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The Spending while Saving Conundrum

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Andrew Kosnaski

Recently, a prominent Canadian economist claimed that the federal deficit was eliminated largely through spending reductions as opposed to revenue increases.1 The study examined changes in fiscal aggregates, such as total revenue and total program spending, in ratio form. Unfortunately, by using ratios, the study failed to properly account for changes in the denominator of those ratios, namely, national output or GDP. A more reasonable approach - examining each source and use of funds individually - shows that revenue increases were overwhelmingly responsible for the elimination of the deficit, and that discretionary spending hardly changed at all between 1993 and 1998.

Ratios don't tell the story

Studies that attempt to match declines in the spending-to-GDP ratio with declines in the deficit-to-GDP ratio cannot shed light on the "contribution" of spending reductions to deficit reduction. The reason is that large spending increases can be inappropriately interpreted as spending decreases, since under normal circumstances the denominator in the ratios, namely GDP, will increase, and thus automatically reduce the spending-to-GDP ratio. That is, spending increases that are less than the relative rate of growth of the economy (GDP) will result in a decrease in the ratio of government spending to GDP, even though spending increased.

Let us use an example from Deficitland to illustrate the methodological problems of using ratios to explain deficit reduction. In year one, Deficitland's total output (GDP) is $1 million. Its government taxes 10 percent (revenues of $100,000) but spends 15 percent ($150,000), resulting in a deficit of 5 percent of GDP or $50,000.

There are four ways the Deficitland government can eliminate the deficit. It can reduce spending, increase taxes, reduce spending and increase taxes, or do nothing and wait for growth in output to eliminate the deficit. With the last option, as GDP increases, the deficit-to-GDP ratio gets increasingly smaller until it disappears.

Assume that Deficitland's leaders choose the fourth option, and assume that national output grows at 10 percent per year. In year two, GDP grows to $1,100,000. Since taxes still amount to 10 percent of GDP, the government receives $110,000 in taxes. Assuming spending increases by 5 percent to $157,500, the deficit is now $47,500, or 4.3 percent of GDP. Thus, the government, while increasing spending by 5 percent, has reduced the deficit-to-GDP ratio through economic growth.

In fact, by following this formula of 5 percent spending increases, Deficitland will totally eliminate its deficit within 9 years, when GDP would total $2.4 million (growth rate of 10 percent per year), taxes would total $240,000 (10 percent), and spending $233,000 (growing at 5 percent per year). The example clearly illustrates the deficiencies of using spending and revenue-to-GDP ratios without adjustments for growth in GDP.

Alternative analysis: relative contributions

To properly assess contributions to government financial performance, we must first agree upon what we are seeking to measure. For the purposes of this analysis, we are seeking to measure changes in total government spending and government contributions to deficit elimination. For the purposes of this analysis, we shall use spending in fiscal year 1993/94 as a baseline, and account for net, not gross, spending reductions.

For example, if spending in Department A were reduced by $1,000 in 1993 but increased by $1,000 in 1994, no net reduction would have taken place. We also measure the changes in revenue and spending in current dollars, since the deficit itself is measured in current dollars. Further, we establish a "sources and uses of funds" framework to properly account for increases in debt charges (which we assume to be unrelated to the directions in government policy), as well as declines in the deficit, so that sources of funds may be apportioned correctly. Table 1 sets out the framework.

Table 1: Sources and Uses of Funds Framework
Item	Example
Source of Funds	w Spending Reductions w Revenue Increases w Decreases in Debt Charges
Use of Funds	w Spending Increases w Revenue Reductions w Increases in Debt Charges w Deficit Reduction

Sources of funds provide "cash" to the government while uses of funds reduce cash. For example, a $100 increase in revenues is a source of cash that can be "used" for increased spending, debt repayment, and/or reducing the deficit or increasing the surplus for a total of $100. This framework will track both cash coming into and out of the government's account.

Sources of funds

Since 1993/94, budgetary revenues have displayed robust growth as a result of strong economic growth, inflation (due to only partial indexation of the income tax system), and government tax policy. The table below sets out changes in each type of budgetary revenue between 1993 and 1998.

Table 2: Changes in Budgetary Revenues
Item	1993/94 ($ billions)	1997/98 ($ billions)	Change ($ billions)	Change (%)
Personal Income Tax	51.4	70.8	19.4	37.7
Corporate Income Tax	9.4	22.5	13.1	139.4
Other Income Tax	1.6	3.0	1.4	87.5
Total Income Tax	62.4	96.3	33.9	54.3
Employment Insurance Premiums	18.2	18.8	0.6	3.3
Goods and Services Tax	15.7	19.5	3.8	24.2
Customs Import Duties	3.7	2.8	(0.9)	(24.3)
Other Excise	7.3	8.6	1.3	17.8
Subtotal	26.7	30.9	4.2	15.7
Non-Tax Revenues	8.7	7.2	(1.5)	(17.2)
Total Revenues	116.0	153.2	37.2	32.1
Source: Economic Update, 1998.

As table 2 shows, the total source of funds from revenue increases amounts to $37.2 billion. Table 3 lists changes in program spending as another source of funds.

Table 3: Changes in Program Spending: Budget 1998
Item	1993/94 ($ billions)	1997/98 ($ billions)	Change ($ billions)	Change (%)
Major Transfers to Persons
Elderly Benefits	19.9	22.2	2.3	11.6
Employment Insurance	17.6	11.8	(5.8)	(33.0)
Subtotal	37.5	34.0	(3.5)	(9.3)
Major Transfers to Provinces
Net Fiscal Transfers	10.5	10.0	(0.5)	(4.8)
Canada Health and Social Transfer	16.8	12.6	(4.2)	(25.0)
Alternative Payments/ Other	0.0	(2.1)	(2.1)	�
Subtotal	27.3	20.5	(6.8)	(25.0)
Crown Corporation Subsidies	5.3	2.5	(2.8)	(53.0)
National Defence	11.3	8.9	(2.4)	(21.2)
Departmental Spending	38.6	42.8	4.2	10.9
Total Program Spending	120.0	108.7	(11.3)	(9.4)
Source: Federal Budget, 1998.

As is evident in table 3, reductions in various programs provide a net source of funds of $11.3 billion. Interestingly, though, the government's own discretionary spending (total spending less transfers to persons and provinces, National Defence, and Crown Corporation subsidies) actually increased over the period - from $38.6 billion to $42.8 billion, or 10.9 percent - evidence that reductions in discretionary federal spending cannot explain the improvement in the federal balance. Rather, large reductions in EI expenditures (33 percent), and reductions in spending on National Defence (21 percent) and social transfers to the provinces (25 percent) accounted for the entire net reduction in spending.

As table 4 delineates, the combined total sources of funds over the deficit reduction period amounted to $48.5 billion.

Table 4: Net Sources of Funds: 1993/94-1997/98
Source	Amount (billions of dollars)	Percent of Total
Revenue Increases	37.2	77.0
Net Spending Reductions	11.3	23.0
Total Net Source of Funds	48.5	100.0

Use of funds

Over the same period, there were a number of uses for the funds. For the purposes of our simple accounting exercise, we have just two uses of funds (since treating sources of funds as net of spending increases, we have already accounted for spending increases): deficit reduction and increased debt charges. Table 5 sets out the relevant uses of funds for the period. It shows that our total use of funds over the period of deficit reduction amounted to $48.5 billion - not coincidentally matching our sources of funds.

Table 5: Net Use of Funds
Use	1993/94 ($ billions)	1997/98 ($ billions)	Change ($ billions)	Change (%)
Budgetary Deficit	(42.0)	3.5	(45.5)	(108.0)
Public Debt Charges	38.0	41.0	3.0	8.0
Total Use of Funds	�	�	48.5	100.0
Source: Economic Update, 1998.

What emerges from the data, and what is probably most important to those who suffer under the heaviest personal income tax burden in the G-7, is that increasing total income tax revenues contributed a full 70 percent to balancing the budget.

Interestingly, in a September 1995 speech at a Symposium on Budget Deficits and Debt sponsored by the Federal Reserve Bank of Kansas City, the Minister of Finance stated that: "We were nevertheless determined not to cut back our support to the provinces by any greater percentage than we were hitting programs in our own backyard." The reality is that by the end of the deficit reduction period, declines in transfers to the provinces made up 60 percent of the total $11.3 billion decline in spending, compared to the 8.8 percent made up by declines in total departmental spending (including Defence and Crown subsidies). Further, adjusting discretionary spending by removing changes in spending on Defence and Crown Corporations shows that rather than contribute to deficit reduction, federal government spending actually hindered deficit elimination by being a net "use" of funds in the amount of $4.2 billion.

Conclusion

The above analysis clearly demonstrates that revenue increases, not spending reductions, accounted for the bulk of the improvement in the federal budget balance. Indeed, if we define federal discretionary spending as total program spending less transfers to persons and provinces, National Defence, and Crown subsidies, federal discretionary spending actually hindered deficit reduction over the period 1993 through 1998. In fact, revenue increases accounted for an overwhelming majority (77 percent) of the net improvement in the federal fiscal balance.

The results of this analysis should provide the government with a clear and undeniable reason as to why public opinion polls continue to show strong support for tax reduction and rising opposition to increases in spending. Indeed, by ignoring these calls for tax reduction and giving in to cabinet pressure to increase spending, the Chretien government is displaying the same behaviour that placed Canadians in the thick of the deficit soup over the last 30 years. Nobel Laureate Milton Friedman once expressed surprise at the pride with which politicians often showed in their budgetary surpluses, since to Friedman, such surpluses were a clear indicator that taxes were too high. Canadians must not allow their government to ignore this indicator and should continue to place pressure on their policymakers to do the right (economic) thing and reduce the tax burden.