The right way to balance the budget: target the corporate surplus, not the government deficit

Deficit reduction is back on the agenda in Canada. And according to recent statements made by Tony Clement, the minister assigned the task of balancing the federal budget, it appears likely that significant cutbacks in public sector spending will occur in the next few years.

This is most unfortunate. At a time when household debt is at a record high and the personal saving rate is near the 40-year low (see chart 1), slashing government budgets is the last thing Canadians need right now. Think about it: for every dollar of reduction in government expenditures, there is one less dollar of income earned in the economy (similarly, if the funds are spent on imports such as US-made fighter jets, the money leaves the domestic economy). The same goes for any tax increase used to balance the budget: each dollar of taxes collected by the government represents one less dollar in private sector bank accounts.

In other words, it is impossible for the government to decrease its deficit in isolation, and any reduction in government spending or tax increase will have an impact on the private sector. In fact, there is a strong argument to be made that the decline in the personal saving rate and the overall weakness in the household sector's financial position during the last two decades is partly the result of the deficit reduction efforts of the federal and provincial governments in years past.

As I've shown elsewhere, public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports. The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

Chart 1 (double click to enlarge) proves that this basic principle is supported by the facts*. As you can see, whenever Canada's government sector (all levels of government combined) is in a deficit, the private sector runs a surplus (or reduces its deficit). The relationship is so close to being perfect that it looks as though each financial balance is a mirror image of the other. If you take into account net imports, you get perfect symmetry (see chart 2).

Chart 1

Chart 2

The Corporate Surplus

A much more sensible approach to balancing the federal budget would take into account the fact that Canada right now has a massive corporate sector surplus (see chart 3). The reason for this large accumulation in corporate savings is that during the last decade the corporate sector significantly reduced its share of productive investment in the economy in favour of short-term investments and speculative activity (Baragar and Seccareccia, 2008).

Chart 3

Based on official statistics (and my own calculations), Canada's corporate sector ran on average a net surplus of 3.7 percent of gross domestic product since 2001. This is a huge jump from the previous 40 years when the corporate sector maintained an average deficit of 1.3 percent. If corporations were to invest these funds in productive, job-creating initiatives, the deficits of both the government and household sectors would shrink significantly without the need to make contractionary cuts to public expenditures.

A good way to achieve this would be for the government to encourage firms to undertake productive investment by imposing a small, yet noticeable tax on retained earnings or on the turnover of corporate financial instruments, as suggested last year by Yves Smith and Rob Parenteau in relation to the case of the US. Marshall Auerback also makes an excellent case here in favour of imposing a tax on the corporate sector to achieve this purpose. As for the idea of a financial speculation tax, economist Dean Baker recently explained the benefits of this policy here.**

According to Smith, Parenteau and Auerback, these measures would create incentives for firms to reinvest their profits in business operations by increasing the cost of speculating with profits.

In a context where the potential for large export growth is weak (due to the current strength of the Canadian dollar and the challenges facing the US, Canada’s major trading partner), enticing firms to increase productive investment is likely to be the only way to balance the federal budget without further causing the household sector’s deficit to grow. 

So next time you're concerned over the size of the federal government's budget deficit, keep in mind that the more pressing matter at the moment is to reduce the massive corporate surplus. Such a policy would not only help to reduce the size of the federal government's deficit, but it would also go a long way in eliminating the current financial deficit of the household sector.

Baragar, F. and M. Seccareccia, Financial restructuring: Implications of recent Canadian macroeconomic developments, Studies in Political Economy, Vol 82 (2008).

* All charts were produced using official Statistics Canada sector accounts/net lending data and my own calculations. 

** This sentence was added on May 28, 2011.