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Budget Analysis: April 21, 2015

Budget Balancing Act: Government Taps Contingency Fund to Balance Its Books

The plunge in oil prices and deteriorating economic conditions have taken a substantial toll on the federal government’s fiscal situation. A weakened economic performance, including a large drop in corporate profits, is expected to take a substantial bite out of government revenues this year. If it were not for the sale of its remaining GM shares and a reduction in the amount it sets aside for contingency, the government would have posted a small deficit this year and could expect a surplus of less than $1 billion in 2016–17. Thanks to a reduction in the amount of sick leave entitlement for federal employees and selected tax reforms, the government was able to create a little room for a few small spending measures while maintaining its plan to keep its books balanced over the next several years.

A modest number of new spending or tax measures were announced, totalling $6.3 billion over the next three years. The largest items were a reduction in the small business tax rate, some support for the manufacturing sector (including an extension of the accelerated capital cost allowance), an increase in infrastructure spending, and a small increase in defence spending. Clearly, the government struggled to find ways to fund new measures as it prepares for the federal election later this year. And those measures leave little room for adjustment if economic conditions weaken in the years to come. Given the limited size of the new measures, the budget will have a minimal impact on economic growth.

Key New Measures in Budget 2015
(revenue/spending changes, $ millions)

2015–16 2016–17 2017–18 2018–19 2019–20 Total
Small business tax cut –43 180 540 845 1,215 2,737
Manufacturing sector support 10 224 532 726 720 2,212
Infrastructure 393 428 485 756 1,276 3,338
Increasing TFSA contribution limit 85 160 235 295 360 1,135
Defence spending 432 106 276 486 704 2,004
Regulatory tax changes* –42 –511 –457 –427 –427 –1,864
Renegotiating federal sick days –900 –200 –200 –100 –100 –1,500

* Includes strengthening of tax compliance and closing of tax loopholes.
Sources: The Conference Board of Canada; Department of Finance Canada.

Oil Price Weighs on Economic and Fiscal Outlook

Economic conditions have deteriorated significantly since the government’s last Fiscal and Economic Update, released in September 2014, as the plunge in oil prices has had a significant and negative impact on the Canadian economy. The government relies on the consensus of 15 private sector economists for the economic assumptions used in its budgetary projections. According to this consensus, economic growth has slowed significantly and may have been flat in the first quarter. Growth is expected to remain sluggish in the current quarter before picking up in the second half of the year. This weakness is due almost entirely to the substantial drop in oil prices. Although the consensus is that oil prices will rise moderately throughout the year, they are expected to remain well below recent highs. In response to these lower prices, producers are projected to cut billions of dollars from their investment budgets. Combined with weaker consumer spending growth and a high level of fiscal restraint, economic growth will remain underwhelming.

The consensus of private sector economists calls for economic growth to average just 2 per cent in 2015, down from the 2.6 per cent projected by the government in its September update. However, government revenues are driven more by nominal GDP, which is essentially the sum of personal and corporate incomes. With the collapse in oil prices, corporate profits will see a substantial decline. At the same time, slack in the labour market will keep wage growth contained. This will restrain nominal GDP growth to just 1.6 per cent for 2015 and put a substantial damper on the government’s revenue projections. Economic conditions are expected to improve only modestly in 2016. According to the consensus forecast, the potential economic growth rate is quickly slowing and will eventually fall to 2 per cent, largely as a result of the aging of the population. From 2016 to 2019, real economic growth is expected to average less than 2.2 per cent per year.

The Conference Board of Canada’s economic outlook is similar to the consensus forecast contained in the budget. A lack of business investment has combined with slowing labour force growth to dampen Canada’s economic potential. And we expect real economic growth will be slightly lower than consensus (1.9 per cent versus 2 per cent) this year. We expect economic growth to improve only slightly over the medium term, with an average of just 2.2 per cent projected over the 2016 to 2019 period, in line with the budget’s forecast. However, by 2019, nominal GDP under our outlook is about $12 billion lower than the consensus forecast. And if we are correct, that would wipe out about half the contingency reserve incorporated in the government’s planning assumptions for that year.

Government Balances Its Books in 2015–16 by Cutting Its Contingency Assumption

As expected, the budget forecasts a return to fiscal surplus beginning in 2015–16. However, the weaker economic outlook has taken a substantial toll on the government’s outlook for revenues. Consequently, the government has been forced to raid the contingency reserve and sell its shares in General Motors in order to balance its books. Without these two measures, the government would have produced a deficit of $1.2 billion this year and a surplus of just $800 million in 2016–17, leaving essentially no money for new measures.

The rapid decline in oil prices and the resulting slowdown in economic growth has hit government revenues hard. Lower projections for nominal GDP have resulted in lower estimates for tax revenues, while lower projections for interest rates reduce the expected returns on interest-bearing assets. The weakness in tax revenues will be partially offset by proceeds from asset sales (mostly from the sale of the government’s remaining shares in General Motors), which will boost total revenues by $2.2 billion in 2015–16. Even with the asset sales, federal government revenues are expected to be $6 billion lower in 2015–16 than had been projected in the September Economic and Fiscal Update and an average of $6.6 billion lower per year over the 2016–17 to 2019–20 period.

On the expenditure side, weaker economic conditions have resulted in some savings, but not enough to offset the decline in revenues. Transfers to persons are expected to see slower growth than projected earlier, thanks to a lower outlook for inflation. The government has also lowered its projection for spending on elderly benefits due to a lower projection of the number of recipients. Compared with the fall update, program expenses will be $900 million lower this year and an average of $200 million lower each year over the next four fiscal years. However, thanks to lower interest rates, bigger savings are expected in public debt charges, which are expected to come in $3 billion lower in 2015–16 and an average of $3.7 billion lower per year from fiscal 2016–17 to 2019–20.

To create additional fiscal room for new measures, the government plans to save $1.5 billion over the next five years by reducing the number of eligible sick days for federal employees. The government also expects to generate an additional $1.9 billion over the next five years by strengthening tax compliance.

These savings and revenue enhancers have allowed the government to announce a cumulative $13 billion in new measures over the next five years while maintaining a small surplus. After a deficit of $2 billion in 2014–15, the government expects to post a surplus of $1.4 billion this year. The government will then maintain a small but growing surplus, averaging just $2.9 billion per year over the 2016–17 to 2019–20 period. The projected accumulated surplus is now $18.1 billion lower than what the government was forecasting in its update of last fall. Breaking it down, $13 billion is lost to such economic factors as lower growth and interest rates, and $12 billion will go to the new budget measures, while the government will gain $7 billion by reducing the contingency fund over the next few years. While the Conference Board’s outlook for nominal GDP growth is roughly in line with the government’s forecast, the latest budget leaves little room to absorb any potential future economic shocks.

Government to Focus on Small Businesses

Even though surplus estimates have been reduced significantly since the fall update, the government was able to create the fiscal room to fund some new measures.

One of the largest measures is a planned reduction in the small business tax rate, which will benefit small businesses and manufacturers. The tax rate will be reduced by half a percentage point a year, going from 11 per cent on the first $500,000 of qualifying income to 9 per cent by 2019. This will cost the government $3 billion over the next five years. The budget also extends the accelerated capital cost allowance for investment in machinery and equipment. This was first announced in the 2007–08 recession and has been extended several times since then. An accelerated capital cost allowance allows corporations in the manufacturing sector to write off their capital investments at a faster pace. The government also announced $1.3 billion in support of research infrastructure at universities and colleges through the Canada Foundation for Innovation, and said it would set up a $100-million fund to help auto parts makers with product development.

For individuals, the federal government boosted the maximum allowable annual contribution to a tax free savings account (TFSA) from $5,500 to $10,000. That is expected to cost the federal government over $1 billion in lost tax revenues over the next five years.

The government also announced some new measures for seniors, including a reduction in the minimum annual withdrawal amount from registered retirement income funds (RRIFs) for those over the age of 71. As well, the budget included a new home accessibility tax credit of up to $1,500 for home renovations for seniors or people with disabilities.

Budget 2015 included an update to the government’s infrastructure plan, including the creation of a dedicated fund for public transit. Spending on the infrastructure plan will be boosted by more than $3 billion over the next five years, with $1.7 billion of that total going to the transit plan. Transit funding, which will start up slowly in 2017–18 will ramp up to nearly $1 billion by 2019–20, the final year of the projection.

The government will increase defence spending. The defence department will see $1.1 billion in additional funding over three years, beginning in 2017–18. The government also raised the automatic escalator on the overall defence budget to 3 per cent, up from 2 per cent. As well, the budget includes funding for the current military missions in Iraq and a small amount of funding to help train Ukraine’s security forces. Nonetheless, the spending increase is not enough to offset the cut in defence spending of $3.1 billion for the 2013–14 to 2016–17 period that was announced in Budget 2014.


Matthew Stewart Matthew Stewart
Associate Director
Daniel Fields Daniel Fields
Economist
Alicia Macdonald Alicia Macdonald
Senior Economist

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