Now is one of those times when running a deficit is right

TheGlobeandMail.com – Opinion/commentary – Now is one of those times when running a deficit is right
November 19, 2008. RON KNEEBONE

Some Canadians are fearful that the federal government may slip into a deficit as a result of the global financial crisis. Before buying into this fear, let’s look at how fiscal policy works in Canada.

First, the economic prescription for sound fiscal policy is straightforward: Governments ought to establish spending programs and systems of taxation that operate according to certain rules, then step aside to let those rules operate during both good economic times and bad. For the most part, Canadian governments have followed this advice. The rules that govern the tax system, for instance, specify that the amount we pay in taxes is proportional to our incomes. During good times, we realize increases in income, and the rules require that we pay more in taxes. During bad times, we suffer losses in income, and those same rules require that we pay less in taxes.

This prescription for sound fiscal policy means we should expect that, during good times, spending on government programs will fall and tax revenues will increase. During bad times, the opposite will be true: Spending on government programs will increase and tax collections will fall. These fluctuations in the amount of taxes we pay and the amount of income support we receive from our governments are to be expected and, most important, are desirable – because these fluctuations are a reflection of how government spending programs and tax policies aid Canadians during economic downturns and pay for that help during economic expansions.

Second, the design of spending programs and tax policies should be such that, when the economy is operating as well as we might reasonably expect, the total amount of spending should closely match the total amount of tax revenue collected. That is, the government budget should be in more or less balance – a zero deficit – during periods of economic normalcy. During periods of stronger than usual growth – when tax revenues are growing and the need for income support is small – the design of spending programs and tax policies should be such that the budget should move into surplus. During periods of weaker than normal growth – when tax revenues are shrinking and the need for income support is greater – the budget should move into deficit.

Third, Canadian governments got into serious trouble during the 1980s and early 1990s by ignoring the advice to maintain a balanced budget during periods of economic normalcy. Instead, governments during those years ran large deficits even during periods when the economy was operating as well as we might reasonably expect it could operate over the long term. The result was a rapid accumulation of debt, high interest rates and slower economic growth. To reduce debt, governments in the mid-’90s increased tax rates and cut spending programs to levels that would yield large surpluses during periods of normalcy. While not an appropriate policy to maintain over the long term, it was a necessary short-term measure to reduce previously accumulated debt. The policy proved effective; government debt fell to a level that, today, is the lowest among the G7.

Fourth, over the past five to eight years, we have seen another adjustment to fiscal policy. As the level of government debt has fallen, the government has adjusted tax rates and spending programs so that, during periods of economic normalcy, it would realize a balanced budget – the budgeting policy economists recommend as appropriate over the long term. This adjustment has seen the government cut tax rates and increase spending in order to more closely align tax revenue with spending requirements. The benefit of this adjustment is that Canadians are paying less in taxes and have seen spending on programs such as health care and national defence increase. The cost is that the government will run a deficit until such time that the financial crisis is resolved, after which it will return to more or less balanced budgets.

Far from being a sign of fiscal mismanagement, the deficit the federal government will realize as a result of the financial crisis is, in fact, a sign of sound fiscal policy. Any decision to increase tax rates or cut spending to prevent the deficit would not only be misguided but also would slow our recovery from the current crisis.

Ron Kneebone is professor of economics and director of the Institute for Advanced Policy Research in the School of Policy Studies at the University of Calgary.

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