Martin Reports a Surplus

Finance Minister Paul Martin's mission was clear in delivering his annual fall economic update. Douse hopes that much new spending is in the works. Dismiss the argument that Ottawa can afford a big reduction in Employment Insurance premiums. Downplay the chances of a really juicy tax cut. When it came to the good news that Ottawa posted a $3.5-billion surplus in the 1997-1998 fiscal year, the first in nearly three decades, Martin buried the historic announcement in the middle of last Wednesday's speech to the House of Commons finance committee - sandwiched between a grim tour of global "uncertainty and volatility" and a glum assessment of the "great care and caution" required on the home front. "What he was attempting to do is reduce the expectations not only of the public, but also of his own backbench MPs," said Bank of Montreal chief economist Tim O'Neill. "It was the appropriate message."

Such approving nods from Bay Street economists, though welcome, are no longer the key to rating the success of a Martin performance. In the early days of the Liberal government, persuading those financial-market opinion shapers that he was deadly serious about balancing the books was often his core goal. With the deficit vanquished, Martin still needs to reassure markets that the government will not backslide. But now he must also offer at least some response to the insistent voices urging him to loosen the purse strings after five restraint-minded budgets in a row. Many rank-and-file Liberal MPs are hungry for new spending, while the provinces, which have endured deep cuts in their transfer payments from Ottawa, are demanding more money to shore up universal health care. And taxpayers, who silently shouldered the biggest burden of the deficit fight, are overdue for a break. So, despite his generally doleful tone last week, Martin allowed that he is planning at least some tax cuts and new health spending in next year's budget. "We will do what we can," he said cautiously. "But we will only do what we can afford."

How much Ottawa really can afford is now the subject of a roiling debate. Martin has clouded the waters by consistently underestimating the government's progress in cleaning up its books over the past few years. The $3.5-billion surplus recorded for the fiscal year that ended last March 31, for example, made a mockery of the 1997-1998 budget's original estimate of a $17-billion deficit for that year. And in just the first five months of the current 1998-1999 fiscal year, the government has pulled in a whopping $8 billion more in revenues than it has spent. Finance department officials insist the results in the next few months may not be so robust. Still, even a pessimist like J. P. Morgan Canada economist Ted Carmichael - the only major forecaster so far to predict a recession in 1999 - expects Ottawa to more or less break even for the rest of the fiscal year, leaving an $8-billion surplus in hand when the books for 1998-1999 are finally closed.

But the surplus piling up this year, like last year's, is beyond the reach of would-be spenders and tax-cutters. Federal accounting rules require those surpluses to go to paying down debt. Any tax breaks or spending hikes must be budgeted for in advance - the government is not allowed to dip into money left over when the final tallies are made. So the key question now is how much fiscal manoeuvring room Martin will admit he has to build higher spending and lower taxes into next year's budget, expected to be brought down in mid-February. The answer depends on how well Ottawa expects the economy to perform. And that remains a guessing game: Martin offered no new official government projections in last week's update.

He did, however, make pointed references to the predictions of private-sector economists. Martin noted that just a few months ago, some forecasters were estimating that if Ottawa offered nothing in the way of new spending or tax cuts, the government would have a $10-billion surplus in 1999-2000. Global economic turmoil, however, has driven down expectations for economic growth so severely that those estimates need to be slashed to about $5 billion, he said. Subtract from that the $3-billion "contingency reserve" that he has made a habit of building into his budgets as a hedge against unexpected economic bad news, and Martin figured he is left with a paltry $2 billion - his so-called fiscal dividend - to play with in 1999-2000.

That, at least, is how he sketched out the numbers. "It is clear the dividend in the next two years will be modest, much less than would be required to provide sufficient funding for the size of initiatives, on taxes and spending, that many are calling for," he concluded. In fact, allocating just $2 billion would leave the Liberals in jeopardy of deeply disappointing many and pleasing few in next year's budget. Quieting the growing uproar over Employment Insurance alone, for example, could easily soak up that amount. The EI deduction now stands at $2.70 for every $100 a working Canadian earns, up to $1,053 a year. At that premium level, the system is pulling in so much more in revenues than it pays out in benefits that the program is expected to record a surplus of $7 billion this year - a windfall that goes directly into general government revenues. Critics are demanding a premium cut in 1999 of at least 30 cents - which would trim $2.1 billion out of EI revenues.

Martin ruled out anything of the sort. "There can be only very limited action, if any, in bringing down the EI rate for 1999," he said, "because we are determined to protect the finances of the nation." That blunt statement brought an angry response from Reform finance critic Monte Solberg, Martin's frequent sparring partner in the House on the EI issue. "What you are proposing to do is confiscate $7 billion a year," Solberg said. "What you're proposing is to take it outright, take it out of the pockets of people who are at the low end of the wage scale."

Martin bristled at the charge that his approach to taxation hurts the least affluent. He is quick to point out that the 1998 budget included measures such as a new child tax benefit for low-income families and a $500 increase in the amount low-income Canadians can earn tax-free. "Our last budget demonstrated very clearly that where we would start with any personal income tax cuts is in fact at the low end of the scale, and that we would work up," Martin said.

By "work up," Martin is clearly signalling his intention to extend tax relief to more middle-income Canadians in 1999. He said that broadly based tax relief is "one key to raising the standard of living and increasing the disposable incomes for all Canadian families." Figures released along with the economic update show how heavily those families, along with corporate taxpayers, contributed to Martin's successful campaign to eliminate the deficit. Ottawa's tax revenues soared 31 per cent from when the Liberals took power five years ago, to $154 billion last year from $117 billion in 1994 (most of that increase reflects steady economic growth). By comparison, federal transfer payments to the provinces and to individuals through social programs fell in the same period by 10 per cent, to $83 billion from $92.5 billion. Ottawa's spending on all its other programs - from running the Canadian Forces to supporting the arts - dipped eight per cent, to $31 billion from just under $34 billion.

Exactly which taxes Martin might choose to shave is hard to predict. Across-the-board cuts are costly. According to finance department estimates, an average $100 reduction - not enough to guarantee the Liberals much political credit - would carve $1.45 billion out of federal revenues. A one-percentage-point cut in each of the three federal tax rates - now 17 per cent, 26 per cent and 29 per cent - would cost Ottawa $3.7 billion. Those figures are daunting for the government - but the chorus of demands for tax relief is now unrelenting. "The fact is that the battle to balance the budget has been won largely on the back of taxpayers," Thomas d'Aquino, president and chief executive of the influential Business Council on National Issues, told the House finance committee the day after Martin's statement. "Those rising tax bills left all but the lowest-income Canadians worse off after tax than in the mid-1980s."

How far Martin decides to go in cutting taxes, and in boosting health spending, will depend largely on the state of the economy come budget day next February. His update warned that Canada's export-driven economy is at risk. "Until recently, we've seen, and benefited from, several years of significant economic expansion around the world," he said. "Now, we are seeing globalization's other face." Among other bad tidings, he cited the steep 28-per-cent drop in world prices for commodities since they peaked in 1996, a plunge that has battered earnings from the natural resources that make up about 35 per cent of Canada's exports.

Just a day after Martin's bleak speech, though, things were looking up. In a surprise move, the U.S. Federal Reserve Board cut interest rates by a quarter percentage point, and the Bank of Canada followed suit the following morning. Stock markets bounced up on the prospect of easier credit buffering the North American economy from global turmoil. "For Canadians, it boosts confidence two ways," said Bank of Montreal's O'Neill. "We get a trade benefit with the United States along with a domestic benefit." Could it be that Martin's best efforts to squelch the notion that he has plenty of money will be undermined by an easing of economic anxieties? For a finance minister who has thrived by consistently dampening expectations - and then handily beating them - a wave of optimism could be the worst possible climate for preparing next year's crucial budget.

Maclean's October 26, 1998