Canada's federal budget: a note on tax cuts, deficit reduction and export growth

Canada's 2011 federal budget was announced yesterday. It includes a number of measures aimed at lowering taxes for individuals and businesses. In a slack economy such as Canada's, tax cuts (especially for individuals) can be helpful from the standpoint of demand and purchasing power because they help move the economy toward a fuller utilization of existing capacity. The problem, however, is that the budget also calls for significant reductions in expenditures as a way for the government to return to a balanced budget by the year 2015. Needless to say, such expenditure cuts would only act to offset (read eliminate) any improvement in aggregate demand achieved through the proposed tax reductions.

The strategy behind the government's plan to return the budget into a balanced or surplus position is reminiscent of the strategy used by the federal government in the early 1990s as part of the deficit reduction initiative that followed the 1990-1991 recession. Take, for instance, the current strategy aimed at eliminating the deficit by reducing program expenditures: this is the famous "program review" of the 1990s all over again. In the 1990s, this strategy seemed to have worked quite successfully given that the federal deficit transformed into a surplus within only a few years. Will it work this time? I'm doubtful of it. Here are a few reasons why.

First, it is important to keep in mind that in the 1990s the US dollar strengthened after President Clinton announced on 19 April 1995 that the US "wants a strong dollar". This change in US exchange rate policy resulted in the rise in the value of the US dollar against other currencies. The ensuing depreciation of the Canadian dollar provided a huge boost to Canada's exports, and helped Canada achieve several years of consecutive current account surpluses. Today, the chance of such a scenario repeating itself is unlikely given that President Obama has publicly pledged to significantly cut the US trade deficit by 2015. To the detriment of Canadian exports, President's Obama's goal is only achievable if the value of the US dollar remains weak against other major currencies. Also, it is important to note that the current large inflow of foreign investments into Canada is contributing to further strengthen the Canadian dollar. This too is jeopardizing the country's export potential.

Second, as discussed in this post, the federal government's success in reducing its deficit and achieving budget surpluses in the late 1990s was in part made possible by the economic growth resulting from the increased indebtedness of Canada's household sector. Today, we are facing a much different situation, as Canadian households are slowly in the process of reducing debt and increasing savings.

Under these circumstances, the only way the federal government can eliminate its deficit is if there is a reversal in the financial positions of the corporate sector and household sector (see chart below). Such a situation would involve the household sector returning to its traditional role of being primary lender to the rest of the economy and the corporate sector resuming its role in fostering growth by increasing its level of investment and activity in the economy.