A number of public finance challenges, both immedi- ate and longer-term, are common across G7 countries. For example, all G7 countries face increasing pressures from population aging, particularly after the end of this decade, on both their structural economic perform- ance and their finances. But, while confronting this com- mon challenge, the extent of the demographic pressure varies considerably across G7 countries, as does the state of their public finances.
By the mid-1990s, Canada had both one of the most severe fiscal problems among the G7, and a sluggish eco- nomic performance. Ten years later, Canada: is the only G7 country in surplus (eight consecutive surpluses); has paid back over 10 percent of its outstanding debt stock; has the lowest net government debt (as a proportion of GDP) in the G7, has an actuarially balanced public pen- sion system (for the next 75 years based on demograph- ic trends similar to the US); and, has been one of the top economic performers among industrial countries over the last decade.
My focus here is on the factors leading to structural deficits in the 1970s in Canada and elsewhere in the G7, the conditions supporting aggressive Canadian fiscal policy reforms in the mid-1990s, and the possible G7 lessons from these Canadian public finance experiences.
The rise of structural fiscal deficits in Canada was heavi- ly influenced by developments in productivity growth and interest rates, and the policy responses to them.
By the 1970s, after two decades of strong productiv- ity growth, which contributed to healthy public finances, Canadian governments began to substantially expand social programs. In the process, they effectively built in an expenditure elasticity significantly greater than unity, one that anticipated a continuation of rapid productivity growth interacting with a progressive income tax system. Maintaining balanced public finances presupposed ongoing fiscal dividends from strong productivity growth.
Unfortunately, this ramping up of government expen- diture programs coincided with a significant ramping down in productivity growth. For example, business sector productivity growth, which had averaged 4.3 percent annually in Canada over the 1950-to-1970 period, declined to 2.4 percent average annual growth in the 1970s and fell further to 1.2 percent in the 1980s.
Therefore, while spending was now structurally designed to grow in antic- ipation of strong productivity and related revenue growth, this did not materialize and thus rapidly increas- ing operating deficits ensued. Although sometimes advanced as a factor, it is not obvious that the intro- duction of indexation in the tax sys- tem added structurally to this structural fiscal problem, although the absence of indexation would clearly have provided fiscal savings.
The 1970s were also the decade of oil price shocks. These impacted the fiscal positions of all G7 countries, directly through their sustained stagflationary impacts and indirectly through the policy decision of central banks, particularly the US Federal Reserve Board, to aggressively employ monetary policy in the early 1980s to shake out the resulting inflation and inflationary expectations. This not only led to a sharp recession that affected all G7 countries, particularly Canada and the US, but also to prolonged high nominal and real interest rates that impacted on the dynamics of debt. This negative debt dynamic interacted aggressively with operating budget deficits. The effect of this unstable debt dynamic was particular- ly prevalent in Canada, where interest rates remained high over a sustained period for a number of reasons includ- ing the transition to low inflation con- sistent with the shift to inflation targets in the early 1990s.
The upshot of all this was an unbroken string of deficits beginning in the early 1970s. And, despite ongo- ing efforts to rein in the fiscal problem in the late 1980s and early 1990s, the debt-to-GDP ratio tripled and the debt- servicing burden rose even more rela- tive to the 1970s.
Why then, after 27 consecutive years of deficits, was the Canadian federal government not only able to balance the books in 1997-98 but to dosoinawaythathasledtoeight consecutive fiscal surpluses through 2004-05? Clearly, the pivotal event was the 1995 budget. What is worthy of further elaboration, however, is why the 1995 budget succeeded in implementing a fiscal consolidation package of sufficient size and struc- ture so as to achieve these results, and what fiscal lessons can be drawn from this experience?
In retrospect, from the experience of a number of countries including Canada, there appear to be several fac- tors that are crucial to achieving a sus- tained fiscal turnaround:
Get the government and the public both focused on the longer- term implications of the fiscal challenges;
Make the fiscal package big enough to do the job;
Don’t wait for better economic times to make the adjustment: better fiscal policy will ”œcrowd in” private sector growth;
Cast the fiscal reform net broadly: do as much as possible on the long-term fiscal challenges as quickly as possible;
Have a strategy for success: both how to sustain the surplus and deploy the fiscal dividend.
In this regard, it is worthwhile exam- ining more fully these five factors in the context of the Canadian experience in the mid-1990s.
First, there was a shift in the nature and intensity of the public debate in 1994-95 on Canada’s fiscal challenges and what they meant longer term. Third-party commen- tary (e.g., international rating agen- cies, IMF, OECD, international business press, Canadian research institutes and the media) stressed the urgency of dealing with the deficit and debt dynamics. The government itself centered the debate on the unstable debt dynamics to highlight the longer-term problem, but also broadened the discussion to focus on the intergenerational unfairness of using debt to finance current con- sumption and the opportunity cost of debt-servicing which was consum- ing 38 cents out of every revenue dol- lar and crowding out other public policy choices.
While this intensive public dia- logue did not result in a consensus on what precisely should be done, it did create a consensus that something sig- nificant had to be done, and paved the way for the subsequent 1995 budget and beyond. Interestingly, 10 years on, public understanding of the dangers of deficits and debt remains very strong according to public opinion polls, as does public support for balanced pub- lic finances.
Second, the fiscal consolidation package was large enough to get the job done (5 percent of GDP between 1994-95 and 1997-98) and, impor- tantly, it was predominantly on the expenditure reduction side (program spending as a proportion of GDP fell almost three percentage points over this same period). The program review exercise that produced this was unprecedented in Canada, and was supported by a broad-based polit- ical process involving a special Cabi- net committee with mirror groups of senior public servants. The program review exercise not only substantive- ly reduced the level of spending, but eliminated many programs, stream- lined government and cut over 50,000 civil service jobs. It was also reinforced by improved institutional arrangements designed to support sustained fiscal balance. These included an annual ”œbalanced budget or better” fiscal target, medium-term economic and fiscal ”œstatus quo” forecasting as part of the annual budget cycle, and impor- tantly, building prudence, or a ”œshock absorber”, explicitly into the fiscal framework.
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Third, and echoing recent cross-country analy- sis by the IMF, the fiscal consolidation was of a size and design (predominantly expenditure-based), that led to a rapid turnaround in economic performance, suggesting substantial crowding out had been occurring in the economy.
As well, with fiscal policy now strong- ly complementary to monetary policy, and with monetary policy itself anchored on inflation targets, nominal and real interest rates declined signifi- cantly. This not only stimulated eco- nomic growth, but led to a fiscal virtuous circle of lower debt-servicing costs and higher revenues. This further interacted with supply-side measures either already undertaken or in train (such as FTA/NAFTA, GST, labour mar- ket reforms, etc) to enhance productiv- ity performance, which also began to improve again in the second half of the 1990s.
Fourth, having focused the public debate on public finance sustainability and intergenerational fairness, and realizing the impending demographic pressures, the federal government and the provinces used the occasion to also tackle the actuarial deficit in Canada’s public pension plan ”” a policy challenge that the US is actively examining today. In Canada, the public pension accounts are com- pletely separate from the government’s budgetary accounts; contribution rates were raised to prefund future deficien- cies, and an independent body, the Investment Board, was created to invest these funds in any instrument of their choice including equities. As a result of those actions, the chief actuary has now indicated that the Cana- dian public pension system is actuarially sound for 75 years based on present demographic projections of aging in the Canadian population and current contribution rates.
Finally, once balanced budgets were achieved in 1997-98, the government generally allocated the ensuing surplus between debt reduc- tion and tax cuts (50 percent) and new expenditure priorities including tax expenditures (50 percent). As a result, over the 1997-98 to 2004-05 period, debt was reduced by 10 per- cent, or over $61 billion; taxes were cut by over $100 billion (including sizeable personal and corporate income tax reductions, indexation, major reform of resource taxation and the elimination of capital taxes); and, roughly $175 billion was allocated to new program expenditure priorities.
The results of this fiscal restructur- ing on the fiscal framework and the economy have been rather dramatic. As the attached charts indicate:
Canada registered seven consecu- tive surpluses from 1997-98 to 2003-04, and has just finished its eighth year of fiscal surplus in 2004-05, despite quite uneven international economic conditions, particularly from 2001 onward. Other G7 countries that had achieved surplus by the late 1990s, i.e., the US and the UK, have slipped well back into deficit.
The federal government debt-to- GDP ratio has dropped 30 percent- age points from its 1995-96 peak of 68.4 percent to under 39 per- cent today. The government has recently set the target of a 25 per- cent debt-to-GDP ratio within 10 years. Debt servicing costs have declined to less than 20 cents of each revenue dollar.
At the G7 level, and comparing total (not federal) government fis- cal positions, Canada is the only country in budgetary surplus in 2004 and is forecast to remain so by both the IMF and OECD over the next two years. As well, it now has the lowest net total govern- ment debt burden in the G7, whereas it had the second highest 10 years ago.
With respect to economic per- formance, as the IMF has recently noted, over the 1995-to-2004 peri- od Canada led the G7 in econom- ic growth (tied with the US) and standards of living growth (tied with the UK) and combined this with the strongest G7 employ- ment growth and low and stable inflation. Thus, Canadian fiscal consolidation was less a benefici- ary of strong growth elsewhere than a generator of better eco- nomic performance in Canada.
To achieve these fiscal results, clearly, large expenditure reductions were initially required. In this con- text, since roughly 30 percent of spending by 1994-95 was financed by borrowing, the required expenditure cuts also needed to be broadly based as all spending including provincial transfers was contributing to the structural deficit. In the event, trans- fers were reduced except for the elder- ly and equalization payments to the poorer provinces. As well, it is not clear, as some maintain, that these reductions led to a vertical fiscal imbalance in Canada. As the Depart- ment of Finance has noted: ”œ…in Canada, unlike in most federa- tions, both the federal and provincial govern- ments have access to all major sources of rev- enue… This means that with access to the same tax bases, it is difficult to see how a vertical fis- cal imbalance can exist.”
Clearly, there have been quite differ- ent fiscal experiences across the G7 countries over the last decade. Only three countries achieved surpluses during this period and these were only temporary for the US and UK. Fiscal rules in the Euro G7 coun- tries appeared to act as both ceilings and floors through the 1990s until they were breached when growth slowed after 2001. Japan saw only large deficits, and its debt burden deteriorated more than any other G7 country over the period. In the US today, there is considerable debate but little consensus on how, when, and by how much deficits should be tackled. The Bush administration is forecast to take on $2 trillion of new debt by the time the president leaves office in 2009.
In this context, several possible les- sons for the G7 countries emerge from the Canadian fiscal experience including:
Consider fiscal targets that are clear, easy to measure and simple to understand. Complex targets of budgetary balance over the cycle, for example, are often appealing conceptually to economists, but risk losing public understanding and hence credibility and support.
Public support for balanced public finances is critical to encouraging fiscal decisions consistent with sustainable public finances. In this regard, attention needs to be paid to the nature of the public dia- logue to engage and maintain the public’s support.
Develop one’s fiscal planning on the usually realistic assumption that there will be unforeseen cir- cumstances. As an example, con- sider the sequence of shocks Canada has experienced since 2000: the dot.com meltdown in 2001; the 2001 terrorist attacks and the 2002 global downturn; SARS and BSE in 2003; and the 20 percent appreciation of the Cana- dian dollar in 2003-04. In such an uncertain world, the ”œharder” the fiscal target, the more important it is to build prudence in the fis- cal framework to maintain credi- bility in the markets and the public.
To the extent possible, avoid long- term projections for fiscal plan- ning as these are extremely sensitive to assumptions. For example, in 2001, the Congres- sional Budget Office (CBO) fore- cast that the US federal government would have a cumulative 10-year surplus of some $3 trillion and policy recommenda- tions were developed on this basis; two years later, the 10-year fore- cast was for a cumulative deficit of $2 trillion ”” an astounding $5 trillion swing. A corollary is to avoid committing long-term fiscal resources to the extent possible until they are realized.
Finally, it is worth noting that managing expectations in a sur- plus world is at least as difficult as it is in a deficit environment. Demands for new resources and initiatives, which are always present, tend to become more magnified and more insistent when governments are in bal- ance. This underscores the value of ”œhard fiscal targets” and prior- ization processes for budgetary planning.
A version of this article was presented at the interna- tional conference, ”œThe Long-Term Budget Challenge: Public Finance and Fiscal Sustainability in the G7,” spon- sored by the John Goodwin Tower Center for Political Studies at Southern Methodist University, the Woodrow Wilson International Center for Scholars, and the IRPP, in Washington, June 2-4, 2005.