995) have consistently proposed something very close to this as an alternative strategy for reducing the federal deficit: reduce interest rates, stimulate economic growth, and preserve social programs and public-sector employment. Our counterfactual simulation suggests that such a strategy would indeed have met Martin’s own deficit-reduction timetable.


3. Of course a freeze in nominal spending, in the context of continuing inflation and population growth, still translates into a real cutback in the services that government delivers. Nevertheless, the social and economic consequences of a freeze would have been far less severe than those that have actually prevailed.

4. This is conservatively within the range of estimated multiplier effects that have been commonly used in estimates of the fiscal drag impact on overall GDP and employment of government cutbacks; other studies imply significantly stronger multiplier effects. See, for example, "Government cutbacks: a checklist," Mike McCracken, Informetrica, May 1994; or "When will the fiscal brake be released?", Jeff Rubin and John Lester, CIBC Wood Gundy, Occasional Report #15, August 1996.

5. The counterfactual exercise assumes the same interest rates that have prevailed in practice; see below for discussion of this assumption.

6. See Jim Stanford, "Is there a risk premium in Canadian interest rates?", Canadian Business Economics, Fall 1997, for a full critique of this view.

7. It is certainly the view of the Bank of Canada itself. For example, Governor Thiessen recently explained the post-1995 fall in interest rates by stating that Canada’s economy "needed a substantial amount of monetary stimulus to respond to the degree of fiscal restraint and problems associated with a major restructuring of the economy." See "Dollar set to climb, Thiessen says," Globe and Mail, p. B1, October 8, 1997.

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