E-Sight November 3: Fall Economic Statement – Smaller Deficit, Little New Spending, Bracing for a Recession

The Government of Canada’s Fall Economic Statement (FES) was a minimalist affair, with updated fiscal projections and limited new announcements. The main story is that strong tax revenue growth, supported by the recent period of high inflation, led to a lower federal deficit in the current fiscal year and setting the stage for a better path forward from a planning perspective. The federal government still spent roughly half of additional windfall of additional tax revenues, but much of that spending was on items already announced – such as the doubling of the GST tax credit. Actual new measures in the FES were extremely limited. For example, the Government of Canada felt that it could not wait to respond to US President Biden’s Inflation Reduction Act that threatened to put Canada at a competitive disadvantage in areas related to the green shift to a low carbon future. Its hard to argue against this point. There were other targeted measures generally aimed at raising skills and investment. The government is vulnerable to criticism that the still-substantial deficit is contributing to inflation, and it is true that the deficit could have been smaller without additional spending, but it has tried to walk a balance between supporting disadvantaged Canadians while keeping the debt-to-GDP ratio on a declining path. One important development is that the FES acknowledged the recession risks. It did this by providing fiscal projections under a mild recession scenario – a scenario that aligns more closely to the Deloitte base case scenario. As such, today’s Fall Economic Statement might be interpreted as the government largely keeping its powder dry – i.e. limiting its new spending – while acknowledging the recession risks and signaling that it has the fiscal capacity to respond if an economic downturn does occur. 

The Fiscal Projection 

The federal budget deficit is projected to fall to $36.4 billion in the fiscal year 2022-23, well down from the $52.8 billion forecasted in the last budget. The fiscal improvement reflected much stronger tax revenues that were helped by high inflation that boosted national income growth and weaker-than-forecasted program spending (primarily unused COVID funds). One partial offset came from rising debt service costs caused by the sharp increase in interest rates this year. 

Looking beyond the current fiscal year, the pace of fiscal improvement diminishes sharply, with the deficit gradually declining in the next two fiscal years and then showing greater improvement in the final years of the six-year projection. For the first time in many budgets, the Trudeau government was projecting a return to fiscal balance – albeit in fiscal 2027-28. The reason for the lesser fiscal improvement in the next two years is a weaker economic outlook. The survey of private sector forecasters, used for budget forecasting, predicts only 0.7% economic growth next year, down from 3.1% when the April budget was prepared. And, the outlook for growth is roughly 0.5 percentage points lower over the six-year fiscal projection. 

However, the survey of private sector forecasters looks optimistic at this stage. Indeed, the Deloitte economic forecast is for Canada to experience a mild recession. So, it was welcome to see the Fall Economic Statement include a downside scenario that is roughly in line with what I think is a more likely outcome. In a scenario where the economy experiences a 1.6 per cent peak-to-trough contraction and the unemployment rate rises toward 7 per cent, the federal government forecasts that the deficit could come in at $49.1 billion in the current fiscal year, rising to $52.4 billion in fiscal 2023-24, before then gradually declining. In this case, the government never gets back to balance.   

Under both scenarios, the base and the downside, the government is projecting that the federal debt as a per cent of GDP will trend lower over time. In fiscal 2021-22, the debt-to-gdp ratio was 45.5%. In the base case scenario, the ratio is projected to steadily decline, reaching 37.3% by 2027-28. In the recession scenario, the debt-to-gdp ratio dips this fiscal year, then rises back to 44.5% in 2023-24 and then trends down to 40.6% in 2027-28. 

The fiscal projection in the base case is entirely reasonable if the economic soft-landing plays out. One could question why a country that is operating at more than full employment has a government still running large deficits in this scenario? Fiscal prudence and desire to restrain inflation would suggest balanced budgets would be called for much sooner than 2027-28. I would be critical were it not for the fact that I think the recession scenario is the more likely.

The fiscal projection under the recession scenario is very close to the Deloitte forecast, but I would flag that there is a risk of a greater deterioration in government finances. There is nothing wrong with the projection in the FES. The issue is simply that the Fall Economic Statement does not allow for any government response to the recession. If the economy has a contraction, even a mild one, some additional fiscal stimulus would likely be implemented. It makes sense that the government would not outline its policy response to a potential future recession in the FES, but the fact is that it would respond. The FES projection is still useful because it shows the sensitivity of the country’s finances to a mild recession and shows that Canada still has a much better fiscal position than its G7 international peers, implying that the government would have scope to deliver stimulus and financial markets are unlikely to become concerned about Canada’s fiscal wellbeing. In this respect, one could interpret this fiscal scenario as a signal that the Government of Canada stands ready to respond if needed.

New Measures

The FES had fiscal projections for measures announced since the April budget to make life more affordable, including: the doubling of the GST credit for six months and the Canada Dental Benefit. Other related measures included an increase to the Canada Housing Benefit, an increase in the frequency of the payment of the Canada Workers Benefit and eliminating interest on federal student and apprentice loans. All of these cost $4.4 billion in the current fiscal year and a cumulative $11 billion over six years. Some critics have complained that the prior announced measures add to inflation while others would argue that the funds should have been applied against the deficit, but personally I think greater appreciation is needed over how painful and regressive inflation is on low-income households. Yes, it might mean that the Bank of Canada has to tighten policy an extra quarter of a percentage point or so, but the support to vulnerable households should not be diminished. 

Then there were new measures not previously announced, a number of which were aimed at responding to the US Inflation Reduction Act. The FES proposes a refundable tax credit equal to 30% of the capital cost of investments in electricity generation systems, electricity storage systems, low-carbon heath equipment and industrial zero-emission vehicles and related charging or refueling equipment. The FES reiterated a commitment from Budget 2022 to establish a tax credit to support clean hydrogen production.

Other new measures included:

$250 million over five years for sustainable jobs training

$962 million over eight years to modernize National Research Council’s scientific infrastructure

$1.28 billion over six years for regulatory processes on major projects

With the announcement of Canada’s increase immigration levels, the government has committed $1.6 billion over six years to support processing and settlement, as well as $50 million in 2022-23 to address immigration application backlogs and speed up backlogs

$801 million over three years to the Youth Employment and Skills Strategy

The total value of the newly announcement measures were $10.9 billion over six years. 

Taxes

The FES announced the intention to introduce a 2% tax on corporate share buybacks as of January 1 2024. This is similar to the 1% tax in the US Inflation Reduction Act. The idea is that by taxing share buybacks, it will incent firms to instead use the funds for investment and job creation. The intention is desirable, as Canada has a poor track record on business investment and low capital per worker. However, the impact of the tax is likely to be limited. For example, if firms want to return the funds to investor, they can simply use the issuance of special dividends instead of share buybacks, unless of course there is a change in taxation of dividends coming. I would view the tax on share buybacks more as a policy nudge to investment than a measure that would make a significant impact. 

 Conclusion

The Fall Economic Statement was a useful update of the federal government’s finances that showed fiscal improvement and provided guidance on how a recession might impact the country’s fiscal position. The government should be commended for providing a mild recession scenario. In my opinion, this should be viewed as the base case scenario as it is the more likely outcome – but that is a personal perspective, and I could be wrong. I also think there is a risk that in a recession scenario, the fiscal deterioration could be greater. Most importantly, an economic contraction would trigger federal fiscal stimulus, but it is still useful to know the sensitivity of the federal finances to a contraction in real GDP before fiscal response. It shows that the federal government would have scope to deliver stimulus and still look fiscally favourable relative to international peers. The government will face criticism that it could have brought the deficit down by more, but given the economic outlook and the current recession risks, I am not convinced that this is the time for fiscal austerity. It could trigger the recession or make it much worse. And, the response to the US Inflation Reduction Action was needed, although the tax on corporate share buybacks is unlikely to spur investment. The individual measures in the Fall Economic Statement all have merit. I think the missing ingredient in the FES is a vision or strategy narrative that holds it all together. This might be missing because this is just a just a fiscal update and not a mini-budget, which is how many people refer to it. In the Spring, we will get the next full federal budget. Ideally, it will have a vision of how Canada will face its economic challenges – inflation, economic slowdown/recession, labour shortages – through a fiscal policy lens that is sustainable, inclusive, and fuelled by increased competitiveness.