The 2010 G20 Summit in Toronto ushered in what likely to be a long period of fiscal consolidation in advanced economies. Although our country is in better fiscal shape than many others in the G20, we suggest that the budget pressures facing most Canadian governments could be as severe as those of the early 1990s — an era of wage freezes, program windups and transfer payment reductions — and that these fiscal hard times could last for two decades or more.
In the months leading up to the G20 Summit, the International Monetary Fund (IMF) developed economic and fiscal projections for major economies. The May 2010 Fiscal Monitor and its accompanying working paper, From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Economies, outline what will be needed for the world to dig itself out of the fiscal hole created by the Great Recession. The IMF calculates the size of the fiscal adjustment (revenue increase plus expenditure decrease) required over the next two decades for each OECD and G20 country to return, by 2030, to the 60 percent debt-to-GDP level that was the median before the 2008 financial crisis (figure 1). The calculations show that most of the world will have to undergo severe fiscal consolidation.
The countries facing the greatest fiscal adjustment include Japan (13.1 percent of GDP), the US (12.0 percent), Ireland (9.8 percent), Spain (9.4 percent), the UK (9.0 percent) and France (8.3 percent). Canada, at 4.7 percent, is in the is moderate adjustment group, along with Italy, Australia and Germany. This means that over the next decade, Canadian general (federal, provincial and municipal) government would need to reduce the percentage of the GDP devoted to government expenditures (and/or increase government revenue) by roughly five percentage points, from 43 percent to 38 percent, and then hold it there for another decade.
The crisis-related fiscal stimulus in Canada is roughly 2 percent of GDP, so if governments remove this amount from their spending the remaining adjustment would be about 3 percent of GDP. At first glance this does not seem large in relation to Canada’s last major period of fiscal consolidation, from 1983 to 1997, when a 10 percent adjustment was achieved. However, there are two crucial differences in the economic and expenditure environment. The first is that, relative to the last consolidation, there will be substantially greater pressure on health care spending — the IMF projects Canada’s health costs as increasing by 5 percent of GDP by 2030 in the absence of substantial policy changes. This compares with an increase of 2.3 percent of GDP from 1987 to 2007. The second difference is that in the 1990s the world economy was growing rapidly and interest rates were falling. The surge in global demand for Canada’s exports contributed to GDP growth and to government revenues, making the reduction in the deficit-to-GDP ratio much easier than it will be when growth in other countries is constrained by fiscal consolidation and interest rates have nowhere to go but up.
Canada does not face an imminent fiscal crunch and has the time to develop a coherent, policy-based expenditure management philosophy to address the coming pressures. This is a luxury unavailable to jurisdictions like Greece, Spain and California, where the fiscal crisis has arrived.
We therefore suggest that during most of the next two decades many Canadian governments will face budget pressures comparable to those in the early 1990s.
Canada does not face an imminent fiscal crunch and has the time to develop a coherent, policy-based expenditure management philosophy to address the coming pressures. This is a luxury unavailable to jurisdictions like Greece, Spain and California, where the fiscal crisis has arrived. We suggest that Canadian governments could avoid crisis-driven, across-the-board cuts if they adopt “program design principles for frugal public management.”
The principles that we propose challenge the premises of what might be called policy uniformity. Let us explain what we mean. When Canadians think about the values that should animate the actions of their governments, equality is among the first to come to mind. The tradition of equality influences the Canadian approach to many areas of public management in the form of a preference for policies and programs where all individuals, groups or institutions are treated equally wherever possible. There is scepticism about policy options that call for explicit differentiation.
Unfortunately, the preference for policy uniformity has become a straitjacket, albeit a comfortable one, in that it inhibits consideration of more efficient and equitable ways of achieving societal goals through policies that involve treating different groups and institutions differently depending on their needs, preferences and capacities. This straitjacket can be convenient for policy-makers because uniformity of treatment for different groups and institutions is often the easiest approach to defend, as no offended constituency is created. Uniformity generally offers the path of least political resistance. It is easier to invoke Canada’s egalitarian tradition and defend uniformity as an extension of that tradition than it is to take more efficient and equitable policy measures that would require data, evidence, imagination and willingness to defend criteria that lead to explicitly differential treatment.
In the uniformity versus differentiation debate it important to distinguish between equality and equity. From a public policy perspective, equity means treating people who are in the same circumstances the same, and treating people who are in different circumstances differently; equality means treating everyone uniformly. In most policy domains, improving equity involves shifting the distribution of public benefits toward the neediest individuals.
The IMF suggests ways of improving the efficiency of spending while ensuring equity. These include changing the composition of expenditure, reducing the wage bill and better targeting social spending.
We suggest seven principles for frugal public management based on common sense efficiency and equity propositions. The efficiency proposition is that you generally get more for your money if you describe clearly what you want, get the incentives right, take advantage of economies of scale and pay only what is needed to get the job done. The equity proposition, supported by the IMF research, is that you generally get more equitable results from social expenditures if benefits are targeted to the individuals in greatest need.
To illustrate the implications of these frugal management principles for program design, we look at how they might apply to the specific example of post-secondary education policy in Ontario.
Results-oriented measures and objectives. In order to achieve a goal efficiently, it helps to be clear on what the goal is. With care, objectives can be stated in ways that make it possible to construct performance measures that can form the basis for appropriate incentives and funding mechanisms. In our example of post-secondary education, successive Ontario governments have articulated a consistent objective: to assure a place for every qualified and willing applicant. During periods of rapidly increasing demand, this objective has often been quantified, such as creating 58,000 additional undergraduate places from 2002 to 2005 or creating 12,000 additional graduate places by 2010. But neither governments nor universities have articulated explicit objectives pertaining to the quality of teaching and learning. Nor have there been explicit objectives for the research conducted by universities. We suggest that Ontario would be better served by more explicit provincial objectives along the lines of delivering the best affordable learning experiences for the diverse population seeking an undergraduate education, providing extra support for students from low-income families, delivering an international standard of graduate education across a range of disciplines and producing peer-respected research results in priority fields. If objectives are stated this explicitly, it becomes easy to see why Ontario’s uniform policy treatment of all universities is unlikely to be the most efficient and equitable program design.
Performance-related incentives for individuals and institutions. Incentives matter. Program designers should carefully think through what behaviour they want from individuals and institutions and create funding and regulatory environments that encourage that behaviour. In the case of universities, funding formulas matter very much. If Ontario wishes to encourage teaching performance, it should design its funding formula to provide financial incentives for institutions to increase class contact hours, student satisfaction and other measures of learning quality. If it wishes at the same time to encourage research performance, it should provide financial incentives for institutions to attract and support the most productive researchers. There are readily available indicators of such performance from the three federal granting councils and it would be administratively straightforward to tie a portion of provincial funding to actual research performance as measured by the dollar value of peer-reviewed federal grants.
Efficiency-related concentration and specialization: There are many public sector processes in which the average cost falls as scale is increased, where efficiencies are gained through specialization and where benefits can be obtained from working in proximity to those performing related activities. This is certainly true for universities, particularly in the areas of graduate education and scientific research. This principle would call for policies that enhance the differentiation among Ontario’s universities so that each could concentrate on activities and disciplines where it is able to achieve the greatest efficiencies.
Market-related compensation. To get the best value for its money, governments should pay what is required, but not more, to secure the inputs needed to deliver programs. There was a time when public sector workers had better employment security but lower compensation than their private sector counterparts. Today, however, most Canadian public sector employees have better employment security and, except for very senior levels and highly specialized occupations, better salaries than equivalent workers in the private sector. Canada’s public sector is paying too much for program inputs. This is true for universities, where approximately 70 percent of costs are in salaries and benefits. In Ontario, most full-time faculty are paid on a similar scale regardless of discipline, region or balance of teaching and research. Some faculty are receiving their market rate in the sense that they can generate competing offers from other institutions. However, given that there are many more PhD holders who would like to work at universities than there are available positions, it is likely that many faculty members are paid more than they would be if universities were able to hire teachers and researchers on the open market.
Policy-oriented fee setting. A frugal public management regime would rely more heavily on user fees, but these would have to be carefully designed to ensure that they are consistent with policy objectives. Raising tuition fees for those who can afford them would increase the total societal investment in higher education and, given the substantial private benefit associated with university education, it is appropriate that the beneficiaries pay a substantial portion of the costs. At the same time, a robust means-tested student assistance program is needed to maintain equity of access.
Equity-oriented targeting. There is a long-standing debate in social policy over the relative merits of targeted versus universal programs. A frugal public management regime would see more targeting, but as in the case of user fees, the targeting mechanism needs to be carefully designed. For post-secondary education, this principle would argue for reducing merit scholarships (which Ontario universities often use in a zero-sum competition for the best students) and increasing the funding for high-potential needy students who might not otherwise attend university. At the same time, our second principle would argue in favour of measures that incent student performance. In setting rules in this area it would be important to bear both principles in mind and look at relevant evidence on the behavioural effects of scholarship funding.
Change-sensitive implementation planning. The example of higher education in Ontario illustrates that the rigorous application of our frugal public management principles would be controversial since they necessarily lead to changes in institutional relationships and changes in the distribution of the benefits of public expenditure. Clearly, implementation and change management would be a challenge. Our final principle is that program changes need to be carefully planned and phased, with appropriate grandfathering and other adjustment provisions.
We suggest that these principles have wide applicability across government. The IMF draws special attention to “age-related spending” (pensions and health care) as the strongest expenditure drivers and those most in need of policy change. It compares the efforts of OECD countries in introducing budget control measures. Canada’s record on pensions is impressive because more has been done with the targeting of benefits here than in any other advanced country, through the guaranteed income supplement and the tax clawback of Old Age Security. But Canada has done less than many European countries in reforming health care. The IMF lists potential cost-reducing measures on the supply side (e.g., case-based rather than fee-for-service payment to providers, ehealth initiatives, reductions in the benefits package, evaluation of cost-effectiveness of different treatments and technologies) and on the demand side (increases in cost-sharing through copayments and coinsurance). The frugal public management principles proposed in this paper would support carefully designed changes to the way providers are paid as well as means-tested copayments.
Despite very different costs of living in various parts of Canada, and different prevailing wage rates, federal public administration salaries for most occupational groups are the same across the country. While the federal government is currently paying above-market rates for labour generally, it is dramatically overpaying for labour in parts of the country where prevailing wage rates and price levels are below the national average.
Application of our principles would suggest a rethink of the federal government’s early childhood education policy, particularly the “choice in child care tax credit,” which is a $100 monthly tax credit paid uniformly to parents for each child under age five. Clarifying objectives in this area would be helpful. If the objective is to maintain a private system of delivery of early education services but to use public policy to ensure access for low-income families, a better program design would incorporate a targeted, differentiated approach based on vouchers or some other mechanism to boost purchasing power for poor families.
Frugal public management principles have clear implications for the federal government’s compensation policy. Despite very different costs of living in various parts of Canada, and different prevailing wage rates, federal public administration salaries for most occupational groups are the same across the country. While the federal government is currently paying above-market rates for labour generally, it is dramatically overpaying for labour in parts of the country where prevailing wage rates and price levels are below the national average.
Frugal public management principles would likely lead to a reformulation of the system of federal-provincial transfers. For example, the current Equalization formula creates a disincentive for governments in recipient provinces to pursue growth-oriented economic reforms, as increases in own-source revenue are largely offset by reductions in Equalization payments when such growth occurs. This creates a bias in favour of spending on politically popular services and transfers instead of infrastructure development and other long-term investments that would promote productivity. A reformed federal-provincial transfer system would place a higher premium on the equity goal of increasing the benefits to the poorest Canadians regardless of place of residence.
Most governments will want to achieve part of their fiscal adjustment requirement through revenue increases. The IMF has examined revenue generation options and recommends particular attention be given to increasing the coverage and level of value-added taxes (in Canada, the GST/HST) and suggests greater reliance be placed on property taxes because of their immobility and low economic distortion effects. The IMF also recommends that countries focus particularly on implementation (because tax avoidance can undermine the best theoretically designed tax initiative) and on the design of taxes that target “high-net-income individuals.” The IMF notes that taxes on high-income individuals constitute a substantial fraction of total income tax (e.g., in the United States taxes from the top 0.7 percent make up 37 percent of total income tax) and face a significant risk of non-compliance.
This implies that one of the best and easiest tax changes in Canada would be an increase in the GST/HST rate. But additional tax revenues from wealthy individuals could also play a role. The Canadian reticence about differentiation may be inhibiting consideration of further progressivity at the top end of the income scale. Specifically, the top marginal bracket in Canada starts at $127,022 for individuals and above that, all Canadian taxpayers are taxed uniformly at the same marginal rate. A higher marginal tax rate on individuals with very high incomes would produce little economic distortion if, as the IMF has noted, such changes were coordinated with measures taken in other jurisdictions to reduce the incentive to change country of residence.
Other types of carefully designed taxes — including estate taxes to capture a small portion of the estimated trillion dollars that will be passed on to Canadians through inheritances in the next 20 years — could effectively target affluent individuals and raise substantial revenues, particularly if they are coordinated with initiatives taken in other countries.
Canadian governments can avoid crisis-driven, across-the-board cuts if they move reasonably quickly to adapt the design of their policies and programs to the fiscal realities that lie ahead. We have suggested a number of principles to improve efficiency while maintaining equity. They would lead to less uniform, more differentiated programs. Although expenditure and tax changes that move away from policy uniformity will not be easy, Canadian governments can learn from the experience of other countries along the way. In contrast to the cuts of the early 1990s, most of the jurisdictions with which Canada traditionally compares itself for purposes of public management will be making even more dramatic fiscal adjustments.