Parliamentary Research Branch

MR-121E

BUDGETARY DEFICITS:  WHY ARE CANADIAN
AND AMERICAN TRENDS DIVERGING?

In January 1993, the Congressional Budget Office (CBO) in the United States was predicting that the American deficit would hover around U.S.$300,000 million until fiscal year 1996,(1) after which time it would increase sharply to more than U.S.$350,000 million by fiscal year 1998. When expressed as a percentage of GDP, those CBO estimates saw the deficit declining from about 5% of GDP in fiscal 1992 to just under 4% in fiscal 1995 and increasing again to 4.3% in fiscal 1998. In February 1993, the President presented his budget proposals and deficit projections to Congress. They promised a dramatic deficit decline to 2.5% of GDP by fiscal year 1996. The President attributed this to the package of spending cuts and tax increases included in his proposal. Not until fiscal year 1998 would the deficit rise as a percentage of GDP, and then only modestly.

The deficit forecast this year is even more optimistic. According to the CBO and the President’s budget proposal, the deficit should be as low as 2.4% of GDP for fiscal year 1995, about half the ratio for fiscal year 1992.

The Canadian situation stands in sharp contrast to the American. The 1993 federal budget predicted a steady decline in the deficit, to less than 1% of GDP by 1997-98, compared to the 5% of GDP ratio in 1992. Today that picture is reversed. Instead of declining, the deficit has recently risen sharply to 6.4% of GDP. For 1993-94 the deficit is now expected to be almost 2% of GDP higher than was predicted in last year’s budget.

The U.S. budget proposed by the President last year, and ultimately passed through the Congress in revised form, contained a variety of deficit-cutting measures that were to total U.S.$500,000 million over a five-year period. In the first two years of the program, virtually all these measures were to be tax increases, according to the CBO. Last year’s federal budget in Canada extended and enhanced spending cuts announced in the December 1992 Economic Statement. Those cuts were estimated at close to $29,000 million over a five-year period.

This year’s American budget offers little in the way of additional deficit cuts. By way of contrast, the Canadian budget offers a further $12,000 million of such measures over the next three years. According to these figures, it would seem that the two governments had taken broadly comparable measures this year and last. In a one-year period, however, the American fiscal outlook has become significantly more optimistic while ours has become more pessimistic (see Figure 1).

Figure 1
CHANGING DEFICIT TRENDS:
CANADA AND THE UNITED STATES
(1993 and 1994 Projections)

Fiscal Year

The Canadian plan to reduce the deficit relied upon stable debt-servicing costs thanks to the dramatic declines in interest rates, program spending that had been brought under control, revenues expected to grow at the same pace as the economy, and strong economic growth.

It appears now that program spending is not as well controlled as was thought in 1993. The budget in that year understated program spending by an average amount equal to 0.5% of GDP for every year since 1992-93, and these ratios actually understate program spending because of the recent reform of the child benefits system.

More importantly, though, earlier deficit projections relied heavily on real growth forecasts in excess of 4% per annum to generate the revenues necessary for deficit reduction. The 1992 budget assumed that growth would be 4.5% in 1993. This assumption was scaled down in last year’s budget, which, however, still predicted real growth in excess of 4% starting in 1994. The latest budget is predicting growth as high as 3.8%, but not until 1995 (see Table 1). Thus, the problem is quite evident: the federal government has been overly optimistic about Canada’s short-term economic prospects and has therefore been overly optimistic about its revenue growth.

Table 1
Canadian Economic Forecasts

In fact, revenue growth has not even been keeping pace with output growth. From 1992-93 to 1993-94, budgetary revenues fell by almost $7,000 million, even though the economy grew during that time. Much of this fall in revenue was due to one-time costs and to the introduction of the Child Tax Benefit, which converted some program spending into a tax expenditure. Nevertheless, what the Department of Finance calls its "underlying revenues" declined in one year by an amount equal to 0.4% of GDP. The 1994 budget seems to assume that some of this decline might be due to the slow recovery from the recession, and as such be temporary. But it might also be partly due to an increasing underground economy and as such be permanent, or at least long-lasting.

Today Canada has a low inflation rate by historical and international standards. Since our tax system is not fully indexed to inflation, the government is now losing some of the revenues it previously collected from the "inflation" tax, a tax which can be quite lucrative when high rates of inflation are combined with a progressive tax system. The Department of Finance estimates that a one percentage point drop in inflation results in an immediate increase in the deficit of just under $1,300 million.

While revenues tend to be linked directly and positively to nominal GDP, spending programs do not move proportionately. Few are fully indexed to inflation. Those that are demand-driven, such as income support programs, increase as economic growth slows. Other programs can operate without direct regard to inflation or nominal GDP in the short run. Thus, an unexpectedly low nominal GDP means unexpectedly low revenues together with unchanging or higher expenditures and consequently unexpectedly high deficits.

On every front save one, the economic indicators forecast in this year’s budget contribute to higher deficits. Forecast growth rates have been scaled back for three years at least and the cumulative effect of this is substantial. The unemployment rate is now expected to decline at a slower pace. And lower inflation, although good for the economy in the long run, might raise the deficit in the short run. The only optimistic note for the deficit in the 1994 budget is with respect to short-term interest rates which, given recent developments in the United States, might not prove attainable.

On the other hand, American economic developments are more conducive to declining deficits. Economic growth is better than was expected last year, especially due to the revised figures for 1992, which doubled that year’s growth rate. From one budget to the next, American growth over a three-year period is expected to improve by 1.5 percentage points while Canadian growth is expected to decline by 2.7 percentage points. In addition, the American unemployment rate is declining more rapidly than its Canadian counterpart. In 1995, the American unemployment rate is expected to be 18% lower than in 1992, while in Canada it is expected to be only 6% lower. This year’s American budget foresees short-term interest rates lower than were forecast last year and well below Canadian rates. The only unfavourable development on the U.S. economic front is the expected rise in inflation; however, as was argued above, this might actually reduce the deficit in the short term.

From one budget to the next, American total spending is forecast to decline as a percentage of GDP, unlike the Canadian projections. This is true even though last year’s deficit- cutting exercise in the U.S. reduced expenditures very little in the short run. On the other hand, American revenues are growing as a percentage of GDP, again in contrast to developments here.

In the 1980s, American budgets became notorious for their excessively rosy forecasts. Recent Canadian budgets seem to have caught that same disease. The diverging trends between Canadian and American deficits portrayed in Figure 1 are largely a reflection of adjusted economic forecasts, becoming more optimistic in the U.S. and less so here.

Also evident from Tables 1 and 2 is the fact that the American economy is better at achieving a low rate of unemployment and in reducing that rate as the economy recovers from recession. This is significant because, given the importance of social programs in Canada, poor unemployment performance has a strong impact, putting upward pressure on government spending.

The 1993 real growth and inflation projections are averages for the 1995 to 1998 period. The 1993 budget forecasts the unemployment rate at 7.5% at the end of 1998. Interest rate forecasts are for short-term rates.

Table 2
American Economic Forecasts

(1) The American fiscal year 1996 refers to the 12-month period ending 30 September 1996. The Canadian fiscal year 1995-96 refers to the 12-month period ending 31 March 1996.