Budget thoughts on the eve of austerity

Austerity is unavoidable. How do we minimize the damage?

Last month I wrote about why the deficit happened and what it will take to fix it. Since then I’ve thought more about the problem and have taken in some good presentations by Auditor General Terry Paddon (slides), and MUN economists Wade Locke (slides), and Jim Feehan (Feehan’s presentation is especially good). Here are my thoughts.

Austerity measures — both tax hikes and spending cuts — are unavoidable. The scale of the problem is far too big to rely only on one or the other. I have tried to work out what a comprehensive plan actually looks like on paper, and it is clear that every reasonable measure will have to be taken. The standard of living of every person in the province will be significantly affected.

So what does a plan look like in broad strokes? Wade Locke has proposed $550 million in tax hikes and $550 million in spending cuts, to be implemented slowly. That’s equivalent to roughly $2,500 in extra taxes per household, plus 3,000 layoffs (through attrition or otherwise), and a four-year salary freeze for public sector workers.

Even this probably won’t be enough because it only cuts the deficit in half. Unless oil prices recover soon, we’ll need to raise taxes and cut spending even more. A more likely scenario is $800 million in tax hikes and $800 million in spending cuts, with the tax cuts introduced within a couple years and the spending cuts spread out over five years or more.

Tax hikes are painful, but not complicated, so they should be done right away. Delaying them will only make things worse.

Locke has proposed: a 2 percent HST hike (worth $200 million), a 1.5 per cent across the board personal income tax hike (worth $250 million), and a 10 cents per litre gasoline tax hike (worth about $100 million).

Locke’s plan is a good start, but we should push for larger increases on income tax (to maybe $350 million, skewed towards high incomes), replace the gasoline tax with a comprehensive carbon tax of $30 per ton of CO2 (worth about $150 million), raise excise taxes on gasoline, tobacco and (eventually) marijuana (about $50 million), and introduce changes to corporate income tax (worth maybe $50 million).

Spending cuts will be complicated and will need to take place over many years. I expect we’ll see cuts to subsidies for ferries, rural electricity, and university tuition happen pretty quickly, because that’s a simple matter of raising user fees. Likewise, certain transfers to individuals, like the baby bonus, can be cut right away. But the big money will have to come over the longer term from shedding salary through wage cuts or freezes and layoffs and attrition. The first will require lengthy negotiations (unless the government imposes a contract — a strong possibility), and the second, if it’s done responsibly, will require careful planning and gradual implementation.

Further observations on the eve of budget day:

Some good news: Once Muskrat Falls is completed, Nalcor is supposed to pay cash dividends to the government of about $450 million per year, and these payments are not included in deficit projections. Some of that money will probably go to reduce power rates, but some of it will go towards the deficit.

Some bad news: The $2 billion deficit projection assumes oil prices would rise to $73 per barrel in 2020, whereas crude oil  futures are under $55 per barrel. We should expect a less optimistic forecast in this week’s budget documents, which will add a couple hundred million to the medium term deficit.

Challenge of geography: My last column didn’t account for our geographic challenges in delivering services. To address this, I ran a mathematical analysis called “multiple linear regression” to calculate what a “normal” level of public spending should be for a province with our characteristics. Specifically, I took into account: population, population density, rates of urbanization, and GDP per capita, and compared these to program spending in other provinces. From this, I calculated that a “normal” level of spending for a province like ours would require $750 million in spending cuts. Of course this calculation depends on a bunch of assumptions, so we shouldn’t place too much faith in this result, but for me it was a valuable sanity check and convinced me that $800 million in cuts is a reasonable target.

Carbon tax: Today, more than 80 percent of Canadians live in provinces that put a price on carbon. A carbon tax similar to what exists in B.C. and Alberta would generate $150 million in new revenue for the province. A lot of that money would come from large industrial emitters in the oil and mining sectors.

Corporate income taxes: The provincial general corporate income tax rate is 14 percent, which is already pretty high relative to other provinces. Raising it further might not raise much revenue; recent estimates by University of Calgary economists Ferede and Dahlby predict that raising our corporate tax rate would actually reduce government revenue by shrinking the tax base. Estimates of this kind are tricky and controversial, but on balance I think a strong carbon tax would be a more effective way to extract more income from large foreign-owned natural resource companies, who as it happens are also major carbon emitters.

On the other hand, manufacturing and processing industries pay a special reduced tax of only 5 percent. No other province charges less than 10 percent. This special treatment for manufacturing is difficult to justify on economic grounds, and has been criticized recently in a report by the Conference Board of Canada and by MUN economist Jim Feehan. People calling for corporate tax increases should focus on the special treatment of manufacturing industries.

We should also consider raising the small business tax rate, which was recently cut from 4 percent to 3 percent. Small business tax loopholes are often abused by rich people to avoid paying taxes (for example, by making their children shareholders and paying them dividends) and there is evidence that reduced tax rates for small businesses hurts the economy by discouraging small businesses from growing (though this might be less relevant in rural areas where there is less prospect for expansion).

Resettlement: There is money to be saved resettling isolated communities. According to briefing notes provided to the minister of Transportation and Works, ferry services often cost taxpayers more than $10,000 per resident to service communities like Little Bay Islands and St. Brendan’s, while other services such as subsidized electricity can add another $10,000 per household (pdf).

But we need to be realistic about the potential savings. If we add up all likely qualifiers for resettlement, I get about $25 million per year in ferry operating costs. If you add in electricity and other services, we are talking about $50 million in potential annual savings, in exchange for hundreds of millions dollars in lump sum compensation under the current program. Resettlement is worth doing, but the budget impact is relatively minor.

Tuition freeze: It is hard to imagine Memorial can retain the lowest tuition rates in Canada given the fiscal crisis. I think we’ll see tuition double over the next few years, moving it closer to Canadian norms, which would generate close to $50 million. This would help offset at least some of the cutbacks coming to MUN, which I expect will exceed $100 million per year. A tuition hike would also serve to reduce enrollment, particularly from out of province, at a time of downsizing at the university.

Even if we weren’t in a fiscal crisis, there’s a case to be made that the tuition freeze should end. University students tend to come from wealthier families, so they receive a disproportionate share of the benefit. Bursaries are a better way to target support to students who need it. Moreover, low tuition reduces the amount of tax credits and student grants/loans that poorer students qualify for. In extreme cases, needy students can be left *worse* off financially when tuition gets cut.

On a personal note, as a professor at Memorial University, I will be sorry to see the tuition freeze go. I am certain it has helped attract excellent students that I would not otherwise have had the opportunity to work with. But given the dramatic cuts that are surely coming to the university and public institutions in general, and given the options available to mitigate the impact of tuition hikes (such as bursaries and loans), preserving the freeze seems untenable.

Hard decisions are necessary

Dealing with our budget crisis will negatively impact every person in the province. Taxes and user fees will go up. Jobs will be lost and wages will be cut or frozen. Services will diminish. We can only hope to minimize the damage by making clear headed choices about how to cut back.

People are absolutely right to be angry about what will unfold tomorrow and in the years to come. We will suffer because of the reckless decisions made by the political elites who created this dire situation. But anger shouldn’t blind us to the necessity of dealing with problem, and making the hard decisions that we have avoided for too long.

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