Canada's Fiscal Edge to Fade Without Tough Action: David Dodge

The problems facing Greece, Spain and Ireland may lead investors to think Canada is free from fiscal worries. They should think again when looking ahead for the next few years.

Canada’s relatively sound position by international standards masks a structural deficit that is poised to resume growth later this decade unless governments find more permanent solutions to cutting expenses than in their latest budgets, and introduce new measures to durably boost revenue.

The global recession, and the fiscal stimulus programs introduced in its wake, substantially increased public debt around the world. Even before the recession, Canada had a structural deficit of about 1 percent of gross domestic product at the federal level and a roughly similar amount at the provincial level. Without action, these will rise over the decade as population aging leads to higher spending and slows the potential growth in government revenue.

While Canada’s deficits are considerably smaller now than they were at their peaks in 1992, when the country was emerging from another recession, the challenge of putting public finances on a solid footing is, in many ways, more daunting today.

Even with strong demand in the first quarter of this year, over the next three years, a host of factors will restrain growth: a relatively sluggish U.S. economy, a strong Canadian dollar, higher Canadian and foreign interest rates, a relatively high debt-to-income ratio for households, a cooling housing market, and the removal of the fiscal stimulus. We need to recognize that economic growth won’t restore fiscal balance, even temporarily.

Slower Growth

Moreover, government revenue is set to grow more slowly during the rest of this decade. Canada’s potential growth will decline as the aging population leads to a drop in labor force participation. Even if the trend of labor productivity growth picks up to 1.5 percent a year, (which would exceed its average rate during the 30 years before 2007) potential growth won’t likely exceed 2.5 percent in 2012-15 and 1.75 percent in 2016- 20.

If we assume 2 percent inflation and moderate gains in the terms of trade from higher commodity prices, this means the trend of Canadian nominal GDP growth would be around 5 percent in 2012-15 and 4.5 percent in the second half of the decade.

The outlook on the spending side of the ledger is also grim, given demographic realities. Without severe restraint, total program spending will rise faster than revenue. In particular, health spending is poised to grow much faster than general revenue with the increasing proportion and aging of seniors. Since the health envelope makes up such a large fraction of total program spending -- 40 percent or more -- spending will rise faster than revenue over the decade even if other program spending rises much more slowly.

Spending Restraint

Debt-service payments also will increase faster than nominal GDP as interest rates rise to more normal levels and government debt keeps growing as long as deficits prevail.

Unless governments act to restrain spending and increase revenue beyond the short horizon of their latest budget initiatives, structural deficits are bound to start growing after 2012.

Can Canadian governments balance their budgets by mid- decade with program spending cuts alone? It would mean a significant reduction in services or income-support programs, even if there were unprecedented productivity gains in public services. Specifically, it would require significant cuts in public-pension payments, employment-insurance benefits and welfare payments, health and long-term care coverage as well as increased co-payments. The quality of education, and investment in roads and public transit also would decline.

More Radical

These cuts would need to be both continuing and more radical than those of the mid-1990s. Moreover, with population aging set to continue in the 2020s and 2030s, further service and transfer payment reductions will be needed.

In my view, achieving balanced budgets through lower spending alone simply isn’t possible; we need more revenue. The key is to do so in a way that has the least negative impact on incentives to work, to invest and to increase productivity.

What this means is higher consumption taxes with appropriate refunds to low-income groups, as Québec and Nova Scotia have proposed in their latest budgets. It also means introducing or increasing fees for services associated with roads, health care and post-secondary education, spurring efficiency both in production and use.

Balancing revenues and expenditures over the decade won’t be easy. But it must be done if Canadians are to enjoy rising incomes in the years ahead. In their 2010 budgets, governments largely failed to set out credible plans to achieve fiscal balance, though Québec began to address the medium-term issues. The federal and provincial governments shouldn’t fail to do so in 2011.

(David Dodge, former governor of the Bank of Canada, is a senior adviser at Bennett Jones and co-chair of the market monitoring group at the Institute of International Finance. The opinions expressed are his own.)

To contact the author of this column: David Dodge at dodged@bennettjones.com

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