2 - Options for Debt and Deficit Reduction
Guidelines for the Way Forward
Based on our hearings, the Committee believes that Canadians want the government to adhere to the following principles when setting future budget policy.
A. Deficit and Debt Targets Must Be Met
With debt levels being so high, we do not enjoy the luxury of being able to miss our deficit or debt targets. Failure would undermine confidence in our ability to put our house in order, and would carry severe economic costs.
B. Deficit and Debt Reduction Should Be Incremental
Liberating Canada from debt and deficits is a long-term exercise of adjustment and transition, not ``shock therapy.'' It took more than two decades to build up the current massive debt. It cannot be made to disappear overnight and at the same time keep faith with Canadians' beliefs in the essential role of government in maintaining both a sharing and compassionate society as well as a growing economy. Precluded, therefore, are apparent quick-fixes or magical solutions that may reduce the deficit in the short-term, but could ultimately reduce our capacity to prosper and provide the kind of country Canadians expect.
"I'm a parent of a child who's se verely disabled. ... When you're talking about cutting the funding to health services, when you're talk ing about moving the funding from the federal to the provincial, the re ality is that you're talking about re ducing the support that keeps my child alive."
Jim Chorostecki.
C. Economic Assumptions Should Err on the Side of Caution
It is important to err on the side of caution in making assumptions about government revenues and expenditures. Neither Canadians nor their governments can assume that good economic fortune will let us all off the hook. The sheer size of the current debt makes Canada vulnerable to unforeseen international shocks and domestic events. We must be prepared for the worst, and employing prudent economic assumptions is, we believe, a key element of responsible fiscal planning.
D. Avoid Replacing Fiscal Debt With Social Debt
"Part of Canada's deficit is declin ing road capital assets that will one day have to be replaced. ... the Ontario auditor general ... said that almost 60% of Ontario's highways are sub-standard and explained why it was going to cost the Ontario government more to rebuild those highways than it would have spent renewing them when they should have. While we wait, our economy falters without the proper infra structure."
Richard Godding, Vice-President, Canadian Automobile Association.
Debt and deficit reduction is not an end in itself. In taking essential actions to address our fiscal problems, the government must avoid replacing fiscal deficits with social and technological deficits. Those who are the least equipped to bear the costs of change should not have to bear the brunt of debt and deficit reduction. Government must continue helping Canadians adapt to the new knowledge-based global economy. Government is an essential partner for innovation, export promotion, job creation and productivity enhancement. The need to pay for the fiscal mistakes of the past must be balanced against the need to create a humane and prosperous future.
E. Budget Choices Must Reflect our Vision of the Future
How we deal with our current economic difficulties will have major implications for our future. This dictates active and responsible management of the economy carried out with strategy and vision. The Committee rejects across the board expenditure cuts. While this approach would obviate the need to make choices, it is not responsible management. Governing is about making choices, and Canadians deserve to benefit from the right choices.
"We don't have an audit of the so cial health of this country, but we do have some indicators to suggest that there is already a social deficit in Canada. This will get worse as the impact of last year's budget cuts becomes realized."
Stella Lord, Committee Member, Real Expectations of Communities Against Poverty (RECAP).
The Options Available
In listening to witnesses this year and last, the Committee heard many proposals for different ways to reduce the federal deficit. Below we consider some of these alternatives.
A. Growing Our Way Out
The least painful way to control and eliminate our deficit is to allow economic growth to do all the work. Unfortunately, growth can't do the job on its own.
Every time the economy grows by an extra 1% of GDP, the deficit declines by $1.3 billion in the first year and $1.7 billion by the fourth year if the growth is sustained.
Most economists do not see the Canadian economy as able to grow much beyond 3% on a sustained basis. Consequently the amount of extra growth that can be coaxed out of the economy to reduce the deficit is actually quite small. More to the point, it is completely inadequate in terms of eliminating the deficit over any reasonable timeframe.
B. Reducing Interest Rates
"...going back to six or seven years ago, one big problem Canada had was that Toronto was overheating. Interest rates had to be raised to cool down Toronto. Can you, as a finance committee, not come up with a way to cool down Toronto without bankrupting the rest of the country?"
Mike Stokes, Regional Representa tive, Public Service Alliance ofCanada, St. John's Region.
The Committee heard from a number of witnesses who argued that monetary policy has been a major contributor to the run-up of government debt. They stated, for example, that Government of Canada interest payments are approaching $50 billion per year (more than 6% of GDP) whereas interest costs were only 4% of GDP 15 years ago and 2% of GDP two decades ago.
While these facts are accurate, they do not take into consideration the real reason why rates are high and the government is spending so much on interest.
The rapid accumulation of debt started in the mid 1970s. It was accompanied by large and persistent operating deficits for over a decade. The government resorted to borrowing to pay for program spending, not just to pay interest charges as it had in the past. Once this major shift in fiscal policy took place, the effects of compound interest came into play with a dramatic impact on our debt buildup.
It is because of the size of our debt that government must spend so much on interest, and the interest rates we must pay are higher than they would otherwise be. The failure, therefore, has been on the fiscal rather than the monetary side.
Some witnesses have suggested that the Bank of Canada could resolve Canada's debt crisis by acquiring and holding more government debt. They cite the fact that the Bank today holds about 6% of federal debt, whereas it held as much as 25% only 15 years ago.
Again, the above facts are accurate. The federal debt in 1980 was only $77 billion and holding 25% of it amounted to only $19 billion. If the Bank were to hold 25% of Canada's debt today, it would have to acquire more than $100 billion of additional debt. While this is possible, the only way it could be accomplished would be for the Bank to print the money to buy this debt, a practice referred to as "monetizing the debt."
The Committee wishes that our fiscal problems could be solved so easily. Other countries have tried this approach with the inevitable result being hyper-inflation.
Critics have also cited the fact that real interest rates today exceed the rate of economic growth, whereas this was not the case in the 1960s and 1970s.
While this is true, again, it is not a valid condemnation of current monetary policy. Even if real interest rates were lower in previous years, nominal interest rates - what one had to pay to the bank - were often extremely high because the rate of inflation was high.
In recent years, the Bank of Canada has been pursuing a low inflation strategy. It is critical that we not return to double-digit inflation and interest rates that hit 22% in 1981. That means continuing to contain inflation.
"If you look at what is holding back the job creation engine in Canada, I cannot help but conclude it is fiscal drag. The combined weight of cut backs at the federal and provincial governments is throttling economic growth and ultimately job creation. ... What...is missing from this entire discussion is... the concept of econ omic policy mix. How does the com bined blend of monetary policy, fis cal policy and, of course, the impact on exchange rate all blend together in terms of the economic impact?"
Arthur Donner, Consultant.
Another important factor is that, because of Canada's high debt burden, much of which is held offshore, Canada cannot isolate itself from the judgment of international capital markets and maintain interest rates lower than international economic conditions dictate. Mr. Ed Neufeld reminded the Committee that when the Bank of Canada tried to lower interest rates by only 25 basis points below the level deemed appropriate by the market, foreign exchange markets quickly bid down the value of the Canadian dollar. Restoring stability required even higher interest rates than before the Bank took such action.
In the interval since this happened, short-term rates in Canada have fallen by about 250 basis points and the differential between 3-month Treasury Bill rates in Canada and the United States is now less than 50 basis points. This suggests that the Bank of Canada is allowing interest rates to fall as market conditions dictate, and has little room for substantial cuts in the absence of interest rate declines in the United States.
In spite of the above, critics have also argued that the Bank of Canada should simply set lower interest rates. It is true that the Bank can lower interest rates by unilateral action, but only with respect to the interest it charges the chartered banks on overnight loans. This lever is a small one, and has little if any impact on the interest rates that the government must pay on its debt.
RECOMMENDATION
While the Committee believes that there is no quick monetary fix for our fiscal woes, our high debt must be well managed. The Committee agrees with recent initiatives facilitating the acquisition of Canada Savings Bonds through RRSPs. The Committee also agrees with witnesses, including Professors Tom Wilson and David Laidler, that the government should issue more indexed debt. Because we are confident that inflation will be contained, we believe there are potential savings to be gained from indexing more debt to the rate of inflation. This would also signal the government's confidence in the Bank of Canada's monetary policy."There is a need to continue to build credibility in the public fi nances. Reduced credibility has a quick reaction in financial markets in terms of interest rates, what gov ernment has to pay, and general confidence in the country."
Edward Neufeld, Visiting Senior Research Fellow, Centre for In ternational Studies, University of Toronto.
C. Using Tax Policy
RECOMMENDATION
Another potential candidate as a deficit reduction option is higher taxation. While this option cannot be ruled out completely, the Committee and the government believe tax increases are of minimal value as a deficit reduction strategy. In last year's report, we recommended that the ratio of spending cuts to tax increases be in the order of 7.7:1. The measures contained in the 1995 budget of the Hon. Paul Martin contained $6.9 of spending cuts for every dollar of increased tax revenues. We still believe that reduced spending should constitute the major component of fiscal actions.
"Since our tax burden is already significantly higher than that of the United States, and since the United States already plan to lower their taxes, we should set aside any idea of reducing the deficit by raising taxes."
Clément Gignac, Chief Economist and Strategist, Levesque Beaubien Geoffrion Inc.
Canada has become a high tax jurisdiction relative to other countries. This is affecting our ability to compete. In 1980, total tax revenues in Canada and the United States were roughly equal, 29.5% of GDP here and 29.8% of GDP in the United States. Since then, total Canadian tax revenues have grown substantially, to 35.8% of GDP, whereas in the United States they have increased only marginally to 30.7% of GDP. There is also the possibility that taxes will be reduced in the United States.
Personal Income Taxation
A partial explanation for our higher tax burden is the fact Canada's public sector delivers more services, in particular health care and post-secondary education, than does the public sector in the United States. Nevertheless, the Committee heard from many witnesses that Canada's personal tax levels are too high.
"Our biggest challenge today is finding the right senior-level em ployees. Because of our very high personal marginal tax rate it has become nearly impossible to recruit outside of Canada, especially from the U.S.
... we get blown out of the water with the personal marginal tax rate. We're so far from being competitive that it's a very sad story."
Shirley-Anne George, Executive Director, Canadian Advanced Technology Association
It is becoming increasingly apparent that labour, especially highly skilled labour, is quite mobile. Doctors, scientists and executives are all being recruited on the basis of lower taxes in the United States. The ability to attract and keep highly skilled professionals in Canada is critical to our economic future.
This point was made forcefully by Ms Shirley-Anne George, Executive Director of the Canadian Advanced Technology Association. In her industry, employment is growing at 16% per year but there is a critical shortage of highly skilled, world-class employees. Employees are being recruited to go abroad, almost on a daily basis. The heavier burden of Canadian taxes figures prominently in this process. Canadians pay about 35% more than Americans in personal income taxes, when measured as a proportion of GDP.
Corporate Income Taxation
"The tax system is dysfunctional. We are being told job creation is priority number one and that the federal government intends to do something. We are waiting."
Bruce Clemmensen, President, Ca nadian Home Builders' Associ ation.
In 1991, the New Democratic Party government of Ontario established the Fair Tax Commission, largely in response to the belief that the Ontario tax system was not fair to all taxpayers. The Report was tabled in December 1993. The concerns heard by the Commissioners were very similar to those heard by our Committee: there had been a long-term decline in the corporate share of provincial income tax revenues, and some profitable corporations were not paying tax. These two features had come to symbolize the perceived unfairness of the tax system.
The Fair Tax Commission noted that in most industrialized countries, corporate income taxes were declining source of government revenues, and the principal reason cited was lower profits. Another was the need to maintain competitive tax levels on a global basis. The Commission concluded that there was little room to raise corporate income tax rates.
With respect to the issue of profitable corporations not paying income tax, a survey of 1989 tax returns showed that over 23,000 Ontario corporations reported profits but paid no income tax. This represented 20% of profitable companies. The Commission estimated that 50% of untaxed profits consisted of inter-corporate dividends, 11% involved loss carryovers from other years, 13% were due to capital cost allowances, 7% involved capital gains rollovers, and 4% were from tax holidays for new small businesses. The Commission concluded that not taxing inter-corporate dividends and permitting loss carryovers were clearly legitimate, but the other tax expenditures could bear investigation.
Tax expenditures has been used extensively to encourage corporations to give more to charity, use more machinery and equipment, invest in certain parts of the country, etc. In some cases, incentives may be ineffective or overly generous, and should be examined but in many cases tax expenditures represent an appropriate and effective tool for achieving needed results.
In examining corporate tax levels, it is also important to recognize that corporations pay many taxes other than income tax, most of which are not based on profitability. These include capital and insurance premium taxes, payroll levies and property taxes. According to the Department of Finance, 70% of the taxes paid by corporations are not related to profitability. In 1994, overall corporate taxes in Canada equalled 60% of pre-tax corporate profits. In 1992, this figure was 70%.
RECOMMENDATION
Based on the above, the Committee concludes that there is little, if any room for either personal or corporate tax increases as a means of solving our fiscal problems. Our tax levels are at or near the upper levels of competitiveness."I would see two negatives to higher corporate tax rates: fewer people coming into the country and, within Canada, lower profits, therefore lower stock markets, lower reinvestment of profits, and fewer jobs."
Don Walcot, Member, Government Relations Committee Pension In vestment Association of Canada.
RECOMMENDATION
While the Committee concludes that our debt problem requires that we maintain tax revenues, it nevertheless recognizes that Canadian businesses must be internationally competitive in order to foster growth and create jobs. On the other hand, Canadian businesses, like Canadians in general, benefit from government services financed by the taxes they pay. The Committee recommends that the government study changes to the tax system that would improve the international competitiveness of Canadian businesses for the future, while maintaining the integrity of the tax system.D. Other Approaches
One suggestion put forward by Bob Blair in Calgary was to use Canada's vast wealth to solve our public debt problems. The World Bank recently estimated that Canada was the second richest country in the world, with an estimated wealth of U.S. $704,000 per capita. The per capita public debt of Canadians pales in comparison.
Mr. Blair recommended a "balance sheet" approach to public budgeting that would convert some of this wealth into debt reduction instruments. In this way, private wealth could be tapped to finance public programs.
In Winnipeg, the Committee heard a suggestion to encourage Canadians to prepay, at reduced rates, income taxes on future pension income. Prepayment of taxes would reduce current deficits, leading to lower debt and debt servicing costs in the future.
The Committee encourages the advocates of these and other innovative proposals to undertake further study and make detailed submissions to the Minister of Finance.
E. Cutting Spending
"I think we have to be very straight with Canadians. We cannot have Canadian-style social programs, medicare, and education, and U.S.- style tax rates. ... I have not yet heard the people who say that we need to have lower tax rates - and that means a substantial dismantl ing of medicare."
Richard Shillington, Research As sociate, Canadian Council on So cial Development.
Having examined other approaches to deficit reduction including economic growth and higher taxes, and finding them insufficient to meet Canada's deficit reduction needs, the Committee is inexorably forced to conclude that fiscal action means spending cuts. As a result of the major cuts already made in the 1994 and 1995 budgets, however, options for further cuts are limited.
Total federal spending in 1995-96 will be about $161.5 billion. Thirty per cent of this amount represents debt service charges over which the government has little or no control. Twenty-three per cent represents major transfers to persons, which the government is reforming (as in the case of employment insurance) or intends to reform significantly following study and consultation (as in the case of the Canada Pension Plan). Sixteen per cent represents transfers to other governments for which longer-term agreements are in place, such as equalization, or for which major reform has already been implemented, such as the Canada Health and Social Transfer which takes effect on April 1, 1996.
"...we can cut, cut, cut in this country until we've totally under mined the federal system, until we've totally undermined anything that's unique about this country. I think we do have a special country here. ... rather than cutting every- thing to the bone until there's noth ing left, maybe we should be focus ing a little more on this idea of rein venting government and how they deliver services and in looking at public and private partnerships for looking at new ways of delivering services in Canada."
Lynden Hillier, Executive Director, Canadian Co-operative Associ ation.
Taking out the above, we are left with about $45 billion in departmental spending, the largest single item of which is defence. All these expenditures, however, have already been subjected to cuts under Program Review I, and will again be subjected to scrutiny under Program Review II.
The cuts already made should not be underestimated. Departmental spending will be 18.9% lower in 1997-98 as a result of cuts in the 1995 budget. More broadly, program spending will decline from $120 billion in 1993-94, the fiscal year in which the government took office, to $106.3 billion in 1997-98.
RECOMMENDATION
The Committee reiterates that the government must continue to
reduce program spending in order to meet its deficit targets. Any new
programs must be undertaken with that principle in mind and must
not reverse the decline in program spending.
