THE BLOG

Flaherty Hasn't Slain the Deficit Yet

11/14/2013 03:17 EST | Updated 01/23/2014 06:58 EST

After federal Finance Minister Jim Flaherty unveiled his latest financial plan Tuesday, much of the media hype centred on the government's larger than expected surplus in 2015-16. Early chatter seemed to accept the government will deliver as promised and some declared its "conservative assumptions" might allow for the deficit to be eliminated even earlier.

But when we look beyond the headlines and understand how Mr. Flaherty is planning to eliminate the deficit, the potential risks to his plan become evident. The reality is his plan relies heavily on strong revenue projections, and for a government with a lot riding on balancing the budget and delivering a substantial surplus to make good on major campaign commitments, this leaves little wiggle room. Future reductions in revenue could spell trouble for the government's budget plan. So put the champagne on ice, it may be too early to declare mission accomplished.

Like we anticipated, Flaherty's financial update decreased projections for economic growth relative to his March budget. In just eight months, his projection for economic growth fell to 3.0 per cent (from 3.3 per cent) this year and to 4.2 per cent (from 4.7 per cent) next year. In principle, the government's capacity to raise revenue is linked to economic growth. Yet, despite gloomier economic growth projections, the government is forecasting robust revenue growth over the balanced budget timeline.

Using the past fiscal year as a baseline, Mr. Flaherty is expecting total government revenue to grow to $293.9 billion in 2015-16 from $256.6 billion in 2012-13- a $37.3 billion increase. On an annual basis, the government anticipates average revenue growth of 4.6 per cent over the next three years including a significant increase of 5.9 per cent in 2015-16 (incidentally the year it slotted a $3.7 billion surplus). All told, this represents a 14.5 per cent jump in revenue over the period.

These projections seem overly optimistic in light of uncertain economic conditions. For perspective, during a period of strong economic performance in Canada from 2002 to 2007, federal budgets did not forecast revenue growth of that magnitude. For instance, Budget 2003 forecasted average revenue growth of 4.0 per cent; Budget 2004, 3.3 per cent; Budget 2005, 4.2 per cent; Budget 2006, 3.6 per cent; and Budget 2007, 3.5 per cent.

And the projections are of course prone to risk. The government's own estimates suggest that a one percentage point decrease in inflation-adjusted economic growth would increase the deficit by between $4 billion and $6 billion due to lower revenues and higher spending.

This risk is hardly insignificant given the important role that robust revenue growth plays in the government's plan to eliminate the deficit.

On the spending side, the government estimates that total program spending will grow to $259.4 billion in 2015-16 from $246.4 billion in 2012-13. This represents 5.3 per cent growth in spending over the three year period. And in the current year it's slated to grow by 2.9 per cent. Part of this increase is driven by unanticipated expenses related to the flooding in Alberta and the train disaster in Quebec. But even after accounting for these costs, total program spending is still projected to grow by 1.8 per cent this year.

Here's the important takeaway: spending is still growing and in light of the risks to revenue projections, there's room to scale it back. That would be the prudent course of action.

To this end, the Mr. Flaherty would be well-advised to continue searching for ways to more aggressively curb spending. Although his plan accounts for a two-year operating freeze and the potential sale of federal assets such as shares in General Motors and properties like Ridley Terminals in B.C., further action to reduce program spending would lower the risks associated with evolving economic conditions and place the government's return to balance on more stable footing.

Mr. Flaherty may indeed eliminate the deficit in 2015-16 as planned. We hope he does. But his plan as conceived still contains considerable risk that shouldn't be ignored. More conservative revenue forecasts and lower program spending would reduce these risks and help to ensure he can deliver on his promise. In the meantime, it's premature to declare mission accomplished.

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