The federal government announced that it will introduce balanced budget legislation as part of its upcoming 2015 Budget. Here is the key text:

If a Finance Minister posts a deficit outside of extraordinary circumstances, an automatic operating freeze would go into effect and the salaries of Ministers and Deputy Ministers would be reduced by 5%.

Some of my initial reactions follow:

Timing: The proposed law will apply to posted deficits (i.e., those incurred after the government’s books are audited and closed for the fiscal year). This is stricter than some other balanced budget laws that only prohibit the Finance Minister from forecasting a deficit rather than incurring one.

Exceptions: Under the law, deficits are allowed, but only in “extraordinary circumstances”, so this definition will be crucially important. While it makes perfect sense to build-in escape clauses for fiscal rules, there are practical difficulties nonetheless.

Economic performance is hard to gauge in real-time and official data are fallible. For example, preliminary GDP data are often revised after the fact — sometime heavily — and they could reveal that a recession was worse than originally-thought, and thus, that a deficit was warranted in hindsight.

Better budget rules can be designed in ways that take explicit account of economic performance. But even here, estimates of the output gap (i.e., the difference between the economy and its potential capacity) and of cyclically-adjusted budget data (that adjust budget results for economic performance and that might make a better balance budget target) are notoriously noisy, and because they are not observable, could be debated indefinitely.

Simpler economic indicators, such as the unemployment rate that are less exposed to large revisions could be used, but they too have problems. Recently, there were communication difficulties for monetary policy-makers in the US and the UK, when their unemployment rates fell, in part because workers dropped out of the labour force not because of underlying economic strength. In that case, this single indicator failed to give a good read on the actual state of the economy. Combining multiple indicators might help, but this comes at the cost of increased complexity and communications difficulties.

Penalties: To affect behaviour, penalties are needed when rules are broken. In this case, the ”œstick” is that salaries will be reduced for Ministers by 5 percent — following a general approach that has been used provincially (in British Columbia, Manitoba, Ontario and Nova Scotia). What seems to be new here is that previous rules applied only to the narrower subset of the elected Executive Council. However, this rule would apply more broadly to include Deputy Ministers. Many of these unelected senior officials (particularly those in line departments or smaller agencies) would be made individually responsible for a deficit in which they likely have played only a tangential role. This seems excessive.

Required response: In this law, deficits would trigger an automatic operating freeze. This feature also looks new. Requiring spending restraint is one option, but budgets can be balanced with corrective actions on either the spending or revenue side, and preferably both. In fact, my analysis finds that most successful fiscal consolidations in Canada in recent decades used both spending and revenue actions (in a roughly 2-to-1 combination), rather than relying entirely on one side of the ledger.*

One implication of this law’s automatic spending response is that deficits are due to excessive government spending, rather than the government collecting insufficient revenue. This sets up a predisposition for smaller government over the long term.

It’s helpful to require a timeline for corrective fiscal actions, but providing a playbook for future governments that includes a single predefined response is probably not. The law should exempt certain essential services from automatic budget cuts.

Effectiveness: Will it work? Too early to tell, without additional details (as well as a crystal ball). I’ve done some research on fiscal rules in Canada and I currently think that, if they are well designed, rules can often help improve fiscal choices and outcomes.

However, this is not the consensus view of Canadian fiscal policy pundits and fiscal rules certainly do not guarantee better budgetary outcomes. Ultimately, such a complex issue shouldn’t be reduced to a simple question like fiscal rules: are they good or bad? Careful research can only really help us better understand the conditions under which rules tend to help and not. The fiscal and economic context matters a great deal, as does the design of the rule.

Big Picture: Is now the right time for federal balanced budget legislation and are we focused on the right fiscal target?

Historically, rules were often used in bad fiscal situations and were part of credible, corrective fiscal strategies. But they have also been used after the ”˜fiscal war was won’ to lock-in budgetary gains and bind future governments, which seems to be the intent here.

If the federal fiscal situation is sustainable over the long-term — as research by both Finance Canada and the PBO suggests — then modest and persistent deficits are not a bad thing. The government could run deficits in normal times and still enjoy a declining debt-to-GDP ratio. In that case, what’s needed is not to shift attention to the short-term annual budget balance, but rather to shift it where it belongs: on the longer-term issue of having a sustainable debt burden as a share of the economy.

* Some have argued that a key difference is that monetary policy tends to be more accommodative of spending cuts versus revenue increases, as the former may be viewed as more permanent and may generate less temporary pressure on headline inflation than the latter.

Photo by Alex Guibord / CC BY-ND 2.0