OBSERVATION. TD Economics THE PRODIGAL SURPLUS IS RETURNED SOME HIGHLIGHTS FROM THE NOVEMBER 2014 FEDERAL FISCAL UPDATE

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1 OBSERVATION TD Ecnmics THE PRODIGAL SURPLUS IS RETURNED SOME HIGHLIGHTS FROM THE NOVEMBER 2014 FEDERAL FISCAL UPDATE Highlights With an electin year lming, the release f the federal fiscal update has prvided Canadians with renewed clarity as t the expected path f the natin s finances ver the next few years. Overall the utlk is psitive, with strnger ecnmic grwth expected t keep revenues buyant while spending remains lw relative t the size f the ecnmy. That said, lwer il prices and a weaker glbal grwth envirnment has led the gvernment t scale back its fiscal frecast relative t Budget The gvernment is prjecting a $2.9 billin deficit fr the current fiscal year. Hwever, surpluses ver the next 4 years are excepted t cme in at a much reduced cumulative $18.1 billin when cmpared t the $32.9 billin prjected in Budget The lwer fiscal frecast largely reflects the adjustment fr risk and tax relief prvided t families in Octber As a result, there will be little rm left t increase spending r cut taxes ging frward. Given the mdest amunt f rm available, tugh chices will be required. With the release f the federal gvernment s Update f Ecnmic and Fiscal Prjectins 2014 (the Update), Canadians nw have a clearer picture f state f the natin s finances in the run-up t the 2015 electin year. Overall, tday s reprt cnfirmed that there is light at the end f the tunnel, with surpluses expected in each fiscal year beginning in At $2.9 billin, the estimated deficit in fiscal is mdest and identical t that expected in February 2014 Budget (Chart 1). Beynd fiscal , abut $18.1 billin in surpluses are prjected ver the next five years, just ver half f that cntained in the gvernment s 4-year utlk in Budget Fiscal reaps $11.4 billin windfall Since bringing dwn the 2014 budget, the gvernment s fiscal utlk has changed significantly. Ahead f tday s Update, Canadians had already received news frm the release f the 2014 Annual Financial Reprt (AFR) that last year s budget deficit came in cnsiderably lwer than prjected in the spring budget. The budget deficit came in at $5.2 billin in , a marked imprvement f $11.4 billin ver the $16.6 billin shrtfall prjected in Budget Much f the utperfrmance reflected higher revenues than prjected at the time f the budget (+$7.7 billin). At the same time, bth prgram expenses (-$2.6 billin) and public debt charges (-$0.4 billin) came in lwer than expected. The lwer prgram expenses prjectin was due t $2.8 billin in savings frm direct prgram expenses (i.e., Derek Burletn, VP & Deputy Chief Ecnmist, Randall Bartlett, CFA, Senir Ecnmist, CHART 1: FEDS EXPECTED TO RETURN TO Budgetary balance SURPLUS IN ($ billin) Budget 2014 Update / / / / / / /20 Surce: Deparment f Finance Canada.

2 all prgrams excluding transfer payments t individuals, businesses and ther gvernments) ne f the few remaining areas f discretinary spending. This said, sme f the better revenue and expenditure numbers were the result f ne-time factrs, such as asset sales, which will nt flw thrugh t later fiscal years. Ecnmic news has been mixed The lwer-than-expected deficit in fiscal generated a better starting pint fr the current fiscal year. Hwever, develpments in the ecnmy since the spring have been decidedly mixed. Ntably, as Table 1 reveals, the gvernment s expectatins fr the ecnmy this year (which are based n the latest private-sectr frecasts) have been revised up relative t the budget, while interest rates have been adjusted dwnward. Bth f these develpments pinted t an upgrade in this year s fiscal utlk. Hwever, tw recent develpments have erded this utperfrmance. First, crude il prices have tumbled since September. Mrever, the gvernment annunced significant new tax relief fr families that will take be effective in 2014, absrbing abut $3.2 billin in revenues this fiscal year alne. Lwer il prices and a mre mdest ecnmic utlk fr the U.S. have put a mdest chill n the Canadian grwth utlk ging frward. Since much f the il price develpments had ccurred Table 1: Ecnmic Assumptins fr Canada Annual, percent change (unless therwise indicated) Calendar Year Real GDP February 2014 Budget Nvember 2014 Update Nminal GDP February 2014 Budget Nvember 2014 Update Nminal GDP ($ billin) February 2014 Budget 1,952 2,040 2,132 2,226 2, Nvember 2014 Update 1,977 2,062 2,153 2,249 2,345 2,442 3-Mnth T-Bill Rate February 2014 Budget Nvember 2014 Update Year Gv't Bnd Yield February 2014 Budget Nvember 2014 Update Surces: Department f Finance Canada, Statistics Canada, Bank f Canada. $ billin 2,450 2,350 2,250 2,150 2,050 1,950 1,850 CHART 2: RISK-ADJUSTED NOMINAL GDP LARGELY UNCHANGED FROM BUDGET 2014 Budget 2014 Update 2014 Adjustment fr risk Surce: Department f Finance Canada. after private-sectr frecasts were lcked dwn, the gvernment has chsen t augment its typical adjustment fr risk with additinal prudence related t the impact f the lwer prices (fr the views f TD Ecnmics, see Of Oil and Output: An Overview f the Impacts f Falling Oil Prices n the Canadian Ecnmy). This adjustment cnservatively assumes Canadian crude il prices remain unchanged at $70 per barrel. Tgether, these adjustments equate t $5.4 billin dllars in lwer revenues each fiscal year frm and beynd than wuld be the case using the ecnmic prjectins alne (Chart 2). These adjustments ffset the better starting pint, leaving the level f nminal GDP fr fiscal-planning purpses bradly unchanged frm Budget Hwever, the grwing cst f the tax cuts will put a dent int surpluses ver the full hrizn. Fiscal prjectins Adjustment fr il price risk Putting it all tgether, while the and fiscal years were better verall relative t Budget 2014, the cumulative surplus ver the remainder f the prjectin is ntably lwer. Specifically, the cumulative surplus frm fiscal year t published in the Nvember 2014 Update ($18.1 billin) is expected t be lwer than the $32.9 billin surplus expected in Budget 2014 (Table 2). Further, the current fiscal prjectin cntinues t ensure that the federal gvernment will meet the debt-t-gdp target f 25% by 2021 it set fr itself in September With a prjected debt-t-gdp level f 24.3% in fiscal , the federal gvernment is expected t cmfrtably meet its debt target. 2

3 Table 2: Nvember 2014 Federal Fiscal Update Frecast Summary (C$ billin, unless therwise specificed) Budgetary Revenues New measures intrduced since Budget 2014 The gvernment built in the cst f the previuslyannunced tax measures int the 5-year fiscal plan. The initiatives include new tax breaks fr families with dependent children, which cme in just shy f $27 billin ver 6 years. Further, the Small Business Jb Credit will cme in t affect in 2015 and 2016, althugh it will have a mre mdest impact f $550 millin. Beynd these measures, there were n new plicies annunced in the Update. The fllwing tax breaks fr families with dependent children under the age f 18 were intrduced in Octber 2014: Prgram Expenses Public Debt Charges Ttal Expenses Budgetary Balance Federal Debt Per cent f GDP Budgetary Revenues Prgram Expenses Public Debt Charges Budgetary Balance Federal Debt Surce: Department f Finance Canada. Family Tax Cut Equivalent t $12.7 billin ver 6 years, the Family Tax Cut is a mdified versin f the incmesplitting prpsal cntained in the Cnservative Party f Canada 2011 Electin Platfrm. The mdificatin t the riginal prpsal relates t the $2,000 cap n taxable benefits. This change was intrduced t address the criticism that high-incme families wuld benefit disprprtinately frm the prpsal. Additinally, the Family Tax Cut will be prvided in the frm f a tax credit, thereby nt affecting the federal r prvincial tax base. Child Care Expense Deductin The federal gvernment als increased the maximum amunt that culd be claimed under the Child Care Expense Deductin by $1,000. The maximum limit nw ranges between $4,000 and $11,000, depending n the child s age and eligibility fr the Disability Tax Credit. In ttal, this measure is valued at $0.4 billin ver 6 years. Universal Child Care Benefit The numbers are a bit messier in regard t the Universal Child Care Benefit (UCCB), as the federal gvernment eliminated the Child Tax Credit at the same time. Further, the UCCB is taxable, thereby reducing sme f the benefit. As a result, the $26.2 billin increase in spending frm the enhanced UCCB will be smewhat ffset by $3.0 billin in taxes n the UCCB and $9.5 billin frm the eliminatin f the Child Tax Credit. Dubling the Child Fitness Tax Credit On Octber 9, the federal gvernment annunced it wuld be dubling the Child Fitness Tax Credit (CFTC) and making it refundable, meaning that thse that dn t pay sufficient tax t claim the credit against will still get smething back. In TD Ecnmics initial fiscal frecast, we prjected the cst f this measure t be at least $0.4 billin ver 6 years. Meanwhile, at a cst f $550 millin ver tw years, the Small Business Jb Credit was intrduced in September 2014 t supprt jb creatin by small businesses. While the federal gvernment has nt prvided an estimate f the expected emplyment impacts f this measure, the labur market impact is expected t be mdest but psitive. What t expect in the run up t Budget 2015 With the intrductin f these additinal measures, the federal gvernment is nw prjected t have abut $28.3 billin in cumulative surplus rm available fr new measures % f GDP CHART 3: FISCAL PROJECTIONS SHOW SURPLUSES AREN'T WHAT THEY USED TO BE Fall 1999 Fall FY1 FY2 FY3 FY4 FY5 Surces: 1999 Ecnmic and Fiscal Update, TD Ecnmics. Nte: The hrizntal axis refers t each fiscal year fllwing the release f the Fall Update. Fr example, 'FY1' refers t bth and

4 ver the next five years. This is mdest by any standard. Fr instance, in its 1999 Ecnmic and Fiscal Update, the federal gvernment issued status-qu prjectins that revealed a sea f surplus black ink that was expected t reach $23 billin, r 2% f GDP, by the end f the 5-year planning hrizn (Chart 3). Fast frward t tday. The cumulative ttal expected ver the 5-year hrizn at the time was $67 billin. The Update s 5-year cumulative surplus frecast beynd is slightly lwer than that prjected in the 1999 Ecnmic and Fiscal Update. Specifically, it nly amunts t abut 0.5% f GDP 5 years ut, r abut ne quarter f the expectatin in the 1999 Update (Chart 3). Beynd the measures currently annunced, the federal gvernment has als cmmitted t intrducing all f its 2011 electin cmmitments prir t the next electin. As such, the nly remaining measures t be intrduced are the dubling f the cntributin limit fr the Tax Free Savings Accunt (TFSA) frm $5,000 t $10,000 and the intrductin f an Adult Fitness Tax Credit (AFTC) f $500. Using infrmatin frm a variety f fficial surce, TD Ecnmics estimated the csts f these measures in a recent reprt at abut a cumulative $2.3 billin and $1.0 billin, respectively, frm t This wuld reduce the cumulative surplus by an additinal $3.3 billin ver the prjectin. As a result, the cumulative surplus ver the next 6 years wuld be lwered slightly t $25.0 billin. Accrding t TD Ecnmics calculatins, this leaves little rm fr additinal tax relief r new spending measures (see The Truble with Surpluses: An Examinatin f the Federal Fiscal Outlk). Fr instance, reducing the lwest marginal federal tax rate by ne percentage pint is estimate cst $15.5 billin, while cutting the crprate incme tax rate culd be expected t cst abut $14.7 billin. Further reducing the Gds and Services Tax (GST) frm 5% t 4%, all else equal, wuld have a cumulative fiscal impact f abut $36.7 billin. Tax relief culd als be prvided thrugh a reductin in Emplyment Insurance (EI) premiums, as the cumulative balance in the EI Operating Accunt is expected t reach $7.0 billin in , befre being gradually reduced. Beynd tax measures, there will be pressure fr the federal gvernment t increase spending after a perid f prlnged restraint. Histrically, perids f spending restraint have been fllwed by perids f significant spending increases. The prvinces may als be lking t share in the wealth, with an increase in the Canada Health Transfer (CHT) and Equalizatin transfers being a frequently heard call. Finally, while the prjected surplus in the Update will nt leave much rm available fr new spending r tax cuts, this prjectin des nt include funds set aside fr general and il price risk. This prudence is equivalent t rughly $31 billin ver 6 years. In ur view, this amunt shuld be mre than ample t address the external risks t gvernment finances. As such, there may be scpe t see higher surpluses and, as such, t prvide additinal rm fr new measures r pay dwn the debt mre quickly. Bttm line Despite the recent drp in il prices and the cst f tax relief annunced recently, the federal gvernment s bks are n track t mve int surplus and debt-t-gdp rati t cntinue t fall twards 25% f GDP. As the gvernment heads int an electin, pressure t prvide additinal tax cuts and increase spending will intensify. Hwever, given the mdest amunt f rm available, tugh chices will be required. Derek Burletn, VP & Deputy Chief Ecnmist Randall Bartlett, CFA, Senir Ecnmist

5 This reprt is prvided by TD Ecnmics. It is fr infrmatinal and educatinal purpses nly as f the date f writing, and may nt be apprpriate fr ther purpses. The views and pinins expressed may change at any time based n market r ther cnditins and may nt cme t pass. This material is nt intended t be relied upn as investment advice r recmmendatins, des nt cnstitute a slicitatin t buy r sell securities and shuld nt be cnsidered specific legal, investment r tax advice. The reprt des nt prvide material infrmatin abut the business and affairs f TD Bank Grup and the members f TD Ecnmics are nt spkespersns fr TD Bank Grup with respect t its business and affairs. The infrmatin cntained in this reprt has been drawn frm surces believed t be reliable, but is nt guaranteed t be accurate r cmplete. This reprt cntains ecnmic analysis and views, including abut future ecnmic and financial markets perfrmance. These are based n certain assumptins and ther factrs, and are subject t inherent risks and uncertainties. The actual utcme may be materially different. The Trnt-Dminin Bank and its affiliates and related entities that cmprise the TD Bank Grup are nt liable fr any errrs r missins in the infrmatin, analysis r views cntained in this reprt, r fr any lss r damage suffered. 5