Federal Budget Surplus Causes Anxiety

Nothing in recent memory changed federal politics more than the vanquishing of deficits a decade ago. The age of multi-billion-dollar surpluses, ushered in by Jean CHRÉTIEN's Liberals, gave Canadian politicians new options at home and bragging rights abroad. Canada morphed from fiscal basket case to bastion of balanced books. Given how central that boast has become to selling Canada, you'd think the prospect of a return to red ink would prompt alarm. Yet as a slumping ECONOMY makes a deficit look possible again, the experts are surprisingly blasé. "I must confess," shrugs Jeff Rubin, chief economist at CIBC World Markets, "I don't see this as the great calamity some economists do." Actually, it's hard to find one who sees it that way. "If Canada slipped into a deficit," says Douglas Porter, BMO Capital Markets' deputy chief economist, "it would be much more a political issue than an ECONOMIC issue."

Most analysts agree Canada's economic fundamentals - manageable public debt, low unemployment, tamed inflation - are so solid that a small, temporary deficit isn't likely to inflict much real damage. The political fundamentals, however, are far less stable, with the CONSERVATIVES and LIBERALS running neck and neck in most polls. One clear advantage Prime Minister Stephen HARPER enjoys over Liberal Leader Stéphane DION is his image on economic matters. Angus Reid's latest opinion poll found that Harper was judged a good economic manager by 42 per cent of respondents, way ahead of Dion's 14 per cent. And history suggests that edge matters: just before the 1988 election, Tory incumbent Brian MULRONEY, the ultimate winner in what turned out to be an epic campaign, was judged best economic manager by 54 per cent, far ahead of Liberal challenger John Turner's 19 per cent.

Presiding over a dip back into deficit could rob Harper of this traditional Tory brand advantage. So he has to be hoping the Canadian economy weathers the current U.S. downturn well enough that Ottawa's balance sheets don't take a beating. The numbers suggest it will be a close call either way. In his February budget, Finance Minister Jim Flaherty predicted a slim $2.3-billion surplus for the 2008-'09 fiscal year, based on a planning assumption that Canada's gross domestic product would grow a mere 1.7 per cent this year. But even that modest hope now looks optimistic. The Bank of Canada recently revised its own forecast for GDP growth down to 1.4 per cent, and some private economists are even glummer. TD Bank Financial Group's economists project 1.1 per cent growth, while the University of Toronto's Rotman School of Management forecasters expect an anemic 0.8 per cent.

Those tepid projections matter because for every one per cent reduction in GDP growth, the federal government expects to lose $2.3 billion in revenues - enough to wipe out Flaherty's surplus. There are other variables, of course, like what interest rate Ottawa pays on its debt and how much the government pays out in employment insurance benefits. So making precise predictions is impossible. As well, many economists suspect Flaherty's officials have hidden some extra cushion in their calculations. After all, in recent years the Finance Department has routinely posted surpluses several billion dollars fatter than planned. "There are all sorts of layers of prudence built into the budget numbers," says BMO's Porter.

Flaherty is certainly talking as if he is confident he won't be suffering any fiscal embarrassment. "Our budget is balanced. I can assure you it will stay balanced," he recently said in a speech in Oshawa, Ont., a gutsy choice of venue, since General Motors plans to cut 970 jobs at its pickup-truck plant there. After another speech last month (at a rather different forum: the Canadian Association of New York at the New York Yacht Club), Flaherty again vowed not to go into deficit, explaining that, if need be, "we also can always do what the government seems to think they can't do, which is to restrain spending from time to time." Back in Ottawa, he repeated outside the House that he will "restrain spending if that becomes necessary."

That possibility has alarm bells ringing over at the Canadian Centre for Policy Alternatives. The left-leaning centre, which produces an annual "alternative federal budget" that reliably advocates more social spending, issued a report back in January that was one of the first anywhere to flag the potential for a deficit, as the economy showed early signs of weakening. Marc Lee, a senior economist at the centre, worried that the government's instinctive reaction would be to cut spending "rather than revisit tax cuts."

The tax cuts Lee was referring to have, like them or not, indisputably played a big part in making a deficit conceivable again. The two percentage points Flaherty has sliced off the GST will cost the government $12 billion in 2008-'09. (Few economists think cutting the value-added tax was a smart move.) Personal and corporate income tax reductions brought in by the Tories will shrink federal revenues by more than $16 billion. Liberals darkly charge that the government has intentionally created a fiscal squeeze that will give them an excuse to trim program spending in the name of keeping the books balanced. "In two years, they have destroyed the fiscal framework," Dion said in the House this week. "Was this their plan so they could cut social services?"

But if the Conservatives secretly welcome deficit fears as a justification for shrinking government, they've done a good job concealing their diabolical intentions. Flaherty hiked spending 6.3 per cent two years ago, and 5.4 per cent last year. His latest budget projects a two per cent increase in this fiscal year and 4.9 per cent next year. Not exactly a pattern of brutal austerity. But does that track record of expansion mean the government is spending so heavily that it could afford to painlessly scale back to avoid slipping into the red? Economists warn that would be the dumbest policy reaction. "If you deliberately try to forestall a deficit by cutting spending or raising taxes," says University of Toronto economics professor Peter Dungan, "you make the situation worse."

Not only would a fiscal contraction to fend off a deficit come at exactly the wrong moment for a sputtering economy, it would also undermine the stimulus Flaherty has already injected into the economy. The GST and personal tax cuts he announced last fall took effect at the start of 2008, just in time to put some cash into the pockets of consumers faced with increasingly discouraging economic news, Dungan says. In fact, it's the second time in recent years that a big Canadian tax relief package has made an appearance at the perfect point in an economic cycle: the sweeping tax cuts announced by then-finance minister Paul MARTIN in the fall of 2000 landed just as the U.S. economy slumped in 2001.

Whether through good luck or great foresight, the Flaherty and Martin tax cuts show how federal action can help offset an economic downturn. Still, going forward Harper and Flaherty might be less preoccupied with fine-tuning the economic impact of their budgetary actions than sidestepping a political hit. After a decade of good news, the Canadian economy looks sturdy enough to withstand the symbolic affront of a minor deficit. The political fortunes of a minority Conservative government with an eye on the next election demand more careful tending.

See also: FISCAL POLICY.

Maclean's May 19, 2008