Fiscal policy after the recession

Eventually, the recession will be over, and we will have to deal with the question of what should be done to recover from the recession-induced deficit. Ideally, the answer should be "Nothing": as the economy recovers, the deficit would go back to zero as tax revenues went back up and recession-induced expenditures went back down. But we don't live in an ideal world; we live in one in which the Conservative government has sailed too close to the wind over the past few years. There's a serious risk of tipping over back in the the bad old days of the Deficit Generation, where we ran huge deficits in bad times, and not-quite-so-huge deficits in good times.

Here's the crux of the problem:

Up until 2006, GST revenues tracked economic growth and grew steadily. The reduction of the GST from 7% to 6% in the 2006 budget took away about $6-7b, and going from 6% to 5% will have a similar effect when it's worked its way through the 12-month moving sums plotted here: the federal government will be working with $12-15b (roughly 1% of GDP) less per year than it would be if the GST cuts had not taken place.

The government could get away with this for the past two years because corporate profits were so strong: the drop in GST revenues was more than compensated by corporate tax revenues. But profits - and hence corporate tax revenues - are extremely sensitive to the business cycle. In 2008, CIT revenues were running at $20b more than their low during the 2002 slowdown - and the 2002 slowdown wasn't really a recession. But the recent sharp drop in the 12-month moving sum of CIT revenues is almost certainly to take away below those levels. A $20b reduction in annual CIT revenues is almost certainly a lower bound.

After you put those two effects together, it's very hard to see how the federal government will recover from a deficit without doing anything. For one thing, even if corporate profits recover in the next couple of years, it won't do much for CIT revenues at first. Since firms can deduct losses from previous years, they won't be paying significant amounts of corporate taxes until at least the second or third year of recovery.

So what should be done? According to the budget that was just passed, the government's strategy seems to be controlling the growth of program expenditures. But let's put that strategy into historical context. Here is a graph of federal program expenditures and revenues in per capita 2008 dollars:

Real per capita spending is at the levels we saw 25 years ago. If spending growth is kept in the 2-3% range, that level is likely to fall.

As a share of GDP, federal program spending is now below Pearson-era levels.

Michael Ignatieff has come into a certain amount of flak for contemplating the possibility of increasing taxes after the recession is over. After looking at these numbers, I think the burden of proof is on those who would claim that the solution to the looming deficit problem is to cut back on program spending.

Comments

[Ian Lippert]

I dont get these graphs. How can revenues be above expenditures if we are running deficits?

[Mike Moffatt]

"I dont get these graphs. How can revenues be above expenditures if we are running deficits?"

I'm guessing interest on existing debt, which doesn't count as program spending. Am I right? :)

[pointbite]

Stephen, you're making the assumption we want to pursue policy that more closely aligns the government with past conditions. I personally couldn't care less what the numbers looked like during the Pearson era, it's a new world and he doesn't represent my model of a more perfect government.

[Stephen Gordon]

Mike: yes, that's it. Total expenditures are program expenditures plus debt charges.

And the annual data are up to fiscal year 2007-2008, which was still in surplus.

[westslope]

Funny how the Mulroney Progressive Conservatives could not reign in the structural deficits despite numerous smart neo-liberal policies like the FTA and value-added sales tax (GST).

It was the Chretien Liberals that co-opted the fiscally conservative platform of the Manning's populist Reform Party, a western Canadian formation that ultimately went on to help form the contemporary Conservative party.

Funny how, some of the worst fiscal policy decisions made in recent years have been under the watchful and ambitious eye of "Trust me I am an economist" graduate-trained Stephen Harper.

[Stephen Gordon]

Actually, the Mulroney government did manage a swing of 5% of GDP in the operating surplus before the recession hit - look at revenues and expenditures in the Mulroney years. That was about half the job; the Chrétien govt did the other half - and got all the credit.

(See also this post.)

[westslope]

I recall the fiscal position improving at the end of the Mulroney period but didn't realize that the Mulroney gov't did "half the job".

The post link links back to this post.

[Stephen Gordon]

Gaah!

Link fixed...

[Nick Rowe]

Another thing that worries me is revenues from the capital gains tax. In previous years, asset markets had been growing strongly, so revenues from capital gains taxes would have been high. For 2008 and probably 2009 tax years we will see a lot of realised capital losses, and the government paying back some of 2007 (and earlier) capital gains taxes. Even when things stabilise, we can't expect to see the capital gains tax revenues in future continuing like they did in the recent past.

I don't know how big an effect this will have.

On the brighter side, remember we can run deficits of around $20 billion annually (IIRC, I did the math in a post a few months back) with the debt/GDP ratio remaining stable, assuming we return to the long-run inflation target and steady growth, because nominal GDP will be growing along with the debt. So it's sustainable.

[Dee]

Even when things stabilise, we can't expect to see the capital gains tax revenues in future continuing like they did in the recent past.

Those numbers should be a reality check. The carry forward losses were changed to 20 years.

O/T Hope you had a good holiday Nick.

[Stephen Gordon]

Anyone got a data source for the revenues generated from capital gains?

[stewart sprague]

Absent further cuts, the GST ought to track the economy going forward.
The income tax data might have been useful in chart 1. (for comparative purposes)
Revenue on a per capita basis is higher than during the Pearson era.
It's been awhile since I looked at this stuff and I forget the definitions. Do "federal expenditures" include transfers to provinces?

[Declan]

Nice post, the charts really clarify the situation going forward - I've got nothing to add, just wanted to make a positive rather than critical comment for once :)

[Dee]

Anyone got a data source for the revenues generated from capital gains?

Sorry Stephen, I've only seen dribbles from lefty policy papers. No idea how they attained the numbers or projections.

Stewart mentioned GST but won't the results be skewed for a little while because of the HST introduction in ON?

[westslope]

Thanks Stephen. I see your point. Mulroney was improving the fiscal situation up until the 1990s recession. I suppose the sheer magnitudes and the occasional difficulty of the government to say "no" to special interests lead many of us to believe the opposite.

I'll add my thanks and appreciation for these posts, especially the charts.

[Andrew F]

Closing italics.

I'll say that this is rather enlightening given that other voices are saying that there is no structural deficit. They argue that holding spending increases to less than 2% per annum (ie, less than inflation+population growth) will eliminate the deficit in time. That sounds like cuts in real terms to me, though.

[Stephen Gordon]

That's what it sounds like to me as well.

[Andrew F]

I guess another question is how much of this decrease in the GDP share federal government spending is due to devolution of spending power to the provinces? I don't know if there are any handy series of provincial+municipal spending over the same time frame.