My blogging has been light, partly because of this, partly because my teaching load this term is heavier than usual, and partly because I've been spending so much time trying to get a good feel for the numbers that will form the background of the federal budget scheduled for March 22. I keep thinking "Okay, I'll get this sorted out and then post", but I never do, so I don't. So I'm going to try to force myself to post what I've figured out so far, and if I make a mistake - as does happen - I'll go back and revise.
Anyway, this post is on what has happened to the 'structural deficit', or the 'cyclically-adjusted budget balance' (CABB) over the past few years. It turns out that what happened to it was the GST cut.
The idea is simple and compelling enough, but putting it into practice is a thorny business indeed. It turns out that aside from certain extreme episodes such as the last recession, it's extremely difficult to determine whether not output is above, at or below normal in real time. So when we look back and see policy decisions that turned out to be mistakes, I'm inclined to be generous. Things that may seem obvious several years ex post were not at all clear at the time.
The budget balance we observe is the sum of two things: the 'structural balance' - what we would have observed if the economy was operating at capacity - and the contribution of the cyclical component. So estimating the structural balance is an exercise in extracting the trend and the cycle from the available data.
Here is a graph of the PBO's estimates for the CABB since FY 1976-77, expressed as a percentage of Gross Domestic Income:
I like these graphs, because they put our current concerns in some sort of perspective. We've seen worse. Much, much worse.
What's curious about that graph is that it shows a CABB that went from about being in surplus of 1% of GDI up until about 2003 to bouncing around zero between 2004 and 2006. The timing of this coincides with the increase of federal transfers to the provinces - in particular, the Canada Health Transfer - under the Martin government. The Conservatives' GST cut then moves the structural balance into deficit.
This is of course what we see in hindsight. At the time these decisions were made, the federal government was cruising along with a surplus on the order of 1% of GDP, and here's why: the economy was running well above potential. Extracting the cycle from the trend is a messy business, but when three different approaches obtain similar estimates for the size of the output gap, it's reasonable to conclude that 2006-2008 were boom years:
The Bank of Canada is the institution with the most interest in getting good estimates for the output gap, and is also the one with the most resources to put into the problem, so their results are as reliable as we're likely to see. According to their estimates, the period 2006-08 was exceptional: the longest and strongest boom in at least the last 30 years.
So this is the fiscal situation that the Conservatives inherited:
- a structural surplus/deficit that was close to zero
- an actual surplus on the order of 1% of GDP, due to a booming economy
Again, it's important to emphasise that no-one really knew that at the time; this is hindsight speaking. Back when the Conservatives first floated the idea, critics said the GST was the the last on the list of any intelligent tax-cutting agenda (which is of course true). I don't recall anyone warning of the risk of chronic deficits in the 2005-06 election campaign.
But this doesn't change the main conclusion: when the economy finally does return to capacity - the Bank of Canada's current forecast is that the output gap will close at the end of 2012 - the swing in the federal government balance will not be enough to close the deficit.
How big is the hole that has to be filled? Unlike, say, corporate income taxes, the effect of the GST on the budget balance is fairly easy to calculate. Since the behavioural responses to changes in the GST rate are small (this property is why they are such a favourite with economists), the numbers in this earlier post - around 0.75% of GDP or $12b - won't be a bad guess. The PBO's estimate is $14b - and again, their estimate also corresponds to the size of their estimate of the effect of the GST cut on the budget balance.
The story of the GST cut just keeps getting worse. It wasn't a good idea at the time, and it blew a $12b hole in the federal balance that will have to be filled somehow.