GLOBAL ECONOMICS FISCAL PULSE

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1 Canada s Federal Fiscal Fall Statement Let the Good Times Roll The Fall Statement provides only very modest additional stimulus over the next two years. It is unlikely to sway Bank of Canada policy in the near-term and no material market impact is expected. The economy is providing a budgetary windfall, though only about onethird of the windfall is spent. CONTACTS Jean-François Perrault, SVP & Chief Economist Scotiabank Economics jean-francois.perrault@scotiabank.com Mary Webb Scotiabank Economics mary.webb@scotiabank.com Deficits and debt are on a solid downward path, but balanced budgets are nowhere in sight. As expected, the federal government is benefitting from much stronger economic conditions than assumed in the last Budget. The improved outlook results in a $46.6 billion windfall from fiscal year (FY18) to FY22. About a third of that windfall is spent through a combination of new or richer programs and tax cuts. Excluding the annual $3 billion adjustment for risk, the budgetary balance improves from a final $17.8 billion deficit in FY17 to $9.5 billion in FY23, the end of their planning horizon. There is no indication of when the budget will be balanced. The federal net debt (accumulated deficit) continues its decline, from 31.2% of GDP as of March 2017 to just over 28% of GDP by the end of the forecast period. Headline policy announcements involve the indexation of the Canada Child Benefit as of mid-2018, costing over $1 billion a year, a more generous Working Income Tax Benefit (WITB) that raises maximum benefits and expands the qualifying income range in (a $500 million yearly expense), and the previously announced private corporation and small business taxation changes (costing $0.6 billion at their peak in FY21). No cost is yet attributed to the announced changes in the treatment of passive income held by private corporations, but we anticipate the revenues accruing from these changes will be substantial, likely more than $1 billion a year. At slightly less than $2 billion, the measures announced in this Statement will provide only a very minor economic boost over the next couple of years. While it goes against Governor Poloz s attempts to cool the economy at the margin, the Update should not have a meaningful impact on Mr. Poloz s views on the economy or interest rates. Very limited, if any, market impact should flow from this Update. While we do not anticipate that the Statement will influence Bank of Canada policy, its measures, when implemented in 2018 and 2019, will provide some relief to lower-income and more highly indebted households. The Canada Child Benefit and the Working Income Tax Benefit (WITB) are means tested and target households that are likely most vulnerable to rising interest rates. Furthermore, the Canada Child Benefit has unquestionably led to stronger household spending and the changes announced today might sustain somewhat stronger consumption growth than possible absent these modifications. Chart Fall Statement Budget 2017 $ billions -60 FY r * Forecasts for FY18 onward include risk adjustment. Chart Canada s Federal Budget Balances*... and Its Accumulated Deficit $ billions % % of GDP, RHS Accumulated Deficit, LHS Budget 2017, RHS 2017 Fall Statement RHS 200 FY r Sources for charts: Finance Canada; nominal GDP forecasts: Scotiabank Economics The WITB helps low-income workers. In 2019 it also will offer a lower-income refundable tax credit outlined in 2016 to offset scheduled premium increases for an enhanced Canada Pension Plan. 1

2 REVENUE DETAILS Deficits in the Fall Statement from FY18 to FY22, excluding the risk adjustment, total $73.0 billion, a $31.8 billion improvement from the cumulative red ink forecast in Budget Higher revenues account for almost $28 billion (87½%) of this progress (table 1). Beginning with a stronger-than-expected hand-off from FY17 final receipts, revenues in FY18 are receiving a further sizeable boost from Canada s robust economic growth in calendar Based on the government s survey of private-sector forecasters, the Fall Statement assumes 3.1% real GDP growth for 2017, compared with the March Budget s projected 2.0% rise (table 2). The somewhat larger rise now expected for the 2017 GDP deflator also boosts receipts. Indeed, before incorporating the policy actions since Budget 2017, economic and fiscal developments since the Budget yield a cumulative FY18-FY22 deficit just over $58 billion. There are less encouraging aspects of the revised economic assumptions, such as a more gradual rise in WTI oil prices and somewhat higher interest and exchange rates, but their FY18 revenue impact is relatively modest. Robust job creation is a key driver of the projected personal income tax (PIT) surges of 6.3% and 5.6% in FY18 and FY19, respectively. For the next four fiscal years, forecast gains in PIT receipts average a healthy 4.1% annually (table 3). Continuing to support federal revenues are the government s stepped-up measures to combat tax evasion and aggressive tax avoidance, both within Canada and abroad, that are expected to result in additional revenues of more than $5 billion over six years. Revenues from Employment Insurance (EI) premiums, however, are expected to fall this fiscal year by about 5% after a 4.1% drop in FY17 given the lower premium rates generated by the seven-year break-even mechanism introduced in This calculation led to the employee premium rate dropping from $1.88 per $100 of insurable earnings in calendar 2016 to $1.63 this year. For 2018, $1.66 is suggested before settling at $1.65 for the following four years to ensure that the EI Operating Account achieves a cumulative operating balance by EXPENDITURE DETAILS The Fall Statement relative to the March Budget outlines a $2.5 billion cumulative program expenditure saving from FY18 to FY22, plus interest charges that are $1.5 billion lower. In part this is a consequence of final FY17 program outlays totalling $3.7 Table 1 The Canadian Economy s Sizeable Assist to the Federal Budget Bottom Line $ billion FY17 FY18r FY19r FY20r FY21r FY22r FY23f FY18-FY22r Budget 2017 : Deficits n.a Risk Adjustment n.a Budget 2017 : Deficits No Risk Adjustment n.a Economic & Fiscal Developments n.a Revised Deficits Before Policy Actions Policy Actions Since Budget 2017 Small Bus.CIT Rate:10.5% to 10%(2018); 9% (2019) Restriction of Income Sprinkling Using CCPCs Other Policy Actions Since Budget Subtotal Policy Actions in 2017 Fall Statement Working Income Tax Benefit Enhancement in Earlier Canada Child Benefit Indexation as of Mid Subtotal Total Policy Actions Fall Statement: Deficits No Risk Adjustment Risk Adjustment Fall Statement: Deficits Source: Finance Canada. 2

3 billion less than the March Budget estimate, with lower infrastructure transfer payments a contributing factor. Nevertheless, program spending is expected to climb 6.2% in FY18, an increase roughly matching the prior two years that elevates outlays 20% above FY15. Chart 3 Federal Major Transfers to Individuals For FY19-FY23, average annual increases in program expenditures, for now, are expected to cool to 2.6%, representing quite modest real gains per capita. It is a prudent strategy in light of the Budget assumption that Canada s real GDP growth will average just 1.7% from 2019 to For the two largest federal transfers to the Provinces, the Canada Health Transfer and Equalization, that are linked to a three-year moving average of national nominal GDP, Canada s more buoyant economic outlook results in a five-year rise in their total payments of $1.2 billion and $0.6 billion, respectively. The Statement s update on Ottawa s infrastructure plan is quite brief. Negotiations on bilateral agreements with each Province and Territory continue, and ongoing announcements include $1.28 billion of federal funding for Montreal s light rail network, Réseau électrique métropolitain, subject to due diligence. The headquarters for the Canada Infrastructure Bank will be in Toronto and the search process is well advanced for the Bank s Board and CEO index, FY10=100 Canada Child Benefit Elderly Benefits Employment Insurance Benefits 75 FY r 20r 22r Source: Finance Canada. Beyond infrastructure, Ottawa s broad involvement in other policy areas critical to the Provinces is illustrated by the following sample of current discussions and scheduled events. In June 2017, the federal government announced a Multilateral Early Learning and Child Care Framework ($7.5 billion over 11 years). Ottawa is aiming to reach three-year agreements with each Province and Territory, working towards an increase in subsidized daycare spaces from 108,000 in FY17 to 153,000 in FY20 to 179,000 in FY28. In April 2017, the Residential Construction Financing Initiative was launched providing $2.5 billion in low-cost loans over four years to municipalities, non-profits and developers to kick start the construction of over 10,000 new rental units across Canada. A National Housing Strategy is expected this Fall. Labour Market Transfer Agreements are being reformed and consolidated in partnership with the Provinces and Territories. For the Superclusters Initiative with five-year funding of up to $950 million, sectors selected for the second phase of the application process this November include: AI-powered supply chains, digital technology, advanced manufacturing, resilient infrastructure, protein innovation, oceans technologies, next generation mobility systems and clean growth mining innovation. A $2 billion Low Carbon Economy Fund also was laid out by Ottawa last June to facilitate progress on the Pan-Canadian Climate Change Framework. OUTLOOK Canada s current economic outperformance is offering a major assist to the federal Liberals ambitious agenda that includes supporting the middle class. The new measures in this Statement build on the multiple initiatives already introduced by this administration since its election, and the multi-year timeframe of many of its commitments represents substantive cumulative resources (chart 3). Upside for the Budget estimates exists. Revenue estimates for all the proposed tax changes for Canadian-Controlled Private Corporations were not available for this Statement. A number of events, such as the current NAFTA negotiations, argue for annual risk adjustments, but if they are not needed, Ottawa s accumulated deficit by March 2023 would drop to about 27½% of GDP. Yet Canada also faces a high probability of slowing economic growth after this year, underscoring the advantages of staying the course on the Statement s outlined deficit path to keep some powder dry. In its FY21-FY23 debt service forecast, the government cites the impact of smaller deficits limiting increases in the net debt as a key offset to higher interest rates. 3

4 Table 2 Economic Assumptions Table 3 annual % change except where noted Ottawa s Budget Arithmetic annual % change except where noted Average 17f 18f 19f 20-22f CANADA - Real GDP Finance: 2017 Budget* n.a 2017 Fall Statement Scotiabank Oct.5, n.a GDP Deflator Finance: 2017 Budget* n.a Fall Statement Scotiabank Oct.5, n.a. Nominal GDP Finance: 2017 Budget* n.a 2017 Fall Statement Scotiabank Oct.5, n.a Unemployment Rate, % Finance: 2017 Budget n.a 2017 Fall Statement Scotiabank Oct.5, n.a T-Bills**, 3-month, % Finance: 2017 Budget n.a 2017 Fall Statement Scotiabank Oct.5, n.a Bonds**,10-year, % Finance: 2017 Budget n.a 2017 Fall Statement Scotiabank Oct.5, n.a Canadian Dollar**, US /C$ Finance: 2017 Budget n.a 2017 Fall Statement Scotiabank Oct.5, n.a U.S. - Real GDP Finance: 2017 Budget n.a 2017 Fall Statement Scotiabank Oct.5, n.a WTI Oil, US$/barrel Finance: 2017 Budget n.a 2017 Fall Statement Scotiabank Oct.5, n.a *Updated for historical revisions. **Annual averages. Sources: Finance Canada, Statistics Canada, BEA, Bloomberg, Scotiabank Economics. FY17 FY18 FY19 FY23* Final Rev Rev Fcst Personal Income Tax (PIT) Corporate Income Tax (CIT) Goods & Services Tax (GST) Total Tax Revenue Employ. Insurance (EI) Premiums Other Revenue Total Revenue Elderly Benefits Employ. Insurance (EI) Benefits Children's Benefits Major Transfers to Persons Transfers to Other Levels of Gov't Direct Program Spending Total Program Spending Debt Service Total Expenditure Reserve Budget Balance Accumulated Deficit Annual Change, % Personal Income Tax (PIT) Corporate Income Tax (CIT) Goods & Services Tax (GST) Total Tax Revenue EI Premiums Total Revenue Elderly Benefits Employ. Insurance (EI) Benefits Children's Benefits Major Transfers to Persons Transfers to Other Levels of Gov't Direct Program Spending Total Program Spending Total Expenditure Memo Items, % Tax Revenue / GDP Total Revenue / GDP Total Program Spending / GDP Budget Balance / GDP Accumulated Deficit / GDP Debt Service / Revenue *Average annual growth for FY20-FY23. Source: Finance Canada; Statistics Canada; nominal GDP forecasts: Scotiabank Economics. 4

5 Proposed Changes to the Federal Taxation of Canadian Controlled Private Corporations (CCPCs) The government has promised to trim the federal small business corporate income tax (CIT) rate from the current 10.5% to 9.0% by This lowers the combined federal-provincial average rate from 14.4% in 2017 to 12.9% in Ottawa intends this low tax rate to encourage investment in the small business sector, but it is concerned that higher-income individuals are incorporating to take advantage of the low small business CIT rate available to CCPCs relative to the average top federal-provincial personal income tax rate of 51.6% this year. This is a very complex area of taxation and considerable information was brought forward during the federal government s consultation on possible tax changes related to CCPCs. Below is a very brief summary of some of the CCPC tax changes laid out in the 2017 Fall Statement. Effective in 2018, income sprinkling by private corporations will be restricted. The government maintains that highincome owners of CCPCs can reduce their personal income taxes by sprinkling CCPC income among family members who do not contribute to the business. To receive CCPC income, family members over 18 years will be expected to contribute labour to the CCPC or make capital or equity contributions, or take on financial risks such as cosigning a loan. Family members also can qualify on the basis of past risk assumption or former contributions of labour or capital. Draft legislation for this provision will be released later this Fall. Passive investment income in a CCPC will face higher tax rates above an annual threshold of $50,000. Complications such as passive income incidental to a CCPC s active income are recognized and fuller details will be provided in Budget The need to save within a CCPC is recognized for contingencies or for further CCPC growth, such as hiring, equipment purchases, or expanded service. The government will ensure that all past investments in a CCPC and the income earned on those investments will be protected and that the proposed tax measures will only apply on a go-forward basis. The government is not proceeding with measures that would limit access to the Lifetime Capital Gains Exemption. It also is not proceeding with measures relating to the conversion of income into lower-taxed capital gains. The government will continue to consult with farmers, individuals in the fishery and other small business owners to develop proposals that will better accommodate intergenerational transfers of businesses. The government plans to bring forward legislative suggestions to ensure that farmers and individuals in the fishery are not inappropriately denied the small business deduction on income for sales to a cooperative. As it moves forward with tax changes, the federal government also will work with the venture capital and angel investment sectors to ensure that incentives are maintained for these investors to continue to invest in the next generation of Canadian innovation. 5

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