The Federal Liberal Government in Action: A Report Card

Acknowledgments

The Fraser Institute wishes to thank the Donner Canadian Foundation for providing the funding for Marc Law's 1996 summer internship. The authors also wish to thank Michael Walker, Victor Waese, Filip Palda, Danielle Smith, Jason Clemens, Craig Yirush and other colleagues at The Fraser Institute for helpful comments and suggestions. The authors, of course, take full responsibility for any errors and omissions.

Preface

Michael Walker

It has been a tumultuous time for public policy in Canada. During the past four years we have proceeded to the brink both with respect to the country's constitutional future and its financial survival. We have dealt with the problems of adjusting to a no-inflation economy. We have begun to live with the most comprehensive and liberalizing international trade agreement in modern history, and we have seen most of the provinces reverse their government debt accumulations. We have also begun to retract the social welfare structure which was allowed to mushroom over the past 30 years and, most importantly, we have abandoned the nanny-state unanimity which used to dominate policy discussion.

Against such a background, it might be difficult to sort out the standard of conduct against which a government should be measured. Fortunately, the current government provided us with the Red Book, a handy guide to what we might expect from it. The authors of this report have used it well as their template for policy assessment.

It has been a particular pleasure for me to read this report card and I think that most readers will find it to be a balanced, even-handed, and helpful assessment of the intended and actual policy performance of the current government. Not only will the reader come away with a detailed knowledge of the policy effectiveness of the current federal government, but also with a clear idea of how current policy could be improved. The recommendations for improvement in every case are derived from solid, theoretical, and empirical research.

This report card is a very important source of information for those who disagree with the current government's policy perspective. However, it is even more useful to those who supported the government's policy course, since it provides a detailed assessment of the policies and their likely impact. Of course, it goes without saying that while a government's policy platform is a political matter, the only interest of the report card is the intended and actual impact of the policies themselves. It is for others to assess the politics of the situation.

In view of the fact that this report, like all of The Fraser Institute's research, was conducted independently and was not subject to preview by the Institute's trustees, the views expressed may not conform to those of the trustees or the members of The Fraser Institute. We are making it available both to assist the federal government in improving its performance, and to stimulate discussion and debate about policy adjustments that would improve our economic condition.

Summary of the Main Policy Recommendations

For more detailed explanations of the following policy proposals, please see the relevant sections in the main text.

Budget Policy: Deficits and Debts

(1)Accelerate the pace of deficit elimination in order to balance the budget by year 2000.

(2)Legislate penalties for cabinet members in the event that deficit targets are not met.

(3)Develop a debt elimination strategy. Legally or constitutionally entrench this strategy.

(4)Entrench in the constitution a balanced budget amendment that would require the federal government to balance the budget over the business cycle (i.e. every 3 years).

Taxation Policy

(1)Replace the current Personal Income Tax with a flat rate income tax.

(2)Replace the GST with a harmonized sales tax.

(3)Reduce payroll taxes.

(4)Entrench in the constitution a taxpayer protection amendment.

Industrial Policy

(1)Stay clear of all interventionist micro-economic policies. End all government-industry partnerships.

(2)Terminate all regional development programs (i.e. WED, ACOA, FedNor, FORD-Q and CQSA).

(3)Refrain from any more "infrastructure renewal" projects.

(4)Push for greater interprovincial free trade.

Social Policy

(1)Limit eligibility for the Seniors' Benefit to seniors whose incomes fall below the Sarlo "basic needs" poverty line.

(2)Privatize Employment Insurance (EI) and operate it as a true insurance program with actuarially correct premiums.

(3)Turn the Canada Pension Plan (CPP) into a fully funded system of mandatory RRSPs.

(4)Discontinue funding of all EI-sponsored training programs.

Health Policy

(1)Repeal the Canada Health Act.

(2)Allot all government funds for health care to consumers directly through a system of Medical Premium Accounts (MPA).

International Trade and Foreign Aid Policy

(1)Eliminate all foreign aid spending.

(2)Expand NAFTA to South and Central America.

(3)Refrain from imposing any environmental or labour "side agreements" on future trade deals.

Transportation Policy

(1)Open all domestic air routes to foreign competition.

(2)Relinquish the ability to regulate transportation prices by amending the Canada Transportation Act.

(3)Avoid any future transportation mega-projects. Do not finance the Windsor-Quebec City TGV.

Labour Policy

(1)Repeal the Employment Equity Act.

(2)Repeal Part 1 of the Canada Labour Code.

(3)Pass Right-to-Work legislation.

Regulatory Policy

(1)Impose a moratorium on new federal regulations

(2)Liberalize compliance by introducing market mechanisms and regulatory alternatives.

(3)Minimize inter-jurisdictional conflict over regulations

(4)Prioritize regulations according to risk. Study economic impact of all proposed regulations before implementation.

(5)Liberalize the financial sector by allowing foreign competition. Eliminate all regulatory pillars in the financial industry by amending the Bank Act.

Agricultural Policy

(1)Eliminate the Canada Wheat Board (CWB).

(2)Phase out all remaining agricultural subsidies, price supports, and tariffs.

Immigration Policy

(1)Reaffirm commitment to maintaining an immigration rate of 1% of total population per year. Restore yearly intake of immigrants to 250,000 to 290,000 per year.

(2)Continue to increase the proportion of independent class immigrants admitted each year.

Cultural Policy

(1)Eliminate the Canada Council and all other federal funding of arts granting agencies.

(2)Repeal all Canadian content regulations.

(3)Privatize the CBC, Telefilm Canada, and the National Film Board.

Justice Policy

(1)Request that the House of Commons Legal Affairs Committee review the client mandate of the Department of Justice.

(2)Do not reintroduce the Pearson Airport Bill.

(3)Put cost restitution into the Young Offenders Act. Remove anonymity protection.

(4)Repeal Firearms Registration Requirement.

(5)Consolidate and reform legal aid funding.

(6)Initiate a substantial civil justice reform initiative along the lines of the Woolf Inquiry in the United Kingdom.

(7)Introduce public tendering for all outside government legal work.

(8)Submit judicial nominations to approval of a parliamentary committee.

Constitution and the National Unity File

(1)Follow the principle of subsidiarity: devolve power to the provinces by way of administrative, as opposed to constitutional change. Engage in a comprehensive review of government.

(2)Pursue more inter-jurisdictional co-ordination so as to minimize overlap and duplication. Abandon all "national standards."

(3)Develop a "Plan B," a contingency plan to hold the rest of Canada together in the event that Quebec should vote to separate.

Introduction: the Federal Liberal Government

In the fall of 1993, the federal Liberals came to power in Canada with a promise to achieve job creation, economic growth, and a rising standard of living for Canadians. Since the 1970s, the Canadian economy has experienced rising unemployment and slow economic growth; over the past three years, the unemployment rate has averaged over 10 percent. The burden of taxes has increased sharply and government budget deficits have exploded; interest payments on the accumulated debt total over one-third of every tax dollar Ottawa spends. In their Red Book of election promises, the Liberals stated that their number one objective would be to fix these problems and get the economy back on track. In fact, in the first chapter of the Red Book, the Liberals declared:

A strong economy is the essence of a strong society. A Liberal government will put jobs and economic growth at the forefront of its objectives. See Liberal Party of Canada, Creating Opportunity: The Liberal Plan for Canada, Ottawa: Liberal Party of Canada, 1993, p. 15.Note

The Liberal government has now been in power for nearly three years. How well has it done in achieving these objectives? Will the policies implemented by the Liberals strengthen the Canadian economy and create jobs or will they make things worse? What policies, if implemented, would bring us closer to achieving the objectives of job creation and strong economic growth? These are questions that can be answered by positive economic analysis. Indeed, these are the questions that should be asked in any rational debate about public policy.

Purpose of the report card

This report card aims to shed some light on the federal policy debate by conducting an economic analysis of the public policies adopted by the Liberal government since it took office in the fall of 1993. It will highlight what the Liberal government has done in each of the major policy areas and evaluate these actions within the framework of positive economics. It is hoped that such an analysis will encourage a more rational debate about public policy, dealing directly with the real consequences of particular policy actions.

The federal Liberal government's proclaimed raison d'etre is to strengthen the Canadian economy and create jobs. Thus, an introduction to this report card could not be complete without a brief discussion on the positive economics of job and wealth creation. Such a discussion aims to make explicit the framework within which this study analyzes and evaluates the federal government's policy actions.

The positive economics of prosperity

Positive economic analysis tells us that the key to the creation of jobs and wealth is economic freedom. A recent collaborative study completed by The Fraser Institute and ten other public policy institutes around the world found that economic freedom-personal choice, protection of private property, and freedom of exchange-is an important condition for economic growth. See James Gwartney, Robert Lawson, and Walter Block, Economic Freedom of the World: 1975-1995, Vancouver: The Fraser Institute, 1996.Note The findings of this study show a clear correlation between economic freedom and prosperity. During the period from 1975 to 1995, no country that had a persistently high economic freedom rating failed to achieve high income levels. Countries that achieved the greatest increase in economic freedom also experienced the fastest economic growth rates; meanwhile, countries that experienced decreases in economic freedom had slow or even negative economic growth rates. The empirical evidence from around the world surveyed in Economic Freedom of the World: 1975-1995 suggests that the way to increase the prosperity of a nation is to increase the economic freedom of its citizens.

Any government that plans to increase the economic freedom of its citizens must restructure itself to ensure the efficient operation of private markets. Operationally, this implies:

(1)Less government spending;

(2)Lower taxes;

(3)Fiscal balance;

(4)Less government regulation;

(5)More private forces in the delivery of public services; and

(6)More decentralization of political decision making.

An ambiguous performance

Since it assumed office in 1993, the Liberal government has adopted a number of public policy initiatives, all ostensibly aimed at strengthening the Canadian economy. A positive economic analysis of the Liberal government's policy actions suggests that their overall performance in this regard has been ambiguous. The Liberals have embraced market forces in some areas, particularly in transportation and international trade, but have implemented fiercely interventionist industrial and cultural policies. Government regulation of the labour market continues to be rigid, inhibiting the ability of the private sector to create jobs, while over-regulation of the economy continues. Some moves have been made towards fiscal balance, but growth in the federal public debt continues unabated. Furthermore, the federal government continues to resist the decentralization in political decision-making that is necessary to hold the country together and to preserve the Canadian economic union.

For this ambiguous performance, the federal Liberal government deserves an overall conditional pass grade of D.

Budget Policy: Deficits and Debt

Grade: B

The politics of deficits and debts For a thorough discussion of the political economy of deficit finance see James M. Buchanan and Richard E. Wagner, Democracy in Deficit, New York: Academic Press, 1977.Note

Rampant government spending and runaway deficits and debts have become pervasive features of Western democracies. As a result of the political pressure to spend without raising taxes, governments in Canada and abroad have run large deficits for nearly 20 years and have only recently started to move towards fiscal balance. Perhaps no greater problem faces governments today than the need to achieve fiscal balance through a regime of austere fiscal retrenchment.

Of course, the political will to achieve this goal is often weak. Few governments like to reduce spending because cutbacks may undermine political support. Tax hikes are similarly unpopular, and there is mounting evidence to suggest that tax increases do not in fact generate more revenue. See Daniel J. Mitchell, "The Impact of Higher Taxes: More Spending, Economic Stagnation, Fewer Jobs, and Higher Deficits," Backgrounder No. 925, Washington: The Heritage Foundation, 1995.Note Deficit reduction is thus inimical to the self interest of a politician whose time horizon does not extend beyond the next general election. Hence, the preferred course of action for the career politician is to stay the course and continue to run deficits.

However, recent evidence suggests that voters may have seen through the fiscal illusion of postponing taxation by running deficits. The success of Premier Ralph Klein in Alberta and Premier Mike Harris in Ontario, and the former Labour government in New Zealand, all of whom won elections on platforms of fiscal retrenchment and deficit elimination, speaks directly to this fact. The responsible politician whose time horizon extends well into the future can take heart; a fiscally responsible economic strategy can be both prudent and politically popular.

The economics of deficit reduction: the need for fiscal retrenchment

The economic case for deficit reduction is straightforward. A deficit is nothing but a deferred tax. To the extent that increases in the deficit are not fully anticipated by households and are not matched by an equivalent increase in the supply of savings, the effect of a deficit is to raise the real interest rate. For a good discussion of the impacts of budget deficits on macroeconomic activity see B. Douglas Bernheim, "A Neoclassical Perspective on Budget Deficits," Journal of Economic Perspectives, vol. 3, no. 2, 1989, pp. 55-72.Note Higher real interest rates increase the cost of borrowing and "crowd-out" private investment. Hence, since deficits reduce productive investment, the long run effect of the deficit is to slow down the accumulation of capital and the rate of economic growth. For the formal proof of this proposition see Peter A. Diamond, "National Debt and Neoclassical Economic Growth," American Economic Review, vol. 55, 1965, pp. 1125-1150.Note

In Canada, there is no evidence supporting the position that increases in the deficit have been anticipated by households and have been accompanied by increases in the level of domestic savings. See Robert Crozier, "Deficit Financing, the Decline of Savings, and the Rise in Foreign Borrowing in Canada from 1970-1994," in Fraser Forum February 1996, Vancouver: The Fraser Institute, pp. 13-17. For U.S. evidence see Edward M. Gramlich, "Budget Deficits and National Saving: Are Politicians Exogenous?" Journal of Economic Perspectives, Vol. 3, No. 2, 1989, pp. 23-36.Note Hence, government deficits have raised both the demand for financial capital and real interest rates. Ibid.Note Furthermore, in recent years there has been a decline in the domestic savings rate. Ibid.Note The coincidence of large budget deficits and a low domestic savings rate has created the problem of "twin deficits:" the simultaneous occurrence of a government budget deficit and a current account deficit. Thus, the full effect of a budget deficit is to reduce our long run growth rate and increase our level of foreign indebtedness since a current account deficit is required to finance the gap between what the government spends and what it collects in tax revenue. It is important to point out, however, that Canada is expected to have an annualized surplus of around $600 million in its current account for the period April to June, 1996. Achieving this surplus is significant in that the country can reduce its dependence on foreign debt.Note

While there may be some agreement among analysts and the public at large on the need to work towards deficit elimination, there is much less agreement as to how quickly the government should work towards achieving a balanced budget. Indeed, many Canadians are concerned that rapid fiscal retrenchment may result in diminished consumer confidence, job losses, and an economic slump. This view is based on fear that a reduction in government spending lowers aggregate demand, employment, and output. See Alexander Macmillan, Macroeconomics in a Canadian Context, Scarborough: Prentice Hall of Canada, 1980.Note While the demand-driven Keynesian economic logic may be persuasive at a superficial level, it fails to account adequately for expectations and leaves the "supply side" of the economy virtually unspecified. For a discussion of the failure of Keynesian macroeconometric models to account for the supply side, see Peter S. Spiro, "The Effects of Fiscal Policy on Canadian Economic Growth and Employment," Ontario Ministry of Finance Macroeconomic Analysis and Policy Branch Working Paper, 1996. For an overview of the fundamental problems with the Keynesian model, see Robert G. King, "Will the New-Keynesian Macroeconomics Resurrect the IS-LM Model?" Journal of Economic Perspectives, vol. 7, no. 1, 1993, pp. 67-82.Note The negative impact of deficit reduction on total aggregate demand is likely to be overstated in a simple Keynesian framework, as recent empirical studies suggest that Canada's fiscal policy multiplier is very small. For estimates of Canada's fiscal policy multiplier see John Helliwell, "What's Left for Macroeconomic and Growth Policies?" Bell Canada Papers on Economic and Public Policy 2, Kingston: Queen's University Press. See also John Bossons, "Issues in the Analysis of Government Deficits," in John Sargent, ed. Fiscal and Monetary Policy, Toronto: University of Toronto Press, 1986, pp. 85-112.Note

A more coherent simulation of the costs and benefits of deficit reduction conducted recently by William Scarth finds that a strategy of deficit elimination does indeed pass the cost-benefit test. See William Scarth, "Deficit Reduction: Costs and Benefits," Commentary No. 61, Toronto: C.D. Howe Institute, 1994.Note While deficit reduction may increase unemployment in the short run, it will reduce structural unemployment permanently by an equivalent amount. According to Scarth, this permanent reduction in structural employment occurs because lower deficits result in lower taxes, lower interest rates, and more investment. Hence, over the long haul, deficit reduction should enhance economic growth and should produce benefits equivalent to a permanent 3 percent increase in living standards.

Experience from other countries reinforces this conclusion. Examining the economic impacts of two severe fiscal retrenchments in Europe, Giavazzi and Pagano found that rapid spending cuts can actually be expansionary under certain

circumstances. See F. Giavazzi and M. Pagano, "Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries," NBER Macroeconomics Annual, 1990, pp. 75-111.Note That is, the "regime change" signalled by a rapid move toward fiscal balance can change the expectations and behaviour of economic agents and stimulate the economy. Thus, practical experience from abroad suggests that deficit reduction may bring about both long run and short run gains, if economic agents believe that the government's fiscal retrenchment signals a permanent decrease in government spending and taxation. Keynesian policy analysis may thus be both inaccurate and misleading. For a fundamental critique of Keynesian macroeconometric methods see Robert E. Lucas Jr., "Econometric Policy Evaluations: A Critique," in Brunner and Meltzer eds., The Phillips Curve and the Labor Market, Amsterdam: North Holland, 1976. For more misgivings about Keynesian macroeconometrics see Christopher A. Sims, "Macroeconomics and Reality," Econometrica, vol. 48, 1980, pp. 1-40.Note

What was promised

The need to gain control over Canada's fiscal situation figured fairly prominently in the last federal election campaign. The Liberal party stated in their Red Book of campaign promises that, if elected, deficit reduction would be a key element in their economic strategy:

A Liberal government will reduce the deficit. We will implement new programs only if they can be funded within existing expenditure. We will exercise unwavering discipline in controlling federal spending and will reorder current spending priorities to make sure that maximum return is obtained on each investment. Liberal Party of Canada, Creating Opportunity: The Liberal Plan for Canada, Ottawa: Liberal Party of Canada, 1993, p. 19.Note

In the Liberals' view, not only should deficit reduction be a priority in their economic program; it must be achieved credibly and realistically:

The Liberal approach is to set realistic targets and to implement the policies necessary to meet them. This philosophy will do more than any other single measure to restore international confidence in Canada. A Liberal government recognizes the need for economic policies that earn the trust and confidence of international markets. Ibid.Note

However, despite the need to restore fiscal balance and work quickly towards a balanced budget, the only explicit target set by the Liberal party in its Red Book was "to reduce the federal deficit to 3 percent of gross domestic product by the end of its third year in office." Ibid.Note Why such a target was set is unclear since the Liberals also concede in the Red Book that "[a]ny responsible government must have as the goal the elimination of the deficit. That is our goal." Ibid.Note

What was done

Since it took office in the fall of 1993, the Liberal government has worked towards getting its fiscal house in order. The federal budget deficit has been cut significantly from $42 billion (5.9% of GDP) in 1993-94 to $32.7 billion (4.2% of GDP) in 1995-96 with an anticipated $24.3 billion (3% of GDP) in 1996-97. Department of Finance, Budget in Brief, Ottawa: Department of Finance, 1996.Note By keeping to its stated targets and using conservative economic forecasts, the federal government has improved its fiscal credibility.

Furthermore, to its credit, much of the reduction in the federal deficit has been due to cuts to program expenditure. Program spending has fallen from a high of $120 billion in 1993-94 to $113.8 billion in 1995-96; it is projected to fall further to $109 billion in 1996-97. Ibid.Note Meanwhile the federal government's operating balance (i.e. the difference between revenues and operating expenses, exclusive of interest payments) has improved from a deficit of $4 billion in 1993-94 to a surplus of $16.8 billion in 1995-96. Ibid.Note These are all signs of an improving fiscal climate and show that the Liberal government has, at very least, been working in the right direction.

Policy analysis

However, there are still reasons to be concerned. For one thing, as long as the federal government runs a deficit, the accumulated debt of the federal government will continue to rise. According to Ministry of Finance figures, the net public debt of the federal government has risen from $508.2 billion in 1994-95 to $602.7 billion in 1995-96. Ibid.Note Hence, although some spending has been cut and the deficit is lower than before, the public debt of the federal government has risen by nearly $100 billion since the Liberal government took office. Thus, we are still a long way from true fiscal balance, which requires that the deficit be eliminated completely, and that the total federal debt be paid off gradually. Prudence necessitates that spending be cut further and that the federal government target deficit elimination at a much faster rate than it is doing currently.

Indeed, a growing body of evidence suggests that current levels of spending are simply unsustainable. Using a technique called "generational accounting," economists are able to estimate how big the tax burden on future generations will be if we leave the entire burden of stabilizing the debt to these future taxpayers. Two "generational accounting" studies done recently for Canada indicate that young Canadians can expect to pay significantly more in taxes than they receive in benefits if debt stabilization is put off until the future. See Christopher Good, "The Intergenerational Accounts of Canada," Fraser Forum Critical Issues Bulletin Vancouver: The Fraser Institute, 1995. See also Philip Oreopoulos and Laurence J. Kotlikoff, "Restoring Intergenerational Balance in Canada," IRPP Choices Montreal: Institute for Research on Public Policy, 1996.Note Older Canadians, by contrast, stand to gain from a delay in fiscal retrenchment. Hence, given that future generations will be unable to bear such a burden, the government should act quickly to stabilize the debt in order to achieve greater intergenerational equity.

Finally, it should be noted that, contrary to the claims of some social policy activists, reducing government spending will not adversely affect social indicators and bring about an explosion in the so-called "social deficit." A paper recently completed by the International Monetary Fund (IMF) is instructive in this regard. In this study, IMF economists Tanzi and Schuknecht review the empirical evidence on the growth of government in the twentieth century. They find that while the initial increase in government spending in the first part of the century may have brought about improvements in key socio-economic indicators, most of the post-World War II increase in government spending (which coincided with the growth of the welfare state) did not bring about significant improvements in these same indicators. Moreover, nations with small governments fared no worse than those with large governments. Specifically, the authors conclude that:

Though the evidence available is limited, various government performance indicators suggest that the growth in [government] spending after 1960 may not have brought about significantly improved economic performance or social progress. In a sense, this growth in spending was less "socially productive" than that before this period. . . . Improvements in economic and social indicators after 1960 have been quite limited and countries with small governments generally have not fared worse than those with big governments. Real economic growth declined somewhat between 1960 and 1990. . . . Gross fixed capital formation and inflation did not change significantly between 1960 and 1990 and by 1990, they did not differ much between country groups. The unemployment rate, the share of the shadow economy, and the number of registered patents suggest that small governments exhibit more regulatory efficiency and inhibit less the functioning of labour markets, the participation in the formal economy and the innovativeness of the private sector. . . . Social indicators, such as income distribution, literacy, secondary school enrolment, life expectancy and infant mortality improved modestly between 1960 and 1990 in all three groups. . . . In conclusion, the evidence available, while limited, suggests that small governments did not "produce" less desirable social indicators than big governments. Furthermore, they have had better economic and regulatory efficiency indicators. From Vito Tanzi and Ludger Schuknecht, "The Growth of Government and the Reform of the State in Industrialized Countries," IMF Working Paper, 1995, pp. 20-21.Note

The authors thus conclude that government's share of GDP could be below 30 percent without adversely affecting key socio-economic indicators. In addition, such a reduction would be accompanied by faster economic growth. Hence, concerns about the effects of fiscal retrenchment on the "social deficit" are probably misplaced. Smaller government is indeed better government.

Policy proposals

In light of the evidence presented above, the federal government should:

(1)Accelerate the pace of deficit elimination. While the federal government has laudably kept to its targets, it is clear that a deficit to GDP ratio of 3 percent is insufficient. Hence, the federal government should develop a clear plan for deficit elimination by the end of this century. Budget balance should be achieved exclusively through spending cuts, not tax increases. See Robin Richardson and Michael Walker, "How to Balance the Federal Budget and Keep Canada Together," in Fraser Forum, Vancouver: The Fraser Institute, February, 1996, pp. 5-17.Note

In order for this to be achieved credibly, the federal government should follow the lead of the Manitoba government and legislate penalties for Cabinet members in the event that deficit reduction targets are not met. See Government of Manitoba, The Balanced Budget, Winnipeg: Government of Manitoba, 1995.Note This will send a clear signal that the federal government is indeed serious about eliminating the deficit, and will properly re-align the incentives of politicians who tend to overspend.

(2)Develop a debt reduction strategy. Balancing the budget is not enough. If we are to do a service to future generations, the debt must be paid back. This debt reduction strategy, enshrined in the constitution, should mandate that all future budget surpluses be allocated exclusively to paying down the debt.

(3)Enshrine both a balanced budget amendment and a taxpayer protection amendment in the constitution. These amendments should require that the federal government balance its budget over the business cycle (i.e. over a three year period). The evidence from the United States suggests that a well designed balanced budget amendment is the most effective way to curb the tendency of politicians to overspend. For a comprehensive overview of the U.S. experience with legislated and constitutional balanced budget measures see Dean Stansel, Taming Leviathan: Are Tax and Spending Limits the Answer?, Washington: The Cato Institute, 1994.Note By "tying the hands" of our elected officials, a balanced budget amendment will make it nearly impossible for the federal government to create another fiscal crisis.

Conclusion: right direction but insufficient action

The need for fiscal retrenchment has never been as acute as it is today. From its rhetoric and actions, it seems that the federal Liberal government recognizes this fact and has initiated the largest round of spending cuts in recent Canadian history. Finance Minister Paul Martin has kept to his targets and has reduced the deficit according to schedule. We must give the Liberal government credit for making significant inroads towards achieving fiscal balance.

However, a deficit target of 3 percent of GDP is clearly insufficient. If we are to solve our fiscal crisis, the deficit must be eliminated completely and the debt must be gradually paid off. The evidence suggests that rapid deficit elimination can bring about economic benefits through lower real interest rates and lower taxes. Although the Liberal government has been moving in the right direction, it has been moving too slowly. In fact, the federal government occupied the bottom spot on The Fraser Institute's revenue and deficit and debt indices. Only a reasonable performance on the spending index saved the federal government from the bottom spot overall.Note

For this the Liberal government deserves a B.

Taxation Policy

Grade: D

Taxation, incentives and economic growth

Incentives matter. Economic theory, buttressed by countless empirical studies, suggests that by altering the costs and benefits of an activity, taxation can change the incentive structure faced by individuals and firms and can motivate outcomes that would not have occurred in the absence of taxation. For a rudimentary discussion of the effects of taxation on economic behaviour, see James D. Gwartney and Richard L. Stroup, What Everyone Should Know About Economics and Prosperity, Vancouver: The Fraser Institute, 1993. A more theoretical discussion is provided in Henry J. Aaron and Joseph A. Pechman, eds., How Taxes Affect Economic Behaviour, Washington: The Brookings Institution, 1981.Note High marginal tax rates on labour income reduce the relative price of leisure and discourage work effort. For an overview of the evidence, see James J. Heckman, "What has Been Learned About Labor Supply in the Past Twenty Years," American Economic Review, vol. 84, no. 2, 1993, pp. 116-121. See also Robert K. Triest, "The Effect of Income Taxation on Labor Supply in the Uniter States," Journal of Human Resources, vol. 25, no. 3, pp. 491-516.Note Payroll taxes increase the price of labour input and thus induce firms to substitute capital for labour. See Organization for Economic Cooperation and Development, OECD Jobs Study: Part 1, Paris: OECD, 1994.Note Taxation of capital gains reduces both savings rates and aggregate investment. See Lawrence H. Summers, "The After-Tax Rate of Return Affects Private Savings," American Economic Review, vol. 74, no. 2, 1984, pp. 249-253. For a more complete discussion of the issues see Norman B. Ture and B. Kenneth Sanden, The Effects of Tax Policy on Capital Formation, Washington: Institute for Research on the Economics of Taxation, 1977.Note Furthermore, a punitive sales tax can encourage tax evasion and may push individuals into the "underground economy." See Paul Starobin, "The Economy You Can't See," National Journal, June 18, 1994. A more detailed discussion can be found in Edgar L. Feige, ed., The Underground Economies: Tax Evasion and Information Distortion, Cambridge: Cambridge University Press, 1989.Note

International evidence suggests that economies with lower taxes experience more rapid economic growth. In his study for the World Bank, Keith Marsden finds that countries with lower taxes grow faster, invest more, and experience higher productivity gains. See Keith Marsden, "Links Between Taxes and Economic Growth: Some Empirical Evidence," World Bank Staff Working Paper No. 605, 1983.Note Another study by economists Robert King and Sergio Rebelo estimates that a 10 percent increase in the tax burden of a country reduces its annual GDP growth rate by 2 percent. See Robert G. King and Sergio Rebelo, "Public Policy and Economic Growth: Developing Neoclassical Implications," Journal of Political Economy, vol. 89, 1990, pp. S126-S150.Note Similarly, William Easterly and Sergio Rebelo conclude that there is "an impressive negative relation between the rate of growth and the ratio of tax revenue to annual GDP growth," as well as a "negative association between growth and . . . the `marginal income' tax rate." See William Easterly and Sergio Rebelo, "Fiscal Policy and Economic Growth: An Empirical Investigation," unpublished manuscript, 1993.Note The economics behind these conclusions is straightforward. Lower tax rates encourage innovation, more work effort, and higher savings rates. Since these activities are instrumental in the growth process, economies that encourage them are likely to grow faster and to create more jobs.

Canada: an unfortunate tax history

Unfortunately, Canada's tax history over the past 30 years has not been favourable. From 1964 to 1994 real federal government spending increased by 304 percent. Canadian Taxpayers Federation, The Taxpayer Protection Amendment: A Constitutional Proposal to Restore Fiscal Responsibility to the Government of Canada, Edmonton: Canadian Taxpayers Federation, 1996.Note Real GDP grew by only 176 percent over the same period. Ibid.Note This massive increase in spending necessarily has led to a similar increase in taxes. Between 1964 and 1994, direct taxes on individuals have increased by 2,501 percent, indirect taxes have risen by 975 percent, and corporate taxes have gone up by 649 percent. Ibid.Note

Another way of looking at this burden is to calculate Canada's Tax Freedom Day, the day when the average Canadian family stops paying taxes. In 1961, Canada's Tax Freedom Day fell on May 3rd. By 1996, it had advanced by 53 days to June 25th. See Joel Emes and Michael Walker, "Canadians Start Working for Themselves on June 25th," Fraser Forum, July 1996, Vancouver: The Fraser Institute, pp. 5-10.Note Viewed from this perspective, it is clear that the tax burden of the average Canadian family has risen dramatically over time.

Furthermore, compared to our major trading partners, our tax burden is relatively high. In Canada, the ratio of total tax revenues to GDP was 37.3 percent in 1991, compared to 30.9 percent in Japan, 29.8 percent in the United States, and 36 percent in the United Kingdom. See Isabella Horry, Filip Palda and Michael Walker, Tax Facts 9, Vancouver: The Fraser Institute, 1994.Note If Canada is to remain competitive with other nations, the burden of taxes on the Canadian economy must be reduced.

Empirical evidence on the effects of taxation in Canada

There is large body of evidence showing that the tax burden is large and growing. Professor Bev Dahlby estimates that each additional dollar of taxes collected through personal income tax costs the economy $1.38 in lost output. See Bev Dahlby, "The Distortionary Effect of Raising Taxes," in W. Robson and W. Scarth eds, Deficit Reduction: What Gain, What Pain, Toronto: C.D. Howe Institute, 1994.Note According to this study, the "shadow cost" of the personal income tax is quite substantial as the tax structure distorts economic incentives.

The effects of payroll taxes are equally negative. Over the past 30 years, payroll taxes have risen from 3 percent to 13 percent of total government revenue. See Livio De Matteo and Michael Shannon, "Payroll Taxation in Canada: An Overview," Canadian Business Economics, vol. 3, no. 4., Summer 1995, pp. 5-22.Note Livio De Matteo and Michael Shannon estimate that a 1 percent increase in average payroll taxes results in a 0.56 percent rise in real wage costs to employers, a 0.55 percent drop in real wages received by employees, and a 0.32 percent fall in employment levels. Ibid.Note This finding is supported by Ron Parker of the Bank of Canada, who finds that the increase in payroll taxes from 10.6 percent of wages and salaries in 1991 to 14.1 percent in 1994 may have reduced employment levels by about 1 percent in 1993. See Ron Parker, "Aspects of economic restructuring in Canada, 1989-1994," Bank of Canada Review, Ottawa: Bank of Canada, 1995.Note It is obvious from these studies that payroll taxes are "job killers."

Furthermore, recent research asserts that rising taxes may be partially responsible for the size of the informal economy, estimates of which range

from a high of 20 percent of GDP See Rolf Mirus, Roger S. Smith, and Vladimir Karoleff, "Canada's Underground Economic Revisited: Update and Critique," Canadian Public Policy, vol. 20, no. 3, 1994, pp. 235-252.Note to a low of 4.5 percent, See Don Drummond, Mireille Ethier, Maxime Fourgere, Brian Girard, and Jeremy Rudin, "The Underground Economy: Moving the Myth Closer to Reality," Canadian Business Economics, vol. 2, no. 4, 1994, pp. 3-17.Note depending on the methodology used. This assertion is supported by Peter Spiro in a paper completed for the Canadian Tax Foundation. Spiro estimates that the advent of the GST in 1992 brought about a tax revenue loss of roughly $2.3 billion to all levels of government in 1992. See Peter S. Spiro, "Evidence of a Post-GST Increase in the Underground Economy," Canadian Tax Journal, vol. 42, no. 4, 1993, pp. 1059-81.Note Thus, part of the impact of high tax rates in Canada (in particular, high sales taxes) has been to encourage the growth of the underground economy and in so doing reduce government revenues.

The Red Book and after: no promises and no action

In spite of the above evidence suggesting that our tax system is both inefficient and uncompetitive, the Liberals made few explicit promises with respect to tax reform in the 1993 election campaign. According to the Red Book:

In the first session of a new Parliament, a Liberal government will give an all-party Finance committee of the House of Commons a 12-month mandate to consult with Canadians and provincial governments and to report on ways to achieve tax fairness. In particular, the committee will be mandated to report on all options for alternatives to the current GST. A Liberal government will replace the GST with a system that generates equivalent revenues, is fairer to consumers and to small business, minimizes disruption to small business, and promotes federal-provincial fiscal cooperation and harmonization. Liberal Party of Canada, Creating Opportunity: The Liberal Plan for Canada, Ottawa: Liberal Party of Canada, 1993, p. 22.Note

While there is a recognition that the GST "is costly for small business to administer and very expensive for the government to collect," and that it may have also "stimulated the underground cash economy," Ibid.Note the Red Book does not mention the need to reform any other tax. In fact, it suggests that the only tax reform needed is sales tax harmonization. No other tax is mentioned. The Liberal government obviously never intended that fundamental tax reform would be a major item driving its economic policy agenda.

Unfortunately, the Liberal government has essentially kept this promise. The tax burden remains high in Canada. Instead of making major efforts to overhaul the system and reduce tax rates, this government has increased some taxes. For example, the Large Corporation Tax was increased, the corporate surtax was raised from 3 percent to 4 percent, and a so-called "temporary" capital tax on large financial institutions was introduced in the 1995 Budget and extended in the subsequent budget to October 1996. Department of Finance, Budget in Brief, Ottawa: Department of Finance, 1993.Note Aside from these increases, little else has been done. While the good news is that the overall tax burden has not increased significantly, the bad news is that the Liberal government is not seizing the opportunity to embark on a fundamental reform of our tax system.

The principle of sales tax harmonization with the provinces is sound, as it will reduce administrative and compliance costs for governments and businesses. Harmonizing the sales tax regime with respect to the tax base and administration will not, however, preclude individual provinces from changing their sales tax rates as they deem fit. The federal government's recent efforts to encourage sales tax harmonization are a cause for concern. In particular, the Liberal government's promise to subsidize the Atlantic provinces by nearly $1 billion in exchange for harmonization is both inequitable and inefficient, as the subsidy ultimately will mean higher taxes for the rest of the country. See Canadian Taxpayers Federation, "News Release: GST Harmonization Plan Will Lead To Tax Increases," April 23, 1996.Note

Policy proposals: what fundamental tax reform should entail

If the current Liberal government is as serious about getting the economy back on track as it claims to be, then it must engage immediately in fundamental tax reform. While, of course, tax reform alone will not solve all of our economic problems, the international evidence suggests that tax reform is a necessary condition for economic recovery. Any fundamental tax reform package should include the following elements:

(1)A flat rate income tax. A single, flat rate tax on personal income will go a long way in enhancing the efficiency and neutrality of our income tax system. The empirical evidence suggests that flat rate taxes encourage more work effort, higher savings rates, and faster economic growth. For a straightforward, general exposition of the merits of a flat rate income tax see Daniel J. Mitchell, "Jobs, Growth, Freedom, and Fairness: Why America Needs a Flat Tax," Backgrounder no. 1035, June 25, 1995, Washington: The Heritage Foundation.Note Furthermore, contrary to popular opinion, flat rate taxes do not penalize the poor. Under a broad variety of flat rate tax proposals, low income families pay less tax than under a progressive tax structure. This point is discussed at length in Daniel J. Mitchell, "Why Liberals Should Support the Flat Tax," F.Y.I. no. 85, February 7, 1996, Washington: The Heritage Foundation.Note Hence, flat rate taxes should be encouraged even by those who wish to promote a more equitable distribution of income.

There are many feasible flat rate tax proposals that have been proposed in recent years, including the Hall-Rabushka and Armey plans in the United States, An overview of the U.S. proposals can be found in Mitchell (1995) op cit. For more details on the Hall-Rabushka plan see Robert E. Hall and Alvin Rabushka, Low Tax, Simple Tax, Flat Tax, New York: McGraw-Hill Book Co., 1993.Note and the Dennis Mills and Reform Party plans in Canada. The two Canadian flat tax proposals are outlined in Dennis Mills, "The Single Tax System: A Proposal for Tax Reform," and in Ken Boessenkool, Herbert Grubel, and Jim Silye, "A Flat Tax For Canada." Both were papers presented at The Flat Tax Conference convened by The Fraser Institute on October 31, 1995.Note Any of the above proposals would be a significant improvement over the status quo. However, any successful flat rate income tax plan should include a single tax rate to any income subject to tax, the elimination of most deductions, credits, and exemptions, and the end of existing double taxation of savings and investment.

(2)A harmonized sales tax. The federal government should work with the provinces to replace the GST and all provincial sales taxes with a harmonized sales tax. According to tax experts Jack Mintz and Thomas Wilson, a simplified, harmonized sales tax would be more efficient than the status quo because it would apply to the same base of goods and services across all provinces, and would impose lower administrative and compliance costs. See Jack Mintz and Thomas Wilson, "Options for the Goods and Services Tax," Canadian Business Economics, vol. 3, no. 1, 1994, pp. 27-36.Note In order to preserve the transparency of the tax, the harmonized sales tax should remain visible so that taxpayers will always be aware of the burden of taxation. Furthermore, no regional subsidies should be offered for agreeing to harmonization as these are both destructive to national unity and costly to taxpayers.

(3)A reduction in payroll taxes. If the current federal government is truly serious about job creation, it must eliminate the ultimate job killer: the payroll tax. Lower payroll taxes reduce labour costs and raise employment. This proposition is well established empirically. See De Matteo and Shannon, op. cit. See also Ted Dixon and Fazil Mihlar, Survey of Senior Investment Managers in Canada: Results for Spring 1996, Vancouver: The Fraser Institute, 1996. In this survey, 67 percent of respondents felt that high payroll taxes and income taxes were the biggest obstacles to employment growth in Canada.Note A reduction in payroll taxes will, over the long run, create far more productive jobs than any national infrastructure rebuilding program.

(4)A constitutionally entrenched taxpayer protection amendment. The evidence from Canada and abroad suggests that there is a built-in tendency for democratic governments to increase their spending. Since this additional spending cannot be indefinitely financed by deficits (and since deficits are simply deferred taxes), higher government spending ultimately means higher taxes. In order to protect taxpayers, we recommend that a taxpayer protection amendment be written into our constitution along with a balanced budget amendment. These would tie the hands of our elected officials and would make it extraordinarily difficult to raise taxes in the absence of widespread public support. For an example of such an amendment, see the Canadian Taxpayers Federation's Taxpayer Protection Amendment. See Canadian Taxpayers Federation, op. cit. For details about the U.S. experience on this topic see Dean Stansel, Taming Leviathan: Are Tax And Spending Limits The Answer? Washington: Cato Institute, 1994.Note

Conclusion: A long way to go

The evidence cited above suggests that Canada's tax system is in need of fundamental reform. Since the federal government took office in 1993, it has made no effort to overhaul the existing tax regime. While taxes have not increased significantly, no attempted has been made to repair our tax system or reduce the burden of taxes on our economy. Given that the federal Liberals were elected on a platform of job creation and economic growth, this neglect of fundamental tax reform is surprising. Such reform is an essential ingredient of any economic recovery strategy.

For this lack of action on a policy area of utmost importance, the Liberal government deserves a D.

Industrial Policy

Grade: F

Neoclassical microeconomic theory and policy

According to standard neoclassical microeconomic theory, the free market will produce an optimal allocation of resources if the market is perfectly competitive. Perfect competition requires complete information, price taking behaviour on the part of economic agents (i.e. consumers and firms take the market price as "given"), constant returns to scale technology, and the absence of externalities and public goods. If any of the above conditions does not hold, the market is said to "fail" and the competitive equilibrium outcome that results will not be optimal. For a classic presentation of this argument see Francis Bator, "The Anatomy of Market Failure," Quarterly Journal of Economics, vol. 72, 1958, pp. 351-379.Note

Market failure, as defined above, is likely to be a pervasive feature of most economies as there are probably few markets which satisfy all of the assumptions of perfect competition. Thus, the competitive equilibrium outcomes which result in most markets are probably not optimal. Traditionally, economists have used this inevitable departure from optimal outcomes to justify government intervention in the economy. The standard argument offered is that, if the market fails to achieve an optimal allocation of resources, then the state should intervene in an effort to promote a more efficient allocation than that provided by the free market. See William J. Baumol, Welfare Economics and the Theory of the State, Cambridge: Harvard University Press, 1965.Note Hence, a host of economic and social interventions have been justified on the premise that markets fail and that governments can and should intervene in order to correct for the inefficiencies of markets and to promote optimal allocation.

Government failure and the theory of the state

However, it is a great leap of faith to jump from the premise that markets fail to the conclusion that government can and should intervene to correct these failures. Experience accumulated from around the world since the Second World War suggests that this leap of faith is a grave error. Government intervention in the economy has not been the panacea that it was initially thought to be. Far from promoting efficiency, much, if not most government intervention has encouraged inefficiency: See Charles Wolf Jr., Markets or Government: Choosing Between Imperfect Alternatives, 2nd Edition Cambridge: MIT Press, 1993. For a very readable discussion of the problem of government failure see William C. Mitchell and Randy T. Simmons, Beyond Politics: Markets, Welfare, and the Failure of Bureaucracy, Boulder: Westview Press, Independent Institute, 1994.Note draconian regulations often impede innovation and productive enterprise; Ibid.Note the growth of the state bureaucracy with its own agenda has encouraged wasteful lobbying and rent seeking behaviour; For a detailed discussion of the economics of bureaucracy see William A. Niskanen, Bureaucracy and Representative Government, Chicago: Aldine-Atherton, 1971. Seminal papers on lobbying and rent seeking can be found in James M. Buchanan, Robert D. Tollison, and Gordon Tullock, eds., Toward a Theory of the Rent Seeking Society, College Station: Texas A & M University Press, 1980; and also in Charles K. Rowley, Robert D. Tollison and Gordon Tullock eds., The Political Economy of Rent Seeking, Kluwer Academic Publishers, 1988.Note activist industrial policies have protected inefficient enterprises and have channelled millions of dollars into politically motivated megaprojects that serve no useful economic function; See Fazil Mihlar, "Picking Winners: A Risky Gamble," Fraser Forum, October 1994, Vancouver: The Fraser Institute, pp. 21-23. See also Terrence Casey, "The Clinton Administration and the Industrial Policy Question," Journal of Social, Political, and Economic Studies, vol. 18, no. 1, 1992. For a critical appraisal of Alberta's experience with an activist industrial policy see Michael Walker, ed., Focus: On Alberta's Industrial and Science Strategy Proposals, Vancouver: The Fraser Institute, 1984.Note regional economic diversification programs similarly serve no efficiency objective. See Donald Savoie, "ACOA: Something Old, Something New, Something Borrowed, Something Blue," in Katherine Graham, ed., How Ottawa Spends: 1989-90, Ottawa: Carleton University Press, 1990, pp. 107-130.Note Such examples of government failure are likely to be more of a drag on our economy than the market failures that intervention was intended to correct.

Fundamental to an explanation of government failure, however, is the fact that government intervention can seldom be efficiency enhancing because successful intervention requires that the state have more information than those who participate in the marketplace. As F.A. Hayek noted long ago, most of the information required for rational economic calculation is specific to time and place and cannot be obtained by a single person or body. See F.A. Hayek, "The Use of Knowledge in Society, American Economic Review, vol. 35, 1945, pp. 519-530.Note The impossible task of acquiring and processing all the information necessary for rational economic calculation essentially precludes the possibility of successful state intervention in economic affairs. Even the most benevolent and enlightened social planner cannot overcome this dilemma. Hence, government intervention in the economy, even if well intentioned, is bound to fail because of informational constraints.

In light of this analysis, the optimal microeconomic or industrial policy of the state is simply to enforce contracts and provide the framework laws necessary for all market participants. There is little else the state can or should do because of the inevitability of government failure and the inefficiencies that result from this intervention.

Enlightened mandarins: an industrial policy for the late 20th Century

Notwithstanding the accumulated evidence documenting the perversities and pervasiveness of government failure, the Liberal Party's pre-election view of the role of the state in microeconomic affairs was decidedly interventionist. Indeed, almost an entire chapter of the Red Book is devoted to a discussion of the kind of activist industrial policy a Liberal government would pursue. According to the Liberals, Canada should embrace an activist industrial policy in which the federal government, in partnership with other levels of government and the private sector, seeks to identify "strategic opportunities" and directs resources towards the realization of these opportunities:

A further task of government in Canada is to help Canadians realize that innovation doesn't "just happen;" rather, it thrives best in countries that consciously understand the process and take appropriate measures to create a national system of innovation. If people are being asked to adjust their attitudes and behaviour, it is vital that they believe that there is such a system and that they see clearly where they fit in. At the local level, community leaders must see how their ambitions dovetail with the national effort. Small businesses must understand how they can relate to and profit from the activities of large corporations. The research community must understand the imperatives of global economic competition.

The crucial role of the federal government in such an innovation system is to work with the private sector to identify strategic opportunities for the future, then to redirect its existing resources towards the fulfilment of those opportunities. Research and development, small business policy, taxation policy, environmental regulation, community economic development, and the availability of venture capital are all areas where the federal government can focus its efforts to achieve strategic economic opportunities and promote economic growth. Our future success will come when we coordinate all these policies with the single-minded goal of producing greater wealth and more good jobs for all Canadians. See Liberal Party of Canada, Creating Opportunity: The Liberal Plan for Canada, Ottawa: Liberal Party of Canada, 1993, p. 44.Note

This is the industrial policy of the late 20th Century-an industrial policy for the information age in which government helps set up a "national system of innovation" and picks the winning high technology firm. The language may be catchy, but the gist is the same. In the Liberal government's view, Canada needs a "national system of innovation" in order to rectify the failure of markets to adapt in a changing technological environment. This is the synoptic delusion that Hayek wrote about: the mistaken belief that all good institutional structures are the product of deliberate human design. For a discussion of synoptic delusion and its influence on modern thought see the first chapter of F.A. Hayek, Law, Legislation and Liberty Volume 1: Rules and Order, Chicago: University of Chicago Press, 1973.Note In the present case, the Liberals believe that the federal government can and should step in to help people "see where they fit in" so that we will have a nation that "consciously understands" the process of innovation. There is, according to the federal Liberals, a missing market in co-ordination.

The Liberal government's industrial policy action plan

Towards this goal, the Liberals aimed to pursue a number of initiatives. They promised to improve the availability of capital to small- and medium-sized businesses through loan guarantees and by establishing a Canada Investment Fund; to encourage more research and development (R&D) activities by continuing to support basic research through stable funding of granting councils like the National Research Council and the Networks of Excellence, and also by establishing a Canadian Technology Network among governments, industries, and universities; and, in partnership with the private sector, to encourage international trade opportunities for Canadian businesses. Liberal Party of Canada, op. cit.Note Additionally, for those less enamoured of high technology buzzwords, the Liberals also promised to pursue a national infrastructure rebuilding program in tandem with provincial and municipal governments as part of a broader job creation and economic growth initiative. Ibid.Note

An activist industrial policy in action

Unfortunately, since it took office in the fall of 1993, the Liberal government has followed through with almost all of the Red Book's industrial policy proposals. Over the past three years, it has raised the share of a small business loan it will guarantee by amending the Small Business Loan Act; See Privy Council Office, Ensuring Opportunity for Canadians: The Record To Date, Ottawa: Privy Council Office, 1996.Note set up a $30 million Atlantic Venture Capital Fund; spearheaded a new federal science and technology plan by establishing a National Technology Network with industries, governments, and universities; Ibid.Note and provided nearly $600 million in interest-free loans to high-technology companies under the much vaunted Technology Partnerships Canada program. See "Qualified Support," The Financial Post, June 15, 1996, p. 6.Note The federal government has also continued to fund regional economic diversification programs like Western Economic Diversification (WED), Atlantic Canada Opportunities Agency (ACOA), the Federal Office of Regional Development-Quebec (FORD-Q), the Federal Development Initiative in Northern Ontario (FedNor) and the Canada-Quebec Subsidiary Agreements on Industrial Development (CQSA), albeit at reduced levels. Some numbers are provided by Gordon Davies, "July Question and Answer: Taxes for Economic Development," Fraser Forum, July 1996, Vancouver: The Fraser Institute, pp. 18-19. The article notes that in 1996-97, Ottawa will spend $3.3 billion on regional development programs, of which $486 million will go to Atlantic Canada, $150 million to Ontario, $369 million to Quebec, and $2.326 billion to Western Canada.Note

In addition, the federal government has spent approximately $6 billion on a high profile Canada Infrastructure Works program to upgrade local infrastructure systems in order to promote economic growth, to enhance "community liveability," and to provide short term employment. See Caroline Andrew and Jeff Morrison, "Canada Infrastructure Works: Between `Pick and Shovels' and the Information Highway," in How Ottawa Spends 1995-96, Susan Phillips ed., Ottawa: Carleton University Press, 1995, pp. 107-136.Note This program was initiated with the co-operation of municipalities and provincial governments and, according to the federal government, has created almost 100,000 new jobs. Ibid.Note Hence, an activist industrial policy is indeed under way. The federal government believes that through increased R&D spending and "technology partnerships" it can pick out successful high-technology firms and micro-manage the economy. Furthermore, it still holds to the belief that it can prime the pump of the economy and create jobs through a "picks and shovels" Ibid.Note infrastructure rebuilding program. Old habits die hard.

Policy analysis: plus ça change, plus c'est la meme chose A rough translation of this French proverb: "The more things change, the more they remain the same."Note

What has been true about government intervention in the economy in the past is likely to be true about government intervention in the present and future: governments simply do not have the information to efficiently micro-manage the economy. That we now live in the so-called "information age" does not change this conclusion. Computer technology does not help us one bit when it comes to "picking winners" and identifying "strategic opportunities for the future" in a dynamic marketplace. Furthermore, self-interested politicians are no less likely in the current age to intervene in a manner which advances special interests at the expense of overall economic efficiency; modern technology will not turn our political leaders into altruists. Therefore, there is every reason to expect that the federal government's activist industrial policy will fail as the state still has neither the resources nor the incentive to pursue an efficient industrial policy.

Regional economic development programs like WED, ACOA, FedNor, CQSA, and FORD-Q are fine case studies in government failure. Designed with the alleged purpose of promoting the economic development and diversification of some of Canada's regional economies, these programs are usually poorly administered and do little to promote either economic development or diversification because the objectives of regional development programs are often too vague to put into operation. In addition, proper assessment of the results of these initiatives is often inadequate. Many of these problems are documented at length in the 1995 Report of the Auditor General of Canada. For example, of ACOA, the Auditor General writes that:

A primary problem is to determine what is being accomplished for the expenditures being made. Without objective assessments of program results, as are required for the ACOA program, the entities cannot answer this fundamental question properly. In our view, in times of serious resource limits, failure to measure and report results is an unacceptable financial risk to the best use of public funds. Auditor General of Canada, Report of the Auditor General of Canada to the House of Commons, Chapter 17, Ottawa: Minister of Supply and Services, 1995, p. 19.Note

In a similar vein, the report asserts that:

The Department [FORD-Q] emphasized primarily the positive aspects and did not report the evaluators' negative comments, such as the fact that the programs had limited impact and that a large number of projects would have gone ahead without the Department's assistance. Ibid, Chapter 19, p. 14.Note

Finally, of WED, the Auditor General writes:

Claims that jobs have been created by the Program are unverified and are based on estimates made at the time of project funding proposals. Combined with the fact that monitoring of projects is limited in both time and scope, this means that the Department has no assurance that the 42,000 jobs projected at the time of proposal actually materialized. Ibid, Chapter 20, p. 22.Note

These quotes highlight government's pervasive failure at running regional economic development programs. Government simply does not have the information to successfully intervene in the marketplace. Furthermore, a quick glance at some of the projects funded by these programs suggests that some of these projects were probably politically motivated. For example, between 1993 and 1996, ACOA offered over $974 million in grants, of which $500,000 went to complete a 9-hole golf course in Newfoundland, $139,035 went towards the construction of a replica Viking Ship, and $13,842 was spent on additional wax figures for the Royal Atlantic Wax Museum. See National Citizens Coalition, Tales From The Tax Trough III: The Liberal Edition, Toronto: National Citizens Coalition.Note Such projects do little to advance the economic interests of the Atlantic region. Moreover, when economic resources are channelled into such inherently unproductive ventures, genuinely viable projects are starved of scarce resources. Hence, not only do regional programs fail to achieve their objectives; they impoverish the regions they are intended to assist by transferring resources from economically viable projects to politically motivated ones.

If political pressures, rent-seeking, and informational constraints render it impossible to successfully implement regional economic development programs, then surely the same factors should make it difficult, if not impossible, for the state to establish an effective "national system of innovation" and to successfully identify "strategic opportunities for the future." In fact, why Canada should even need such a national innovation policy is unclear. Research done by Kristian Palda, an expert on the economics of innovation policy, demonstrates that Canada's R&D expenditures, when properly measured, are quite adequate and that efforts to raise R&D spending through the instruments of the state are likely to be ineffective. See Kristian Palda, Innovation Policy and Canada's Competitiveness, Vancouver: The Fraser Institute, 1994.Note The Liberal government's belief that Canada needs to spend more on R&D is thus misinformed. Moreover, a casual glance at recent experience suggests that Canadian high-technology firms do quite well in the absence of government intervention; companies such as Corel and Northern Telecom come to mind. Hence, there is little evidence to suggest that Canada needs a government sponsored and co-ordinated "national system of innovation." The "invisible hand" of the free market has already created one.

Finally, there is the Canada Infrastructure Works program, the big ticket item in the federal government's industrial policy gambit. Like the regional economic development programs discussed above, Canada Infrastructure Works probably serves political interests at the expense of economic welfare. It is no accident that many of the projects funded under the rubric of "infrastructure renewal" can only be interpreted as "infrastructure" under the broadest of definitions. For instance, consider the $500,000 Canoe Hall of Fame in Shawinigan, the Prime Minister's home riding. See WED statement for January 27, 1995, Press Conference in Tsawwassen, B.C., Cliff Breitkreuz, M.P. Yellowhead.Note Furthermore, given that the fiscal policy multiplier is very small, See John Helliwell, "What's Left For Macroeconomic and Growth Policies?" Bell Papers on Economic and Public Policies, vol. 2, Kingston: Queen's University Press.Note it is unlikely that Canada Infrastructure Works has contributed significantly to our economic recovery. In an $800 billion a year economy such as Canada's, a $6 billion increase in autonomous expenditure over a multi-year period is just a mere "flash in the pan," even under the most generous assumptions. The federal government's claim that Canada Infrastructure Works is responsible for nearly 100,000 new jobs is patently misleading as it fails to account for all those jobs which would have been created if resources had not been redirected towards "infrastructure renewal."

Policy proposals: a non-interventionist microeconomic policy

In light of the fact that government intervention in microeconomic affairs inevitably fails due to political pressures and informational constraints, the federal government should:

(1)Stay clear of all activist industrial policies. The state is incapable of developing a "national system of innovation" or of identifying "strategy opportunities for the future." The federal government has neither the incentive nor the information to conduct an efficiency-enhancing industrial policy. The federal government should stop attempting to "pick winners" and withdraw its participation in all government-industry partnerships and networks.

(2)Terminate all regional economic development programs. These programs, including WED, ACOA, FedNor, FORD-Q, and CQSA, promote neither economic development nor diversification. Rather, they encourage inefficiency and waste by supporting unsuccessful enterprises at the expense of successful ones, and provide politicians with an avenue for satisfying special interests at the expense of general economic welfare. Indeed, since the very presence of such programs can make socially unproductive rent-seeking profitable, the federal government should declare a moratorium on all future regional development initiatives.

(3)Refrain from indulging in any more general infrastructure rebuilding programs. Infrastructure renewal is simply a euphemism for political patronage and pork-barrelling. We should not rely on infrastructure renewal programs to create lasting employment. This cannot be overemphasized given that the federal government is apparently considering yet another round of spending on infrastructure renewal. See "Cabinet Jobs Hinge on Job Making," The Vancouver Sun, July 11, 1996, A3.Note The only way the federal government can create lasting and meaningful employment is for it to get its fiscal house in order, and to reduce job-killing payroll taxes.

Of course, not all infrastructure renewal is inherently wasteful. Certain federal infrastructure projects may, in fact, need to be rebuilt or repaired. Under such circumstances, the federal government should, wherever possible, contract out these projects to the private sector and operate them on a full cost-recovery basis.

(4)Push harder for interprovincial free trade. Progress in implementing the Internal Agreement on Trade has been slow. Discriminatory government procurement procedures and restrictions on labour mobility remain a fact of life. See Neville Nankivell, "Professionals lead push for effective internal free-trade agreement," The Financial Post, August 20, 1996, p. 9.Note Estimates suggest that interprovincial trade barriers cost Canadians about $6.5 billion per year in lost income. See Filip Palda ed., Provincial Trade Wars: Why the Blockade Must End, Vancouver: The Fraser Institute, 1994.Note If the federal government is truly interested in advancing the economic interests of Canadians, it should act quickly to ensure the free mobility of goods, services and factors of production throughout the nation.

Conclusions: Industry Canada intervention can't solve the problem

Although the federal government now uses the language of the technological age, the fundamental problem of government failure remains the same. Ottawa cannot and should not try to conduct an activist industrial policy. The identification of "strategic opportunities for the future" should be left to private enterprise as government has a sorry history when it comes to "picking winners." This fact rings true regardless of how many experts Industry Canada employs.

For pursuing a wrongheaded industrial policy from the start, and for believing that such a policy could in fact be successfully implemented, this Liberal government deserves an F.

Social Policy

Grade: C

Life without risk? The ideology of the welfare state

The 20th Century undoubtedly will be remembered as the era of the welfare state. During this century, the role of the state in Western nations has been transformed considerably. There are a number of studies that try to explain the growth of the state. For example, see: G. Warren Nutter, Growth of Government in the West, Washington: American Enterprise Institute, 1978; Sam Peltzman, "The Growth of Government," Journal of Law and Economics, Vol. 23, October 1980, pp. 209-87; Allan H. Meltzer and Scott F. Richard, "A Rational Theory of the Size of Government," Journal of Political Economy, Vol. 89, No. 5, October 1981, pp. 914-27; Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government, San Francisco: Pacific Research Institute, 1988.Note Initially concentrating on enforcing framework laws that protected persons and their property, the state eventually assumed most of the responsibilities that were once considered the domain of the family and private charities. The modern state is now expected to provide welfare for the poor, unemployment assistance and job training for those who cannot find work, pensions and old age benefits for the elderly, and universal health care for everyone. In short, the state has become every person's "guardian angel," ensuring that no one "from cradle to grave" is left without its extensive social assistance.

But life is inherently risky . . .

However, in making the series of decisions that led to the gradual adoption of the welfare state, politicians and policy makers failed to consider two important facts about the nature of risk in human life. First, life is an inherently risky venture, and it is virtually impossible to eliminate even just its substantial risks. Indeed, if the state were to try to do so, we would pay dearly for that additional certainty with our individual freedoms. F.A. Hayek, Law, Legislation, and Liberty, Chicago: University of Chicago Press, 1973.Note

The economics of risk elimination: a costly venture

The second fact about risk in human life is that it is grounded in economic logic. While the formal microeconomic theory of information and incentives was only in its infancy when the welfare state was being built, economists have always known, at least intuitively, that if the state tries to eliminate or reduce risk, it is an economically costly proposal. The reason is relatively simple. When the risk involved in participating in a particular activity is reduced, the cost to the individual of being involved in that activity falls. Hence, the reduction of risk changes the incentives that individuals face. To the extent that the state is unable to charge optimal premiums for the reduction of such risks (as is done in private insurance markets), the result of such state-provided risk reduction is to encourage individuals to engage in activities that they would otherwise have avoided. For a more detailed discussion see Chapter 10, "The Economics of Information," in Walter Nicholson, Microeconomic Theory: Basic Principles and Extensions (5th Edition), Orlando: Dryden Press, 1992.Note For instance, consumer advocacy groups have often argued that the state should try to protect drivers and car passengers by enacting strict automobile safety legislation. The standard argument is that with safer cars there will be fewer traffic fatalities and accidents. In contrast, economists have argued that with safer cars, individuals will drive more recklessly as the risk of being in a serious accident is reduced. Economist Sam Peltzman's analysis of the effects of the National Traffic and Motor Vehicle Safety Act of 1966 empirically supports this position. See Sam Peltzman, "The Effects of Automobile Safety Legislation," Journal of Political Economy, vol. 83, no. 4, 1975, pp. 677-725.Note By changing the incentives that individuals face, a well meaning policy of risk-reduction can encourage individuals to make socially costly choices.

The welfare state, risk reduction, and individual choice

Similarly, the instruments of the welfare state have reduced many of the risks individuals face, and have changed the structure of incentives that motivates a wide range of human behaviour. This is because the state, in general, has been unable or unwilling to charge individuals the "correct" premium for this risk-reduction. This premium, if set properly, would neutralize the change in incentives. Activities that are socially costly are encouraged because the changed incentive structure imposed by the welfare state makes them privately profitable. For example, the presence of unemployment insurance benefits without actuarially correct premiums reduces the costs of being unemployed, and encourages workers to stay unemployed, which in turn raises the unemployment rate. Empirical evidence from around the world seems to support this proposition. See, for example: Herbert G. Grubel, Dennis R. Maki and Shelley Sax, "Real and Insurance-Induced Unemployment in Canada," Canadian Journal of Economics, vol. 8, no. 2, May 1975, pp. 174-91; Herbert G. Grubel and Dennis R. Maki, "The Effect of Unemployment Insurance Benefits on U.S. Unemployment," Weltwirtschaftliches Archiv, vol. 112, 1976, pp. 274-99; Dennis Maki and Zane Spindler, "The Effect of Unemployment Compensation on the Unemployment Rate in Great Britain," Oxford Economic Papers, vol. 27, 1975, pp. 440-54.Note Similarly, generous welfare benefits can have the effect of discouraging individuals from finding employment. See, for example, John Richards and William Watson, eds., Helping the Poor: A Qualified Case for "Workfare," Toronto: C.D. Howe Institute, 1995; Organization for Economic Cooperation and Development, OECD Surveys: Canada, Paris: OECD, 1994.Note Finally, the prospect of receiving state funded social security discourages individuals from saving, as they no longer have to provide for their own retirements. See Jagadeesh Gokhale, Laurence J. Kotlikoff, and John Sabelhaus, "Understanding the Postwar Decline in United States Savings: A Cohort Analysis," unpublished manuscript, 1994.Note Thus, well intentioned measures aimed at reducing the risks of unemployment, poverty, or impoverishment in old age may in fact encourage costly behaviour because society at large, rather than the individual, bears the costs of this behaviour. Good intentions are clearly not a sufficient condition for good public policy.

The Canadian situation: a welfare state in fiscal crisis

Unfortunately, the most enduring legacy of the Canadian welfare state is not the "elimination of want," to quote Lord Beveridge. Nor is it the permanent reduction in the risks of life. Rather, it is the most serious fiscal crisis this country has ever encountered: a federal public debt of over $600 billion; See Department of Finance, Budget in Brief, Ottawa: Department of Finance, 1996.Note a yearly federal budget deficit in the neighbourhood of $30 billion; Ibid.Note interest payments that consume nearly one-third of every tax dollar; Ibid.Note and a pension system (the Canada Pension Plan) with unfunded liabilities totalling $600 billion. See Actuarial Division, Office of the Superintendent of Financial Institutions, Special Report for The Fraser Institute, Ottawa: Office of Superintendent of Financial Institutions, 1996.Note Given that the various social services consume the largest non-interest payment portion of the federal budget, it is an inescapable conclusion that the welfare state has played a significant role in bringing us to the brink of fiscal ruin. With this severe fiscal imbalance, there is little choice but to roll back the welfare state and introduce significant reforms. This does not necessarily imply that all social insurance should be eliminated wholesale; the state does have a role to play in helping those who are unable to help themselves. However, it does mean that the federal government, and in fact all governments, must reduce the size and scope of their social programs, and must redesign the instruments of the welfare state so that they are more neutral with respect to the incentive structure faced by individuals.

The Red Book on social policy

The Liberal Party's Red Book states that:

From our beginnings as a nation, Canadians have believed in the principle of shared social responsibility. Over the years, successive Liberal governments have shown their commitment to this value through their actions. Many of the laws and policies that they enacted remain the basis of our system of social support, through which we pool our resources to create programs that benefit all Canadians and help to sustain people through difficult times. This is the framework of fundamental fairness and decency within which Canadians are able to pursue their individual goals.

The Liberal legacy includes universal medicare, unemployment insurance, old age security, the Guaranteed Income Supplement, the Canada Pension Plan, the Canada Assistance Plan, the Canadian Human Rights Commission, and the Charter of Rights and Freedoms. See Liberal Party of Canada, Creating Opportunity: The Liberal Plan for Canada, Ottawa: Liberal Party of Canada, 1993, p. 73.Note

The above quote highlights the Liberals' pre-election attitude towards social policy. Canada, in the Liberal view, is a nation based on the principle of "shared social responsibility." According to the Liberals, the purpose of social policy is to ensure a "framework of fundamental fairness and decency" for all Canadians. This framework is manifested in the "Liberal legacy" of the Guaranteed Income Supplement (GIS), Old Age Security (OAS), Canada Pension Plan (CPP), and Unemployment Insurance (UI) programs.

However, in spite of the importance attached to social policy and the fact that any effort to get the deficit under control (which the Liberals also promised) must imply some restructuring of social policy status quo, the Red Book had remarkably little to say about this. It remains a mystery how, exactly, the federal government intends to redesign our social programs in order to guarantee a "framework of fundamental fairness and decency" while ensuring fiscal balance at the same time. The few specific proposals discussed by the Liberals included vague promises to "ensure that the funds paid out as unemployment benefits are better spent to help the unemployed acquire the skills necessary to find work" Ibid, p. 37.Note and to expand support for child care conditional on the agreement of the provinces. Ibid, p. 40.Note Furthermore, the Liberals displayed no recognition of the flaws inherent in the social insurance system and the extent to which these flaws have contributed to our fiscal problems. Thus, while much was made about the virtues of the Canadian welfare state, very little was said about how it would be funded in circumstances of fiscal crisis.

The federal government's social policy agenda in action

Fortunately, since the autumn of 1993, the federal government has made a few reforms to Canada's social policy network-reforms that will put some (but not all) of our programs on a firmer footing. These changes will enable the federal government to work very slowly towards fiscal balance while at the same time target its scarce resources more towards those who are truly in need. In particular, the Liberal government has:

(1)Proposed that the existing Old Age Security (OAS) and Guaranteed Income Supplement (GIS) be phased out and replaced by a new Seniors' Benefit. Under the Seniors' Benefit, payments will be based on household rather than individual income. Furthermore, assistance will be more effectively targeted to those in need. Couples with yearly incomes of $45,000 or more will receive less; those with lower incomes will receive more. For more details, see Government of Canada, The Seniors' Benefit: Securing the Future, Ottawa: Government of Canada, 1996.Note

(2)Replaced the Unemployment Insurance Act with Bill C-12, An Act Respecting Employment Insurance in Canada. Under this new act, the requirements for eligibility for benefits are based on hours rather than weeks worked. In addition, the "maximum insurable earnings" will drop from $815 per week to $750 per week. Premiums have been reduced marginally and a new "intensity rule" has been introduced in order to reduce the frequency of repeat claims. This rule states that for every 20 weeks of benefits collected over the past five years, a recipient will face a 1 percent decline in the normal benefit rate of 55 percent of insurable earnings up to a maximum decline of 5 percent. See Mary C. Hurley and Kevin B. Kerr, Legislative Summary of Bill C-12: An Act Respecting Employment Insurance in Canada, March 8, 1996, Ottawa; Library of Parliament Research Branch.Note

(3)Increased spending on various job training programs. Under the provisions of Bill C-12, approximately $800 million from the EI fund will be spent on five federal "employment benefits": wage subsidies, earnings supplements, self-employment assistance, direct job creation projects and training. See Hurley and Kerr, op. cit.Note The purpose of these programs is to help the unemployed acquire skills so that they are better able to find work.

From OAS and GIS to the Seniors' Benefit: right direction, insufficient action

The replacement of the OAS and GIS programs with the Seniors' Benefit is a positive development in an effort to gain control of an income support program badly in need of repair. Currently, OAS and GIS account for almost one-fifth of all federal program spending. See Government of Canada, The Seniors' Benefit: Securing the Future, Ottawa: Government of Canada, 1996, p. 24.Note Because Canada's population is aging, the share of program spending devoted to OAS and GIS is expected to rise considerably over the next few years. In order to prevent OAS and GIS from "crowding out" other expenditures, it is necessary for the federal government to reduce the costs of these income support measures.

There are many other problems inherent in the design of OAS and GIS that need to be corrected. For one thing, OAS benefits are calculated on the basis of individual, as opposed to household income. Given that household consumption is a function of combined earnings, rather than individual earnings, it is more efficient and equitable to transfer resources to the elderly on the basis of their overall purchasing power, rather than on the basis of their individual earnings. This problem is rectified under the Seniors' Benefit, where combined spousal income is used in the calculation of benefits. Another problem with OAS and GIS is that a large portion of the benefits paid out go to seniors whose income is well above the Canadian average. However, under the Seniors' Benefit, no couple with a combined yearly income in excess of $78,000 will be eligible for assistance. Couples whose combined income is more than $45,000 will receive less; those with incomes below $40,000 will receive more. Ibid.Note In this way, the Seniors' Benefit will better target our old age income support programs.

Although the Seniors' Benefit is an improvement on the status quo, it still has some problems. Perhaps the most serious of these is that although the Seniors' Benefit will be somewhat less costly for the taxpayer than the OAS and GIS programs, it will still be very costly to support. According to analysts from William Mercer, a benefits consulting firm, the federal government's tax revenue estimates have assumed that wages will rise by one percent above the inflation rate. However, given that real wages have been largely stagnant in the past 20 years, this assumption is overly optimistic. Cited in "Senior Benefit's `perversions' formula for disaster, analyst says," The Vancouver Sun, June 10, 1996, p. C8.Note Furthermore, there is evidence that the presence of such programs discourages savings and investment. Some analysts speculate the Seniors' Benefit makes private pension plans "tax inefficient" because income from private pensions will reduce the size of a recipient's Seniors' Benefit. Ibid.Note Indeed, empirical work from the U.S. suggests that the presence of generous social security programs discourages individuals from saving for their retirements. See Lawrence H. Summers and Chris Carroll, "Why is United States National Saving So Low," Brookings Papers on Economic Activity, vol. 2, 1987, pp. 607-35.Note Since a lower savings rate implies less investment and slower economic growth in the long run, there are reasons to believe that the Seniors' Benefit will have negative longer term aggregate effects. Thus, while the Seniors' Benefit is an improvement on the status quo, there is still much work to be done in this area.

From UI to EI: still not enough

Like the old age security system, Canada's unemployment insurance regime is in desperate need of reform. As discussed earlier, one of the most undesirable features of unemployment insurance is the negative effect it has on the willingness of the unemployed to find work. Because benefits are generous, the relative price of leisure falls, and temporarily unemployed workers have an incentive to remain unemployed for a longer period. See Gene Chapin, "Unemployment Insurance, Job Search, and the Demand for Leisure," Western Economic Journal, vol. 9, 1971, pp. 102.Note Empirical work shows that UI raises the reserva-tion wage The reservation wage is the minimum wage a job seeker must be offered if he is to accept a job offer.Note and the duration of unemployment. See P. Y. Cremieux, P. Fortin, P. Storer, and M. Van Audenrode, "The Impact of Unemployment Insurance on Wages, Search Intensity, and the Probability of Re-employment," HRDC Evaluation Brief 27, 1995.Note Econometric estimates suggest that substantial increases in UI benefits during the 1970s raised Canada's "natural rate" The natural rate of unemployment is the long run unemployment rate that is consistent with a fully anticipated inflation rate.Note of unemployment by as much as 1.3 percent. See Ronald G. Bodkin and Andre Cournoyer, "Legislation and the Labour Market: A Selective Review of Canadian Studies," in Herbert G. Grubel and Michael A. Walker eds., Unemployment Insurance: Global Evidence of its Effects on Unemployment, Vancouver: The Fraser Institute, 1978, pp. 62-88.Note Furthermore, because premiums are set more or less uniformly across all sectors and regions, the unemployment insurance fund subsidizes workers and firms in those industries and regions that have very unstable employment histories, at the expense of those with more stable histories. A small number of firms and industries receive a large

proportion of benefits paid. See M. Corak and W. Pyper, "Firms, Industries and Cross-Subsidies: Patterns in the Distribution of UI Benefits and Taxes," HRDC Evaluation Brief 16, 1995.Note This has adverse allocative effects as it reduces the incentive for workers to move to those regions with the best economic opportunities. The presence of generous UI benefits is perhaps one of the major reasons why there are too many fishermen in the Atlantic region. Thus, while UI does provide assistance to those out of work, the cost in terms of misallocated resources is very high.

By moving from UI to EI, the federal government will reduce some of this inefficiency. Under the new rules, eligibility will be based on hours rather than weeks worked. To qualify for EI, workers will have to work for 420-700 hours, depending on the regional unemployment rate. This will increase the incentive to work and lessen dependency on the system. See Business Council of British Columbia, Submission to the Minister of Human Resources Development and the House of Commons Standing Committee on Human Resources Development: Bill C-12-An Act Respecting Employment Insurance in Canada, April 15, 1996, Vancouver: Business Council of British Columbia.Note Furthermore, the move to reduce the "maximum weekly insurable earnings" and to also reduce the maximum length of time benefits can be collected will reduce costs, provide workers with greater incentive to get off EI, and may enable a reduction in the payroll tax. Ibid.Note Finally, the proposal to reduce benefits marginally for those who collect benefits on a frequent basis (i.e. the "intensity rule") does represent a step in the right direction; without some kind of penalty, there is no incentive for frequent users to stay off the program. Ibid.Note

However, from a wider perspective, it is obvious that these changes do not go very far in addressing the most serious problems with the old UI system. Rather, these changes simply "trim at the edges" and do very little to solve the problems inherent in the design of UI. For example, although the move to hours as opposed to weeks of work may marginally increase the incentive to work, the fact that the entrance requirement continues to vary from province to province The number of weeks one must work in order to qualify for EI benefits depends on the province in which one lives. It is shorter in provinces with above average unemployment rates and longer in provinces with below average unemployment rates.Note means that there is still no incentive for workers to move out of less economically viable regions. Hence, one of the major structural problems of our system remains unaddressed. In addition, the fact that the amount of the premium does not reflect the risk of unemployment means that workers with good employment histories will always be subsidizing workers with poorer employment histories. This is perhaps the greatest inequity of the program as it penalizes those with stable employment. It is also inefficient, as it severs the link between the premiums and the risk, a link which is a necessary component of any viable insurance scheme. For premiums to be set correctly, they must accurately reflect the risk of the person being insured. For example, someone in a seasonal industry who experiences regular spells of unemployment should pay a higher premium, as there is a greater risk that this person will become unemployed. If the insurer is unable to charge a higher premium for this person, the insurer is unduly exposed to risk. This problem is known as "adverse selection." For a more detailed discussion, see Chapter 10, "The Economics of Information," in Nicholson, op. cit.Note Finally, although the new "intensity rule" is a step in the right direction, it will not have much of an impact on the incidence of repeat use of EI, which is known to be considerable. Empirical estimates show that at any given time, up to 40 percent of claimants have had five or more claims. See M. Corak, "Unemployment Insurance, Temporary Layoffs and Recall Expectations," HRDC Evaluation Brief 8, 1995.Note If the federal government is to reduce the chronic dependence of some workers on the EI program, it must reduce benefits by far more than 1 percent for every 20 weeks of benefits received as currently proposed.

The CPP fiasco

Canada's pension system is in crisis. As a result of changing demographics and slower real wage growth than anticipated, the Canada Pension Plan has become unsustainable. When the CPP was first introduced in 1966, Canada's birth rate was very high. It seemed reasonable to operate the CPP on a "pay as you go" basis because of the anticipation that there would always be more young working people than old people. However, contrary to expectations, the birth rate fell significantly in the subsequent decades, real wage growth stagnated, and yet the size and scope of pension benefits increased. A relatively smaller work force must now support a growing population of retired people; this implies a gross intergenerational transfer of wealth from young to old Canadians. At present, the CPP's unfunded liabilities total over $600 billion. Unless significant changes are made to the system, there will have to be a substantial increase in the CPP payroll tax. Indeed, estimates show that with no change in the benefit structure, the CPP payroll tax will have to rise to 14.2 percent of wages by year 2035 (up from 5.6 percent of pensionable earnings in 1993). See Appendix B of Canadian Institute of Actuaries, Canadian Retirement Income Social Security Programs: Report of the Task Force on Social Security Financing, February 1995.Note Since payroll taxes kill jobs, See Organization for Economic Cooperation and Development, OECD Jobs Study Part 1, Paris: OECD, 1994.Note the implications of such an increase for job creation are simply disastrous.

The federal government has held a series of public hearings on the future of the CPP. Apparently, the federal government and the provinces are also considering a proposal to increase the current CPP contribution rate to over 10 percent in order raise additional funds so that the payroll tax will not have to be increased even further in the future. See "Ottawa accused of hiding impact of CPP rate hike," The Financial Post, May 7, 1996, p. 1.Note According to Nesbitt Burns economist Douglas Porter, such a massive increase in the payroll tax could kill as many as 125,000 jobs. Cited in Ibid.Note The federal government is caught in a bind. Unless the pension plan is overhauled immediately, the federal government has no choice but to raise payroll taxes in order to meet its CPP obligations. However, by raising payroll taxes, the federal government will reduce employment opportunities and will undermine political support for the very program these additional taxes are supposed to finance. The status quo is unsustainable; it is both unreasonable and inequitable to expect young Canadians to pay for the CPP when they realize they will not benefit from it.

EI-sponsored training programs: a solution to our problems?

Supporters of so-called "active" social policy programs often claim that the best way to get the unemployed off the EI rolls is to provide them with job training. The standard argument offered in support of this position is roughly as follows: individuals are unemployed because they do not have marketable skills; with job training programs, these individuals will learn the skills necessary to make them attractive to employers. Proponents of such programs also argue that it is up to the government to provide this training as Canadian employers tend to underinvest in skills training. This argument is advanced in Gordon Betcherman, "Are Canadian Firms Underinvesting in Training," Canadian Business Economics, vol. 1, no. 1, Fall 1992.Note

While this argument may sound good at first, a careful look at the evidence suggests otherwise. For one thing, it is not clear that Canada needs to invest more in job training. A study completed by Constantine Kapasalis found that Canadian employers invest as much in their workers as employers from other OECD nations. Constantine Kapasalis, "Employee Training in Canada: Reassessing the Evidence," Canadian Business Economics, vol. 1, no. 4, Summer 1993, pp. 3-11.Note Kapasalis also found that access to training is equally available to all workers, regardless of gender, age, or company size. There is no case for more government intervention in this area because the private sector already invests adequately in skills training. Moreover, evidence from the United States suggests that job training programs are not the panacea their proponents expected. Neither the Job Training Partnership Act (JTPA) nor the Federal State Jobs program was able to get a significant number of people off state welfare rolls. For a review of the evidence on JTPA see U.S. Department of Labor, Employment, and Training Administration, "The National JTPA Study: Impact on Earnings and Employment at 18 Months," Research and Evaluation Report 93-C, Washington: U.S. Department of Labor, 1993. For a review of the Federal-State Jobs program see "Babies making Babies," The Economist, December 11-17, 1993, pp. 27-28. Also see Robert J. Lalonde, "The Promise of Public Sector-Sponsored Training Programs," Journal of Economic Perspectives, vol. 9, no. 2, Spring 1995, pp. 149-168.Note Overall, the evidence shows that EI-sponsored training is unlikely to improve the job prospects of the unemployed.

Policy proposals

In light of the above analyses of the Seniors' Benefit, Employment Insurance, and Canada Pension Plan programs, the federal government should:

(1)Rework the Seniors' Benefit so that it is on a much firmer financial footing. In particular, the federal government must significantly scale down its benefits so that no senior whose income (or no couple whose combined income) exceeds the Sarlo "basic needs" poverty line can be eligible to receive benefits. See Chris Sarlo, Poverty in Canada: 2nd Edition, Vancouver: The Fraser Institute, 1996.Note This is fair because the purpose of the Seniors' Benefit should be to help those elderly Canadians who cannot help themselves, not to subsidize people simply because they happen to be old.

(2)Overhaul Employment Insurance so that it really functions as insurance, and not as an income supplement or a subsidy. In particular, the federal government should privatize EI, and permit its new operators to run it just like any other insurance scheme. This would mean allowing EI operators to charge experience-rated premiums that truly reflect the actuarial risk of insuring particular types of workers; to establish uniform entrance requirements that do not fluctuate between provinces or industries; to impose stiffer penalties and higher premiums for repeat claimants; and to reduce benefit rates so that the incentive to get off the program and back into employment is stronger. Such changes will enable a the EI payroll tax to be reduced, which in turn will help stimulate private sector job creation.

(3)Phase out the CPP and gradually replace it with a mandatory, private RRSP scheme for all workers. Ninety-one percent of respondents to The Fraser Institute's Spring 1996 Survey of Senior Investment Managers in Canada felt it likely or very likely that the CPP will face a major funding crisis over the next 25 years. The most preferred solution to the crisis among those surveyed was to replace or expand the current CPP with a mandatory private RRSP. See Ted Dixon and Fazil Mihlar, Survey of Senior Investment Managers in Canada: Results for Spring 1996, Vancouver: The Fraser Institute, 1996.Note Chile's recent experience with pension plan reform is most instructive in this regard. For a review of the Chilean experience, see Canadian Taxpayers Federation, Towards a Sustainable Pension Plan: A Submission to the Federal, Provincial and Territorial Governments of Canada with respect to the Canada Pension Plan, May 8, 1996, Edmonton: The Canadian Taxpayers Federation. See also William Robson, Putting Some Gold in the Golden Years: Fixing the Canada Pension Plan, Toronto: C.D. Howe Institute, 1996.Note Once operated on the same "pay as you go" basis as the CPP, the Chilean pension system is now a fully funded scheme of competitive, privately operated pension plans in which each individual has his or her own account. The success and popularity of the Chilean system suggests that pension plan reform can be financially viable if managed appropriately. The federal government should stop vacillating on this issue and embark immediately on a major reform initiative.

(4)Discontinue funding for all EI-sponsored training programs. The empirical evidence shows that the private sector already invests adequately in skills training and that government intervention in this area is unlikely to be successful. Job training programs are not a panacea.

Conclusions: a long way to go

The federal Liberal government has started a much needed review of Canada's social policies and has begun to move in the right direction with respect to parts of our old age security system and unemployment insurance network. However, these changes have been mostly superficial, and have done little to address the real structural weaknesses within the existing social policy network. Furthermore, the federal government has failed to properly address the problems with the Canada Pension Plan. Both politicians and policy makers must recognize that the federal government cannot and should not use the instruments of social policy to shield all Canadians from the risks of life. Rather, the purpose of social policy should be to help those who are unable to help themselves.

For failing to accept this fact and for being much too timid in a policy area that needs immediate reforms, the federal government deserves a C.

Health Policy

Grade: D

Economic principles and health care

Economics is often defined as the study of how society allocates scarce resources in the presence of unlimited human desires. Choices about health care-how it should be provided and financed-necessarily involve choices about how to use scarce resources. Whether society should devote more resources to finding a cure for AIDS or to building a hospital is ultimately an economic decision as either option involves choices about resources that have alternative uses. Therefore, any rational debate about the future of Canada's health care system must include a consideration of the principles of economics. Most economists would agree that the best way for society to allocate resources is through the competitive market, because the market produces a system of relative prices that are the most efficient mechanism for coordinating individual human action. See F.A. Hayek, "The Use of Knowledge in Society," American Economic Review, vol. 35, 1945, pp. 519-530.Note However, for the last 50 years or so, competitive market mechanisms have been largely absent in the Canadian health care sector. For political, ideological, and historical reasons, politicians and policy makers have not allowed market forces to play a role in the provision of health care. The standard argument offered is that since health care is such an important service, its provision and financing should be left to the state, as the market cannot be trusted to provide reliable and effective health care to all Canadians. In this way, the principles of economics have been essentially frozen out of the health care debate.

Canadian style health care

Canada's current expanding need for health care, created by our aging population, therefore is occurring in the absence of economic incentives in the health care sector. Faced with rising costs and large deficits, the various levels of government in Canada have been forced to cut their health budgets; as a consequence, many services have been delisted, and long waiting lists have developed for many non-elective procedures. Clearly, the Canadian health care system is in a crisis.

Some myths about Canadian health care

In spite of this, most Canadians continue to cling to the myth that our nation has the best health care system in the world. Indeed, a large number of Canadians still believe that our health care system upholds the principles of the Canada Health Act: universal, accessible, portable, comprehensive, and publicly administered. Even a cursory examination of the evidence shows that these beliefs are misplaced.

Universality requires that all Canadians be covered by our health care system, but in reality, not everyone is covered. For example, in B.C., over 100,000 people are not covered by the provincial Medical Services Plan. Estimate from the B.C. Ministry of Health, cited in William McArthur, Cynthia Ramsay, and Michael Walker, "Improving Health Care for Canadians," in W. McArthur, C. Ramsay and M. Walker eds., Healthy Incentives: Canadian Health Reform in an International Context, Vancouver: The Fraser Institute, 1996.Note So it is incorrect to suggest that Canadian health care covers all citizens universally. Similarly, it is also incorrect to suggest that our health care system is completely accessible. Waiting lists for various medical procedures vary widely across the country, depend-

ing on the province in which one lives. See Cynthia Ramsay and Michael Walker, "Waiting Your Turn: Hospital Waiting Lists in Canada" (6th Edition), Fraser Forum Critical Issues Bulletin, Vancouver: The Fraser Institute, 1996. The survey finds that in 1995, the average time waited from appointment with a specialist to treatment was 9 weeks in B.C., 6.6 weeks in Alberta, 5.2 weeks in Ontario, and 11.8 weeks in Prince Edward Island. Clearly there is considerable regional disparity in waiting times.Note This is a violation of the principle of accessibility which requires that health care be easily available to all, regardless of where one lives.

Canadian health care is not fully portable either. For one thing, it does not completely cover Canadians travelling outside of Canada. Furthermore, it does not cover some Canadians when they are not in their home province. A Quebecer who needs medical attention outside of Quebec must pay for medical services out-of-pocket and is reimbursed later only for the amount that the service would have cost in Quebec. See McArthur, Ramsay, and Walker, op. cit.Note

The federal government and the health care myth

Notwithstanding these facts, in their Red Book the Liberals show the extent to which they, too, have bought into the mythology of Canadian medicare. Consider the following:

A top priority for a Liberal government will be preserving and protecting our universal medicare system, maintaining the values that underpin it while we reinvent the means by which health care services are delivered to people. See Liberal Party of Canada, Creating Opportunity: The Liberal Plan for Canada, Ottawa: Liberal Party of Canada, 1993, p. 74.Note

As one of our greatest national projects, our health care system is a defining element of Canadian society. Medicare has contributed to a quality of life in Canada that is recognized to be one of the best in the world and a comparative advantage in the global marketplace. It represents the best of the Canadian spirit, reminding us of the good that we can achieve together. Ibid, p. 77.Note

A Liberal government will not withdraw from or abandon the health care field. That would be to accept the notion of a two-tier health care system: one for those living in more advantaged provinces, and an inferior system for those living in the less advantaged provinces. Liberals cannot and will not accept a health care system that offers a higher quality of care for the rich than for the poor. Ibid.Note

According to the Liberals, medicare is "one of our greatest national projects" and "represents the best of the Canadian spirit." The federal government is committed to preserving and protecting our "universal medicare system." There will be no two-tier medical system for Canada since such a system, in the Liberal view, would enable individuals who live in richer provinces to get better medical care than those living in poorer provinces, and that would be unacceptable to the Canadian psyche. Thus, the Liberals promised to maintain a firm federal presence in the funding and regulation of Canadian health care.

The federal government's health care plan in action

Under the constitution, health care is an area of provincial jurisdiction. However, during the post World War II period, the federal government began to influence how health care is provided in Canada through the use of its spending power. That is, by offering to finance a portion of a province's medicare expenses, the federal government has managed to influence how provinces deliver medicare.

Since the fall of 1993, the federal government has changed the way it transfers funds to the provinces. Until 1995, federal funds for social programs were provided under the Canada Assistance Plan (CAP) and the Established Programs Financing (EPF). CAP covered welfare and social services while the funds transferred under the EPF were directed to health care and higher education. However, in the 1995 budget, CAP and EPF were consolidated into a single block grant called the Canada Health and Social Transfer (CHST). For more information about the CHST see Thomas J. Courchene, Redistributing Money and Power: A Guide to the Canada Health and Social Transfer, Toronto: C.D. Howe Institute, 1995.Note Under this new scheme, provinces are freer to determine how to allocate their portions of the transfer to the various social programs. The only conditions attached are that the provinces must abide by the Canada Health Act (and hence uphold the five "fundamental principles" of medicare) and that no residency requirement be imposed on welfare recipients. Ibid.Note For now, at least, the federal government has effectively locked our health care system in a time warp since any province that tries to deviate from the present system will be financially punished.

Policy analysis: time for a reality check

The advent of the CHST is a mixed blessing. On the one hand, it is an improvement on the status quo as it enables provinces to determine their own spending priorities with respect to social programs. Since different provinces will have different spending priorities depending on their constituencies and economic circumstances, this is a positive development. Block grants give provinces more flexibility to tailor their spending to the needs of their residents. In this respect, the CHST is an improvement on the old system of program-specific grants since it gives the provinces more spending autonomy.

On the other hand, however, the CHST does little to advance the cause of genuine social policy reform because the provinces continue to be bound by the arcane provisions of the Canada Health Act. As a result, the medicare system will continue to be beset by the problems of too much government control and not enough competition. This is distressing because in the absence of competition and prices, the incentives will never be in place for the efficient delivery of health care services. It is also unfortunate because the Canadian health care industry, as the single largest employer in the country, could potentially be an engine of economic growth if market forces were allowed to play a greater role in the provision of health care.

The federal government's stubborn insistence on maintaining the status quo is destructive. It obscures the fact that virtually every other industrialized nation has a two-tier health care system, and that such systems have not increased the disparity of health care services available to rich and poor persons. See the relevant chapters i