Tax, Borrow or Wait? Something Has to Give in Trudeau Budget

2017-02-23 17:02:01

By Theophilos Argitis, Bloomberg News

Justin Trudeau’s embrace of deficits won him accolades from global investors and policy makers, but not a full year into his first budget and Canada has run out of fiscal runway.

Faced with deficits of almost C$100 billion ($76 billion) in the prime minister’s first mandate — just over 1 percent of annual gross domestic product — the tone in Ottawa for months has been one of prudence, penny pinching and scaled-down expectations. Cabinet ministers worry they will get only cents on the dollar for funding requests. Provinces have been frustrated in their requests for health-care transfers.

A possible downgrade of Australia’s credit rating and a recent finance department report showing Canada may not return to balance for decades only stoked worries.

A weaker-than-expected economy and the massive cost of Trudeau’s two marquee initiatives — enhanced child benefits and infrastructure — means there is little room for anything else as Finance Minister Bill Morneau puts the finishing touches on a budget expected within weeks.

The likeliest option: keep the focus on delivering infrastructure spending, build out an innovation and competitiveness agenda, and hold off doing much else on the fiscal side until the next election in 2019. Which is a long time to resist political pressure to spend.

Or, if he’s feeling ambitious, Trudeau can test Canadians’ (and investors’) appetite for even higher deficits, tighten spending in lower priority areas to create fiscal room or even raise taxes.

1. What shape are Canada’s finances in?

The economy has unfolded largely as the government expected in its five-year fiscal update last November, when it predicted the deficit peaking at C$27.8 billion this year before narrowing to C$14.6 billion in 2021.

The fiscal update, however, didn’t include any new commitments or take into account any adverse impacts from Donald Trump’s protectionist administration. Adding risk cushions for increased uncertainty — it isn’t uncommon for the finance department to shave C$3 billion annually from revenue projections as a precaution — would drive up deficits and curb fiscal leeway further.

Take into account Canada’s rapidly aging population and Trudeau’s decision to lower the eligibility age for state pensions — as this finance department study did in December — and there is no clear path to balance any time soon.

Another constraint is the government has also pledged to grow its debt at a slower pace than GDP expands. That effectively places a cap on deficit increases.

2. What’s driving the deficits?

A weaker economy for one. GDP is coming in at about C$100 billion less annually than projected two years ago, generating shortfalls in revenue worth well over C$10 billion.

More structurally, however, has been a permanent shift up in program spending under Trudeau’s Liberals, to the tune of about 1 percent of GDP. About half the increased spending is being allocated toward additional transfers, mostly benefits for families with children and the elderly. The other half is being put toward higher transfer payments to provinces and increased operating expenses — reflecting in large part the government’s ambitious infrastructure plans.

Had spending come in at levels projected in former Conservative Prime Minister Stephen Harper’s last budget — and that’s a big if — federal government expenditures would be about C$30 billion less in 2019 than under Trudeau’s current fiscal plan.

3. Has the revenue picture changed?

No. The Liberals have kept the revenue level as a share of GDP largely in line with what was projected in the last Harper budget, even though levels will be lower in absolute terms given the weaker economy.

Essentially, unless someone is prepared to curb the additional transfers, Canada has a long-term revenue shortfall of about 1 percent of GDP — or slightly less than the interest it pays on federal government debt.

Put another way, while Canada’s government can pay off all its current bills with existing revenue streams, it doesn’t raise enough money to fully pay off interest on debt.

4. Is it really a problem?

Well, technically it doesn’t need to be. Canada can essentially run a deficit indefinitely as long as debt isn’t growing faster than GDP. Even if it were, investors would likely tolerate some increase in the debt-to-GDP level given Canada’s relatively strong finances. In fact, some are recommending the government do exactly that.

The problem comes if there is some type of economic shock that really blows the country off track, creating dynamics for the sort of debt spiral the country went through in the 1970s.

People also forget that the federal government isn’t alone at borrowing on behalf of Canadian taxpayers. So too do the provinces and municipalities, and combined Canada’s total government debt doesn’t look so world-beating. Measured in aggregate, Australia has less overall debt than Canada and is facing the prospect of losing the coveted AAA credit score.

Combine that with record household indebtedness and Canada’s debt looks heavy.

5. How about tax increases?

A 1 or 2 percentage point increase of the federal government sales tax would go some way in closing the fiscal gap, but the Liberals have ruled that out. In fact, they’ve ruled out any tax increases at all on “middle-class Canadians.”

Trudeau’s government may also be hitting pause on plans to eliminate some costly tax credits and deductions, as it waits to see what moves Trump makes on the tax side. That takes away another revenue source.

The government’s revenue problem has left them targeting higher-income earners for funding sources, but that’s hardly a deep enough pool of taxpayers to pay for any structural deficit. Nor is it cost free. Canada has become one of the highest tax jurisdictions in the world for well-paid professionals.

6. What can Trudeau do now?

The Liberals are in a bind. They’ve promised not to raise taxes, even while shifting the country’s spending profile higher. Provinces aren’t happy with the federal expansionism, since it takes up fiscal room that they both share. Investors and rating agencies are unlikely to tolerate any further easing of fiscal anchors — currently a promise to reduce the country’s debt-to-GDP ratio. Not to mention public opinion, which in Canada consists of a formidable collective aversion to government borrowing.

Something has to give.

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