Canadian fiscal policy in the event of a downturn

With each passing day, more and more commentators are concerned about an economic slowdown. South of the border, the talk is even more pessimistic with the consensus essentially that the US economy is headed for recession in 2008, if not already in one. The Center for Budget and Policy Priorities and Brookings have each released papers on principles for fiscal policy to respond to the downturn.

In Canada, things have been better through 2007, especially in Western Canada. The key issues are how bad things get in the US, and how much of that spills over here. But certainly the possibility of a downturn is stronger than it has been in a decade (even in 2001, when the US had a short recession, Canada’s real GDP growth only just slipped below 2%). With three-quarters of Canadian exports headed south, there will be some impact and policy makers need to be prepared for that rather than reassure themselves with blithe claims that we have “decoupled” from the US economy.

Which takes us to fiscal policy. In a technical paper for the AFB released today, I take the baseline numbers from the October Economic and Fiscal Update, which was issued under more rosy economic forecasts, and stress-test them for reduced GDP growth.  Because most of the available fiscal room was used up on tax cuts, a downturn could lead us to Canada’s first federal deficit in a decade. At least under status quo conditions – the key question for political leaders, with an election anticipated, is what they would do. My concern is that the Conservatives would cling fiercely to the tax cuts and would instead cut spending in order to balance the budget, thereby making the underlying situation worse. I’m not sure the Liberals would be any better, given that the own the mantle of “fiscal responsibility”.

In the last part of the paper I challenge the conventional wisdom that deficits are bad, and argue that the feds can and should run a deficit if we have a downturn.

The CP wire story by Julian Beltram does a decent job reporting on the technical paper (the Globe ran it on page A5):

 Federal tax cuts could push Ottawa back into deficit, says think tank

OTTAWA – The federal government’s recent tax cuts are taking up so much fiscal room that even a mild economic downturn could result in the first budget deficit in over a decade, says a new report to be released Monday.

The paper by the left-leaning Canadian Centre for Policy Alternatives finds that last October’s budget cuts, along with previous reductions announced by the Stephen Harper government, will cost the treasury $40.2 billion annually at the end of the five-year cycle.

“The fiscal update came at a time when they thought the worst of the financial crisis and U.S. slowdown was over,” said economist Marc Lee, who wrote the study for the think tank, a persistent critic of the Conservatives’ tax and spending policies.

“So now, it would not take much of a drop in economic growth before the budget returned to deficit. It’s possible they miscalculated, or they might argue that tax cuts are just what the economy needs heading into a recession”.

The paper slated for release Monday uses government estimates contained in last October’s fall update, but substitutes four different growth scenarios for gross domestic product (GDP) – each gloomier than the previous one – in place of the government’s now rosy-looking forecasts”.

The most surprising finding is that it does not require a recession – two consecutive quarters of economic contraction – to push the federal government into a budgetary deficit.

“In terms of tipping the balance, a nominal GDP growth rate in 2008 under 2.65 per cent (or about 0.65 per cent real GDP in real terms when inflation of about two per cent is taken out) will lead to a deficit for the 2008/09 fiscal year,” the report determines.

Finance officials last week downgraded the forecast for real growth in 2008 to just over two per cent, excluding inflation, from its previous projection of 2.4 per cent. Most of that growth will come from energy-rich western Canada.

While the federal government generated a surplus of nearly $14 billion in the 2006-2007 fiscal year – mainly from soaring corporate and personal tax revenues – the federal Finance Department has projected a relatively small surplus of $3.3 billion for the current fiscal year, which ends next March 31.

Prime Minister Stephen Harper and Finance Minister Jim Flaherty have cautioned against expectations of any major new tax cuts or spending programs in future budgets because of the expected slowdown in the Canadian economy. And the federal budget usually contains a cushion of a few billion dollars to offset any unexpected changes to economic growth, so Ottawa may have some flexibility in avoiding a deficit.

However, a lot depends on how deep the slump is in the United States and its impact on Canadian exports of everything from lumber and autos to machinery and petrochemicals. If the troubles get worse in the manufacturing sector in Ontario and Quebec and jobs lost in the industrial sector aren’t made up by growth in finance, government, health care, energy and resources, the federal government will face a squeeze on its finances.

Some economists say that even a two per cent annual growth rate for Canada may be optimistic. Global Insight Canada, an economic forecasting company, said the economy could actually shrink further, to 1.4 per cent growth in real terms. And J.P. Morgan chief economist Ted Carmichael predicted Canadian growth would be a negative 0.5 per cent during the first quarter.

“Forecasters have been lowering their estimates for Canadian economic growth in recent months, and historically (they) have tended to be excessively bullish until the economy was actually in recession,” notes the report.

Under the mild slowdown scenario proposed by the advocacy group, about one per cent real growth this year, followed by a 1.5 per cent advance next, would result in a balanced budget in the 2008/09 fiscal year, but push Ottawa into a $2.4 billion deficit in 2009-2010.

Under the most gloomy scenario – a two per cent contraction this year and flat growth next – the federal government would post deficits of $6.2 billion in 2008/09, rising to $12.7 billion in 2009/10, assuming no other measures, like spending cuts, are taken.

Such deficits would prove embarrassing to the Conservative government, which is seeking to present itself as better economic stewards than the Jean Chretien-Paul Martin Liberal tandem that ended decades of massive budget deficits in the mid-1990s.

But Lee said the government’s fiscal position would still remain strong relative to the past, noting that after 16 years of growth, Canada’s debt to GDP ratio has plummeted from 68 per cent a decade ago to a more manageable 32 per cent.

“The conventional wisdom in Ottawa these days is that deficits are to be avoided at all costs, it’s almost like they treat surpluses like companies treat profits,” he said. “But the fact is we have a lot more room to move in terms of running deficits than we did in the past”.

” Lee said if the worst does happen, the Harper government should avoid cutting spending to avoid falling into the red as that would likely harm the economy even further”.