The federal budget represents the most important fiscal event in Canada. It not only provides Canadians with a blueprint of expenditures and taxes for the upcoming year, it presents a short-term outlook regarding the nation’s economic prospects and the government’s financial position.

The budget is the outcome of a long process, involving legislation, government officials, professional economists, business and labour. The budgetary process has evolved over time in response to economic and financial circumstances. Since 1993-94, the Pre-Budgetary Consultations (PBC) process has allowed for the active and public participation of Canadians from all walks of life, leading to enhanced transparency. The PBC process is now well known by Canadians and they have demonstrated their interest by their active participation. Each year,²² the House of Commons Standing Committee on Finance travels across Canada to consult individuals, business, labour and other groups to ensure that it is exposed to the widest range possible of public opinion in Canada. This increased transparency has even been internationally recognized and applauded. In commenting on the process, the OECD said that: “The Pre-Budget Consultations have been an important element in opening up the budget process and creating an atmosphere where the public feels it can have an input.”²³ Canadians have seen the concrete results of that participation through the ultimate incorporation of many of the Committee’s recommendations in budget initiatives.

I for one want to commend, you, the Committee, and the Minister of Finance and the government for listening through this pre-budget consultation process. We don’t always get everything we would like to get, but this is the dialogue that we would encourage. Peter Smith

This year, the events of September 11 only served to heighten our perception of the budget-making process in general, and pre-budget consultations in particular, as a balancing act. Canadians from all walks of life told us that greater attention to national security is their clear priority, but that we must not neglect the future. During our hearings in Vancouver, C.T. (Manny) Jules, chair of the Indian Tax Advisory Board and member of the Kamloops Indian Band, eloquently summed up the dilemma facing the Committee:

This is one of the reasons I came here to this Committee. I feel the Finance Committee has one of the toughest responsibilities of any federal committee, … given the events of September 11, what are we going to do right now? We’ve got all of these requests, and It’s like what I went through when I was a chief: ‘Manny, what are your priorities going to be? You’re a chief, so what are your priorities? How are you going to change the world so that your people can live better?’ That’s the responsibility of each and every one of you sitting here: how can we continue to have Canada remain strong and how can we have Canada remain a true partner in terms of international issues dealing with the economy or dealing with you name it?

Influencing the Budgetary Process

Not only has the budgetary process changed in the sense that public participation is now actively encouraged, it has changed in the manner in which the budget establishes its own set of constraints, namely the time frame over which it applies, the manner in which data are presented and the targets it sets for fiscal policy. These were crucial elements in the government’s battle to eliminate deficits and consequently stop the debt from growing. These changes were readily accepted by the Canadian public, as were the budgetary measures. The key elements to success can be summarized by the elements of the Debt Repayment Plan:

• Two-year fiscal plans based on prudent economic planning assumptions;
• The inclusion in the fiscal plan of an annual Contingency Reserve to cover unexpected expenses;
• The use of the Contingency Reserve, when it is not needed, to pay down the public debt; and
• More recently, the promise to announce each fall how much of the projected surplus in excess of the contingency reserve would be used to pay down the debt as well as the explicit inclusion of an economic prudence amount.

Another important aspect of this process is the fall Economic and Fiscal Update. This document contains the most up-to-date economic and fiscal data coming from the Department of Finance, based ultimately on a consensus view of private sector economic forecasts. In the past, it was at this time that the Minister of Finance established the deficit target for the next year. Together, these reforms were meant to improve the budget-making process so that the government could deliver budgets better able to address the economic and financial realities of Canada.

Lessons from the Former Budget-Making Process

There has been a long tradition of budget secrecy in Canada. The unveiling of the government’s fiscal policy intentions took place on budget day, often without any public inkling as to what the budget may contain. This was especially true with respect to tax matters. This secrecy also affected the budget-making process. While a variety of groups met on a one-on-one basis with the Minister of Finance prior to the budget to plead their case, this was all done behind closed doors. This stands in sharp contrast, for example, to the tradition in the United States where the budget is debated in public over a prolonged period of time.

The failed attempts of the Government of Canada to control budgetary deficits in the 1980s and early 1990s was, to some extent, due to the older, more secretive, budget-making process. Budget-makers seemed incapable of providing credible forecasts. The reliance upon five-year planning horizons enabled governments to present rosy scenarios for the future while they were failing to meet their short-term commitments. Deficit projections were not met even in periods of strong economic growth, the justification being that interest rates were higher than had been anticipated. As a result, in good times as well as bad, the debt grew at unsustainable rates. Put simply, budgetary forecasts were never realized, hurting government credibility and ultimately leading to higher interest rates as investors demanded higher risk premiums to invest in Canadian debt. In other words, the justification for missed forecasts — higher interest rates — had become the result and not the cause of ongoing deficits.

The Need for Credibility in the Face of Heightened Uncertainty

The 1990s showed just how important credibility and fiscal discipline were for our overall economic well-being, with Canada enjoying particularly strong growth in the last third of the decade, just as the government’s spending cutbacks were beginning to bear fruit in the form of surpluses. We must not lose sight of this hard-earned lesson in the wake of September 11. The Committee believes the short-term need for increased spending on security and the military, with a strong emphasis on security, actually complement these longer-term objectives given the new economic context. The productivity gains of tomorrow depend on a secure business environment today, as the events of September 11 clearly demonstrate. Tomorrow’s productivity gains also depend on maintaining a commitment to balanced budgets, the $100 billion worth of tax cuts announced last fall, increased health care spending and efficient health care delivery and medium-term debt-reduction targets.

The progress that we have made over the past decade in strengthening our economic foundations is remarkable. And it should stand us in good stead, no matter what short-term turbulence and uncertainties we face. David Dodge

A cornerstone of the government’s fiscal credibility has been the creation of planned contingency and economic prudence reserves to cushion against unforeseen changes of the kind now being experienced. The current crisis demonstrates the wisdom of this policy because these reserves have provided the government with the necessary breathing room to respond to current events: living up to our NATO commitments, responding to challenges in the airline industry, all without incurring a deficit and undermining our hard-earned credibility. It is, however, misleading to think of these reserves as “money in the bank” since they are really just anticipated or forecast surplus funds and not something that can be spent without risking a deficit.

To the extent that new spending on security and defence could lead to a deficit, the government must balance this new spending with spending cutbacks elsewhere. The Committee recommends that the government make a firm commitment to balanced budgets.

I would say stand pat on fiscal policy and let the Bank of Canada deal with the short-run confidence issues. David Laidler

The Benefits of Program Review

It is worth recalling just how precarious Canada’s financial situation was in the early 1990s and why it is so important that we again work hard to avoid a deficit today, especially after many years of fiscal retrenchment and as the consequent sacrifices imposed on Canadians were beginning to bear fruit in the form of a reduced tax burden and re-investment in health care and measures in support of innovation. During the 1980s, governments faced almost unrelenting bad fiscal news in the form of missed deficit forecasts and a growing public debt. In 1990, the government attempted to control expenditures and restore credibility by implementing the Expenditure Control Plan. This plan affected only 60% of program spending and could not prevent the $42 billion deficit in 1993-94. In 1994, the government recognized that it had to act decisively as there was almost a “crisis atmosphere”²⁴ with respect to Canada’s financial position. It decided to establish, and maintain, hard budget constraints via short-term deficit-to-GDP targets. The biggest test of this resoluteness came as a result of the 1994-95 Mexican peso crisis, an event that had a significant impact on Canadian financial markets, the Canadian dollar, and the economy. The government reacted to these events in the 1995 budget, setting the stage for the complete turnaround of its fiscal position and helping the country weather the Asian economic crisis. A key element of this turnaround was the Program Review exercise that set the stage for spending cuts, based on the following six questions, or tests; all of which are even more pertinent now that the country faces a crisis of a different sort:

• Public Interest Test: Does the program area or activity continue to serve a public interest?
• Role of Government Test: Is there a legitimate and necessary role for government in this program area or activity?
• Federalism Test: Is the current role of the federal government appropriate, or is the program a candidate for realignment with the provinces?
• Partnership Test: What activities or programs should or could be transferred in whole or in part to the private or voluntary sector?
• Efficiency Test: If the program or activity continues, how could its efficiency be improved?
• Affordability Test: Is the resultant package of programs and activities affordable, given the government’s overall fiscal objectives? If not, what programs or activities should be abandoned?

Increased spending on security is essential, but we believe it can be offset by reduced spending on less important programs. New initiatives can be postponed until a budget surplus has been restored to a more adequate level …. . We would benefit substantially from some of the elements that have been proposed for the innovation agenda. But we feel that there are ample grounds at the moment for postponing the launching of these initiatives until the budget surplus is in better shape. David Paterson, Executive Director, Canadian Advanced Technology Alliance

This review offered an opportunity to gauge the pertinence of programs to the public interest and provided the basis for the budget cuts contained in that, and subsequent, budgets. The government responded with some deep spending cuts. Nevertheless, the public mood has clearly come to side with the government’s actions. The Committee has in the past recommended that the federal government strive to limit program spending growth to the rate of inflation plus population growth. Program Review is an important tool for achieving such a goal.

The Committee recommends that the government follow the Program Review process while maintaining a balanced budget in the face of new priority spending.

In 1993, the federal government announced its desire to reduce the fiscal deficit to 3% of the GDP, as an interim target. Many analysts at that time considered this decrease to be too slow or too easily achievable. In the crisis atmosphere of 1994, others considered it unattainable, especially in light of past experience. Nevertheless, the government remained committed to its targets, even in the face of this economic turmoil.

It was widely acknowledged that the 3% deficit-to-GDP target was only an interim one and that the ultimate goal of the government was to balance the budget. However, by sticking to two-year rolling targets, the government was able to provide realistic and achievable goals. It also provided clear benchmarks against which the government’s performance could be judged, allowing Canadians to know if it was going off track. In the words of the OECD, by this approach, “ … the government had — by design — created heavy potential costs for itself if it did not succeed.”²⁵ This enhanced the commitment to the targets and enhanced the likelihood of success.

Limiting its forecasts to the short term also increased the probability of success. The odds of success were also improved by employing what some pundits referred to as “a liberal dose of conservative assumptions.” This was achieved by employing prudent economic assumptions, i.e., being more pessimistic than the projections of private sector economists. By assuming that interest rates would be as much as 100 basis points higher than forecast by private-sector economists, the government inflated the projected budgetary deficit through higher debt servicing costs. In addition, this procedure lowered forecast growth rates, implying higher unemployment, higher government spending and lower tax revenues.

New Challenges Demand New Approaches

In its last pre-budgetary report, the Committee argued that the new economic environment demanded a new approach to budget making that better suited a world of rapidly expanding budget surpluses. The short-term focus of previous budgets was designed primarily to restore credibility to the federal budget, something that has largely been achieved.

While the events of September 11 and the possibility of a recession and deficit could be seen as a reason to retain the two-year rolling targets, it is worth remembering that most forecasters expect the economy to begin recovering by the middle of next year and return to trend or capacity growth by 2003. This suggests the long-term environment projected in the 1999 and 2000 budget documents is intact; a view apparently shared by Bank of Canada Governor David Dodge, who in a recent speech to the Greater Moncton Chamber of Commerce noted that “it is important that we look through the short term to the longer-term trends and potential of our economy. The first decade of the twenty-first century will continue to bring to Canada and to the rest of the world important technological changes … . This transformation can be expected to raise the potential of our economy to grow and to generate income gains in the decade ahead … . In addition, Canada has made great progress over the past decade in strengthening its economic foundations: low inflation has been firmly established; the fiscal health of governments has been largely restored; and Canadian businesses have undertaken major restructuring.”

In other words, we should continue to look to productivity-friendly initiatives to ensure that long-term prosperity is achieved. New short-term priorities may cause us to detour somewhat, but they should not cause us to lose sight of that longer-term objective.

This means a firm commitment to the government’s plan, including such elements as:

• Cutting taxes by $100 billion over five years;
• Injecting $23.4 billion into health care over the same period;
• Continuing to support innovation by funding the CIHR and the granting councils; and
• promoting investments such as the Canada Foundation for Innovation, the Millennium Scholarship Fund and the Chairs of Excellence.

 As we noted in our report, Productivity With A Purpose: Improving the Standard of Living of Canadians, “productivity growth that promotes a higher standard of living does not arrive overnight. The results will be seen only after some time. Thus it will require that the government look far into the future, and resist the temptation to seek quick fixes.” We also stressed in that report that productivity is really the result of many types of investments. These investments not only produce results far into the future, they will only work if they are maintained into the future as well. All of this indicates that we should fix our gaze beyond today or tomorrow and look instead further into the future, in terms of desired effects and in terms of program commitments.

I think my colleagues would support me in saying that one of the problems that we often see is that there isn’t enough long-term planning. I’m not talking just in terms of fiscal budgeting fl the current government has made strides to try and do that on a longer term … . I think that’s what needed in this country. We [also] have to look at our [physical] infrastructure because it’s not a case of whether or not we’re going to be reinvesting in our infrastructure … . It’s a case of when and how much. Michael Atkinson

Beginning with the 1999 Economic and Fiscal Update, the Minister of Finance has presented five-year estimates of the planning surpluses, arguing this would enhance the policy debate concerning future fiscal policy. These estimates included, for example, the estimated costs of the government’s tax-reduction plan as well as its re-investment in health care and other social programs. However, the Minister also said it would continue to take decisions only within the context of rolling two-year horizons, i.e., its planning horizon will continue to be two years. It considered longer-term commitments to be subject to too much risk, preferring instead to leave room for greater flexibility in the event of changing economic circumstances.

While the Committee is broadly in agreement with this approach, it is concerned that the May Economic Update employed only two-year fiscal projections. The Committee feels that the five-year estimate of surpluses for planning purposes presents a framework within which the budgetary debate can take place. It also provides an opportunity to make the government’s longer-term intentions known. Fiscal measures would, however, only be enacted if the economic and fiscal position permits. The Committee also feels that the government must make decisions within the context of a five-year instead of two-year horizon.

Businesses would have a clear sense of the government’s intentions during the next five years and could plan accordingly, making the kind of investments that enhance productivity and lead to a higher standard of living.

Notwithstanding the Committee’s preference for a five-year planning horizon, we recognize that we are experiencing unique circumstances. The immediacy of our security needs requires a special focus on the near term and we recommend that the upcoming budget take such a view.

Another important element in the long-term approach should be a renewed and dedicated effort to reduce the country’s debt-to-GDP ratio. This, after all, is the legacy of past budgets. It looks far back into our fiscal history and provides a summation of the consequences of that fiscal history. The large size of the debt reminds us of an era when government did not adopt firm targets and consequently mortgaged the future of subsequent generations.

While there has been improvement, Canada’s total government net debt (i.e., federal, provincial and municipal debt) as a share of GDP remains well above that of the United States, as can be seen in Chart 13.

So far, the federal government has been reluctant to establish an explicit debt-to-GDP ratio although in last fall’s Economic Statement and Budget Update, it promised it would announce each fall how much of its anticipated surplus over and above the $3 billion set aside in the contingency reserve would go towards debt reduction. In the absence of targets, we have been left merely with projections and a commitment to, at a minimum, balanced budgets. While important especially in light of current events, this commitment is not, by itself, a guarantor of sound fiscal policy in the long-term, especially since it appears that the contingency reserves for this year and next will be used for increased spending on security and the military, leaving little if anything for debt reduction. Unfortunately, there is no consensus on what constitutes an optimum debt-to-GDP ratio. Nevertheless, it is important that Canada’s debt ratio fall in relation to the United States and other major industrialized countries.

We recommend that the government publish in each budget an analysis of debt trends in G-7 countries.

The arguments for paying down the debt are very simple. It is unfair to leave future generations with a high tax burden to service the debt, especially since the baby boom generation which incurred it and blew it on consumption is about to leave productive employment and retire. The very high per capita debt service charges faced by working Canadians in a few years will require even higher taxes … than they do now and thus decrease the incentive to work, save, invest and take risks. Herbert Grubel, Professor Emeritus, Department of Economics, Simon Fraser University

The Committee further believes the contingency reserve should be more than just a financial safety net: it should be an integral component of debt reduction. Indeed, it should constitute a guaranteed measure of debt reduction. We recommend that any time the full amount of the Contingency Reserve is not available for debt reduction, the difference should be added to the Contingency Reserve of the following year. This approach provides the government with a certain amount of flexibility in any given year but reinforces the debt-reduction priority. As a result, the past deficiencies of longer-term planning horizons can be avoided while at the same time providing Canadians with a longer-term blueprint of the government’s intentions.

The private sector has demonstrated its ability to provide credible projections about the state of the economy, notwithstanding recent events. It has sufficient capacity to provide a wide range of projections, each of which can be judged for accuracy against the performance of other economic forecasters. We recommend that the Department of Finance continue to use the private-sector consensus forecast for its own economic projections. This practice goes a long way towards addressing the criticisms of those who believe the government hides the true extent of its budget balance so as to dictate the parameters within which fiscal policy is debated.

The Committee applauds the government’s commitment to use un-utilized contingency reserves for debt reduction. The Committee also supports the government’s commitment to announce each fall how much of the anticipated surplus over and above the contingency reserve will be used to pay down the debt.

Program Review/Productivity Covenant/Regulatory Audit

Program Review was launched in 1994 when the federal government faced a financial crisis, rapidly growing debt and debt service charges. It was implemented within the context of program reductions designed to meet the needs of the 1995 budget — to reduce spending on certain programs by 5% to 60% over the following three years.

While this type of assessment is almost always valuable, the struggle against terrorism demands a quick response, the kind that cannot necessarily wait for the Program Review process to run its course. The government will have to continue to increase spending on security, defence and assisting certain key industries, in addition to what has already been provided. At the same time, and notwithstanding the economic slowdown and widespread calls for maintaining fiscal integrity, the government is still under a great deal of pressure to initiate a variety of new programs, dealing with social concerns as well as physical infrastructure, health care, research and development and others.

While the Committee does not automatically rule out such spending initiatives, it believes they must meet the very strict standards set out above. Spending programs — including security and defence spending — should have to be justified on a regular basis. Simply because they were required at one point in time does not mean that the original justification is still relevant or useful. The Committee recommends that any new spending initiative be subject to the rigorous and detailed tests of the principles of Program Review.

In our view, program spending should also support productivity growth. A good example relates to the use of regulations to achieve certain government goals. Regulations can be effective substitutes for government spending programs. However, the major costs of regulation are borne by the private sector, not the government and hence government committed to budgetary controls might not be as rigorous with regulations. In its 1999 report Productivity with a Purpose: Improving the Standard of Living of Canadians, this Committee recommended that these regulations be assessed in the same way as new programs. The government should specify the justification for the regulations (what they mean to accomplish), the total costs (administrative, compliance and behavioural), and the alternatives to regulation. The government should only proceed where regulation is the best alternative and where the benefits clearly exceed the costs. If they do not meet this test, the regulations do not improve living standards and should be rejected.

The Committee recommends that the federal government initiate a regulatory audit of all regulations to ensure relevancy and benefit of regulations in our current context. This audit should include a clear process and schedule for the elimination of undesirable regulations.