Marc’s Notes on the Economic and Fiscal Update

The surprise Economic and Fiscal Update delivered today demonstrates how politically clever the Harper government is, and at the same time, how out of touch they are. At a time when there are major challenges facing the country, this update, as predicted, squanders the opportunity. Tax cuts will not build any affordable housing, they will not reduce poverty, they will not make it easier to get to work in the morning, they will not improve the life chances for your child, they will not improve conditions on First Nations reserves, and they will do nothing to tackle climate change.

Let’s take a quick walk through the document. First up, the GST cut to 5%, which everyone knew was coming but has been accelerated to Jan. 1, 2008. Good politics for Harper, as he can claim credit for delivering on an election promise that seemed to be a tough one a year ago. Many economists will complain about GST cuts versus other “more efficient” tax cuts, and I will not get into that here.

Next, big corporate income tax cuts. Corporate income tax rates are already lower than in the US, and more tax cuts were already in the pipeline. The EFU accelerates the tax cuts and lowers the bar even further to a 15% rate in 2012 from a scheduled 18.5%. And the feds want the provinces to commit to a maximum combined corporate tax rate of 25%. For comparative purposes, note that back in the heyday of high investment and productivity growth in the 1960s, the federal rate alone was 40%.

Corporate tax cuts are justified on the grounds that they will increase investment in Canada. This is a dubious claim, as corporations invest for so many other reasons: access to resources (think oil patch), access to markets, availability of skilled labour, and energy costs are the main ones. If Canadian rates were way out of line, and all of these other factors were the same as comparator countries, there might be some justification for this move to cut corporate rates, but this is not the case. I have some sympathy for the argument that the Nordic countries tax capital relatively lightly and make up their revenues elsewhere, but I do not see evidence that our rates are that high in comparative terms.

Another related claim is that Canada’s rates on the margin for new investment were too high. This is the marginal effective tax rate claim, advanced by CD Howe and loved by the Finance bureaucrats. There are some questionable methodological issues in how these rates are calculated and how comparable they really are across countries (see this post). At heart, they are based on a neoclassical model that poorly correlates to the corporate sector and investment as we know it in the real world.

In the end, this is huge upper-income tax cut because the ownership of corporate Canada is pretty concentrated in the top decile of the distribution. A second impact is that by maintaining lower rates than the US, the subsidiaries of US-based corporations, who are taxed at home based on their global profits, will simply be paying that tax to the US treasury instead of the Canadian treasury. Why this is seen as good economic policy is rather baffling.

Politics is deeply embedded here, as the Dion Liberals had been talking about their own tax cut package with a big emphasis on corporate tax cuts. This thunder has now been stolen by the Tories, making it hard for the Liberals to vote against the package.

Ditto for the personal tax cuts. More political cleverness here as they restore the 15% bottom bracket rate that the Liberals had brought in just before the 2006 election, and that the Tories raised to 15.5% as part of paying for their first-round GST cut. This is what we get when both the government and the official opposition want tax cuts first and foremost.

Finally, there is an increase in the basic personal exemption, the threshold for paying income tax. This is deceptive, however, as the exemption has already been tied to inflation. The ways and means section has a table showing that the exemption is increased by about $671 in 2007, $298 in 2008, and $6 in 2009 above what would have otherwise been. That last number is not a typo, but $6 dollars (giving it a value in my pocket of $6 x .15 = $0.90).

While increasing the personal exemption is often popular on both left and right, I personally do not like it. It creates two classes of people: those who pay income tax and those who do not. I prefer a system where everyone pays and everyone benefits from the tax system. Even if the rate is very low at the bottom this gives the poor a rightful claim to the public goods and services we provide through taxes.

A final thought is around the possibility of an economic downturn. In the fiscal section, it is reported that a one percentage point drop in real GDP would lead to a negative change in the budget balance of $2.8 billion. Given that the $9.4 billion in tax cuts in 2008/09 leave a planning surplus of $4.4 billion, if real GDP came in at 1% growth for 2008 instead of the latest estimate of 2.4%, then all of the surplus would be eaten up. If growth dropped to zero or below, we would be back in deficit territory – and that would mean spending cuts, I’m willing to bet, not a reconsideration of the tax cuts. This is a classic “starve the beast” strategy as pioneered by the Republicans in Washington.

3 comments

  • Marc and co.:
    Below appears my Straight Goods editorial that gets posted tomorrow. Am now working on a HarperIndex.ca article as well and wanted your comments. My editorial, you’ll see, condemns the govt for putting money into tax cuts rather than combatting climate change. I was wondering if you or other readers could help with some ballpark estimates of the costs of:
    – a national public transportation strategy
    – a national home and industrial energy conservation strategy
    – the cost replacing low-efficiency appliances and vehicles for homeowners? for govt itself?

    It would be good to have such figures for comparison purposes.

    My point is that these kinds of activities would be more important uses of surplus funds than ideologically driven tax cuts.

    Any info anyone can provide would be appreciated.
    Thanks
    Ish

    Save the house for our grandchildren or trash it today?
    Tax breaks from “surprise” federal surplus are irresponsible with environmental crisis at hand

    by Ish Theilheimer

    Tax cuts are the big story in Canada this week. With a $14 billion “surprise” federal surplus (see HarperIndex.ca’s story on this ), speculat
    nt.

    With climate change creating crisis after crisis, spending the surplus on party favours is like wild teenagers hosting a text-message rave and trashing the house when their parents are away. In this case, however, it’s the other way around. The parents are trashing the house and leaving the mess for the kids.

    Politicians and voters alike should ask themselves this question. How will you explain your behaviour in 2007 to your grandchildren in 2027? While the baby boomers are getting ready for their final trip, their grandchildren are likely to be struggling to cope with a grim reality of extinct species, stripped forests, extreme weather, water and food shortages, mass evacuations, and worse.

    “What were people thinking?” they’ll ask us when they hear about how federal and provincial governments continually chose tax cuts and perks instead of the serious action that might have helped avert disaster. “Why didn’t you build rail and transit lines? Why didn’t you super-insulate your homes and switch to renewable energy? Why didn’t you junk all those inefficient appliances and cars you used for decades?”

    Well, we’ll wheeze to them. It would have cost money, so the politicians didn’t say anything very much about it. In fact, most of them competed to see who could give away the most. First they’d cut corporate and upper-income taxes, then throw a bone or two to ordinary people, then they’d go back to cutting corporate and upper-income taxes.

    “But weren’t you aware there was a crisis?” the kids will ask us. Sure we were aware, we’ll tell them, but no one really gave a rat’s ass. We wanted our SUVs and cheap gas, luxury homes and toys, and we really didn’t care about anything else very much, we’ll have to tell them.

    “And when Canada could have taken the lead in getting other countries to stop producing greenhouse gas, we actually did the opposite?” they’ll gasp. Yes, we’ll have to tell the kids it’s true. At a time when scientific reports were confirming the disastrous consequences of unchecked development, Canada was encouraging other countries to adopt phony “aspirational goals” to pollution reduction. Just to prove how little we thought of the crisis, our government thumbed its nose at every international agreement and convention it could.

    “Hey, you shoulda seen our dollar go crazy back then,” we’ll cackle with glee. “It was great…,” we’ll trail off in thought, not finishing the sentence with the candid truth “…until it all went kerflooey.”

    Some gutsy politician might find a great deal of resonance standing up to the Harper Conservatives over choosing to trash the house instead of protecting it for future generations.

    Good luck, kids.

  • Marc,
    Breaking radio silence for a moment to say I thoroughly agree with your analysis, especially the starve the beast bit.

    It’s hard to imagine how the Canadian economy can weather a $1.05 Canadian dollar for long without some dire economic consequences, let alone the pure accounting impact of all that cross border shopping on GDP (see for example this article today from the G&M: http://www.theglobeandmail.com/servlet/story/RTGAM.20071030.wpostal1030/BNStory/Technology/?page=rss&id=RTGAM.20071030.wpostal1030)

    One other note : assuming the economy goes “south,” the budget puts the squeeze on the Libs in another very important way. Because they spawned our balanced budget orthodoxy, the Libs will be hard pressed to put forward any kind of serious spending proposal whether for daycare, health or any other worthy spending project. Worse yet, the Libs would likely play the Democrat card and trumpet their fiscal responsibility with all that that entails.

    Sigh…

    Arun

  • It is clear from the mini-budget, that the Harper plan for the environment is the antithesis of a what is needed. I wonder where the voter opinion polls are on the environment. I guess his statement of a couple years ago that the environment is merely a international socialist plot, is most likely not far from his current beliefs. I think it is time we put together a Canadian version of the Stern report. The economics of the environment are clearly not accounted for in this budget, and the direction forged with these tax cuts is so irresponsible. Again the Canada fails the international community, a country that many see as having fiscal surpluses and the one that could potentially afford to try out some different policies and potentially lead the way. Instead we go the way of the tax cut. Such a lack of vision and small mindedness that it really is embarrassing.

    sigh…..

    pt.

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