Focus
March 31, 2023 | 13:15
Green Energy Goals, Red Ink Realities
Green Energy Goals, Red Ink Realities |
Overview: Food for Fiscal ThoughtThe 2023 federal budget is set against a backdrop of still-elevated inflation, disruption in the global financial sector and a likely looming recession. Despite uncertainty on a number of fronts, and a weaker-than-expected underlying budget balance, Ottawa continues to roll out net new stimulus to the tune of $4.8 billion in FY23/24, and $43 billion over six years. That mostly comes through targeted spending and a swath of tax credits aimed at the clean energy sector. While tax revenues are raised in a few areas and there is some trimming of government operations, the budget deficit sits at $43.0 billion in FY22/23, and about $10 billion per-year deeper through the forecast horizon, with no plan to balance the books. Indeed, the first hint of a balanced budget that we’ve seen in years, which showed up in the Fall Economic Statement for the out-years, lasted all of four months. |
It’s notable that the FY23/24 deficit of $40.1 billion is now roughly back to pre-COVID levels ($39 billion deficit in FY19/20). Over that period, revenues have surged by $120 billion. But, program spending has jumped by $110 billion, even after pandemic-era support spending has fallen away. In that sense, there has been some permanence to the jump in government spending that has prevented more fiscal consolidation. While the average price level in Canada is up about 13% from before the pandemic, and the population has expanded by another 4%, we’re still seeing program spending hold above pre-COVID norms in real per-capita terms and as a share of GDP, and we continue to see each budget add progressively more spending (Chart 1). This budget does a number of things. There are immediate direct household transfers of $2.5 billion, billed as a “grocery rebate” even though groceries have nothing to do with it. Ottawa is also acknowledging the possibility of recession through a stress test of how finances would look in a below-expected economic outlook. This downside scenario features a recession-like 0.2% decline in real GDP in 2023 that comes with a $47 billion deficit. On the policy front, there are measures aimed at the clean energy sector in a response to the U.S. Inflation Reduction Act. More money flows into health and dental care, and there are some more tax increases aimed at higher-income Canadians and businesses worth roughly $4 billion annually a few years down the road. |
This budget also avoids doing a number of things. Most importantly, large-scale immediate fiscal stimulus is held in check with net new measures weighing at around 0.2% of GDP this year. While inflation has shown signs of cooling, the Bank of Canada remains in a dog fight with price and wage pressures, rendering stimulative measures counterproductive (like direct support payments), although Ottawa just couldn’t fully resist on that front. Oft-rumoured and more contentious policy measures (e.g., broad capital gains inclusion rate, top income tax rate and principal residence exemption) are again unchanged in this budget. All told, this budget continues to push fiscal priorities against a weaker and riskier economic backdrop, leaving behind a deeper deficit path. Steady Fiscal Outlook |
The budget deficit is pegged at $40.1 billion in FY23/24 (1.4% of GDP), improved slightly from $43 billion in FY22/23. The latter is revised wider from $36.4 billion in the Fall Economic Statement (FES), as increased spending dwarfs a further in-year improvement resulting from the economy. While the deficit is now well down from the record $328 billion at the depth of the pandemic in FY20/21 (thanks to resurgent revenues and expired emergency programs), still-elevated spending, higher interest costs and a downward turn in economic momentum keep the balance in the red through the forecast. Cumulatively, the total deficit between FY22/23 and FY27/28 is now running $69 billion larger than in the FES, split roughly one-third due to economic developments, and two-thirds the result of new measures net of tax increases. Revenues are projected to rise 4.5% to $457 billion in FY23/24, led by gains in personal income and sales tax receipts. Meantime, program spending is projected to rise 2.5% this fiscal year, with medium-term growth pegged at a similar rate. In the five years pre-COVID, total spending averaged a steady 14.5% of GDP. This year, total spending will run at 15.9% of GDP, before fading to 15.4% late in the forecast. That’s still a noteworthy increase in government spending as a share of the economy, especially at a time of full employment and when nominal output itself has surged on the back of rising prices. The debt-to-GDP ratio will rise to 43.5% in the coming fiscal year, from 42.4% in FY22/23, before declining gradually to just under 40% by FY27/28. Given that economic momentum is stalling, the major positive surprises of the past two years seem to have run their course. The downward drift in the debt-to-GDP ratio is now the key major fiscal objective, and this budget continues to project a gradual decline over the forecast horizon, but only after a near-1 percentage point increase this coming fiscal year. 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) slows or falls, as is the case this year. |
Cloudy Economic Assumptions |
As is the convention, the budget projections are based on the private sector consensus. This round was put in place before turmoil broke out in the global banking sector, which would ordinarily point to immediate downside risk. But, the pre-turmoil consensus was on the conservative side, especially for early-2023 growth. That combination leaves the 2023 growth forecast looking light, but we’re fully aware that this could turn back in a hurry depending on how the situation evolves in coming months. |
The budget is based on real GDP growth of 0.3% this year (we are now at 1.0% with Q1 tracking strongly), and 1.5% next year (1.3%). While real growth gets the focus, nominal growth has been the big story and the driver of revenues. Ottawa expects nominal growth to slow substantially to 0.9% this year after an 11% pop in 2022 (we’re at 2.6%) and pick up to 3.6% in 2024 (3.6%). After a multi-year run of large and persistent upside surprises to nominal GDP and revenues, it looks like the bar has been reset to a more neutral level, even if there is some immediate upside room. In the downside scenario of a more significant recession (-0.2% real GDP growth this year and muted 1.0% rebound in 2024), the full path of the budget deficit runs about $7 billion deeper per year. Meantime, interest rates now sit much higher than Ottawa expected along the curve last year. The 10-year yield is pegged at 3.0% this year, while the Bank of Canada is presumed to be finished raising rates. Both of those assumptions are generally consistent with our current view, although we are a bit higher than consensus in 2024. Summary and Market ImpactThis budget continues to press ahead with policy priorities despite a more challenging and less certain economic backdrop, leading to deeper deficits through the forecast horizon. But, those deficits hold at or less than 1.5% of GDP, still a long way from the depths of a few years ago. From a high-level perspective, temporary spending-driven deficits have subsided and Ottawa is now back to budget deficits roughly consistent with pre-pandemic levels. That said, an opportunity for even faster or more significant fiscal consolidation has been foregone given high-side persistence in program spending. Longer-term measures that aim to spur investment and improve the supply side of the economy remain worthwhile goals. From a credit perspective, a gradually falling debt-to-GDP ratio remains the fiscal target, but history (and even the year ahead) remind us that the ratio can turn quickly. The budget should have a negligible market impact overall. Broadly, the tax-and-spend nature of fiscal policy now and in recent years, along with persistent and larger deficits, could be viewed as somewhat negative for the loonie. But, Canada has not been alone on this front and other major drivers such as interest rates and oil prices will dominate. For bond yields, a small step down in borrowing runs alongside central bank quantitative tightening, leaving still-chunky issuance for the market to absorb. But, inflation and recession dynamics will far outweigh any impact on yields. Finally, aside from another tax increase on financial institutions, a tax on buybacks and the impact of some credits, there’s not much for the equity market to digest. |
Appendix: Highlights of Major MeasuresThe net additional stimulus in Budget 2023 amounts to $4.8 billion in FY23/24 and $43 billion over six years. The total net fiscal impulse for Canada this budget season, if we consider also the GST rebate booked at the end of FY22/23 and provincial tax measures, looks to be in the 0.4%-to-0.5% range. Here are some of the most significant measures: Affordability measuresGST rebate increase: While billed as a “grocery rebate”, it really has nothing to do with groceries. The GST credit for lower-income Canadians is increased in what amounts to a maximum of $153 per adult. This is an immediate direct cash transfer to lower-income Canadians worth $2.5 billion, with the cost booked in FY22/23.Student affordability: The Canada Student Grant is lifted by 40%, and the interest-free loan limit is raised modestly. Total relief will amount to $814 million in FY23/24.RESP withdrawal limit: Limit is increased from $5,000 to $8,000 for full-time students, and from $2,500 to $4,000 for part-time students.Taxation measuresAlternative Minimum Tax (AMT) framework: The AMT is a tax calculation run parallel to ordinary income tax rules, with the taxpayer paying whichever amount is higher. Three broad changes include lifting the AMT rate from 15% to 20.5%; raising the basic exemption level from $40k to $173k; and devaluing many exemptions and deductions (e.g., increase the capital gains inclusion rate from 80% to 100%).Global Minimum Tax: Ensures that large multinational corporations are subject to a 15% effective tax rate on profits in the jurisdiction they are operating in, and is consistent with moves made in other countries.Taxes on financial institutions: Changes the tax rate paid on dividends received by financial institutions by treating the flow as ordinary income. Ottawa is expecting roughly $900 million per year from this measure, starting in FY24/25.Tax on the share buybacks: A 2% tax on share buybacks will apply to public companies as of January 1, 2024, if those buybacks exceed $1 million. The revenue impact will reach north of $600 million in two years.Clean economy and response to the U.S. Inflation Reduction ActThe majority of Canada’s focus in this area looks to be coming in the form of tax credits to incentivize investment. The following new/expanded credits come with modest fiscal cost in FY23/24, rising above $5 billion per year by FY26/27, and come with some labour market requirements.Clean Electricity Investment Tax Credit: A 15% refundable tax credit on eligible investments (e.g., wind, solar, electricity, transmission equipment).Clean Technology Manufacturing Investment Tax Credit: A 30% refundable tax credit on machinery and equipment in clean technology manufacturing, and to offset the cost of mining and production equipment for critical minerals.Clean Hydrogen Investment Tax Credit: Credit ranges from 15%-to-40% on project costs.Clean Technology Investment Tax Credit expansion: The recently-announced 30% refundable rate for those adopting clean technology will expand to include geothermal energy, and the credit will be phased out later.Carbon Capture, Utilization and Storage Tax Credit expansion: The list of allowable expenses under the credit is expanded, and the credit expands to projects in B.C.Other notable measuresCanadian Dental Care Plan: Coverage for all Canadians with family income below $90k and without insurance, and will cost an additional $2 billion per year by FY24/25 ($1 billion more than previously budgeted).Provincial health transfers: The provinces are receiving an immediate $2 billion top-up the Canada Health Transfer amount, and annual growth is set at a minimum of 5% for the next five years (the formula is normally driven by nominal GDP growth).Various measures to monitor and limit foreign interference, money laundering and risk in the crypto space. For example, OSFI’s mandate will expand to oversee measures related to limiting foreign interference; and a federal beneficial ownership registry will be created. Amendments to the criminal code will be made to strengthen the AML/ATF regime.Cost savings: Ottawa will clamp down on internal travel and outsourcing work to consultants. Savings in this area look to run at $7 billion over five years before settling into $1.7 billion per year thereafter. Other departmental spending reduction targets look to cut 3% by FY26/27 for additional ongoing savings of $2.4 billion per year. A good chunk of this ($3 billion per year by FY26/27) was built into last year’s budget.Gross bond issuance is expected to fall to $172 billion, down $13 bln from the prior year. After accounting for maturities, that pegs net issuance at $19 billion.Canada Mortgage Bond program is under review to be potentially consolidated into the regular Government of Canada borrowing program. |