How Lessons from Canada’s 1995 Budget Can - "Not" - Be Applied Today
Recently, the Fraser Institute released its annual pre-budget report entitled "Budget Blueprint: How Lessons from Canada's 1995 Budget Can Be Applied Today". The report argues the federal government's current fiscal situation mirrors that of the 1980s and early 1990s and that drastic actions, like those in the 1995 Budget, are again required to return to fiscal balance. Here are some of the lessons we have learned or not learned from the Fraser report.
Lesson #1: Conservative governments are incapable of good fiscal management.
We agree with the Fraser Report that the Conservative government under Brian Mulroney failed to deal with the deficit and growing debt problems during the 1980s and early 1990s. The Report observes that this failure is "perplexing considering that the government of the day (Progressive Conservative Party) was at least notionally predisposed to lower levels of government spending and balanced budgets".
During the 1980s, the government produced budget after budget showing the deficit declining, but it remained stuck at about $30 billion. There was a general feeling that the deficit was cyclical in nature and that a rebound in economic growth would solve the deficit problem. Only when the situation became severe were sizeable restraint measures introduced to address the deteriorating fiscal situation. The current Conservative government is now pursuing a similar strategy
Lesson #2: The Mulroney Government understood the need for sound structural changes. The current Harper Conservative government does not.
Although the Fraser Report is right to criticize the overall budget policy of the Mulroney government, it is wrong to ignore the fact that actions taken by the Mulroney government did help the Liberal government in 1990s. In fact, a case can be made that the groundwork for the elimination of the deficit was laid well before the 1995 Budget.
The reform of the personal and corporate income tax systems in 1987 broadened the bases and lowered rates, resulting in a much more efficient and effective tax system for these two major revenue sources. The replacement of the federal manufacturer's sales tax with the Goods and Services Tax in 1991 removed economic distortions and provided the government with a more reliable and stable revenue source. The free trade agreements enhanced economic efficiencies. Structural changes to the employment insurance programs in the late 19980s and early 1990s reduced benefits and eliminated direct government financing of the program. The 1985 Budget introduced modified indexation of the personal income tax system and a number of social programs, thereby providing ongoing and growing savings. These structural reforms, undertaken by the Conservative government, were of the longer-term nature, not designed to generate immediate large saving. But over time, they played a critical role in eliminating the deficit and creating surpluses. The Liberal government took full advantage of these policy changes in eliminating the deficit.
The current Conservative government does not seem to understand good economic policy, reducing the GST and littering the income tax system with costly tax preferences.
Lesson #3: The current fiscal problem is in no way similar to that of the early 1990s; to-day we have a " fiscal problem", in the early 1990s we had a " fiscal crisis".
Table 1 presents a number of fiscal indicators for early 1990s and today.
In 1994-95, the federal deficit stood at $36.6 billion, or 4.8 per cent of GDP. In 2009-10, it was $55.6 billion – the largest absolute level since Confederation. However, over half of the 2009-10 deficit can be attributed to the inclusion of temporary measures under the Economic Action Plan and one-time accounting adjustments. Excluding the impact of these factors reduces the 2009-10 deficit to $22.1 billion, or 1.4 per cent of GDP.
The federal debt – the accumulation of deficits and surpluses since Confederation – stood at $524.2 billion in 1994-95, or 68.0 per cent of GDP. In 2009-10, it was $519.1 billion, or $484.9 billion excluding the temporary measures. This was 31.8 per cent of GDP – less than half that recorded in 1994-95.
In 1994-95, public debt charges as a percentage of revenues amounted to 33.8 per cent. In 2009-10, they were 13.5 per cent. Public debt charges as a percentage of interest-bearing debt (the average effective interest rate) in 2009-10 is about half that in 1994-95. In 1994 high interest rates combined with high debt were the main cause of the rising deficit and debt. Without a significant decline in interest rates, it would have been impossible to eliminate the deficit. This is not true to-day.
The reality was that by the early 1990s, the surplus in the operating balance was not sufficient to pay the interest on the debt. The government was simply borrowing to pay interest. We are clearly not in that situation today.
In 1994, among the G-7 countries, total general government debt in Canada (including federal, provincial-territorial and municipal governments and the activities of the Canada and Quebec Pension Plans) was the second highest (Table 2). Today, it is the lowest. In 1995, the Wall Street Journal suggested that Canada was close to bankruptcy. Today, its fiscal situation is the envy of most advanced economies. Today, the government has considerable credibility, for whatever reason, whereas in 1994 the government had absolutely none.
All of the fiscal indicators today are much better than in the early 1990s. And they will continue to improve with the ending of the stimulus spending.
This is not to imply that there is no urgency to address the fiscal situation today. It is simply not true that "the federal governments struggled with the same fiscal problems during the 1980s and early 1990s that confront them to-day".
As shown in previous studies (www.3dpolicy.ca), the federal government has a relatively small structural deficit. This needs to be addressed because of the pending adverse impacts of an ageing population on economic growth and on government revenues and spending. Unlike the early 1990s, the government has time to implement a strategy to address this. In the early 1990s, time had run out. Of course, if the government continues to ignore this reality time may run out for it as well.
Lesson #4:"What is clear and critical for understanding the current situation is that a balanced budget was (NOT) achieved almost entirely through reductions in spending" (NOT) added by authors.
There is no doubt that the expenditure reductions undertaken in the 1995 Budget were critical to building credibility and in restoring market confidence in the federal government's commitment to address the fiscal situation. The headlines, the day after the budget, that 40,000 public servants would be losing their jobs, was the deciding factor that the government "got it".
The main benefit of the expenditure cuts was their contribution to creating fiscal credibility for the government. This gain in credibility contributed to a rapid decline in long-term interest rates, which in turn significantly reduced public debt charges and contributed to stronger economic growth and government revenues.
However, although program spending was cut in an absolute term for the first time ever, and this was essential to building credibility, many of these expenditure cuts were not lasting. Many departments had cut their capital budgets and tried to find "efficiency" savings to meet their saving targets. In the end, the Treasury Board Secretariat had to undertake a Program Integrity Exercise, as many departments were unable to manage programs under their jurisdiction. The 1999 Budget included new funding to address "health and safety" issues resulting from the measures taken in the 1995 Program Review Exercise.
There were two other factors critical to the elimination of the deficit. First, the Government accumulated significant surpluses in the employment insurance account, by keeping rates higher than called for under the spirit of the legislation. Second, growing accrual surpluses in the federal government employees' pension accounts allowed the government to amortize these surpluses on an annual basis. These two factors alone contributed about $10 billion annually to deficit reduction.
We agree with the Fraser Institute's recommendation that there needs to be a new Program Review Exercise. A new Program Review Exercise must, however, generate lasting savings. This can only be done through reduction/elimination of existing programs. It will not be achieved through administrative savings. The role of the Treasury Board Secretariat will need to be strengthened to provide a "challenge" function to the proposals offered by departments. The current government rejects this entirely. It wants to cut spending without cutting programs.
Lesson #5: Restraining the growth in program expenses to the growth in population and inflation is not credible.
Not surprising, the Fraser Institute is recommending major cuts to program expenses as the only way to achieve a budgetary balance by 2012-13 (see Table 3). They propose that program expenses be allowed to increase in line with the growth in population and inflation from the base of $207.9 billion in 2008-09 to 2015-16. Beginning in 2011-12, this would then require cuts to program expenses of $7 billion and $18 to $20 billion per year thereafter. The Fraser Institute claims that the Government's revenue projections are too rosy but makes no allowance for this. To achieve their proposed fiscal track, the savings would likely need to be even greater as there is a general feeling that the October 2010 Update understated the deficit track. The Parliamentary Budget Office, the International Monetary Fund and 3dpolicy all have higher deficits, especially in the outer years. Additional cuts to program expenses of up to $13.5 billion would be required to achieve the Institute's proposed budgetary target in 2105-16. This would require expenditure cuts, totaling about $32 billion in that year alone.
The Institute proposes cuts to the Canada Health Transfer and the Canada Social Transfer of $3.1 billion in 2011-12 and $6.2 billion thereafter. The remainder would be secured through a Program Review Exercise.
How realistic is this proposal to keep the growth in program expenses to no more than the growth in population and inflation? This proposal is not just unrealistic, it makes absolutely no sense in economic, social or political terms.. This proposal has been made in the past. The Conservative government proposed it in their 2006 election platform, only to find out quickly that such a target was not achievable. This is an extremely simplistic recommendation. It demonstrates a lack of understanding of government programs .and the nature and role of the federal government.
First, there are a number of components of federal program expenses that are sensitive to economic developments, most notably employment insurance benefits. These components of expenses have no direct correlation to increases in population and inflation. They move up and down with the economic cycle.
Second, a number of programs are influenced by demographic factors not related to overall population base. For example, the growth in the elderly is currently much faster than the growth in the overall base and is projected to grow even faster in the future. Similarly, the growth in the Aboriginal population is much faster than the growth in the general population and prices experienced on reserves are significantly higher than in urban centers.
Third, a number of components in program spending are directly related to the circumstances of the day, e.g. defence spending, disaster assistance, etc.
Fourth, although the funding formula is up to discretion of the government, equalization entitlements are enshrined in the Constitution. Successive governments have attempted to find the "perfect" funding formula, with little success.
Fifth, there are a number of programs whose spending is financed wholly or partially by charges/fees for their services. These include the consolidated Crown corporations, the Canadian Air Transport Security Authority, among others. Including their expenses in the base, when most of their expenses are covered by outside revenues, makes no sense. The federal government also transfers the offshore resource royalties to Nova Scotia and Newfoundland and Labrador. The royalties and resulting transfers show up as revenues and expenses, respectively with no impact on the budgetary balance.
Sixth, the government financial statements are on an accrual basis of accounting, recognizing liabilities when they are incurred not when they are actually paid. These liabilities related to court cases, environmental cleanup, loans and loan guarantees, etc. Trying to offset the impact of these non-predictable, irregular liabilities on an annual basis would be extremely disruptive to effective planning and management.
Seventh, the proposed cuts to the CHT/CST begin in 2011-12, two full years before the current legislation expires. There is a commitment by the government to give the provinces one year's notice before any changes become effective. Their proposal requires changes to the current legislation and a breaking of the one-year notice commitment.
In developing the criteria for the original Program Review Exercise, the nature of federal spending was taken into account. The central agencies had a full understanding on what was possible, and what was not, in developing the appropriate departmental spending reduction targets.
The Fraser Institute is not the first to recommend changes to the CHT and CST funding. The C.D. Howe Institute, in their 2011 Pre-Budget Report, proposed to freeze the CHT/CST funding at the 2013-14 levels. We will not comment on the practicality of these proposals. What is important, however, is that the federal government begin public discussions with the provinces now rather than waiting until 2013-14.
Lesson #6: The Government needs to be much more transparent in explaining changes to program expenses.
The Fraser Institute notes that in the 2009 Budget, program expenses for 2011-12 were projected at $235.1 billion (see Table 4). However, in the October 2010 Update, they were revised up to $242.7 billion, an increase of $7.6 billion. This is a significant increase and needs to be explained.
First, about $3.5 billion of the increase is due to economic factors – higher employment insurance benefits, higher Children's Benefits and lower recoveries under the Alternative Payment for Standing Programs. Second, $1.5 billion is due to the incorporation of the financial activities of the Canadian Commercial Corporation. This reclassification affects both budgetary revenues and program revenues by roughly a similar amount and therefore has little impact on the budgetary balance. Third, direct program expenses in the October 2010 Update were revised up by $2.9 billion, but no explanation was given for this increase, despite the fact that the Government had introduced measures in the 2010 Budget to constrain the growth in this component of expenses. Adjustments of approximately $1 billion were made to the previous two fiscal years as well with no explanation.
Unfortunately the Fraser Institute interprets federal budget history from its desire to reduce significantly the size and role of the federal government. It sees the 1995 budget as the model to follow notwithstanding that the circumstances in 1995, both economically and politically, are totally different from those that exist today.. The Fraser Institute's recommendations fail to understand the context of the 1995 budget, and the key elements that led to its success. The proposals the Institute makes are both unrealistic and unnecessary. Unfortunately, the Institute has let its ideology get in the way of good policy making.
Nevertheless, there is an important message for the government in the Report. And that is that the government should start taking the budget situation seriously. Otherwise what is now a fiscal problem can soon become a fiscal crisis.
 Studies in Budget and Tax Policy February 2011 "Budget Blueprint How Lessons from Canada's 1995 Budget Can Be Applied Today" by Niels Velduis, Jason Clemens and Milagros Palacios; Fraser Institute
 Ibid page 16.
 Ibid page 30