COVER/SPECIAL REPORT

A DEBT HANDBOOK

Public concern about the deficit is acute, but understanding how Ottawa collects and spends money can be a challenge. Often, even the basic facts are in dispute.

MARY JANIGAN September 27 1993
COVER/SPECIAL REPORT

A DEBT HANDBOOK

Public concern about the deficit is acute, but understanding how Ottawa collects and spends money can be a challenge. Often, even the basic facts are in dispute.

MARY JANIGAN September 27 1993

A DEBT HANDBOOK

Public concern about the deficit is acute, but understanding how Ottawa collects and spends money can be a challenge. Often, even the basic facts are in dispute.

MARY JANIGAN

THE SITUATION

Ottawa predicts that the gap between what it spends and what it collects in taxes will be $32.6 billion this year. That shortfall is called the deficit. To pay for it, Canadians must borrow $89.3 million every day. They borrow $625 million every week. Ottawa has been running deficits almost every year since the late 1950s. Those deficits were tiny until the mid-1970s, when they began to grow dramatically. The sum of those annual deficits—the debt—will hit $491.2 billion at the end of this 1993-1994 fiscal year. That is more than $18,000 for every man, woman and child in Canada. Every year, Ottawa must pay interest charges on that debt. This year, it predicts that it will pay $39.5 billion in interest. Those payments do not affect the size of the debt itself—which keeps growing with each year’s annual deficit.

THE SIZE OF THE PROBLEM

As the debt has grown, interest payments have consumed an increasing proportion of Ottawa’s spending. They now constitute an enormous strain on the treasury. In 1974-1975, interest charges were only 11 per cent of the annual budget. This year, Ottawa will devote almost one-quarter of its total spending of $159.5 billion to interest charges.

The best way to gauge the seriousness of the debt is to compare it with the size of the economy. The total of all goods and services produced every year in Canada is called the gross domestic product (GDP). This year, Ottawa estimates that those goods and services will be worth $719 billion. In the mid-1970s, Ottawa’s debt was less than 20 per cent of the nation’s GDP. In 1982-1983, it was 36 per cent. This year, the federal debt is more than two-thirds—68.3 per cent—of the GDP. That means that the federal debt is growing faster than the economy.

HOW DID WE GET INTO THIS?

In hindsight, both governments— and taxpayers—missed some crucial warning signs during the past two decades:

• The productivity of Canada’s manufacturing labor force scarcely grew. As a result, Canada started to lose its competitive edge. Its economy slowed—and increases in government revenues became sluggish.

• During the mid-1970s, Canada tied its basic tax exemptions and its income security payments such as the old age pension to increases in the cost of living. But inflation was increasing at an enormous pace. As a result, taxable income dwindled at the same time as Ottawa’s expenses for income security payments were mounting.

• Throughout the 1970s and early 1980s, federal policies were crafted to stimulate growth through the expansion of spending and the introduction of new tax breaks. The impact on growth was not great—but the impact on the deficit and the debt was serious.

• Throughout the 1970s and early 1980s, federal leaders believed that economic growth would generate enough revenues to balance the budget—if they got the basic cost of government operations under control. They were wrong. This year, Ottawa’s day-to-day operations, defence and foreign aid will cost $34.3 billion. Interest payments alone will be $5 billion more—$39.5 billion. If the government were to shut down, the savings would not cover the interest on the debt.

PUBLIC-SECTOR DEBT

The federal government is not the only public borrower: provincial governments are also borrowing heavily to make ends meet. In fact, provincial debt is now growing at a faster rate than Ottawa’s debt. Last year, the combined debt of Ottawa and the provinces was $630 billion. That works out to more than $23,000 for every Canadian. And it equals 91.6 per cent of last year’s GDP. This year, the total of the 11 governments’ debts is expected to reach more than $680 billion—or more than 95 per cent of the nation’s GDP.

WHY DOES THIS MATTER?

The burden of high deficits and debts has been extremely heavy. In Canada, in the early 1980s, Ottawa’s first response to cope with its growing deficit was tax increases. Such continuing tax increases have slowed the growth of the economy. But they have never raised enough revenue to cover the yearly shortfall—largely because of the ever-increasing interest on the ever-increasing debt. As more money went to pay the interest on the debt, Ottawa had less money to spend on programs. In the mid-1980s, it began to curb its contributions to such areas as health, education, welfare and economic development. Taxpayers began to pay more for less.

Meanwhile, both governments and the private sector were competing for funds to borrow. The demand was too high for the available pool of domestic savings. So borrowers increasingly looked for funds abroad. Most estimates now put Canada’s total public and private external debt at $300 billion. Ottawa and the provinces owe about two-thirds of that debt. Canada now has the highest level of net public and private foreign debt among the so-called G-7 nations—Canada, Italy, Great Britain, the United States, Germany, Japan and France. Canada’s net foreign debt in 1992 was 43.8 per cent of GDP. Italy was second highest—at 14.9 per cent of GDP.

That foreign debt creates additional problems for Canada. Increasingly, more Canadian income is going to foreigners to service the debt. That money is lost to Canada. More importantly, Canada must keep a wary eye on its foreign investors when it makes domestic decisions. If foreigners lose confidence in Canadian monetary and fiscal policy, they could unload their Canadian holdings— such as their Canadian bonds—and cause the Canadian dollar to become volatile in international currency markets. To regain foreign confidence, Canada might be forced to make those holdings more attractive by raising interest rates. Higher interest rates, in turn, increase the cost of the interest on the national debt—which increases the annual deficit. Higher interest rates also cripple economic _—_ growth—so tax revenues decrease.

CANADA’S FOREIGN DEBT

Canada has the highest level of foreign debt relative to GDP of all the G-7 countries

43.8

20-

-20-

Canada

OTTAWA'S REVENUE SOURCES

This year, Ottawa estimates that it will collect $126.9 billion in taxes. The main sources of that revenue include:

1. PERSONAL INCOME TAX: $58.1 billion. The revenue from personal income tax has doubled from $29 billion in 1984-1985. Between 1984 and 1992, personal income has also increased to $622 billion from $372 billion.

2. CORPORATE INCOME TAX: $9.7 billion. The revenue from corporate income tax was $9.4 billion in 1984-1985. Corporate tax revenue has remained stagnant because profits have been sluggish: corporate profits in the vital industrial and manufacturing sector, for example, dropped from $47.3 billion before taxes in 1984 to $5 billion before taxes in 1992.

3. UNEMPLOYMENT INSURANCE CONTRIBUTIONS FROM EMPLOYERS AND EMPLOYEES: $19 billion. The revenue from Ul premiums was $7.6 billion in 1984-1985.

4. THE GOODS AND SERVICES TAX: $17.4 billion. The GST replaced the manufacturers’ sales tax in 1991. In 1984-1985, the manufacturers’ sales tax generated $7.6 billion.

5. EXCISE TAXES AND DUTIES: $12.1 billion. In 1984-1985, those taxes produced $10.6 billion.

6. OTHER REVENUES: $10.6 billion. This category includes service fees and Ottawa’s return on its investments. In 1984-1985, those revenues totalled $6.7 billion.

WHAT IS OTTAWA DOING ABOUT IT?

Ottawa has made an effort to curb the deficit. In 1984-1985, the deficit was $38.5 billion—or 8.7 per cent of GDP. Last year, it was $35.5 billion—but only 5.2 per cent of GDP. This year, Ottawa estimates that it will be $32.6 billion—or 4.5 per cent of GDP.

That decline has come about for several reasons. First, Ottawa hiked taxes: federal tax revenues constituted 15 per cent of the GDP in 1980; this year, they will be 18 per cent. Ottawa also curbed spending. It controlled the growth of some transfers to the provinces. And it managed to keep the cost of government operations below the rate of inflation.

The result is interesting. In 1984-1985, Ottawa collected $71 billion in taxes—and spent $87 billion on programs. This year, it estimates that it will collect $126.9 billion in taxes—and spend $120 billion on programs. If Ottawa did not have to pay the interest on the debt, it would have a surplus.

TAX INCREASES

There are several reasons why Ottawa probably cannot introduce further major tax increases:

1. The public will not tolerate more taxes. Some economists now believe that the size of the socalled underground economy could be as high as 15 per cent of the GDP. Further tax increases would likely drive more taxpayers underground—so it is not likely that they would yield more revenue.

2. Tax increases drag down the rate of growth ii the economy. But the economy has to grow at a robust rate—or revenues will flag and the deficit will grow even larger.

3. It is difficult to slap large tax increases on corporations because they are already reeling from the recession.

4. In 1989, Ottawa imposed a tax on all large corporations which is levied against a company’s value—rather than its profits. As a result, it is more difficult for large corporations to avoid minimum taxes.

5. The world has grown highly competitive. Capital equipment and raw materials flow easily across borders. Canada’s taxation levels must compete with those of its powerful neighbor, the United States—or investment could flow south.

TRANSFERS TO PERSONS

There are two major categories of transfers to persons: old age pensions and unemployment insurance.

1. OLD AGE PENSIONS: Traditionally, politicians have tinkered with the old age pension at their peril. In 1989, Ottawa braved that storm—and slapped a repayment provision on that pension for taxpayers who earned more than $50,000 each year. That is, pensioners, who are already taxed on their old age pensions, must pay an additional surtax on their pensions whenever their individual net income exceeds $50,000. This year, that threshold has increased to $53,215 because of inflation.

The distribution of the $20 billion for old age pensions is fascinating. About $9.1 billion goes to households where the family income is less than $20,000. About $2.4 billion goes to recipients who live in households where the family income is more than $53,000.

2. UNEMPLOYMENT INSURANCE: Technically, the UI fund is supposed to pay for itself: premiums from employers and employees should sustain it. Last year, the fund collected $17.5 billion—and paid out $19.2 billion. In response, Ottawa reduced the unemployment insurance benefit rate for new recipients from 60 per cent of insurable earnings to 57 per cent. Ottawa also denied benefits to employees who quit their jobs or who were fired for misconduct. This year, the fund will collect $19 billion—and pay out an estimated $19.4 billion.

TRANSFERS TO OTHER LEVELS

This year, Ottawa will transfer $40.4 billion to the 10 provincial and two territorial governments. About $26.4 billion of that amount will be cash grants. Provinces receive the rest of the money through the transfer of tax points: that is, since 1977, Ottawa has lowered its personal income tax rates—and provinces have increased their rates by an equivalent amount. There are three major programs to transfer funds:

1. EQUALIZATION: these grants are cash payments from Ottawa to the poorer provinces. Ideally, those payments allow provinces to provide similar levels of service at similar levels of taxation. Three provinces do not receive equalization: Alberta, British Columbia and Ontario. The remaining seven provinces receive payments that depend on their fiscal capacity and their population. This year, payments vary from $1,587 per person in Newfoundland to $517 per person in Quebec. They will total $8.3 billion, up from $4.9 billion in 1982-1983.

2. ESTABLISHED PROGRAM FINANCING (EPF): this provides financial support to the provinces for health insurance and postsecondary education. In 1977, governments established the current funding formula: each province’s entitlement is based on its number of residents—and it escalates according to the growth in its population and in the Canadian economy. The entitlement is first met by the value of the tax points. If that is not sufficient, Ottawa pays the balance in cash. This year, the cash grants will total about $9.3 billion. Ottawa has consistently curbed the entitlement, which, in turn, has reduced the cash grant. In 1986, the federal government limited the grant’s rate of growth to two percentage points less than the rate of growth in the economy. In 1990, Ottawa froze the grant for each person at its 1989-1990 level until 1994-1995. The EPF grant now grows only because the population is growing.

3. CANADA ASSISTANCE PLAN (CAP): In theory, this ensures that Ottawa picks up 50 per cent of the tab for eligible provincial and municipal spending on social assistance and welfare. CAP funding has increased to $7.2 billion from $6.5 billion in 1992-1993. In most provinces, Ottawa has little control over the growth of its share: it simply pays 50 per cent. In 1990, Ottawa curbed the growth of its CAP payments to five per cent per year in the three wealthier provinces: Ontario, British Columbia and Alberta. Unfortunately,

MAJOR SUBSIDIES

Ottawa will spend about $13.3 billion on subsidies this year.

1. BUSINESS: $3.3 billion. Business subsidies in 1992-1993 included the following:

A. ENERGY: $137 million for the Hibernia oilfields; $353 million for petroleum incentive payments.

B. REGIONAL DEVELOPMENT:

$993 million

C. SCIENCE AND TECHNOLOGY:

$1.4 billion

D. TRANSPORT:

$391 million

2. NATIVE PEOPLE:

This year, Ottawa will spend $3.6 billion on subsidies to native people. (Total native spending, including housing and other departments, is estimated at $5.4 billion.) In 1992-1993, those subsidies included:

A. $134 million for economic development

B. $873 million for education

C. $806 million for social development

D. $263 million for band management

E. $208 million for health services

F. $620 million for capital and community services

3. AGRICULTURE:

Subsidies to agriculture will be $2.4 billion this year. Last year, those payments included:

A. $237 million for crop insurance

B. $256 million in subsidies to dairy farmers

C. $788 million in subsidies for Western grain transportation

D. $214 million in income stabilization

4. OTHER:

$4.1 billion. This category of subsidies included the following payments last year:

A. External: $428 million, including $20 million for trade promotion, $152 million for contributions to such political and economic organizations as the United Nations and

$171 million for peacekeeping. (That tab is expected to hit $226 million this year.)

B. Secretary of state: $1 billion, including $522 million for interest payments on student loans, $72 million for citizenship development and $53 million for multicultural programs.

C. Employment and Immigration: $1.6 billion, including $1.3 billion for job creation and training and $251 million for immigration programs.

welfare expenses across Canada have grown more than five per cent per year—because more people have required assistance during the recession.

PAYMENTS TO CROWN CORPORATIONS

Ottawa is handing over $4.7 billion to Crown corporations this year. That includes the following:

A. $2.1 billion for the Canada Mortgage and Housing Corp. Most CMHC funds are used for subsidies. They also provide new housing for shelters for victims of family violence, natives on reserves and the disabled.

B. $1.1 billion for the Canadian Broadcasting Corp.

DEFENCE

Ottawa will spend about $11.3 billion on defence this year. That includes the following expenditures:

A. $5.2 billion for wages, salaries and benefits for about 78,000 military personnel and 34,000 civilians.

B. $3 billion for operating costs such as fuel, maintenance and supplies.

C. $2.7 billion for capital

expenditures such as patrol frigates, the modernization of the air defence system and helicopters.

INTERNATIONAL ASSISTANCE

The tab for international assistance is $2.7 billion this year. This includes:

A. $168 million in administrative costs

B. $1.2 billion for international aid agencies such as the International Monetary Fund.

C. $1.2 billion in direct aid such as food, humanitarian assistance and scholarships.

GOVERNMENT OPERATIONS

This is the cost of running the government. It includes salaries for civil servants, capital works such as the construction of ports, and a range of programs from food inspection, police services and tax collection to the operation of airports and national parks. This year, the tab will be $20.6 billion. When inflation is taken into account, those budgets have dipped from 22.5 per cent of total program spending in 1984-1985 to 15 per cent in 1992-1993.

OTTAWA’S PLANS

Last April, Ottawa predicted that its budgetary deficit would dwindle to $8 billion in 1997-1998, largely because of the cumulative effect of its spending cuts. There is a lot that can go wrong with that scenario:

1. Ottawa expects interest rates to stay low. If interest rates rise, that would increase the cost of interest payments on the debt.

2. Ottawa predicts that the economy will grow by an astonishing 4.6 per cent after inflation next year. If economic growth remains sluggish, that would slow the growth of government revenues.

3. There could be unexpected emergencies such as another severe drought on the Prairies.

As a result, it is highly unlikely that Ottawa will meet its deficit targets—or balance its books—under the current federal game plan. □