The 1976 Budgets: A Shift toward Restraint

Canadian Public Policy

The 1976 Budgets: A Shift toward RestraintAuthor(s): Judith MaxwellSource: Canadian Public Policy / Analyse de Politiques, Vol. 2, No. 4 (Autumn, 1976), pp. 620-626Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3550203 .

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indefinite future period, it is hard to see how the country can avoid this process of working out the distortions.

Moderate monetary and fiscal restraint, of the variety now being applied, may be able to bring us close to the four per cent target by 1978 without causing unbearable unemployment or idle capital. If so, we may expect that the Government will progressively relax the restraints under the Anti- Inflation Act, while retaining the Act itself, in order to permit an orderly re- turn to market-determined bargaining relationships in the private sector.

SJudith Maxwell

The I976 Budgets: A Shift Toward Restraint

JUDITH MAXWELL / C.D. Howe Research Institute

The shifting economic and political forces of the past year have encouraged both the provincial and federal governments to introduce fiscal restraint in their spring budgets. The new environment includes at least three forces: the recent backlash against the growth of government, an increased awareness of the linkages between fiscal policy, monetary policy, and inflation, and the growing realization that Canada must set national goals that are consistent with its economic potential.

The change in public opinion concerning the growth of government in the past year or so is basically a healthy one, because it indicates that Canadians are beginning to realize that they cannot expect governments to come up with some new program to provide the solution to every economic and social problem. However, there is a risk that the pendulum of public opinion has swung too far too fast and that many commentators are looking for a severe cutback in government expenditure. There are two persuasive arguments against this:

First, government spending has been one of the driving forces in each economic recovery of the past decade. In 1970, for example, government spending in real terms increased by ten per cent. This year the provinces are planning an increase of less than three per cent in real terms and the federal government somewhat more. That in itself means a more modest recovery than we have experienced in the past. It would be foolhardy to curb spending dramatically now and jeopardize the recovery.

Second, short-run efforts at cutting spending are not only inefficient but unsustainable. Inevitably, the cuts occur where a program is postponable or where it is discretionary. They do not occur where inefficiencies exist. What is really required is control of government expenditure. Canada has made a commitment to provide a wide range of services on a collective basis and there is no reason to think that we have to back away from those commitments. This means that governments should be making a careful attempt to consolidate and rationalize the proliferation of new programs introduced in the past decade. They need to seek ways to control costs and to get more value for the money spent.



Views and Comments/Commentaires / 621

Many of the spring budgets have tinkered with revenues and expenditures in order to give the appearance of restraint in the short-run, but most have failed to begin the difficult process of examining priorities and searching out means of making government spending more productive over the medium- term.

Most analysts of the spring budgets have focused their attention on the size of the deficits - largely because of their concern about the pressures of government borrowing on capital markets and on the effectiveness of monetary policy. Certainly the size of the deficits is important but it is also essential to assess the changes in patterns of revenues and expenditures to see how governments are responding to the need for control of expenditure and to the key questions concerning the nature of the economic recovery.

One of the handicaps that economists face in analysing fiscal policy is the lack of a satisfactory measure of governments' overall deficit or surplus. Economists have traditionally preferred the national accounts measure (which has the attraction of capturing total revenue and expenditure of non- budgetary accounts such as the uIc). The May 25 federal budget overcomes one major problem by presenting a new set of tables giving the 'extended national accounts' which include the investment and loan transactions of federal government agencies. Still, it is difficult to decide how to deal with such provincial funds as the Alberta Heritage Trust Fund since revenues are being transferred from the consumer spending stream to a government fund which may not reinvest for some time. Finally, there is the problem that each of the provinces presents their accounts according to a different accounting tradition and they make no effort to translate those accounts into the national accounts framework. Thus any analysis of the impact of the provincial budgets requires some heroic assumptions and is subject to a wide margin of error.

Once we have a measure of the deficit, we must then decide whether that deficit is appropriate. The key guideline to keep in mind is that the economy is now operating at roughly seven per cent less than its productive potential, even allowing for the fact that the annual growth in potential output is slowing. In other words, Canada has more than double the amount of unused resources of manpower and production capacity that it had after the 1970 slowdown. Under conditions of such slack demand, it is quite appropriate to incur deficits that are larger than in the early I970s. (A federal cash requirement of $4.5 billion in 1976 amounts to 2.5 per cent of actual gross national product, for example. A similar percentage in 1970 would have required a deficit of only $2. I billion.) One should also make an adjustment in the appropriate size of the deficit to account for differences in the other factors, such as monetary policy, that are influencing the economy at the same time.

OBJECTIVES FOR ECONOMIC POLICY

Before commenting on the specifics of the spring budgets, I would like to setout three objectives for economic policy in general and then to give a short survey of the other factors influencing the economy just now.

First, policy must be directed towards unwinding both inflation and reces-



622 / Judith Maxwell

sion. This means that we must bring about a deceleration in the rate of price increase without allowing an increase in the amount of unused capacity. This is not an impossible task because Canada can achieve a great deal on the inflation front by ensuring that growth is strong enough to generate solid gains in productivity. This will lead to a moderation in unit production costs that will, through the AIB's price and profit guidelines, be passed along to the consumer.

Second, governments must begin to address the structural and institutional bottlenecks that have emerged over the past few years. Two examples would be a serious effort at energy conservation and an attempt to resolve the problems that are now disrupting public service wage negotiations.

Third, governments must begin to establish social and economic priorities that are consistent with the amount of national income Canada is likely to produce in the future.

Now, fiscal policy does not exist in a vacuum. It is strongly influenced by general economic conditions, by the stance of monetary policy, and by special events such as the ongoing increase in the domestic price for oil and natural gas. These three elements provide the context in which fiscal policy decisions are taken, so I will give a brief sketch of each one, in reverse order.

Energy prices The price of crude oil will rise by $1.05 per barrel this summer and the increase will be reflected in retail prices after the first of September. A further increase of 70 cents will affect retail prices in March. Natural gas prices will continue to be tied to the price of oil. The combined price increase will cost Canadian energy users an extra $1.4 billion (at annual rates), absorbing a large chunk of purchasing power that they would otherwise be able to spend on other goods and services. The price increases will therefore act as a real restraint on the growth in demand for goods and services (unless people are able to cutback significantly on energy consumption) and will give a significant boost to the rise in prices.

Canada does not have any real alternative to energy price increases at this time. In fact, the current subsidies are probably preventing the essential adjustments in consumption habits and production plans needed to prevent possible energy shortages in this country. Still, energy price increases cannot help but add to both inflation and recession and they therefore tend to exacerbate the country's short-term economic problems.

Economic conditions The economy is now twelve months into a rather subdued economic recovery. Most forecasters expect real growth in the four to five per cent range, a moderate deceleration in the rate of price increases, and an increase in the unemployment rate. The reason that we have a subdued recovery now is that we borrowed a good deal of domestic demand from the future by following expansionary policies during the recession. Policies such as the temporary reduction in Ontario's sales tax on automobiles mean that there will be no backlog of replacement sales in the domestic market to add extra thrust to the recovery process. (A similar argument can be made with respect to housing activity.)




When this generally subdued state of affairs is combined with the restraints on government spending, the normal cyclical downturn in investment, and the extra restraint created by the energy price increases, it seems quite unlikely that the Canadian economy will grow by as much as the annual increase in potential in 1976 and 1977. This would lead to a rise in unemployment. There is also some risk that the recovery will not be strong enough to generate the kind of productivity gains needed to make the anti-inflation guidelines work in the way they were designed.

Monetary policy The Bank of Canada has made a sharp readjustment in the growth in the narrowly-defined money supply since the beginning of the year with the result that money supply growth was less than five per cent at annual rates during the period August, I975 to April, I976 and was about nine per cent between April, 1975 and April, 1976. The monetary base increased by about II per cent in both periods. These rates of increase are well within the target range of Io to 15 per cent set out by the Bank of Canada. However, the broadly defined money supply has grown much more quickly - by 18 per cent at annual rates in both periods. This faster growth seems to reflect a shift in the kinds of assets that savers wish to hold.

The recent constraint on the growth in money will give the Bank more flexibility in adapting its policy to conditions in the capital market and the foreign exchange market over the next year. The Bank will not need to worry too much about occasional monthly blips in the money supply and thus will be able to pursue its overall target of bringing the money supply into a better balance with the volume of transactions taking place in the economy. This means that monetary policy will not need to lean too heavily against the economic recovery in order to meet its target. However, it is essential to keep in mind that the central bank could still be diverted from its course by unexpected shifts in conditions in the foreign exchange market or in interest rate levels in other countries.

To summarize the general context to which fiscal policy must respond this year, Canada has embarked on a subdued economic recovery but it does run some risk that that recovery will lose momentum if governments are too anxious to impose additional restraints on the system.

THE PROVINCES ATTEMPT RESTRAINT

The provinces have made a sharp shift toward restraint in the I976-77 fiscal year, largely by increasing sales and excise taxes and medical insurance premiums. Many of these tax increases have a direct impact on the measured rate of price increase, so they make Canada's inflation performance look worse than it would otherwise have been. The tax increases will also take about $1.4 billion out of the consumer spending stream, an obvious restraint on economic growth.

The provinces plan to increase expenditure by about II per cent, a modest increase in comparison to recent years. Revenue growth will be more than 17 per cent, thanks to the tax increases. The result is that the overall cash



624 / Judith Maxwell

requirement of the provinces has been reduced by about $1.5 billion to about $2.7 billion in the current fiscal year. Moreover, a great deal of the public financing of the deficits took place during the early part of 1976 when the provinces were able to borrow at attractive rates in foreign capital markets. All in all, the shift toward restraint will bring a great deal of relief to the credit markets, but at the same time, the budgets as a whole will place a damper on economic growth and will add to the rate of price increases.

For many of the provinces, this shift has been brought about by some wrenching adjustments in expenditure and revenue. But by and large, the adjustments have been short run. Indeed, the primary longer-range change contained in the ten budgets is that the higher tax rates will give them a permanently larger share of the national income.

Much of the spending restraint in the spring budgets was achieved by means of short-run shifts in expenditure patterns that do not seem to be sustainable. Several provinces have transferred the real restraint to the municipalities, for example, so the results are likely to be higher property taxes or cuts in municipal services. Eventually, the pressures on the municipalities will be- come intolerable and it seems likely that the provinces will end up providing aid of one sort or another.

One municipal service that is being badly hit by this shift is public transit, particularly in Quebec and Ontario. One has to wonder whether this trend is really in the best interests of the country, since public transit provides one of the keys to solving both the energy and the urban problems that represent major policy challenges in the years ahead.

In summary, the provincial budgets have not met the three objectives outlined earlier. They aggravate both inflation and recession, although the shift toward restraint has salutary affects on capital markets which will make it easier for the Bank of Canada to stick to its targets. But the provinces have done little or nothing to come to grips with the other longer-range objectives of addressing structural problems and setting appropriate social and economic goals for the future.

THE RISK IN THE FEDERAL BUDGET

The May 25 budget introduced by Finance Minister Macdonald is based on an optimistic set of assumptions about the strength of the recovery and about the growth in federal revenues. The minister has therefore been ready to take the risk of restraining economic growth. The restraint is being imposed in a number of ways: higher fees for government services such as postage and transportation, a curtailment of unemployment insurance income support, and general restrictions on expenditure.

This restraint will be strongly reinforced by the fiscal drag created by the personal income tax system. One of the astonishing aspects of this budget is that, despite indexing, the government expects personal income tax revenues to grow by 26 per cent this fiscal year. This implies an elasticity of about 1.5 (that is, a 1.5 per cent increase in tax revenue for every one per cent increase in personal income). Obviously, this fiscal drag leaves the consumer with significantly less spending power than the rise in earnings would imply.




Mr. Macdonald indicated in the budget that he expects real gross national product to increase by about 5 per cent in 1976, a forecast that is higher than the average pre-budget forecast in the private sector. He expects this to occur despite the restraint in the budget. (He estimates that the national accounts deficit will decline by $9oo00 million to $3,300 million.) This overall forecast does not seem to be consistent with another forecast in the budget - that employment would increase by 250,00ooo. Placed in the perspective of recent labour force growth trends, this employment forecast could easily mean an unemployment rate averaging 71/2 per cent or more in late 1976 compared to 7 per cent in I975.

Only time will tell whether Mr. Macdonald's forecast is correct. But there is no question that, for the time being, he has chosen to err on the side of restraint and that the target of fighting recession has been quite secondary to the target of inflation. The result is that the country faces the prospect of an even greater amount of unutilized resources at the end of this year than in

I975. This decision carries with it at least one serious risk. There is the prospect that we will experience a U-turn on policy in 1977 because a rising unemployment rate leads the government into a panicky effort to boost economic growth.

Budgets influence the economy for a number of years into the future and the C.D. Howe Research Institute has recommended in a number of recent publications that the federal government should present revenue and expenditure estimates for the next five years in each budget (as the us government does). Mr. Macdonald has followed established practice and presented information only for the next ten months, even though much of the impact of this budget will occur after March, 1977. Even without that forward information, I suspect that the fiscal plan will have to be revised before March. If the revenue forecast of a 26 per cent increase in personal income tax revenues turns out to be correct, for example, the budget will be such a drag on consumer expenditure that the government will be forced to reduce taxes early next year to keep the recovery going.

CONCLUSIONS

One of the important sources of irritation between the public and private sector at this stage is that governments are slow to act while the public is impatient for action. Governments are slow to act partly because they are steering large ships and they ought to be steering their ships toward longer- term objectives like the ones outlined earlier. But governments are also slow because they are incredibly ponderous in the way they respond to new situations.

My own impatience on this point is illustrated by the energy conservation measures introduced in the May budget. The taxes on large cars and on automobile air conditioners could easily have been introduced two and a half years ago, when we first began to understand that there could be a problem of future energy supply. Those measures would have had a pronounced effect on consumers at that time because public concern about energy shortages was at its peak. In other words, we have lost time and impact in delaying the



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introduction of these measures for so long. Yet these were easy decisions. On that kind of performance, what can we expect from governments with respect to the hard decisions on Canada's future?

SRobert L. Comeau

Money, Inflation and the Bank of Canada*: A Review

ROBERT L. COMEAU / Department of Economics, Dalhousie University

Professor Courchene has provided another valuable contribution in his ongoing critique of the role of monetary policy in Canada - and one can only wish him a long and productive life in which to keep up the good work. We now have a comprehensive and sophisticated analysis of the accomplishments and vagaries of Canadian policy for the last quarter century, extending both through his own paper, 'Recent Canadian Monetary Policy' (Courchene, 1971) covering much of the sixties and the earlier book of Paul Wonnacott, The Canadian Dollar, 1948-1962 (Wonnacott, 1965). Courchene's current book is a more elaborate piece of work than his earlier article, reflecting for one part, his own professional growth and, for the other, a loftier ambition to provide a theoretically consistent framework for the events examined. Perhaps he falls short of his full goal but the results are scarcely less impres- sive for that.

The book has four parts: a theory of money; a theory of Central Banking as interpreted from the activities of the Bank of Canada; an evaluation of recent policy; and an assessment which draws conclusions and implications. It is the first part in which Courchene's monetarist point of view is unabashedly exposed - and which thereafter colours the evaluations and criticisms of current policy - which may be most controversial. He certainly throws down the gauntlet to the Keynesians and the Radcliffians at the Bank who are not apt to absorb their punishment in silence. On the whole, I think, Courchene makes his case well: the arguments are well organized and buttressed by considerable recourse to data and the literature of banking. He is repetitive at times, overly brief at others (particularly when analysing the opposing points of view) but he still manages to compress into a fairly slender volume (278 pages of text) an amazing variety of information. It is unfortunate that the book lacks an index which would facilitate recovery of that information.

The summary of Monetarist monetary theory under fixed and flexible exchange rates contain nothing new or startling but it does focus attention quite well on the theoretical concepts the author intends to use. The chief objection I can see is the tendency, common to most Monetarists as direct heirs of the classical faith, to excommunicate the 'Keynesians' from any part

* Thomas J. Courchene. Money, Inflation and the Bank of Canada: An Analysis of Canadian Monetary Policy from 1970 to Early 1975. Montreal, C.D. Howe Research Institute, 1976. Pp. 283.



The 1976 Budgets: A Shift toward Restraint

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