Fiscal policy

Intertemporal budget balancing

Over the past few decades, governments across Canada have been accustomed to running large budgetary deficits. Faced with the choice of either raising taxes or borrowing to meet expenditure commitments, governments of the day chose the less unpopular route of borrowing to cover their costs. In doing so, both federal and provincial governments amassed large public debts. It was not until the early 1990s that provincial governments finally awoke to their unhealthy financial state. Following the lead of Saskatchewan, governments across Canada began to reverse the trend of rising deficits and debts. Most governments, including those in Ottawa, Alberta, Manitoba, Saskatchewan, Nova Scotia, and New Brunswick, have already secured balanced budgets; other provinces, such as Ontario and Quebec, are on their way to establishing balanced budgets. It would appear that the era of fiscal prudence has finally taken hold in Canada. One exception is British Columbia, which continued to run budget deficits in spite of strong growth in government revenues during the first half of the 1990s (British Columbia Ministry of Finance and Corporate Relations 1998b).

It is not difficult to understand why governments throughout Canada have been forced to reverse the trend of deficit financing: all governments must eventually balance their budgets and eventually expenditures must correspond with revenues. This is true for individuals, for businesses, and for governments (Blanchard and Fischer 1993; Romer 1996; Good 1995). If governments incur budgetary deficits during the current period, they must generate surpluses in the future in order to pay off the debt they have accumulated. Today, governments in Canada are working toward balancing their budgets in order to generate the surpluses required to pay off their accumulated deficits. In short, sooner or later the bill must be paid.1

The financial state of British Columbia

Premier Glen Clark once remarked "balancing a budget in BC . . . is extremely easy. Absolutely one of the easiest things I could imagine doing" (Robson 1994). However, after almost eight years in government, British Columbia's New Democrats have failed to deliver a balanced budget. Since the late 1980s, British Columbia has experienced persistent budgetary deficits. When the NDP government of Mike Harcourt came to power in the fall of 1991, the provincial deficit stood at $773.6 million (British Columbia Ministry of Finance and Corporate Relations 1998b). Both Premier Harcourt and Glen Clark, then Finance Minister, were of the opinion that deficits had no stimulative effect on the economy (Robson 1994) but, nevertheless, in their first year in office they permitted the deficit to climb to an all-time high of $2.5 billion (British Columbia Ministry of Finance and Corporate Relations 1998b). Since then, the provincial government has promised balanced budgets on a number of occasions but has failed to deliver. During the provincial election in 1996, for example, Premier Glen Clark and his government declared that British Columbia had balanced its budget. When re-elected, however, the government announced that there was a budgetary deficit instead of the much anticipated surplus.

While the government's Consolidated Revenue Fund (CRF) now projects a budgetary shortfall of $95 million in the fiscal year 1998/1999, these numbers fail to reflect the real deficit figure (British Columbia Ministry of Finance and Corporate Relations 1998a). According to the government's own 1998 Summary Financial Statement, the actual deficit for fiscal year 1998/99 is projected to be about $949 million, and not $95 million as the government continues to claim publicly. The more accurate figure of $949 million reflects the inclusion of deficits incurred by Crown corporations (British Columbia Ministry of Finance and Corporate Relations 1998a). It is important to include these deficits since the government guarantees the debt load of most Crown corporations. Hence, the government is on the hook if these corporations are unable to pay off their debts or balance their books. While the government acknowledges the deficit figures for Crown corporations on a separate table, they refuse to consolidate these numbers with the province's CRF as outlined in the annual budget document, and as recommended by George Morfitt, the province's Auditor General (BC MinFinCorpRel 1997a). The unfortunate fact in all of the accounting gymnastics practised by the British Columbian government, is that the taxpayer cannot decipher between whether the government and their enterprises are spending more or less than their revenues. The governments' accounting methods lack transparency for both the provincial legislature and the public.

Between 1991 and 1995, government revenues in British Columbia increased by 37 percent (BCMinFinCorpRel 1998b). However, as figure 7 shows, since 1991 provincial government spending has also increased and the government is now predicting that its expenditures will be $20,536 million by fiscal 1998/99, a 36 percent increase since 1991 (BCMinFinCorpRel 1998a, b). Clearly, British Columbia has an expenditure problem, not a revenue problem. The government has opted for permanently high expenditures as opposed to making significant cuts to its programs. In doing so, total debt in the province of British Columbia has increased significantly (see figure 8). More precisely, the province's debt load is projected to hit $31.2 billion by 1999, representing an increase of 81 percent over eight years (BCMinFinCorpRel 1998a, b). The government has continually failed to meet even its own targets for debt and deficit reduction as outlined in their Debt Management Plan (Lippert 1995). As figure 9 shows, taxpayer-supported debt as a percentage of provincial GDP has also increased since the NDP government came to power, and is projected to continue its upward trend.

Optimal public financing

Since a government must balance its budget intertemporally, it is only logical to ask what is the most efficient method for a government to finance its expenditures. Should it pay off its bills immediately or incur deficits? Modern economic theory contends that governments should opt for a strategy of deficits and off-setting surpluses that act to lessen the burden of taxation (Barro 1979). In short, what makes government spending so costly to the economy is that it must eventually be financed by taxes, which inevitably causes economic distortions. In a free-market system, prices act to allocate resources efficiently. The introduction of taxes, however, distorts relative prices and, as a consequence, economic incentives are diminished because taxes build a barrier between marginal costs and benefits (Aaron and Pechman 1981). Economic efficiency requires governments to minimize the distortionary effect on the economy that results from changes in taxation required to finance expenditures.

Since tax revenues and government expenditures fluctuate according to the business cycle, requiring governments to balance their books in each and every period would not be optimal. This strategy would require tax rates to fluctuate according to the business cycle, and since taxes have a distortionary effect on the economy, this option would be unwise. Also, the costs associated with collecting taxes that fluctuate with government expenditures and the business cycle would be very high. Since these fluctuations are a product of the business cycle and thus temporary, a more prudent option would be to run deficits during periods of economic downturn, and to pay back these deficits with surpluses generated when economic conditions improve. This option would permit the government to maintain stability in the tax system over time and minimize the distortionary effect of taxes (Aiyagari 1989).

If the government decides to increase its expenditures permanently, taxes must also be permanently higher as all government expenditures must eventually be paid for. It is impossible to finance ever-increasing government expenditures through the use of deficits, particularly if spending continues to rise and tax rates remain constant. Such a scenario would preclude the opportunity to accumulate the future surpluses required to pay incurred deficits and to help finance the government's increasing expenditures. Thus, the optimal policy response is a permanent increase in taxes.

While the analysis just provided is helpful in addressing the issue of how governments ought to finance their expenditures over time, it does not address adequately the issue of government expenditures. Since government's ability to finance its spending has been accounted for sufficiently, we must now ask what the optimal level of government expenditures is. How big should government be?

The optimal size of government

How much should government spend? In the previous discussion, it was noted that intertemporal budget constraints require governments eventually to pay for their expenditures through the use of tax revenues nd that what makes government debt so damaging is that it must eventually be paid for via taxes, which creates distortions in the economy (Browning 1976). Thus, since rising government expenditures require parallel increases in taxation, it would follow that larger governments are less efficient and more expensive to operate since they require higher tax rates than governments that are small and accordingly impose lower levels of taxation. Thus, bigger governments create greater distortionary effects on economic growth than smaller governments.

Empirical studies conducted by Landau and Barro concluded that nations with smaller governments experience higher levels of economic growth than those with larger governments (Landau 1983; Barro 1991). Furthermore, studies show that countries with lower marginal tax rates have levels of economic growth higher than those of countries with higher levels of taxation (Easterly and Rebelo 1993; Marsden 1983). As a result, countries with smaller governments are more likely to be efficient and to experience higher levels of economic growth than countries with large governments (Easterly 1993; Tanzi and Schuknecht 1995).

As already noted above, deficit financing may be a sensible solution to making up for temporary shortfalls in government revenue but it is not an appropriate strategy for financing permanent increases in government expenditures. Governments should opt for permanently lower levels of spending since this would lower the burden of taxation on the citizenry, impose the least amount of distortion on economic growth, and create an atmosphere suitable for generating economic wealth and increasing the standard of living.

Recommendations

In light of this evidence, we suggest that the British Columbian government adopt the following policy recommendations.

1. Reduce government expenditures by 10 percent over the next three years
   Given the fact that government spending has continued to increase since 1991, we suggest that the government of British Columbia act quickly to cut expenditures by 10 percent over the next three years. The government of British Columbia should move towards a permanently smaller government, particularly given the evidence suggesting that jurisdictions with small governments experience stronger economic growth.
2. Enact a balanced budget law
   This law will require the British Columbia government to balance its budget over a three year period. Evidence from the United States and Canada (particularly in Alberta and Manitoba) points to balanced-budget amendments as an effective tool for curbing the tendency of politicians to overspend (Law and Mihlar 1996).
3. Legislate a debt reduction plan
   Since the government of British Columbia has been unable to meet its own targets for debt reduction as outlined in their Debt Management Plan, a legislated plan to eliminate debt over 10 to 15 years needs to be implemented.
4. Include the Summary Financial Statement in the Consolidated Revenue Fund as outlined in the
   annual budget document
   As recommended by the provincial Auditor General, the government of British Columbia should include the Summary Financial Statement in the Consolidated Revenue Fund as outlined in the annual budget document. If the government is going to guarantee the debt of Crown corporations and provide them with financial aid when required, the public should be aware of their performance as well. This would restore some accountability to the province's accounting methods and allow the public to judge the financial performance of their government accurately.
5. Stop providing loans and loan guarantees to business
   By discontinuing the practice of providing loans and loan guarantees to business, the British Columbia government will improve economic growth in the province by minimizing distortionary effects on the economy. By reducing hand-outs to businesses across the province, the government will be in a position to reduce the size of the state significantly and thus levels of taxation required to sustain its expenditure commitments.
6. Stop guaranteeing the debts of Crown corporations
   Since these Crown entities were created to operate at arms-length from the government in the first place, the government of British Columbia should allow these self-sustaining corporations to be exactly that. Given that they were created to operate independently of the government, they should be responsible for their own financial health.2

Conclusion

Since governments must inevitably finance their expenditures through taxation, which is inherently distortionary, governments ultimately retard economic activity. Therefore, economic efficiency requires governments to minimize the distortionary effects on the economy that result from increases in taxes. Moreover, the evidence suggests that jurisdictions with smaller governments are best positioned to experience strong and sustained levels of economic growth. Since smaller governments require lower levels of taxation to sustain their expenditures, they create less distortion of economic growth than large governments. Unfortunately, the Clark government has failed to stop the growth of the state in British Columbia. Instead, they have chosen to follow in the foot-steps of the previous Harcourt government, opting for a permanently large government. Therefore, for failing to balance the budget, increasing the provincial debt, and increasing government expenditure, the Clark government deserves an F for its fiscal policy.

1. For a non-technical discussion of Ricardian Equivalence Theorem, please see Law and Clemens 1998.
2. This refers to all non-self-supporting Crown corporations.

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Last Modified: Wednesday, October 20, 1999.