GLOBAL ECONOMICS COMMENTARIES

Patrick Grady
"Getting Over Budgetary Paralysis Induced by Fear of the Deficit"
May 8, 2003.

The Liberal government has pursued an approach to budgeting designed to prevent a recurrence of deficits and to reduce the burden of the public debt. Its overwhelming success has restored the confidence of the public in its fiscal responsibility. After six consecutive years of budgetary surpluses, even the most skeptical Canadian must by now be convinced that huge deficits and ballooning debt are unlikely to recur. Unfortunately, however, like many other good things that have served their purposes, the government's approach to budgeting is increasingly getting in the way of good expenditure management by artificially limiting budgetary choices and by making the public accounts less transparent. In effect, the Canadian government has become a victim of budgetary paralysis induced by fear of deficits.

The idea behind the government's prudent approach to budgeting is quite simple, which is perhaps why it has been so successful in exorcizing the demon of deficits. Instead of basing its fiscal projection on its own forecast, which had become somewhat suspect over the years, it uses an average of private sector forecasters and conservatively makes allowances for prudence and contingencies to guard against the emergence of deficits. This is the forecasting equivalent of wearing both a belt and suspenders at the same time, which while it may not be the most elegant way to dress, certainly holds your pants up.

The large surpluses that have been generated have presented the government with something of an embarras de richesses at the end of the fiscal year. What to do with them has been the enviable problem facing the government since 1997-98. If the government does nothing, all of the surplus goes into debt reduction. While that might be the preferred outcome for fiscal conservatives who want to get the debt-to-GDP ratio down as low as possible, it really grates on a Liberal government committed to a more balanced approach to budgeting that would really like to spend some more money.

The government's solution to this perennial budgetary problem has been to spend large chunks of money near the end of the year in creative ways that prevent the surplus from being as large as it otherwise would be. While the government has never published the exact amount of such spending, a good idea of its proximate order of magnitude can be obtained from the current year spending recorded in recent budgets and statements (see table). This amount, which admittedly provides something of an overstatement of year-end spending since it also includes some money for initiatives announced earlier in the year such as the response to 9/11 and agricultural assistance, totaled a whopping $28.9 billion over the last six fiscal years for an average of $4.8 billion per year. In this February's legacy budget alone, the amount reached a record $6.8 billion. Such hefty year-end spending is certainly a way to keep unanticipated government revenues from going to debt reduction. But it is not a very good way to ensure that the government gets the best value for the taxpayer dollar.

The main problem is that there are relatively few things on which the government can spend large sums of money at the last minute and that they all suffer certain drawbacks. The vast majority of more desirable spending and tax cutting options are automatically ruled out at the offset because they usually require a certain lead time and multi-year spending horizon. Most spending programs can not be turned on and off like a tap.

A second problem is the fog that such year-end spending infuses into the government's accounts. Anyone who doubts this is a problem is referred to the table in The Budget Plan 2003 (p.68) that sets out federal support for health care from 2003-04 to 2007-08. Its four footnotes explaining the timing of payments to third party trusts make it almost incomprehensible to anyone who would like to compare what the government actually did with what was recommended by the Romanow Commission on the Future of Health Care in Canada.

The largest amount of year-end spending, or $8.7 billion, has gone to increased payments to the provinces under the Canada Health and Social Transfer. This raises accounting issues about the appropriate recording of the timing of public spending. While the federal government books the spending in the year it is announced, the provinces have the option of taking the payment into their income over the proposed periods set out in the budget, which has usually been three years. This can result in a disconnect between the spending of the two levels of government.

Ignoring this accounting issue, an increase in the CHST would probably be fine with most Canadians if they could be sure that the money would actually be spent on health. However, money that drops into provincial budgets at the end of the year, like manna from heaven, can sometimes be used to reduce debt instead of to increase health spending (there are grounds to believe that this is the case for Ontario which booked its 2003 allocation in 2002-03 and for Nova Scotia and Newfoundland which are taking theirs in 2003-04). Spending on health requires a longer lead time and some guarantee that the money will continue to be available, particularly if more staff must be hired to deliver the services. This same type of criticism applies with equal force to the promised $2 billion for health that will be transferred at the end of the current fiscal year provided that the Minister of Finance determines in February 2004 there is a sufficient surplus above the Contingency Reserve.

Another important vehicle for year-end spending sprees is the foundation or trust. Since 1997, the government has transferred $7.5 billion to ten foundations. The largest of these foundations are: the Canada Millennium Scholarship Foundation, which was given $2.5 billion to provide scholarships to post-secondary students; the Diagnostic/Medical Equipment Fund, which was granted $1.5 billion to spend on staff training and equipment to improve access to publicly funded diagnostic services, and the Canada Foundation for Innovation, which was allocated $1.4 billion to encourage innovation.

While the Auditor General has yet to qualify her opinion, she expressed concern about the treatment of transfers to foundations in her Observations on the 2002 Public Accounts of Canada. Her main point is that the money should be treated as spending in the year when it is actually spent on its ultimate intended purpose and not when it is transferred. She has also voiced legitimate concerns about accountability and transparency. That she is not the auditor for these foundations and trusts has added to her worry.

The government responded to the Auditor General's criticisms in the 2003 Budget. Its defence of the continued use of foundations and third party trusts is based on the Treasury Board's new Policy on Alternative Service Delivery, which is designed to try to subject these vehicles to the normal rigours of government financial management procedures. However, the very fact that the government feels that it is necessary to try to do this is evidence of the unsatisfactory nature of these vehicles for delivering government programs. In effect, the only reason the government is using them is to get around accounting rules that require spending to be booked when the government actually spends the money.

It is ironic that the government is moving to introduce full accrual accounting at the same time it is dismissing the Auditor General's concerns about its use of foundations. One of the main advantages of full accrual accounting is that it produces government revenue and expenditure figures that more closely correspond to the underlying economic activity. For instance, income taxes are adjusted to correspond to tax liabilities in the fiscal year in question, which are generally agreed to be more closely tied to the spending and saving decisions of households. Yet the money allocated for federally funded scholarships is still counted when it is transferred to the Millennium Scholarship Fund and not when it is given to the students who will actually spend it.

The movement to full accrual accounting without the proper accounting treatment of year-end foundations and trusts will actually give the government even greater flexibility to reduce the surplus at year end. Now it will be able to add announcements of retroactive tax cuts for a tax year just ending to its already ample repertoire of year-end accounting tricks designed to lower the deficit. Unfortunately, such retroactive temporary tax cuts have little or no effect on the behaviour of economic agents and are thus not a very effective way to stimulate the economy.

The government needs to get over its fear of deficits resulting from year-end surprises and to stop wasting so much time and much energy tinkering with the public accounts at the end of the fiscal year. Instead it needs to focus back on the more fundamental issue of making the most appropriate spending and taxing decisions. It makes no sense to have a budgeting approach designed to avoid small and temporary deficits if it results in bad spending decisions and a needlessly complicated set of books.

The government needs to set a target for the budget balance over a period of several years. If the government runs a small deficit in one year, it should be allowed to make up for it in subsequent years. Alternatively, if the government runs a surplus that is larger than desired, it should be able to spend the money in the future even if it means running a small deficit. There should be nothing sacred about avoiding a deficit in each and every year.

On the other hand, it is possible that the public has been so traumatized by past deficits that it is unwilling to tolerate the surprise emergence of even a small deficit. In this case, the government will have to seek some other mechanism to reassure the public of its commitment not to tolerate deficits.

One possibility is some form of balanced budget law that will require the government to take action to reverse any deficit within a reasonable period of time. All of the provinces except Newfoundland and Prince Edward Island have experimented with some form of balanced budget legislation during the 1990s with greater or lesser degrees of success.

The thing that it clear is that the government needs to stop letting its spending decisions be driven by its deficitophobia.