The budget path out of deficit

The Department of Finance’s own estimates for the structural balance in the 2012-13—that is, what it would be even after the economy returned to potential—is a deficit of $15 billion. On the face of it, it is difficult to reconcile a structural deficit of this size with the quick return to surplus projected in the 2014-15 budget. How was the government expecting to engineer a $20-billion swing in its budget balance without making major changes in its fiscal policy stance?

Part of the answer is on the spending side. The government’s strategy laid out in the 2011 budget has been to let transfer payments to individuals and to provinces grow at the same rate as GDP, while holding the line on direct program spending. Since the costs of these programs grows over time, holding spending constant has the effect of gradually eroding the means to deliver the programs. This explains the regular flow of stories of program cuts coming out of Ottawa in the past few years.

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This austerity campaign is being ramped up in 2014-15. Transfer payments to individuals and provinces will continue to grow: there are no reductions planned to programs that send cheques to people and that provide funding to provinces. But direct program spending will fall by $5.7 billion, which works out to a 4.8 per cent reduction. As the budget documents make clear, much of this reduction will achieved by cutting back on public-service benefits.

But these expenditure cuts are not enough to erase a deficit of $16.6 billion; the government is also counting on rapid revenue growth. Revenues are projected to increase from 14.1 per cent of GDP to 14.5 per cent over the medium term. In other words, revenues are expected to grow more quickly than the economy. Nominal GDP is projected to be about $2 trillion, so an increase of 0.4 per cent of GDP works out to $8 billion.

This seems large, especially since there are no new tax measures that would generate revenues of that magnitude. It turns out that most of this increase is generated by personal income tax (PIT) revenues. Since personal taxes are progressive, revenues are very sensitive to increases in GDP. The Department of Finance estimates that a one per cent increase in GDP produces an increase in PIT revenues of about 1.2 or 1.3 per cent. PIT revenues were roughly 7.4 per cent of GDP before the recession; this ratio fell to 6.7 per cent on 2009-10, even though the PIT regime changed little. This ratio has been increasing slowly as the economy recovered, and the projected ratio of 7.3 per cent of GDP is roughly in line with what PIT revenues were before the recession.

Unless there’s a large, negative shock to the economy, the increased austerity and the rebound in personal income tax revenues should be enough to get the government within hailing distance of a balanced budget next year. Federal governments have any number of ways to make marginal adjustments to their budget balance—selling assets, such as its stake in GM, shifting the timing of various transactions—so the Conservatives should be in a position to plausibly announce a surplus in 2015-16 before the next election.