On the timing, size and form of an eventual fiscal stimulus

The federal government released its economic update yesterday. Some things were silly: the nickel-and-dime budget cuts are at best pointless, and are much more likely to be counter-productive. One of the benefits of getting public finances under control was supposed to be that we wouldn't have to play these games. And the proposal to cut the subsidies to federal parties is clearly an up-and-in fastball designed to intimidate the opposition.

A noteworthy feature of the fiscal update was the lack of a proposal for an immediate fiscal stimulus. This has provoked shrieks of outrage and incomprehension (an example from the usually-sensible Alain Dubuc), but it's not at all clear why anyone would insist that Jim Flaherty should be starting an 11-figure spending spree right away.

This is going to be a long post, and the rest starts below the fold.

Regular readers will no doubt recall the point that I've been trying to make over the past weeks and months: Canada is not the United States, and the scary headlines emanating from the south do not represent our economic reality. The US has been in a recession for almost a year, the Federal Reserve is running out of ammunition, the housing market has collapsed, and massive public spending is pretty much the only policy instrument that is left to them. None of this is true for Canada. For one thing, we're not even in recession. At least, not yet. As far as timing goes, there is no harm in waiting until a February budget for a fiscal stimulus package.

The next question is how big it should be. Once again, our instinct is to match whatever the US is doing, and the US is thinking about spending USD 700b. Apply the rule-of-ten and this translates into CAD 70b. But once again, that is clearly an inappropriately large response: Canada is not the United States. Canadian employment rates (employment as a percentage of the working-age population) are close to an all-time high; US employment rates have fallen by 1.5 ppts over the last two years, and are almost 3 points from their 2000 peak. And although Canada is not likely to have much in the way of growth next year, the forecasts for the US are even worse. My guess is that something like $20b-$30b would be more appropriate - and probably half of that will happen anyway as the automatic stabilisers kick in.

How should the government spend that money? It's important to remember the story we tell when we explain why increasing government spending is a good idea: if firms are operating at less than capacity, then the government can provide the missing demand. In the US, it makes sense to talking about spending on infrastructure: the construction industry has been hard-hit, and there's plenty of slack. But Canada is not the United States. Here is what's been happening with housing starts in the two countries:

There doesn't appear to have been much slack created in the construction sector in Canada. Indeed, it looks as though it's already operating at capacity, if not beyond.

Historically, unemployment has been higher in the construction sector than elsewhere. Even during good times, there's a lot of churn in and out of unemployment as workers move from one job to the next. But that gap has disappeared.

 
If there's to be a significantly large increase on infrastructure spending, you have to wonder just where we're going to find the workers to build it.

Which brings us to transfers and/or tax cuts. The case against temporary transfers is that consumers will treat it as a very small change in their lifetime wealth, and spend a correspondingly small part of it. Of course, that story is less compelling for the liquidity-constrained households at the lower end of the income distribution, so I'd like to see the budgets of targeted transfer programs such as the GST credit and the Working Income Tax Benefit increased substantially. And while we're at it, make it permanent.

There are two interesting tax proposals for increasing consumer demand:

• In today's Globe, Jack Mintz proposes permanent income tax cuts to increase consumer demand.
• The suggestion made by Nick Rowe and others for a temporary reduction in the GST.

Both would do the job: a permanent income tax decrease would affect permanent income and consumption patterns. And a temporary GST cut would encourage consumers to move forward planned expenditures in order to take advantage of the lower GST.

The problem is the longer-term outlook for the budget balance. Here's my proposal:

• Permanently reduce income taxes.
• Increase the GST to 7%, effective January 1, 2010. (Perhaps accompany this with a reduction to 4% for 2009).

The idea here is to treat the Harper govt GST cuts as a temporary measure, and the prospect of an increase will induce people to shift expenditures planned for 2010 up to 2009. And the increase in the GST will also offset the revenue lost from personal income taxes.

Comments

[Robert McClelland]

Wow, tax cuts. I never saw that coming. Is there any situation where you and your colleagues wouldn't recommend cutting taxes?

[Stephen Gordon]

It didn't occur to me that increasing the GST to 7% could be interpreted as a tax cut.

[Nick Rowe]

Dear examiners: despite the coincidence of timing, and despite the similarities of our answers, we didn't collude on these essays. Honest!

[Stephen Gordon]

:)

[Chris S]

I agree on the GST -> 4% -> 7% cycle. That's even a little bit inspired.

I recall when the GST came in in 1991 - I know people who pushed major purchases into the end of 1990, even to the extent of fully paying for major goods that could not be delivered until early January 1991, so that both they and the business could account for it in 1990.