====================================================================== Note: The electronic version of the following Appendix E is for informational purposes only. The printed version remains the official version. There are no tables in Appendix E. ====================================================================== APPENDIX E FISCAL POLICY AND THE PROVINCIAL ECONOMY INTRODUCTION The Canadian economy grew rapidly during the late 1980s but little progress was made in improving the fiscal position of the government sector. Deficits and debt remained at high levels. As a result, governments in Canada had little flexibility to raise spending or cut taxes to stimulate the economy during the recent recession. Nevertheless, the downturn in the economy meant that deficits and debt have grown sharply over the last two years. Recent reports by public policy research institutes and credit-rating agencies raise the possibility that Canadian governments may soon face real constraints on their ability to finance deficits. The first and second sections of this appendix outline the reasons for the deteriorating finances of the government sector in Canada. The third section focuses on the evolution of British Columbia's fiscal position. This section distinguishes between the part of the deficit that will disappear as economic growth picks up and the structural portion -- the part that will not go away as the economy improves. The last two budgets have reduced British Columbia's structural deficit by as much as $1.4 billion. Reducing the structural deficit is important if spending on programs for people is not to be crowded out by mounting debt service costs. THE FISCAL POSITION OF GOVERNMENTS IN CANADA The seeds of Canada's current fiscal problems were sown in the mid-1970s when accelerating inflation and slowing economic growth produced the first large federal deficits. Federal deficits grew steadily through the late 1970s and the 1981-82 recession. Policy changes and a stronger economy arrested this trend in the mid-1980s, but the federal deficit remained stuck at close to $30 billion through the second half of the decade. The 1990-91 recession caused the deficit to widen again to a projected $34.4 billion in 1992/93. As a result, debt has accumulated rapidly and debt interest costs have been absorbing an increasing share of federal revenue. Federal net debt hit a post-World War II low of 16 per cent of GDP ($27 billion) in 1974/75. However, by 1992/93 federal net debt had risen to $457 billion, or 66.5 per cent of GDP. Debt service charges absorbed 32 cents of every dollar of federal revenue in 1992/93. Until the 1980s, provincial finances in aggregate were in comparatively good shape. However, a cyclical deterioration during the 1981-82 recession caused a sharp increase in provincial indebtedness, which only began to slow in the late 1980s. In 1990, the federal government began reducing the growth of transfer payments to provincial governments, as part of its expenditure control program. In addition, several provincial governments had allowed spending growth to accelerate rapidly during the economic boom in the late 1980s. When the 1990-91 recession arrived, these two factors caused provincial deficits to widen considerably as revenue growth fell sharply. The aggregate provincial deficit grew to an estimated $23 billion in 1992/93 (see Chart E1). Several provinces now find themselves on the same debt treadmill as the federal government, with debt interest costs absorbing a rapidly growing share of their revenues and crowding out program spending. British Columbia is still in a relatively good position, although debt interest payments have risen from 3.7 cents of each dollar of revenue in 1990/91 to 5.7 cents in 1993/94. Today, the combined federal and provincial deficit is over $57 billion, or 8 per cent of GDP. Mounting deficits have caused the combined debt of the federal and provincial governments to rise to about $635 billion, which is equal to 92 per cent of GDP. Canadian governments find themselves in their present fiscal situation because of a combination of poor fiscal planning and management, bad luck and the lack of a public consensus on how, or even whether, to deal with the deficit issue. In part, the lack of agreement on what to do reflects conflicting public demands for more government services, less bureaucracy, lower taxes and a balanced budget -- all at the same time. WHY DEFICITS AND DEBT GREW The notion that government should actively manage the economy by varying the level and growth of public expenditures and taxation became widely accepted following the Second World War. Through the 1960s and early 1970s, a consensus existed that governments could and should "fine-tune" the economy by using countercyclical fiscal policy to produce growth and full employment without inflation. This consensus broke down, partly because of the onset of "stagflation" in the late 1970s and early 1980s. Also contributing to the downfall of countercyclical fiscal policies was the tendency of deficits to keep rising in bad times and good times alike. Countercyclical policies were designed to boost spending and/or cut taxes -- thus raising deficits in order to stimulate the economy out of recession. In theory, the deficits and debt produced in bad times would be paid off by running surpluses when the economy recovered and was growing at capacity. While many governments followed the first part of the prescription, most failed to run surpluses in good times. Instead, they succumbed to pressure to divert revenue windfalls to fund new or expanded programs or to cut taxes rather than pay off the debt accumulated in previous recessions. Nonetheless, fiscal policy remains an important tool for stabilizing economic activity. Deficits incurred during recessions should be eliminated during recoveries, however. PROVINCIAL FISCAL POLICY Designing and successfully implementing countercyclical fiscal policies at the provincial level proved to be difficult. Many provinces' revenue bases are subject to large fluctuations because of their dependence on a limited range of economic activities. As a result, fiscal policy has tended to be pro-cyclical, particularly in resource-based provinces. The typical pattern is that in boom times spending increased rapidly as revenues poured in. A commodity price shock would bring the boom to a sudden halt and the economy would go into a nosedive. The government would retrench by sharply cutting spending or boosting taxes, often making the situation worse. þ The British Columbia Experience This pattern matches British Columbia's experience in the late 1970s and early 1980s. The oil price shocks of 1973 and 1979 helped pave the way for double-digit inflation and the commodity price boom of the late 1970s. This generated massive increases in government revenue and similarly large increases in spending soon followed. The commodity price boom and the accompanying exaggerated expectations were brought to a halt by the 1981-82 recession. After accounting for the effects of inflation, provincial revenues collapsed and the government responded to the prospect of ballooning deficits by cutting spending sharply and raising taxes. This helped deepen the recession, as did concerns that the province would never again see the prosperity of the late 1970s. This created a climate of fear and uncertainty among the public, and further reduced consumer spending and business investment. The result was the deepest recession in recent history. Economic activity did not return to the peak reached in the second quarter of 1981 until the fourth quarter of 1984. þ Pro-cyclical Policies and the Emergence of Structural Deficits When the economy began growing again in the mid-1980s, revenues rose rapidly due to very strong economic growth and tax increases. In response to strong revenue growth, provincial government spending began to rise, growing considerably faster than the rate of inflation through the second half of the 1980s. However, despite the booming economy, revenues ultimately could not keep pace with the 13 per cent average annual increases in spending in 1989/90, 1990/91 and 1991/92. Although budget surpluses were recorded in 1988/89 and 1989/90, the pro-cyclical fiscal policy caused a deficit in 1990/91. When the economy did not grow in 1991, a sharp slowdown in revenue growth and the cumulative effects of rapid increases in spending during the 1987-90 boom produced the province's largest-ever deficit -- almost $2.4 billion -- in 1991/92. As a result, the current government inherited a large structural deficit. By definition, this is the part of the overall budget deficit that will not recede when economic growth returns to normal (see box for more details). Policy actions such as tax increases or changes in expenditure policy are the only way to reduce a structural deficit. To help offset the impact of the recent recession, the provincial government maintained investment. As the economy recovered, however, actions have been taken to reduce expenditure growth, thereby reducing the deficit from a peak of $2.4 billion in 1991/92 to $1.5 billion in 1993/94. As Chart E2 illustrates, British Columbia has the lowest deficit relative to gross domestic product of any jurisdiction in Canada. CONCLUSION Progress has been made in reducing British Columbia's structural deficit. However, if the government is to have the flexibility to respond to economic downturns in the future, it must take the opportunity provided by a strengthening economy to bring spending and revenue growth into better balance. If this is not done, British Columbia will find itself on the same debt treadmill as the federal government with more and more tax dollars going to pay debt interest rather than providing services to people. This does not mean slashing social program spending or massive across- the-board tax increases to eliminate the structural deficit in one year. It means a balanced approach of modest tax increases this year aimed at those with the ability to pay, reasonable limits on government spending growth -- not reductions as other provinces are being forced to consider -- and greater efficiency in the delivery of public services. In future years, program spending growth will have to be held below revenue growth. This will require cooperation from taxpayers, from public employees and from those who manage the delivery of key public services. With ongoing progress in controlling spending, British Columbia will move towards its goal of a balanced budget.