COVER

WHAT IS THE DEFICIT?

WILSON IMPLIED THAT TAXES WILL CLIMB AND AXES WILL FALL IN A TOUGH CAMPAIGN

D’ARCY JENISH May 1 1989
COVER

WHAT IS THE DEFICIT?

WILSON IMPLIED THAT TAXES WILL CLIMB AND AXES WILL FALL IN A TOUGH CAMPAIGN

D’ARCY JENISH May 1 1989

At the age of 16, Ruby Walsh quit school and took a job sewing burlap bags in a Nova Scotia sugar refinery to help support her family. Later, she married, raised two daughters and earned extra money selling Avon products and teaching dressmaking. Now approaching 70, a widow and a grandmother, Walsh lives in Dartmouth, N.S., on her monthly old-age pension cheques and the survivor benefits from her late husband’s pension. But now, Walsh, who has been following the emotional debate over the federal budget deficit, says that she fears higher taxes and cuts in government services would make her life more difficult. Still, as a self-reliant individual who always paid the family bills on time, she acknowledged the government’s dilemma. Said Walsh: “The money has to come from somewhere, and the pot’s empty. I just worry about cutting pensions.”

As he prepared to deliver his fifth annual budget on April 27, federal Finance Minister Michael Wilson faced the daunting task of balancing the concerns of millions of Canadians like Walsh against reams of advice, much of it highly contradictory, about how to manage the deficit—which was slightly less than $29 billion in a budget of $132 billion last year—and the $321-billion overall national debt. Among the voices arguing for a drastic cut in the deficit, Alfred Powis, chairman of Toronto-based Noranda Inc., described it as “a time bomb ticking away underneath us.” On the other hand, Robert White, president of the 160,000-member Canadian Auto Workers union, was among influential Canadians who argued that the business community is deliberately “trying to create hysteria” about the size of the deficit in order to convince the government to cut social programs. But as budget week loomed, it was evident that the finance minister was intent on reducing the deficit. In a speech delivered on April 10 to a Toronto audience, Wilson declared ominously: “As we look to the future, we must face one problem squarely—the growing public debt and the exploding cost of paying interest on that debt.”

Large: Even before Wilson announced his course, he was deluged with arguments and counterarguments. Fiscal conservatives within Prime Minister Brian Mulroney’s government and the business community said that by consistently overspending—and increasing the nation’s debt—the government is threatening Canada’s well-being. They argued that the deficit encourages inflation and high interest rates and will undermine the country’s ability to finance social programs. Even though governments have often run deficits since Confederation, they said the shortfalls in the past 15 years have been so large and the national debt has grown so fast that the federal government’s largest single expenditure—$33 billion last year—is now interest on that debt.

Problem: On the other hand, some labor leaders and economists continue to maintain that the deficit is not a problem at all. Even among those who accepted that the deficit should be reduced, many said that the solution was not in drastic cuts in government programs. Instead, economists such as John Fryer, president of the National Union of Provincial Government Employees, argued that the government could impose higher taxes on large corporations and wealthy individuals and reduce unnecessary business subsidies. They also insisted that the Bank of Canada should abandon its policy of using high interest rates to combat inflation. Lower interest rates, they said, would cut the government’s debt-servicing costs and stimulate the economy.

Wilson’s Toronto speech climaxed a carefully orchestrated government campaign to prepare the Canadian public for what was widely expected to be one of the toughest budgets in Canadian history (page 48). Besides the April 3 speech from the throne and Wilson’s own speeches, the finance department distributed a 38-page booklet, Where Your Tax Dollars Go—all of which appeared to set the stage for deep spending cuts and steep tax increases. Moreover, opposition politicians and many business leaders said that they suspected Wilson’s department of leaking an internal report from the Washington-based International Monetary Fund that called for an immediate $9-billion reduction in Canada’s federal deficit. Since Jan. 1, the anti-deficit campaign has had a boost from many business leaders who called almost daily in public speeches and briefs to the minister for massive government spending cuts. But labor organizations, social welfare groups, church leaders and many leading economists remained skeptical about Wilson’s crusade to slash the deficit. Said White: “We do not have a crisis like the government and the business community are painting it.”

Shortfall: At the heart of the issue is the annual budgetary deficit, which stood at slightly less than $29 billion in the federal fiscal year that ended on March 31. In order to make up that shortfall between spending and revenue, Ottawa borrows money by issuing Canada Savings Bonds, short-term treasury bills—which mature in 90 to 365 days— and long-term bonds, which mature in two to 25 years. Each year that the government operates with a budget deficit, the national debt goes up, and so do the interest charges that must be paid. Both Liberal and Conservative governments have run periodic annual deficits ever since Confederation. But many observers say that the federal government’s current financial predicament is unprecedented. William Mackness, dean of the University of Manitoba’s faculty of management, said that between 1945 and 1975 the average annual deficit was zero because minor government shortfalls were offset by subsequent surpluses. But since 1969-1970, when Pierre Trudeau’s Liberals had a $332-million surplus, there have been 19 consecutive deficits, reaching a high with the $38-billion shortfall in 1984-1985. The provinces had a combined deficit of $5.7 billion in 1988, down from $10.8 billion in 1987.

Concerned: And judging from public opinion polls, it appears that the average voter is becoming more concerned over the deficit. Surveys by Winnipeg-based Angus Reid Associates Inc. during last fall’s election campaign, in January and again in March, showed that the numbers of respondents rating the deficit as the government’s most pressing issue rose from four per cent to 10 per cent and then to 18 per cent. In the March poll, the deficit ranked second only to the environment, which 28 per cent of respondents rated as the top issue. Said Reid: “The Tories have been successful in softening the populace.”

Meanwhile, both the Liberals and the New Democrats appeared to be convinced that the deficit and national debt must continue to be held in check (the deficit has in fact declined steadily in the past five years). One major disagreement was over how deep the cuts should be. NDP finance critic Lorne Nystrom said that his party favors lower interest rates, job creation in economically depressed regions, a minimum corporate tax of 20 per cent and abolition of “unproductive” subsidies to business.

Prior to budget day, the Liberals did not seriously challenge the Tories’ deficit-cutting drive, partly because they had few policy alternatives of their own and partly because of the need to create the impression that they would be financially responsible if returned to office. Said Liberal party chief financial officer Michael Robinson: “It would be foolhardy for the party to suggest that attempts to deal with the deficit are unnecessary.” And Robinson said that because Canadians want the deficit brought under control, the Liberals would have to choose their targets carefully in their response to the budget. “If we are going to attack the government, we have to use a rifle rather than a shotgun,” he said. And there may, indeed, be plenty of targets for the opposition on April 27. On April 11, the Tories gave the country an example of the potential program cuts that loom when Employment and Immigration Minister Barbara McDougall announced sweeping proposals to change Canada’s $13-billion unemployment insurance program—including $1.3 billion in cuts. And in an ironic underscoring of the shrinking value of money, the Royal Canadian Mint stopped printing $1 bills last week as part of Canada’s changeover to the so-called loonie dollar coin.

Charges: Still, many economists say that the government is simply overreacting to the current high interest rates that are increasing the cost of financing debt payments. Carl Beigie, chief economist with the Toronto-based brokerage firm McLean McCarthy Ltd., said that Ottawa’s debt-servicing charges have risen with the Bank of Canada rate, and as the bank rate inevitably falls, so will interest charges on the national debt. And Michael McCracken, president of the prominent Ottawa-based economic consulting firm Informetrica Ltd., concurred. “Much of the present crisis has to do with the fact that higher interest rates mean that they are going to shift their 1989 deficit forecast by great gobs,” he said.

McCracken, along with some prominent labor leaders, also criticized the government’s recent policy of combating the threat of inflation with higher interest rates. Instead, he said, the government should create jobs by stimulating the economy, thereby creating more wealth and, subsequently, tax revenues. McCracken said that a three-to four-per-cent cut in the Bank of Canada interest rate would reduce the government’s debt-servicing burden by $15 billion over the next two years. Jeffrey Rose, president of the Canadian Union of Public Employees (CUPE), representing 355,000 government workers, said that the Canadian economy can tolerate an extra one-per-cent inflation, provided that the government increases its spending on job creation. Said Rose: “The deficit is a tool. If used properly, it can help a country grow.”

Despite the rise in interest rates over the past year, some liberal-minded economists have argued that the Tories should stick to their long-term deficit-reduction program, which, since its introduction in 1984, has proved effective. University of Toronto economist Frank Longo pointed out that, by the end of 1987, the deficit had fallen to 5.3 per cent of gross domestic product (GDP) from 8.9 per cent in 1984. Said Longo: “There is no cause for panic.”

Had the Tories opted for a moderate deficit-reduction approach similar to their first term, they could maintain social programs and still balance the budget by the turn of the century, said Peter Dungan, associate director of the policy and economic analysis program at the University of Toronto. In January, he released a report that showed that the government’s current financial plan would produce a budget surplus early in the next century. Dungan’s analysis assumes that the economy will grow annually throughout the next decade.

In fact, Canada’s national debt as a percentage of the country’s total output has previously been higher than the current 54 per cent—and has fallen without the aid of drastic government action. Longo noted that the debt stood at 66 per cent of GDP in 1937 then fell to 48 per cent five years later before soaring to 107 per cent of GDP by 1947. Similarly, the problems associated with debt-servicing charges are being overstated, said Ruben Bellan, an economist at the University of Manitoba. Bellan argues that almost all of the government debt is owed to Canadian institutions and individuals. He added that as long as the government does not resort to foreign borrowing to finance the majority of its operations, the debt charges do not impose a significant burden on the economy (page 50). Said Bellan: “The government is taking money from people as taxpayers and giving it back to them as bond-holders.”

Tough: But in his April 10 speech to the Retail Council of Canada, Wilson said that the government has to take a tough stand because interest rates have risen almost four per cent since early 1988. Even Bank of Canada governor John Crow ventured into the debate when releasing the bank’s annual report on April 14. Crow said that lowering the deficit would ease some of the pressures that lead to inflation and higher interest rates.

Many economists say that if the central bank rate remains at its current 12.61 per cent, the 1989-1990 federal deficit could rise to $33 billion from the projected $29-billion shortfall in the fiscal year that ended on March 31, largely because of higher interest charges on borrowing. They also say that, after seven consecutive years of economic growth, a downturn is inevitable, which would increase both the demand for government services and the deficit. Said Warren Jestin, chief economist with the Bank of Nova Scotia: “Even with a tough budget, we are not much better off than a year ago.”

Changes in the economic climate mean the government cannot stick to its earlier deficit-reduction schedules, as some liberal economists have argued, Jestin said. He noted that the Canadian economy is expected to grow by only three per cent this year, compared with 4.5 per cent in 1988. Lower growth will cut government tax revenues, he said, while a higher rate of inflation will automatically increase social benefits to individuals because of indexing. Maureen Farrow, president of the Toronto-based C. D. Howe Institute, said that the forecasts of a steady decrease in the deficit through the 1990s do not account for possible recessions or economic upheavals.

Critics of the deficit also maintain that the government cannot simply order the Bank of Canada to cut interest rates, as CUPE president Rose advocates, without triggering a huge exodus of money from the country. Furthermore, they argue that government deficits have contributed to persistently high interest rates in Canada. And Edward Carmichael, senior economist at the Toronto-based brokerage firm Bums Fry Ltd., pointed out that the interest rate on treasury bills in Canada is currently three per cent higher than the rate on U.S. treasury bills. He added that Canada’s budget deficit, as opposed to inflation or unemployment, is the major cause of the interest rate spread between the two countries. Inflation is running at close to the same rate in Canada and the United States, he noted, while Canada’s unemployment rate is 7.5 per cent compared with the U.S. rate of five per cent.

Smaller: Investment portfolio managers, who regularly buy federal, provincial and corporate bonds, maintain that there is an even more direct link between federal deficits and high interest rates. Donald Walcot, president of Toronto-based Sun Life Investment Co., said that 15 years ago, when Ottawa was a much smaller borrower, government of Canada bonds and treasury bills attracted investors even though they normally offered one per cent less interest than provincial or corporate securities. Since then, the size and frequency of federal issues have grown with the deficit, and Ottawa has had to offer higher interest rates in order to keep attracting buyers.

Critics of the deficit are also alarmed at the growth of the national debt—the total accumulation of annual surpluses and deficits since Confederation—and the country’s rising interest burden. On March 31, at the end of the government’s 1988-1989 fiscal year, the debt stood at $321 billion, or 54 per cent of the country’s GDP, compared with 26 per cent at the start of the decade. Interest payments on the national debt were $33 billion last year, the largest single item in the federal budget. The other major expenditures in descending order: $30 billion for pensions for the elderly, unemployment insurance benefits, family allowances and veterans’ pensions; $24.3 billion for transfer payments to the provinces for health education and equalization programs; and $16.2 billion for government operations. Said Allan Taylor, chairman and chief executive officer of the Royal Bank of Canada: “If we do nothing, we will be spending ourselves into an insurmountable burden of debt.”

Owes: Opponents of the deficit also dispute the argument that the national debt poses no problems to the economy because the government merely owes the money to Canadians. “It is one way to redistribute income, but it is a poor one,” said the Bank of Nova Scotia’s Jestin. Although many Canadians buy Canada Savings Bonds, most do not purchase the long-term bonds and treasury bills used to finance two-thirds or more of the government’s annual deficit. They are primarily purchased by large financial institutions and wealthy individuals. As a result, most of the interest that Ottawa pays goes to those relatively well-off sources. Brokerage houses and trust companies frequently sell treasury bills to individuals in minimum allotments of $15,000. Said David Wilkes, vice-chairman of the Toronto-based brokerage firm Moss Lawson & Co. Ltd.: “It’s not rare at all to have a guy with $100,000 in treasury bills. Not rare at all.”

Many economists trace the current deficit situation to a decision made by the Trudeau Liberals in the 1974-1975 fiscal year, when current Liberal Leader John Turner was finance minister. U of T economist Richard Bird, author of the 1970 book The Growth of Government Spending in Canada, said that at that time, the Liberals made a mistake when they indexed personal tax rates and the basic personal tax exemption to the rate of inflation. That meant that a person’s salary could increase by as much as the annual rate of inflation without being subject to a higher rate of taxation. At the same time, the basic personal exemption—the amount of earnings on which no taxes are paid—rose annually with inflation.

Decades: As a result, tax revenues did not keep pace with increases in government spending. When the indexing policy began, the government deficit was $2 billion. Ten years later, the deficit had skyrocketed to $38 billion. Bird argues that the resulting deficits have been fundamentally different from those of previous decades. Prior to indexing, government revenues rose or fell depending on the health of the economy. The result was a cyclical deficit or surplus. Indexing produced what economists call structural deficits, because the government’s revenues were less sensitive to changes in the economy. The Tories have eliminated indexing of the basic exemption and partially deindexed the personal tax rates to correct the problems, said Bird. But for 10 years, federal spending grew much more quickly than revenues.

The advocates of lower deficits have been calling for a double-barrelled approach that includes spending cuts and higher taxes. And in fact, government figures show that federal benefits paid to individuals fell to 5.2 per cent of GDP in 1986-1987 from a postwar high of 6.1 per cent in 1982-1983. Similarly, federal transfer payments to the provinces have dropped since hitting a record 4.3 per cent of GDP in 1984-1985. Said Valerie Sims, acting executive director of the Canadian Council on Social Development: “The notion that spending on social programs is excessive is not acceptable.”

But even among those who favor a sharp reduction in the deficit, there is a growing recognition that the government’s options are limited. In the fiscal year that ended on March 31, Ottawa spent about $100 billion on programs and $33 billion on debt charges. But more than half of the program spending—a total of $54 billion—went to individuals and to the provinces through various transfer payment arrangements, which can only be changed by amendments to federal legislation. For their part, many labor leaders and economists say that the best place to look for cuts is in the government’s subsidies to individual companies and industries, which total about $5 billion annually.

But regardless of which programs it attempts to cut or eliminate, the government risks a political backlash. The Mulroney government created a furor in May, 1985, by attempting to deindex old-age pensions, then had to back down within two months. Similarly, the Tories backed away from cuts to the Canadian Wildlife Service in December, 1984, including cancellation of a study of Great Lake herring gull eggs to monitor pollution. As well, tax increases can be political dynamite. Indeed, John Crosbie’s proposed gasoline tax of 18 cents a gallon in the 1979 budget led to the defeat of Joe Clark’s minority government.

Prior to budget week, labor leaders contended that the government should increase its revenues through corporate rather than personal income taxes. John Fryer, president of the National Union of Provincial Employees said that the government could virtually eliminate its deficit by abolishing a provision that allows corporations to apply previous losses against current profits to avoid paying taxes. Fryer also argued that the Tories have lowered the business sector’s tax burden by $7 billion annually since taking office by reducing corporate tax rates and maintaining tax incentives.

Dangers: Still, amid the conflicting views over how to cut deficits, a number of experts in both Canada and the United States are challenging the conventional assumptions about the dangers of accumulating debt. Said Edward Yardeni, chief economist at Pruidential-Bache Securities Inc. in New York City: “Debt fear occurs in spasms. If a government wants to raise taxes, make cutbacks on transfer payments, or deny funding, the deficit can be used as a convenient excuse.” Roger Hickey, vice-president of the Economic Policy Institute, a liberal Washington-based think-tank, said that deficits stimulate economic growth. Said Hickey: “Without the kind of government spending we have had in the 1980s, we would be in a recession.”

For federal Finance Minister Wilson and the officials in his department, there were no risk-free or simple solutions as they prepared the April 27 budget. Despite growing concern over the deficit, an austerity budget of spending cuts and higher taxes could create a huge political backlash against the government. Once the budget is delivered, the size of that political backlash will be determined by voters such as Dartmouth pensioner Ruby Walsh.