Overview: Tax & Spend, to a Degree

Faced with a myriad of ambitious plans but also beset by the fastest inflation in more than three decades, the 2022 Federal Budget attempts to strike a middle ground. It opts to add a moderate increase in spending, while relying on stronger underlying economic activity and some tax measures to slightly improve the deficit track. The initial to-do list for this Budget was formidable with earlier commitments on child-care funding, emissions reductions, and housing, but was recently extended to include dental care and defence spending. To accommodate this raft of priorities (and there was indeed a full raft in this budget), spending has been spread out over a number of years on some files, a variety of tax measures have been enacted—with some details to be determined—and the higher revenue base has been tapped. As a result, the deficit and debt projections from late last year have improved overall, even with the new spending announcements. However, given the already extreme pressure on inflation, we judge that the modest improvement in the deficit outlook could have been more ambitious in repairing the pandemic’s fiscal damage. And, while most were probably braced for even more spending, net policy measures will still add roughly 0.3 ppts to growth this year, at a time when an inflation battle is well underway.

This budget was billed as fiscally responsible, since the debt/GDP ratio is projected to remain on a downward path (after a huge jump in 2020). But, a key reason that Ottawa was able to hold the line on its deficit and debt projections is that revenues have swelled led by the recent run-up in resource prices (a 40% rise in the past four months alone for the Bank of Canada’s commodity price index). To be clear, this has supercharged nominal GDP far beyond prior expectations, but has done nothing to boost the outlook for real GDP. In fact, looking at how the economic forecast assumptions have changed since December reveals that while the outlook for nominal GDP has been raised by nearly 3 percentage points this year (from 6.6% then to our latest call of a whopping 9.5%), real growth for this year has actually been shaved (from 4.2% to 3.5% over the same period). Essentially, revenues have been boosted by a short-term rush of higher inflation—but that’s not a healthy development, as eventually costs will also face upward pressure, including borrowing costs.

As we have long maintained, fiscal policy has a very big role to play in controlling inflation as does monetary policy. And, with inflation clocking in at a 30-year high of 5.7%, and likely headed higher, there is some urgency for the task at hand. The Bank of Canada is in the early days of reversing course, with potentially rapid tightening measures on the near horizon—we see the overnight rate rising 150 bps by year-end to 2.0%, higher than pre-pandemic levels. For fiscal policy, the appropriate stance with the economy operating at full capacity and revenues rising rapidly would have been to let the windfall largely flow through to the bottom line. Instead, the focus in the Budget is channelling a healthy portion of the revenue windfall to new priorities, while also layering on additional net tax increases. That said, a number of the new measures do commendably focus on the supply side of the economy, targeting investment in some sectors, as well as the availability and mobility of labour. And, because some massive pandemic-era programs are rolling off, program spending does fall meaningfully this fiscal year. On balance, this fiscal policy calibration will keep the onus squarely on the Bank of Canada to control powerful inflationary pressures.

Fiscal Outlook: Finding Normal

The two opposing forces of a stronger-than-expected economy and new spending priorities lean in favour of the former, with the deficit track running better than expected in the Economic and Fiscal Update. The deficit is pegged at $52.8 billion in FY22/23 (2.0% of GDP), down from $113.8 billion in FY21/22 (revised meaningfully from $145 billion thanks to higher revenues). While that is well down from the record $328 billion at the depth of the pandemic in FY20/21, thanks to resurgent revenues and expired emergency programs, new spending measures keep the balance in the red through the forecast horizon. Cumulatively, the total deficit between FY21/22 and FY26/27 is now running $50 billion smaller than in the prior fiscal update, alongside an $86 billion improvement from economic and fiscal developments. In other words, over the fiscal forecast, Ottawa has allowed roughly 60% of the improvement to flow to the bottom line.

Revenues are projected to rise 3.5%, to $408 billion in FY22/23, led by gains in personal income tax receipts. Meantime, program spending is projected to fall another 10% this fiscal year, as some one-time support measures roll off. Over the medium term, spending growth runs at a moderate pace around 2% per year through FY25/26. The track for program spending is actually less aggressive than some might have expected. In the five years pre-COVID, total spending averaged a steady 14.5% of GDP. This year, total spending will run at roughly 16% of GDP, before fading to around 15% late in the forecast. That’s still a noteworthy increase in government spending as a share of the economy, especially at a time when nominal output itself is surging on the back of rising prices, but it might not be as heavy as expected.

The debt-to-GDP ratio will fall to 45.1% this year, from 46.5% in FY21/22, before declining gradually to 41.5% by FY26/27. The full track for the debt burden is running notably lower than expected late last year (the ratio for this fiscal year is pegged more than 2 ppts lower), thanks in part to surging nominal GDP.

A Loose Fiscal Anchor

There remains no plan in place to balance the budget, and the ‘fiscal anchor’ is defined as a commitment to “unwinding COVID-19-related deficits and reducing the federal debt-to-GDP ratio over the medium term”. Recall that Ottawa laid out a set of ‘fiscal guardrails’ in the 2020 Fall Economic Statement, to assure that there would be some medium-term fiscal anchor to guide a return “to a prudent and responsible fiscal path”. Each of the employment rate, total hours worked and the unemployment level, the three “data-driven triggers” identified by Ottawa, have indeed fully recovered, and it’s clearly time to be more forcefully pinned to a firmer fiscal anchor. While the deficit track is slow to improve, the budget does show a consistent decline in the debt-to-GDP ratio. The issue with this as a fiscal anchor is that the debt-to-GDP ratio is not a hard anchor, and it is usually destined to jump when the economy (the denominator) stumbles. Indeed, before the pandemic, this anchor was steady just above the 30% mark, a level we’re not getting back to in this fiscal plan.

Economic Assumptions: Behind the Curve

As is the convention, the budget projections are based on the private sector consensus forecasts, but this round was put in place before some major dislocations on the growth, inflation and interest rate fronts. The budget is based on real GDP growth of 3.9% this year (we are now at 3.5%), 3.1% next year (3.0%) and then fading further to 2% in 2024 (2.7%). While real growth gets the focus, nominal growth is the big story and the driver of revenues. Ottawa expects nominal growth at 7.7% this year (we’re at 9.5%) and 4.8% in 2023 (5.8%). Based on our forecast, this would be the strongest three-year surge in Canadian nominal output since 1982. Indeed, the biggest forecast discrepancy in this document versus the reality on the ground today is an under-accounting of near-term inflation pressure. Interestingly, this might actually drive further revenue upside, and Ottawa estimates that a 1-ppt increase in GDP inflation adds $2.2 billion to the bottom line in the first year.

The only real downbeat note on the economic forecast is that borrowing costs are moving higher. The 10-year bond yield assumptions have been lifted slightly both this year and next, but are still roughly 0.4 ppts behind our current view. And, while the budget now builds in more aggressive Bank of Canada tightening, it still looks behind the curve relative to our current forecast. Again, this is simply a matter of the market moving quickly between the time the budget assumptions were locked in, and today. Finance estimates that a 1 percentage point rise in interest rates boosts the deficit by $5 billion in the first year, which could offset revenue gains.

Debt Management Strategy

With the deficit still large, Canada will remain an active borrower this year and, because of dynamics with quantitative tightening, the market will have plenty to absorb. Gross bond issuance is expected to fall to $212 billion, down $43 bln from the prior year. After accounting for maturities, that pegs net issuance at $30 bln. While the issuance figure is down from prior years, keep in mind that the Bank of Canada is in the midst of shifting policy from effectively absorbing all the federal government’s net issuance early in the pandemic (i.e., in the big deficit year of FY20/21), to likely tightening through balance sheet runoff. In other words, the Bank will have roughly $85 billion of bonds maturing this year, adding to the amount that will need to be taken down by the market. Depending on any caps that are put in place, and at what amount, that could leave what could be the largest nominal net bond supply on record for the market to absorb.

Prior-year moves in the Debt Management Strategy to extend the term of the debt remains a theme, though issuance in the 10-year and 30-year sectors is set to decline in FY22/23. Planned issuance is $54 bln in the 10-year sector (25% of total) and $16 bln in the 30-year sector (8% of total), versus $79 bln (31%) and $30 bln (12%) respectively in the prior fiscal year. As well, $4 billion in ultra-long bond issuance is anticipated again this year. Meantime, 2-year issuance is the only sector set to see an increase, though it’s a relatively modest rise from $67 bln to $74 bln. And, combined 3-, & 5-year issuance will dip slightly to $58 bln. Benchmark sizes will decline in most sectors, consistent with the lower overall issuance. Treasury bill issuance is planned to rise to $213 bln which, along with a $28 bln cash drawdown, helped limit bond issuance. Ottawa will aim to continue the Green Bond program, with $5 billion in issuance targeted, dependent on market conditions.

Summary and Impact

This budget foregoes an opportunity for more significant fiscal consolidation, in exchange for another round of spending and tax increases. Fundamentally, this has raised questions of appropriateness. First, it is indeed questionable if continued new spending (aside from defence) is warranted at this stage of the cycle, with the economy clearly pushing against capacity constraints, and the Bank of Canada now actively battling persistently-high inflation. For example, some provincial governments are currently rolling out stimulative measures to counter inflation, and this budget adds to the mix. That said, a number of measures aim to spur investment and improve the supply side of the economy, which are worthwhile goals. From a credit perspective, a gradually falling debt-to-GDP ratio is again the fiscal target, but history reminds us that the ratio can deteriorate quickly, and some faster improvement would be prudent at this stage.

The market impact tends to be minor given how much these budgets get leaked in advance, and considering that many of the measures were already highlighted in the election platform. Broadly, the tax-and-spend nature of fiscal policy, even if more muted, along with persistent deficits, could be viewed as somewhat negative for the loonie, but Canada is not alone on this front and other major drivers (such as interest rates and oil prices) will dominate. For bond yields, still-elevated borrowing will now likely run alongside central bank quantitive tightening, leaving a large amount of issuance for the market to absorb. Finally, for equities, the financial sector was a clear target, but that should have been well anticipated, while major tax increases on oil & gas and REITs were absent, for now.

Appendix: Highlights of Major Measures

The budget contains a massive array of measures, covering wide swaths of the economy. The net additional stimulus amounts to $7.4 billion in FY22/23, or roughly 0.3% of GDP. Here are some of the most significant measures or proposals:

Housing Policy

Housing was the key focus of this budget, but the volume and sheer number of measures likely well surpasses the actual impact we’ll see on the ground. Measures attempt to add supply, while also pushing further on demand, and implementing some tax measures that will take time to filter into the market. While there are some commendable efforts coming, any impact on home price inflation will be entirely incremental against a backdrop of Bank of Canada tightening.

Housing supply: Ottawa’s lofty (if not impossible) goal is to double the rate of housing construction over the next decade, building at least 3.5 million homes by 2031. The Housing Accelerator Fund aims to add an additional 100,000 homes by FY24/25, by transferring cash ($4 billion total) to municipalities that add supply at a faster rate than historic norms, increase densification, speed up approval times and encourage mixed-density zoning. Other measures include tapping infrastructure funding envelopes for housing. The challenge here is that we are already seeing a record number of units under construction, and the sector is pushing against labour and capacity constraints as it is. This will take a massive effort across all levels of government to achieve, and would likely add to inflation pressures.

First Home Savings Account: This will be a tax-free account, with deductible contributions going in, and tax-free withdrawals coming out if used for a first home purchase. The maximum annual contribution will be $8,000, with a lifetime maximum of $40,000. This program will begin in 2023.

Extension of First-Time Home Buyers’ Incentive to March, 2025: This is the shared equity program that has seen very little take-up. Ottawa will seek to make the program more effective. The First-Time Home Buyers Tax Credit will also be doubled to $1,500 of relief.

Multi-generational home renovation tax credit: A 15% tax credit worth up to $7,500 for adding a second unit to a home. This does not appear to apply to those adding a rental suite, and starts in 2023.

Speculation/flipping tax on homes sold within 12 months. If not held past the 12-month period, the sale will be subject to full taxation as business income. There will be some exemptions for situations like relocation and family changes. It will apply to properties sold on or after January 1, 2023. This is a worthy measure that addresses a legitimate issue, but one wonders if the 12-month period will just hold back re-listings a little bit longer than otherwise would be the case, especially in a rising-price environment.

Assignment sales tax: Effective May 7, 2022, assignment sales will be charged GST/HST on the purchase amount net of the initial deposit amount.

Proposed ban on non-resident purchases: A two-year ban will be proposed, targeting foreign businesses and non-permanent residents. Students, temporary workers and those with permanent residence will be exempt. Key details and an implementation date are still to be determined, but it seems as though large corporate buyers from outside the country would be the main target.

Other measures to address ownership of residential real estate by large corporation/REITs, and rent changes post-renovation, will be under review for a later date.

Direct cash payments: A $500 payment to those “facing housing affordability challenges” will be coming with a price tag of $475 million. Details are to be determined, and the appropriateness of such a measure is questionable at any rate.

Homebuyers bill of rights: Will aim to make the home-buying process smoother and more transparent. Among the most notable items is a ban on blind bidding, but that will have to filter down through provincial real estate bodies, and could take a number of years to organize. There is also mention of a right to have a home inspection, but that too will be complicated to implement.

Notable Tax Increases

Tax on banks and insurance companies: A 1.5% permanent surtax will apply to profits above the $100 million mark, raising the marginal corporate rate from 15% to 16.5%. Meantime, a one-time 15% tax on taxable income above $1 billion in the 2021 tax year will be payable over four years. Combined, these measures will cost the sector $1.1 billion this fiscal year and $1.3 billion by FY26/27. Based on dollar amounts, this appears to be less onerous than outlined in the election platform. That said, the precedent being set here is a concerning one, especially with an eye on investment, productivity and supply-side growth spread elsewhere in the budget—if one sector can be arbitrarily taxed after a period of strong performance, who is next?

Other taxes in the financial sector include an increase on hedging and short-sale activity through the “dividend received deduction”; and changes related to IFRS 17. Combined, these measures will raise roughly $700 million per year, and appear to backfill a good portion of the lower dollar amount in the above-mentioned taxes.

Crackdown on tax planning by Canadian-Controlled Private Corporations. This largely focuses on ensuring that investment income earned by a corporation in a foreign jurisdiction is subject to the same taxation as a Canadian corporation. Ottawa aims to raise $735 million this fiscal year, and $4.2 billion over five years.

Minimum personal income tax: The 2022 Fall Economic Statement will provide details on a new framework for a minimum tax regime.

Notable Tax Relief

Small business tax cut: A more gradual phase-out of the small business tax rate. The rate will be fully phased out at a capital level of $50 million up from $15 million currently. This will provide $160 million per year in relief.

Investment tax credit for carbon capture and storage: For 2022 through 2030, a 60% credit for direct air capture; 50% for any other carbon capture project; and 37.5% for other related investments. This will depend on take-up in the energy sector, but Ottawa estimates $1.5 billion by FY26/27.

Investment tax credit for clean technology: A 30% credit for investments that focus on net-zero and battery technologies, and clean hydrogen. Details will come later in 2022.

Critical mineral exploration: A 30% tax credit on exploration expenses for critical minerals.

Zero-emission vehicle incentives: ZEV incentive program (up to $5,000) will be extended to March 2025, with eligibility broadened to include more models, vans, trucks and SUVs. Transport Canada will announce more details in coming weeks.

Other Notable Measures

Dental care: National benefits would be restricted to families with income below $90,000, and begin with a focus on children under 12, seniors and people with disabilities. The cost will run at $5.3 billion over three years, and then $1.7 billion per year thereafter.

Defence spending: A gradual ramp-up in additional spending to $2 billion per year by FY26/27.

Canada Growth Fund: Will aim to invest in low-carbon and green technology industries. The fund will be initially capitalized with $15 billion, and aim to raise $3 in private capital for every $1 of public money.

New dollars for supply-chain infrastructure and an aim to expedite some provincial infrastructure projects by pulling forward funding deadlines.

Immigration: Meaningful dollars to expedite the inflow of international immigrants and meet the annual target of 451k per year by 2024, as well as improvements to the Temporary Foreign Worker program (aimed at expediting the flow of labour).

Labour Mobility Deduction for skilled trades: Up to $4,000 per year deduction for travel and relocation expenses for tradespeople and apprentices.

Zero-emission vehicle mandate: By 2026, 20% of light vehicle sales will be required to be zero-emission. That will rise to 100% by 2035.

Elimination of flow-through shares for oil, gas and coal exploration and development: This will apply after March, 2023.