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Budget Analysis: March 29, 2012

Feds on Track to Balance the Books: Numerous Other Measures Announced—but no Big Surprises

In Budget 2012, the Conservative government has put the focus on facilitating long-term economic growth. The budget keeps the government’s deficit-elimination plan on track by bringing federal spending as a share of the economy back in line with historical levels. To do this, the government will curtail direct federal program spending by a cumulative $9.7 billion over the next three years and eliminate 19,200 federal positions, many in Ottawa. (Roughly one-third of the job losses will come through attrition.)

The path back to balanced budgets could be shortened by a better-than-expected economic performance and a stronger starting point. In the year just ending, the deficit is estimated at just under $25 billion—$4.7 billion ahead of plan. And given the prudent economic outlook and conservative estimates for nominal income and revenue growth included in the budget to account for risk, we could see the deficit eliminated ahead of the budget’s target year of 2015–16.

Most other measures in the budget—and there are a multitude of them—are focused on supporting Canada’s long-term growth. For businesses, there are no tax increases. Instead, the federal government has introduced a number of measures to foster private investment, employment, and innovation, including measures to promote venture capital and to facilitate R&D. Most importantly, the government promises to simplify the current, multi-layered environmental review process to a “one project, one review” concept in a clearly defined time period. This should be especially encouraging to resource sector investors, whose large capital projects have often been held up by a review process that is time-consuming, uncertain, and expensive.

Budget 2012 also addresses Canada’s looming labour shortages, although many of the details have yet to be announced. The government will work to reduce the regional bias in the employment insurance system and reduce disincentives to work for those receiving benefits. Other labour market initiatives include training programs, tax incentives for hiring, efforts to facilitate immigration, and the expanding of opportunities for Aboriginal peoples. Less popular with households will be the tightening of Old Age Security (OAS) benefits over the long term, but this reform should improve peoples’ willingness to work longer. The generosity of public sector pensions will also be reduced and the normal age of retirement for new employees will be increased from 60 to 65.

Finally, the federal government will add modestly to its infrastructure budget. The largest single measure—$5.2 billion over 11 years—will go toward renewing Canada’s Coast Guard fleet.

Fiscal Outlook

Over the next four years, the federal government’s main focus will be on returning to fiscal balance. Although a stronger economic outlook has made that job somewhat easier, fiscal restraint will provide the majority of the improvement going forward—and that is the main theme of this budget. In last year’s budget, the government announced its intention to complete a program review that would find $4 billion in savings by 2014–15. In fact, the government has exceeded that target, as it laid out a detailed program review that will cut $5.1 billion in annual funding across various departments by the target date. It also announced some small revenue measures aimed at increasing overall tax receipts by closing tax loopholes and phasing out some preferential tax credits, such as the Atlantic Investment Tax Credit and the Corporate Mineral Exploration and Development Tax Credit. As a result, the government has been able to announce some relatively small new spending measures while presenting a plan that will balance the books by 2015–16.

The expected deficit for fiscal year 2011–12 now stands at $24.9 billion. This is a substantial improvement from the $55.6-billion deficit two years ago, and $5 billion better than predicted almost five months ago in the November Fiscal Update. The better-than-expected numbers are the result, in large part, of the removal of the $6.6 billion in unused adjustment for risk in 2011–12. In fact, 2011–12 program spending is now $500 million higher than previously budgeted, as the government has set aside $900 million for buyout packages as part of its plan to eliminate 19,200 positions over the next three years. (This will be partially offset by a $400-million delay to capital funding for National Defence.)

Although the government has reduced the deficit by more than half over the last two years, there remains substantial work to do. Much of the improvement has come from a bounce-back in government revenues. While the government has held the line on further increases to program spending, spending levels are still up 16.4 per cent compared with three years ago. And although some of this increase is due to higher employment insurance payments (a by-product of the 2008–09 recession and its accompanying rise in unemployment), most of the spending increase is the result of higher direct program expenses and transfers to other levels of government. To balance the books by 2015–16, the government will restrict growth in total program spending to just 1.9 per cent per year. This will return total program spending as a share of GDP to where it was in the five-year period before the recession. (See chart.)

Program Spending as a Share of GDP to Return to Pre-Recession Levels  

To support the restrictions on program spending, the government has announced a number of new cost savings initiatives, estimated to be worth $20.3 billion over the next five years. The National Round Table on the Environment and the Economy will be eliminated, as will the Katimavik youth experience program and Assisted Human Reproduction Canada. The federal public service will decline by 19,200 positions over the next three years, with roughly 7,000 of those losses coming through attrition. The overall total includes the elimination of 600 executive positions, or 7.4 per cent of the executive workforce. To put the total decline in perspective, the federal government has increased the size of the public service by almost 30,000 jobs in just the last three years and by 80,000 since 2001. The largest cuts in percentage terms are slated to occur in the Department of Finance (16.8 per cent); the Privy Council Office (11.9 per cent); Transport and the Treasury Board (10.7 per cent declines each); and Agriculture and Agri-food, Natural Resources, the Public Service Commission, and Shared Services Canada (with each seeing a 10 per cent decline). In dollar terms, the biggest cuts will be in National Defence ($1.1 billion) and Public Safety ($688 million).

Capital funding of $3.5 billion will be delayed at National Defence over the next seven years. Although the government remains committed to replacing its fleet of CF-18 jetfighters, the 2012 budget states that it will seek an “affordable replacement,” suggesting that it might now be looking at alternatives to the F-35. The government will also make changes to the Public Service Pension Plan so that public service employee contributions rise to equal those of the government. The normal age of retirement for government employees will also be increased from 60 to 65.

As a result of the improved fiscal forecast, the outlook for the federal debt is much improved, peaking at $614 billion in 2014–15. Although considerably better (by $23 billion) than predicted in the November update, public debt is still up $156 billion from 2007–08, prior to the recession. Interest payments on public debt will rise by almost 17 per cent over the next five years.

New Measures

The government has announced many new measures in Budget 2012. Although most are small in financial terms, they include important changes to the delivery of government programs. The new measures in general aim to promote economic growth and job creation.

The government will extend the Employment Insurance (EI) Hiring Credit for Small Businesses by an additional year. It will limit increases in the EI premium rate to five cents per year. Canadian businesses will continue to benefit from the government’s commitment to reducing red tape through a so-called “one for one” rule. Under this rule, every time the government adopts one new regulation, it must eliminate one existing regulation. Furthermore, the government aims to improve business access to the U.S. market, and vice-versa, by aligning the regulatory approaches between Canada and the United States.

Elevated commodity prices and strong demand from developing economies are driving demand for Canadian natural resources, helping to support investment activities, develop infrastructure investment, and create jobs in resource-rich areas. To further benefit from Canadian natural resource development, the government is proposing to streamline the review process for new projects in the resource sector through a “one project, one review” strategy. If properly implemented, the strategy will improve the regulatory process for businesses and speed up the pace of investment while safeguarding the environment through various measures, including consultation with First Nations.

Recognizing the innovative potential of business start-ups and the challenges they face in raising capital, the budget includes specific measures aimed at increasing private sector involvement in the Canadian venture capital market. In particular, the budget allocates $400 million to encourage private sector investments in early-stage start-ups and to support creation of large-scale venture capital funds. This funding is on top of $100 million in previously announced funding to the Business Development Bank of Canada to support its venture capital activities. Furthermore, the Scientific Research and Experimental Development (SR&ED) tax incentive program—one of the most generous systems for research and development (R&D) anywhere in the industrialized world—will be streamlined to better serve businesses while reducing the financial impact on government.

The budget also contains measures to address Canada’s looming labour shortages. Specifically, the government will spend $3.6 billion over the next five years on myriad measures to support job creation. It will invest $482 million over the next two years to revamp the EI program, by providing more timely information to unemployed Canadians, aligning the program with local labour market conditions and reducing disincentives to accept work while receiving EI benefits. The $330-million Youth Employment Strategy program will be bumped up by another $50 million to help more young Canadians gain skills and find employment.

As expected, the government announced that it will push back the age of eligibility for the OAS program from 65 to 67. The move is in response to population aging and the expected labour shortages that will emerge as baby boomers leave the work force. However, almost the entire baby boomer cohort will be protected from the current change. Without changes to the program, the Conference Board estimates the cost of OAS would increase by an average of 5.8 per cent between 2011 and 2030, significantly faster than revenue growth. By 2030, old age security would cost the federal government $105 billion a year or 20 per cent of revenues, up from $38 billion in 2011. The changes will be phased in gradually, starting in 2023, with full implementation coming only in 2029. Based on Conference Board estimates, this reform will reduce program costs by over 11 per cent when fully phased in.

Measures aimed at encouraging job creation include extending the Hiring Credit for Small Business program for another year. Under the program, employers receive a credit of up to $1,000 for every new worker they hire. The extension will cost the government $205 million. An added $275 million will go toward improving education facilities and opportunities—and thereby employability—in First Nations communities.

A more “targeted” approach will be taken toward immigration. That means attracting immigrants with skills that are in short supply in Canada, but discouraging the use of temporary unskilled workers if there are unemployed Canadians who can do the job. Skilled workers who applied under the previous program will be eligible to receive refunds of their application fees—a move that will cost the government up to $130 million.

Economic Outlook

The Department of Finance relies on the consensus of 14 private sector forecasters to provide the economic assumptions for its budgetary projections. This budget is based on an economic outlook that is less optimistic than what the Conference Board has projected in its most recent outlook. Therefore, there exists some upside potential to the budget’s fiscal outlook.

While there has been a marked improvement in key U.S. economic indicators recently and the European Union has made strides toward keeping its sovereign debt crisis under control, the government and the Conference Board both believe there remains substantial economic risk to the near-term growth outlook. As a result, growth is still projected to be modest in the near term. Although real GDP growth in 2011 was revised upward by 0.2 percentage points, to 2.5 per cent, growth is expected to slow this year. The Canadian economy is expected to expand by 2.1 per cent in 2012, followed by 2.4 per cent growth in 2013.

Still, growth projections for nominal GDP (the broadest measure of the country’s tax base) have been adjusted upward 0.5 percentage points, to 4.6 per cent, for 2012. This adjustment is due mainly to an increase in the forecast for commodity prices—which increases nominal income in Canada. The U.S. economic recovery, combined with strong demand from developing countries and tensions in the oil-rich Middle East, will likely put upward pressure on commodity prices over the forecast horizon. Despite this, the budget assumes a largely flat profile for commodity prices—another element of prudence in the budget’s assumptions. As well, the Department of Finance decided to adjust downward the private sector forecast for GDP by $20 billion per year over the 2012–16 horizon. This adjustment is equivalent to a decline of about 1 percentage point in nominal GDP growth, translating into $3 billion less in revenue receipts.

Overall, the Conference Board’s economic outlook is more optimistic than the assumptions used in Budget 2012, due to stronger projected growth in the United States and a better outlook for commodity prices. As a result, we forecast slightly stronger growth in 2012 and significantly stronger growth in 2013, both in nominal and in real terms. For 2012, our estimate of nominal GDP growth is 0.1 percentage points higher than that contained in the budget. For 2013, that figure rises to 0.6 percentage points. Our stronger forecast for economic growth translates into a faster pace of job creation. The Conference Board expects the jobless rate to drop below 7 per cent by 2013—one year ahead of what is assumed in the federal budget. That means the improved labour markets, together with the ongoing low interest rates, should further support the domestic economy.

Pedro Antunes
Director
Matthew Stewart Matthew Stewart
Principal Economist
Ksenia Bushmeneva
Economist

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