A Strategy for Deficit Control Through Faster Growth

The February 1994 federal budget stated the government’s intention to achieve a budgetary deficit that will not exceed 3 per cent of GDP in the fiscal year 1996-971. It also announced a number of tax and spending measures as first steps towards that goal. But these were clearly insufficient for the target to be met on schedule. Table 1 presents the government’s most recent grey book projections based on a “prudent” economic scenario and unchanged policy (Department of Finance, 1994b). They show the budgetary deficit to fall from an expected $39.7 billion in 1994-95 to $35.8 billion in 1995-96 and to $31.3 billion in 1996-97. This reduction in the deficit follows healthy increases in budgetary revenues reflecting the recovering economy, and a twoyear freeze on program spending in nominal terms. The operating surplus is thus expected to increase by $15.1 billion, from $5.4 billion in 1994-95 to $20.5 billion in 1996-97. However, the budgetary deficit is not expected to decrease by the same amount over the period, but only by $8.4 billion. This is due to the build-up of the contingency reserve, and to higher interest payments arising from increasing debt levels and higher-than-expected interest rates. The February Budget Plan had underestimated short-term interest rates by 120 basis point and long-term rates by 200 points for 1994 (Department of Finance, 1994b). Accordingly, interest rate projections for 1995 have been adjusted upward. The Race Between Economic Growth and Debt Accumulation With nominal GDP projected to be $826 billion in 1996, a deficit equivalent to 3 per cent of GDP would be equal to $24.8 billion. Given that the deficit is projected at $31.3 billion, a $6.5 billion shortfall must be made up to meet the deficit target. The policy options flowing from this exercise are very unpalatable. The government must either: 1) cut spending and raise taxes again by a combined amount of at least $6.5 billion; 2) accelerate growth with the help of low interest rates; 3) extend the deficit target deadline beyond 1996; or 4) adopt a combination of the above. A crucial aspect of the policy quandary is timing. There are three dimensions to consider here. First, the deadline for decision is very close. Because fiscal and monetary policy affect the economy with long lags, the key decisions that will determine what 1996 will look like have to be made within the next few months. It is already late in the day. The second aspect of timing is that the American economy is just about to close the gap between its actual output and its non-inflationary potential. Now that the catch-up process is almost complete there, actual real GDP in the United States is likely to grow more in line with potential real GDP, at an annual rate of less than 3 per cent. It is also possible that actual output will exceed potential output in the United States, in which case inflation will return and restrictive monetary policy could inflict another recession on that country. If, at that point, we have not ourselves already recovered from the 1990-1993 slump, such a development