Research Branch. Mini-Review 86-7E THE FEBRUARY 1986 FEDERAL BUDGET: A CLEAR SIGNAL REGARDING THE DEFICIT? Marion G. Wrobel Economics Division

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1 Mini-Review 86-7E THE FEBRUARY 1986 FEDERAL BUDGET: A CLEAR SIGNAL REGARDING THE DEFICIT? Marion G. Wrobel Economics Division 28 February 1986 Library of Parliament Bibliotheque du Parlement Research Branch

2 CANADA THE FEBRUARY 1986 FEDERAL BUDGET: A CLEAR SIGNAL REGARDING THE DEFICIT? Shortly after the election victory in September 1984, the federal government announced its serious concern. over the trend in its finances. In his statement to the House of Commons on November 8, 1984, the Minister of Finance, the Hon. Michael H. Wilson, highlighted the disturbing nature of the government s fiscal position and outlined a coninitinent to reduce the size of the deficit, which he considered to be a major obstacle to economic recovery and growth. In that statement,( 1 ) the Minister announced a modest deficit reduction plan which would reduce the growth of net debt by about $3,500 million by the end of Despite these measures, the deficit was still expected to reach about $35,000 million as a result of changes in forecast revenues and expenditures, an amount far in excess of the previous government s projections. The 1984 Economic Statement also provided medium-term projections, indicating the status quo deficit and debt levels up to fiscal year It is on the basis of these figures that one would normally judge the progress of the government. In May 1985, the Minister of Finance brought down his first budget and it was to have been the true start of a new era of fiscal restraint. In fiscal year , the government would reduce the deficit by $4,400 million, to $33,800 million. In , the total deficit reduction would exceed $8,000 million, bringing the deficit down to $32,700 million.( 2 ) And by the annual deficit was to be $20,000 million lower than it would have otherwise been and the cumulative reduction (1) The Hon. Michael H. Wilson, A New Direction for Canada - An Agenda for Economic Renewal, Department of Finance, Ottawa, November 8, (2) The Hon. Michael H. Wilson, The Fiscal Plan, Department of Finance, Ottawa, May 23, 1985.

3 2 of the net debt was to reach $75,000 million by that year. At the time the Minister s strategy to control the deficit in the short run while exacting significant reductions by the end of the decade sounded very convincing. Just how reliable, though, are these numbers? They were based on status quo projections as of May 1985 which differed significantly from those of November In the intervening eight months, the increase in the status quo deficits amounted to $1,100 million (+3%) for ; $6,700 million (+20%) for ; and $13,000 million (+35%) for A very large part of projected deficit reductions, then, was accounted for by these changes in the base of calculation (the deficit reductions from the initial projections were much smaller). This experience was not unique to the May 1985 budget. From February 1984 to November 1984, deficit projections published by the Department of Finance increased by: $8,950 million (35%) for ; $13,800 million (59%) for ; $14,600 million (74%) for ; and $16,450 million (88%) for The recent fall in the value of the Canadian dollar has brought to the forefront the problem of the government s credibility with respect to its budgetary stance. While the Minister kept citing his deficit reduction figures, the market kept observing that the deficit was far higher than when the Liberals were in power and, despite all the effort by this government, there was no real prospect for the deficit to come in at less than $30,000 million. The problem may lie less with the Minister s stance or that of the government than with the credibility of the projections of the Department of Finance. Projections of revenues and expenditures by the Department have been wide of the mark, even in the short term. From November 1984 to May 1985 the Department revised its deficit forecasts for and by over $2,300 million; it had understated expenditures by $858 million and overstated revenues by $1,450 million. These alterations were attributed to changes due to economic factors although it was recognized at the time of the budget that the economy was performing better than had been expected only eight months earlier. The changing economic factors therefore should have worked in the opposite direction to increase revenues and decrease expenditures.

4 3 The signals to Canadians and market participants in the May 1985 budget also did little to convince them of the government s ~ effectiveness in reducing the deficit and debt. The November 1984 Economic Statement viewed the status quo deficit and debt projections with alarm, noting that the debt/gnp ratio would increase to 0.63:1 by if nothing was done. Yet it appeared that all the deficit cutting measures in the 1985 budget would have no impact on that ratio by The budget failed to provide useful targets by which its deficit cutting measures could be judged the measures sounded impressive but the results were not. In November 1985, the Department issued a background paper on the deficit and debt.m) In terms of new estimates on the government s financial position, the paper added little that was useful. It did, however, give some idea as to the targets of the government in this regard. In the first place it offered a medium term goal of stabilizing the debt/gnp ratio by the early l990s. This was not a particularly impressive goal since, at that time, the ratio was still on essentially the same path as - outlined by the 1984 status quo projections, with the rate of debt growth substantially lower by In that sense it was almost a target by default. The second announced goal was to reduce the debt/gnp ratio to the level that existed before the 1980s, about 0.25:1. This is an impressive goal; however, no real time frame has been established in which to achieve it. It must be remembered that the government is expecting to take about six years to stabilize the debt/gnp ratio and in the process will end up with a ratio that will have grown by about 50%. It is within this context that one must judge the government s ability to reduce the ratio from just over 0.60:1 to about 0.25:1 within a measurable time frame. We now look at the February 1986 budget on the basis of its continuation of, or break with, the tradition established in these three initiatives. (1) The Hon. Michael Wilson, Reducing the Deficit and Controlling the National Debt, Department of Finance, Ottawa, November 1985.

5 4 The second budget of Mr. Wilson promises total deficit reductions of $4,700 million in , $10,200 million in , $14,900 million in and $26,700 million in l99o_91.(l) These figures include the results of all previous measures by the Minister as well as those outlined in this budget. These~reductions are higher than the ones announced last May and unlike the reductions in previous announcements there is no phantom component to them. The status quo deficit projections in this document are essentially the same as those presented last year. If this budget is judged in accordance with the goals outlined on the previous page, it seems to be effective. The measures stabilize the debt/gnp ratio before and, indeed, stabilize it at about 0.55:1. This is significantly below the 0.63:1 ratio indicated in the May 1985 budget. By the annual deficit, as a proportion of GNP, is forecast to fall by well over 50%, from about 9% of GNP in to about 3.5% of GNP in If one ignores the deficit cutting figures of the Minister and looks only at the bottom line results, the budget does reduce the deficit in dollar terms and the deficit/gnp ratio to levels well below those experienced in the recession and immediate pre-recession years. As a signal this is very clear and gives rise to optimism in those who view the debt with real alarm. More important than these overall figures is the fact that, the Minister is projecting an increasing primary surplus starting in As such, he has indicated the importance he places on the debt accumulated in the past. It is highly unlikely that the debt/gnp ratio could ever be reduced significantly below forecast levels without a willingness on the part of the government to incur primary surpluses for extended periods of time. If the budget is viewed in this regard, it does provide a clear signal that the government intends to reduce the deficit. Some might complain that the signal has come too late or is not strong enough. But it (1) The Hon. Michael H. Wilson, The Fiscal Plan, Department of Finance, Ottawa, February 26, 1986.

6 5 is clear that, based on forecast deficit and debt levels, the message in this budget is very different from that found in the Minister s previous documents. Is this the signal the market has been looking for? The early indication is that these deficit reductions have not resulted in a general increase in the confidence in the Canadian dollar. Such a judgement is likely to be unfair because it is still too early to judge the budget s impact. Nevertheless it does indicate that the market may have been looking at more than the deficit; it may also have been looking at the size of the government in general. On the surface, the government has indicated its desire to reduce the overall size of its activities, as measured by total expenditures. Expenditure reductions (including induced interest savings) are to account for 70% of total deficit reductions. This is not to be taken to mean that total expenditures will fall they will increase. What it means is that they will increase at a substantially slower pace than would otherwise have been the case. The discretionary expenditure cuts come from the projected non-statutory expenditures of the government. Statutory programs were exempt from the deficit cutting process as presented in this budget. It appears, however, that the base upon which expenditure cuts are measured is too high. Using the data of the budget and the Estimates, two series of non-statutory expenditures have been calculated; a status quo series and a post-budget series. These are the last two rows of the following table. In the absence of any restraint measures, non-statutory expenditures were projected to grow, on average, 1% per year faster than program expenditures as a whole from to If the status quo projections for non-statutory expenditures are restricted by the growth rates of status quo program expenditures (i.e. row four in the table), total net expenditure cuts fall by $1,900 million in , $1,700 million in , $2,100 million in , and $4,300 million in Such a change in status quo projections eliminates over 30% of the direct expenditure reductions outlined in the budget. -

7 6 In conclusion, the budget finally projects a deficit position which is under control. This is quite a change from the bottom line results presented previously. Nevertheless, there are still a number of issues to be resolved concerning the expenditure path of the government. If spending on non-statutory programs is subject to the greatest political control, why does the growth rate of non-statutory spending exceed that of total program spending in the absence of any budgetary measures? To what extent do the status quo expenditures include items which were designed to be temporary when they were initially introduced? And just how much additional statutory government would like deficit cutting can take place without addressing the question of program expenditures? At this stage it appears that the has not controlled the spending side of the ledger as much as it to. FEDERAL GOVERNMENT EXPENDITURE PROJECTIONS (in billions of dollars) Total Expenditures: Projected Status Quo Program Expendi tures: Projected Status Quo Non-Statutory Expenditures:* Projected Status Quo * Estimated.

Economic and Fiscal Outlook

Economic and Fiscal Outlook Ottawa, Canada 28 www.pbo-dpb.gc.ca The mandate of the Parliamentary Budget Officer (PBO) is to provide independent analysis to Parliament on the state of the nation s finances,