The 1998 Alternative Federal Budget - What 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

II. What Happened?

Glinda: "She brings you good news, or haven’t you heard.

When she fell out of Kansas, a miracle occurred."

Dorothy: "It really was no miracle, what happened was just this."

According to national accounts data, the federal government deficit declined from over $31 billion in the second quarter of 1995 (immediately following Paul Martin’s historic budget, and prior to the implementation of his announced cutbacks) to almost zero just two years later, during the second quarter of 1997. A number of factors contributed to the rapid erosion of the deficit, including the program spending cutbacks, some announced tax increases (and the unannounced tax increases that result from "bracket creep"—the failure to index the tax system to inflation), higher tax revenues that automatically accompany economic growth, and the post-1995 decline in interest rates.

The overall improvement in the deficit can initially be decomposed into three broad components:

  • the reduction in program spending;
  • increases in tax revenues; and
  • savings on interest payments.

These latter two components can be further decomposed. Some of the growth in taxes results automatically from economic growth—which generates more income against which existing taxes are levied. But some of the growth results from tax increases: either explicit tax increases (which have been very rare in the Liberals’ deficit-reduction scheme), or the implicit tax increases that result from the less-than-full indexing of the tax system to inflation and other factors (often referred to as "bracket creep"). Similarly, the net reduction in the government’s interest payments can be decomposed into two portions: the savings resulting from the decline in interest rates, less the increase in interest payments resulting from the continued growth of the federal debt. In summary, then, we can identify five mutually exclusive fiscal changes that together produced the sum change in the total federal deficit over the two-year period being considered:

  1. the reduction in program spending;
  2. "bracket creep" and other tax increases;
  3. increased tax revenues resulting automatically from GDP growth;
  4. savings resulting from lower interest rates; and
  5. higher debt service charges resulting from continued growth in the debt burden.

The first four components all contributed toward the reduction of the deficit; the last term offset some of this improvement.

Table 1

Decomposition of Federal Deficit Reduction

2ndQuarter 1995 to 2ndQuarter 1997

2Q 1995

2Q 1997

Nominal GDP ($billion)

$773.8

$828.0

Total Federal Revenue ($billion)

$147.0

$160.3

"Tax Ratio" (% of GDP)

19.0%

19.4%

Program Spending ($billion)

$130.3

$116.8

Debt Service Payments ($billion)

$47.9

$44.7

Deficit ($billion)

$31.1

$1.2

Opening Debt ($billion)1

$545.7

$593.3

Effective average interest rate (%)

8.77%

7.53%

Sources of Deficit Savings:

Billion Dollars

Percent of Total

Improved Macroeconomic Environment

GDP Growth

Lower Interest Rates

TOTAL

$10.3

$7.3

$17.7

34.4%

24.5%

58.9%

Reduced Program Spending

$13.5

45.0%

Tax Increases

$3.0

10.0%

Increased Debt Burden

-$4.2

-13.9%

TOTAL

$29.9

100.0%

SOURCE: Canadian Economic Observer, Statistics Canada Catalogue 11-010, Tables 1 and 3.

1. Closing debt at March 31 each year, reported in federal Budget PlanEconomic and Fiscal Update.

It has been the historic and painful reductions in federal program spending that have received top billing in the federal war on the deficit—and won the most plaudits for the Finance Minister from the business and financial communities. But do the spending cutbacks indeed deserve most of the credit for the subsequent balancing of the government’s books? Based on the preceding decomposition of the overall change in the federal deficit over the past two years, the relative importance of the various factors contributing to that reduction can be estimated, as illustrated in Table 1.

Paul Martin’s cuts to federal program spending, deep as they have been, account for just 45% of the total $30 billion improvement in the federal deficit attained over the two-year period. More important have been the favourable macroeconomic conditions—lower interest rates and subsequent economic growth—that have prevailed since late 1995. These two factors account for close to 60% of the total deficit reduction. Tax increases and "bracket creep" (under which federal taxes have increased as a share of GDP from 19.0% to 19.4% over the two years) account for another $3 billion (or 10%) of deficit reduction. Finally, the negative impact of the higher federal debt load has offset overall deficit reduction by about $4 billion (or some 14% of the total net fiscal improvement).

If there is a lesson to be learned from the surprisingly rapid turnaround of federal government finances since Paul Martin’s historic 1995 budget speech, therefore, it is not the conventional wisdom that "getting tough" on spending is the only way to effectively reduce a fiscal imbalance. Instead, a more accurate conclusion would be that the government’s fiscal position is improved strongly and relatively painlessly when Canada’s macroeconomic engines are pointing in the right direction. Compared to the ultimate effects of discretionary, pro-active spending and taxation decisions, the fiscal impacts that arise automatically from macroeconomic trends are actually the more important determinants of the government’s bottom line. If those macroeconomic trends had not been so favourable over the past two years, the federal government’s fiscal position would not be in its present sunny state, despite the deep spending cuts that Canadians have endured.


1. Similar calculations to those reported here can also be conducted using Public Accounts data, instead of National Accounts data. See Appendix for discussion.

2. See Appendix for a complete algebraic description of this disaggregation.

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