Drummond Analysis

Recommended Government Response to a Weakening Canadian Economy

by Don Drummond,
chief economist for TD Bank




The federal government will deliver a Speech from the Throne January 26, 2009 and a Budget the following day. Expectations are that fiscal stimulus will drive the economy out of the doldrums. That is not realistic. The Canadian economy has been sideswiped for a softening world economy and will only recover when the U.S. and other key economies revive. That is likely a year away. In the meantime, the focus here should continue to be on sustained improvements in economic and social outcomes of Canadians. The softer economy presents opportunities to advance that agenda. The infrastructure and tax reductions Canada needs for longer-term prosperity can be accelerated without worrying about creating inflation pressures.

The Budget must start with credible projections. These will be much less optimistic than those in the November 2008 Economic & Fiscal Update. TD Economics expects real output to decline 1 ½ per cent in 2009 with a fall in nominal income of more than twice that magnitude thanks to the plunge in commodity prices. Lower nominal incomes will drag down government revenue and result in a deficit for 2009-10 of at least $10 billion before any further policy action is taken. Further, the expected tepid economic recovery will keep the budget in deficit for several years.

History provides clear lessons on what government should not do in these circumstances. Canada must not return to persistent, structural deficits. Temporary tax cuts have been tested and failed. A temporary income tax cut would be largely saved. And what is spent would largely go to imports. Temporary sales tax cuts just alter the timing of purchases such that the output decline in the first half of 2009 could be mitigated but at the expense of recovery once the tax rate was restored. Politicians frequently succumb to pressure to extend temporary measures so they become part of a structural problem rather than a near-term fix.

Infrastructure should be accelerated as capital and labour markets can more readily absorb the demand. Care must be taken that the projects have positive long-term returns while delivering a bulk of their stimulus in 2009 and 2010. Public transit and building retrofits would simultaneously address a green agenda. Expanding the stock of affordable housing, including on reserves, could deploy labour from the softening residential construction sector.

A jumpstart could be given to the imperative of reducing Canada’s crippling marginal effective personal income tax rates. The combination of the tax rates with the sharp clawbacks on social benefits means that most low and modest income families get to keep less than 40 cents of the last dollar they earn. Doubling the Working Income Tax Benefit would at once raise after-tax incomes and sharpen the incentives to work for those with relatively low paying jobs. Other personal income tax reductions could also be implemented as long as they are enacted through cutting marginal tax rates so there is a bang for the buck in terms of incentives to work, save and invest. Lump sum tax cuts, whether temporary or permanent, fail to deliver this bang. Any tax relief could be made retroactive to the 2008 taxation year so in addition to the ongoing benefits Canadians would receive tax refunds shortly after the budget.

A sharper incentive to scrap pre-1996 cars, whose emissions are on average 19 times worse than a new car, would simultaneously improve the environment and support the struggling auto sector. An investment tax credit would spur purchases of machinery and equipment and be supportive to the longer-term productivity agenda.

Attention must also be paid to cushioning the blow of the economic downturn on those losing their job. The Employment Insurance rules on eligibility and duration of benefits need to be relaxed so more of the unemployed qualify. Consideration could be given to special treatment in terms of benefit duration and access to training to those with a long record of paying premiums without drawing benefits.

Now comes the bill. Somewhere between $3 and 5 billion of infrastructure can likely be brought forward into 2009. Doubling the Working Income Tax Benefit would cost $0.6 billion. Cutting everyone’s marginal personal income tax rate by 1 percentage point is $6.5 billion per year. Any significant relief on Employment Insurance would cost $1 billion. An investment tax credit, an incentive to scrap old cars and various green measures would cost about $0.5 billion each. That comes to $12.6 to 14.6 billion of stimulus next fiscal year. Adding that to the TD Economics projection of the status quo brings the total deficit to $23-25 billion. Only the tax cuts would have a significant ongoing cost. But that, along with the expectation of a lingering deficit on a status quo basis, would have to be offset by tighter spending discipline over the medium term. So the plan must involve a significant fiscal twist with near-term stimulus, but medium-term spending restraint to finance ongoing tax relief.

Don's Bio:

Don Drummond was born and raised in Victoria, British Columbia, where he graduated from the University of Victoria. He subsequently received his M.A. in Economics from Queen's University.

Mr. Drummond joined the federal Department of Finance upon completing his studies at Queen's. During almost 23 years at Finance, Mr. Drummond held a series of progressively more senior positions in the areas of economic analysis and forecasting, fiscal policy and tax policy. His last three positions were respectively, Assistant Deputy Minister of Fiscal Policy & Economic Analysis, Assistant Deputy Minister of Tax Policy & Legislation and most recently, Associate Deputy Minister. In this latter position Mr. Drummond was responsible for economic analysis, fiscal policy, tax policy, social policy and federal-provincial relations. In particular, Mr. Drummond coordinated the planning of the annual federal budgets.

Mr. Drummond joined the TD Bank in June 2000 as Senior Vice President and Chief Economist. Mr. Drummond leads TD Economics' work in analyzing and forecasting economic performance in Canada and abroad. For Canada, this work is conducted at the city, provincial, industrial and national levels. TD Economics also analyzes the key policies which influence economic performance, including monetary and fiscal policies.