The 1998 Alternative Federal Budget - What Might Happen Now?
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
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OVER THE RAINBOW: The Balanced Budget, How We Got It, And How to Hang Onto It
Scarecrow: "It looks like we came a long way for nothing."
Dorothy: "And I was so happy. I thought I was on the way home."
Now that its budget has been balanced, the federal government will start to benefit from a virtuous circle of declining debt (measured as a share of GDP) and declining debt service charges (measured as a share of GDP or as a share of total federal revenues). This will open up significant budgetary room in coming years for new fiscal initiativeswhether that be additional program spending, tax cuts, or paying down the accumulated federal debt.
The likely size of this "fiscal dividend" depends crucially on the future course of key macroeconomic variablesespecially interest rates and economic growth. This is hardly surprising, given the central role that these macroeconomic factors have played in delivering a balanced federal budget in the first place. If interest rates remain low and growth strong, then the fiscal dividend will be huge: revenues will grow rapidly with economic growth, debt service charges will shrink rapidly as a share of GDP, and the federal government will soon enjoy a budgetary surplus (in the absence of other tax or spending decisions) equal to tens of billions of dollars. On the other hand, if interest rates rise and growth slows, then the fiscal dividend will shrink accordingly. Current debates in macroeconomic policyin particular regarding whether or not the Bank of Canada (backed by the Finance Minister) should be raising interest rates now to slow growth, despite Canadas low and stable inflation, and despite continued high unemployment will bear centrally on which fiscal path is ultimately followed.
To estimate the size of the likely fiscal dividend, and illustrate the importance of the macroeconomic environment to the governments fiscal balance, consider three different scenarios. The first two assume the continuation of "status-quo" monetary policy: the Bank of Canadas low target band for inflation is the ultimate macroeconomic priority, and the Bank will control interest rates and growth levels in order to stay well within that band. Short-term interest rates are seen rising to 4.5% over the next year, and the effective average interest rate paid by the federal government increases to 7.75%. In a best-case scenario, the Bank manages to attain a "soft landing" for the economy: raising interest rates starting now to gradually slow real GDP growth to the 2.5% annual rate it considers sustainable by fiscal 1999 and thereafter. In a less desirable status-quo scenario, real growth is actually stopped in fiscal 1999 by the higher interest rates, and then regains steam thereafter; this is similar to what actually transpired in 1995, the last time the Bank of Canada raised interest rates to cool off what it considered to be an "overheating" economy.
An alternative third scenario assumes the replacement of the current single-minded emphasis on low inflation with a more expansionary macroeconomic stance. The Bank of Canada is assumed to maintain interest rates at their early-1997 level, allowing current real growth rates (of close to 4%) to continue for a total of five yearsas opposed to the two years of strong growth that are allowed in the soft-landing scenario. This sustained growth would only be sufficient to reduce the unemployment rate to about 7% by the end of the five-year period, while allowing the re-entry of only about one-half of the discouraged workers who have left the official labour market since 1990; so it is hard to conclude that even this "sustained expansion" scenario will be testing the real capacity limits of Canadas economy. Short-term interest rates stay at their early-1997 levels (about 3%), while the average effective rate paid by the federal government declines slightly to 7.0% (as persistent shorter-term rates gradually filter through a larger share of the total federal debt). Inflation reaches the top of the Bank of Canadas target band (3%) by fiscal 1999 and thereafter. The key economic assumptions underlying these three contrasting scenarios are summarized in Table 3.
A federal fiscal "dividend" is estimated on the assumption that "core" nominal program spending by the federal government increases from its budgeted 1998 levels ($103.5 billion) at a rate equal to the sum of inflation plus population growth. This, in essence, freezes "core" federal program spending at its 1998 level, in real per capita terms. With tax revenues rising automatically with economic growth, a budgetary surplus arises in 1998 and thereafter. This, in theory, is the "dividend" that will become available for some combination of new program spending, tax deductions, and actual paydown of the federal debt. In the more optimistic status-quo scenariothe "soft landing"the projected surplus grows to over $20 billion by the year 2001. If continued economic growth is stalled by the Bank of Canadas tightening, however, then the estimated surplus almost disappears until fiscal 2000, and is much smaller than in the "soft landing" projection in following years. With a macroeconomic commitment to sustained expansion, however, then the funds available to the federal government swell dramatically, creating an estimated surplus of $50 billion by fiscal 2002 (see Figure 2 and Table 4).
In other words, there will be a huge fiscal cost imposed on Canadians and their governments as a result of the pre-emptive tightening this year of monetary policy. If the Bank of Canada allowed current growth rates to continue for just another four years, still leaving the economy a considerable distance from full-employment, the federal government would have an additional $70 billion to spend on new programs, tax cuts, or debt repayment, compared to an optimistic "soft landing" scenario, over the next five fiscal years. The coming "dividend," then, will be almost cut in half by the continued top priority placed in macroeconomic policy on maintaining Canadas ultra-low inflation rate. If real growth is stalled by the Banks tightening, then the "dividend" may virtually disappears altogether.
Canadians are demonstrating that they are already skeptical of the Bank of Canadas quick action to slow down our long-delayed economic recovery. Imagine, however, their reaction if the Bank were to present the federal government with a bill for $70 billion, as the ultimate fiscal cost of its emphasis on continued low inflation. In the wake of the unprecedented belt-tightening and sacrifice that Canadians have (needlessly) endured for the sake of putting our fiscal house in better order, the notion of the federal government "spending" $70 billion over five years in support of this dubious goal of low inflation would spark an outright taxpayers revolt. Yet that is exactly the ultimate cost that Canadians will bear if the current restrictive direction of monetary policy in Canada is endorsed and continued.
8. The rise in the governments effective average rate is not as large as the rise in short-term rates due to the fact that interest rates on longer-run bonds (which make up a significant portion of total federal debt) are not expected to increase as much as short-term rates.
9. Some other estimates of the coming fiscal "dividend" assume a continued nominal freeze on program spending at the budgeted 1998 levels. However, this would translate in practice into a need for ongoing continued real program cutbacks (since that frozen spending will be insufficient to keep up with inflation and population growth). Thus the size of the estimated "dividend" in these studies cannot be equated with the volume of spending available for new programs (since some of that so-called "dividend" would be needed just to maintain the real delivery of existing programs).
10. This methodology is somewhat misleading, in that if some or all of the dividend is "spent" on new programs or tax cuts, then the size of the dividend itself will be somewhat smaller in future yearssince the net federal debt will be no longer falling in absolute terms (as would be the case if the dividend was allocated to debt repayment).
11. This is quite consistent with the base-case projections of the Royal Bank, CIBC Wood Gundy, and other forecasters, updated to reflect the lower-than-expected 1996-97 deficit announced recently by Paul Martin; see "Canadas new fiscal order," Globe and Mail, p. D1, October 11, 1997.
12. This is to say nothing of the huge social and economic costs resulting from the continued high levels of unemployment that are a necessary feature of the status-quo approach.