Although it was only lightly discussed on the campaign trail, the core challenge for fiscal policy makers will be to address Canada's fading economic growth potential. We offer the following advice on the conduct of fiscal policy and its impact on economic growth, over three time phases – the immediate period, the business cycle (or medium term) and the longer term.
Immediate Context
The broad Canadian economy is still operating below its potential growth path. This reality could provide a prima facie case for fiscal deficits. That said, there are large differences in growth performance and potential among regions and provinces. The strongest case for fiscal stimulus today is in those provinces still in recession as a result of the oil-price meltdown – Alberta, and Newfoundland and Labrador.
We regard fiscal stimulus as a powerful medication with significant side effects, such as rising public debt. It should be used when truly needed, notably when the national economy is in deep or prolonged recession. That said, we agree fully that much higher federal public infrastructure investment is warranted, and on a sustained basis. Middle-class tax cuts may also provide a mild short-term boost to demand by shifting income to a group that will likely spend the money, not save it.
The new government is expected to pursue small fiscal deficits in the near term to pay for items such as public infrastructure. If this remains its immediate fiscal objective, we would advise the government to adopt three conditions:
– Use modest economic growth projections to guide expectations for future revenue growth.
– Be prepared to consider ways to generate more fiscal revenue without impairing the economy, such as reducing the revenue leakage from existing tax expenditures that are not a high economic priority.
– Aim for continued decline in the federal debt-to-GDP ratio when the economy is growing. The ratio, now around 32 per cent of GDP, would be expected to decline if the target fiscal deficit is $10-billion or less annually.
Countercyclical Fiscal Policy
Fiscal policy, if managed properly through the business cycle, provides a powerful tool for boosting aggregate demand and warding off the worst effects of a recession. In our view, the strongest reason to reduce the federal debt-to-GDP ratio and seek to maintain rough fiscal balance when the economy is growing is to create and build the capacity to provide significant and exceptional fiscal stimulus in periods of recession.
Canada was well positioned to add fiscal stimulus during the 2008-09 financial crisis and recession precisely because it had spent more than a decade getting its public debt under control.
Our core message on countercyclical fiscal policy is: Prudent fiscal management in good times provides the federal government with the ammunition to inject significant fiscal stimulus during bad times, while still being able to adjust spending priorities over time and maintain control over federal public debt.
Structural Fiscal Reform
The third phase of fiscal policy is structural, implemented incrementally over the longer term through a series of budgets. Well-designed structural measures in both the design of the tax system and the evolving allocation of overall public spending can help build the growth capacity of the Canadian economy, offsetting some of the negative impact of aging demographics. This phase is arguably the most important but is often overlooked.
After decades of incremental interventions, the Canadian tax system has become cluttered, complicated and administratively inefficient. The federal and provincial governments have introduced some specific reforms to business taxation in recent years in an effort to improve business competitiveness, but promoting robust economic growth has not been a key design principle for the full tax system. This issue received scant attention during the election campaign, and the attention it did gain – proposed tax cuts for small business – headed in the wrong direction in terms of economic impact.
Similarly, the full array of government spending priorities could be examined through an economic-growth lens. With the notable and welcome exception of investment in public infrastructure there was limited discussion about how and where federal spending could support economic growth. Redefined federal spending priorities for growth would focus on building the economy's productive capacity through long-term funding commitments for public infrastructure, advanced education and skills, research and development (R&D), and the commercialization and implementation of innovation.
Future budgets and overall fiscal policy should also aim to take on a "greener" hue and reflect a full awareness of environmental consequences. A greener budget would be an enabling force for fostering greener economic growth.
The new government might consider creating an independent, arm's-length commission to examine the options for structural fiscal reform that promotes stronger, greener economic growth. A thorough examination of tax policy and the priorities for public spending could be part of its mandate. The commission could then share its research findings and policy advice with the public, the government and Parliament.
Canada is being challenged by forces largely beyond its control, such as demographics and globalization. Budgetary and fiscal policy will define how the new federal government plans to respond to those forces.
Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada.