As federal budget season draws closer, Finance Minister Jim Flaherty has been making noises that more cuts might be necessary to reach the government's goal of balancing the budget by 2016/17. Yet, the evidence to date suggests that the government is still on track.
According to the recent November 2012 update of the economic and fiscal projections, the 2012/13 fiscal year should see a total federal budgetary deficit of $26 billion, with the budget balanced by 2016/17. The program-expenses-to-GDP ratio has returned to its pre-recession level, so if anything, the government appears to be on track despite some evidence of a slowing economy.
In addition, the December 2012 fiscal monitor shows a budgetary deficit of $600 million compared to a $500-million deficit in December 2011, which hardly seems a fiscal catastrophe. The same report says the April 2012 to December 2012 nine-month budgetary deficit was $13 billion compared to a deficit of $16.1 billion reported over the same nine-month period the previous year. Moreover, revenues were up three per cent while program expenses were up only 2.2 per cent. This suggests that 2012/13 should come in with a deficit well below the revised November forecast of $26 billion.
So what is Jim Flaherty up to? Part of the issue may be the date for a balanced budget has been shifting forward. The forecast for 2012/13 in the 2011 budget was a deficit of $19.4 billion, with a return to budgetary balance in 2015/16.
The spring 2012 budget forecast the 2012/13 deficit at $21.1 billion again with a return to a balanced budget by 2015/16.
Yet the November update now has the deficit at $26 billion and a return to a balanced budget one year later.
What is happening?
Well, it could be that external conditions are getting a lot worse than we have been led to believe. Given the effect of sequestration on the U.S. federal budget and its spillover impact on the U.S. economy, there may be a larger-than-anticipated spillover on the Canadian economy. International commodity prices are not robust and, by extension, there will be flatter growth in the Canadian resource sector. Moreover, the situation in the euro zone is about to get much more complicated, given the results of the Italian election, and there may be a spillover onto international credit markets and interest rates.
The potential impact of higher interest rates is certainly evident in the November update. According to the summary statement of transactions, between 2012/13 and 2016/17, program spending is forecast to rise only 8.6 per cent while revenues are expected to rise 21.4 per cent. Public-debt charges, however, are expected to rise 16.6 per cent. While the anticipated gap in growth rates between revenues and program spending is quite substantial, between revenues and public-debt charges it is much narrower. This makes the federal plan to balance the budget much more sensitive to interest rate fluctuations than the government has been willing to admit.
When you have a federal debt of $609 billion that is expected to reach $635 billion by 2016/17, it is understandable why even the potential of small increases can have a substantial effect on debt charges and spending.
A 100-basis-point increase in interest rates -- that is a one per cent increase in interest rates -- would decrease the budgetary balance by $600 million in the first year and by about $2.1 billion five years down the road. The impact rises over time as debt matures and is refinanced at a higher rate.
The effective interest rate being paid on Canada's federal debt is currently about 4.9 per cent. By 2016/17, the estimates for the federal debt and the estimated value of public-debt charges suggest an effective interest rate of 5.4 per cent -- a 50-basis-point increase. Given that the growth in program spending over the next few years was already forecast to be quite low, there are really only two reasons for Flaherty's musings. Either government revenues are about to tank or it looks like interest rates may be expected to go up more than was planned. Both these scenarios must be keeping Jim Flaherty awake at night.
Livio Di Matteo is professor of economics at Lakehead University.