Here’s how big the federal deficit might get

Sluggish growth is very likely to put the new federal government into deficit, whichever party wins

 
Finance Minister Joe Oliver addresses a parliamentary scrum
Finance Minister Joe Oliver in May 2015. (Sean Kilpatrick/CP)

As reported by the Globe and Mail, new figures released by Consensus Economics forecasts that Canadian real GDP will grow at a 1.1% pace in 2015, down significantly from the 2.0% projection in Budget 2015. Growth next year has been downgraded slightly as well, falling from 2.2% to 2.1%. We should be worried about the multi-billion dollar budgetary hole created by slower-than-expected economic growth. However, more worrying for future federal budgets is the post-recession track record of economic forecasts.

Before we begin, it is helpful to review the surplus forecasts in Budget 2015, which show small and growing surpluses along with a small and growing contingency reserve.

Fiscal Year Contingency Surplus (Deficit)
15-16 1.0 1.4
16-17 1.0 1.7
17-18 2.0 2.6
18-19 2.0 2.6
19-20 3.0 4.9

(All figures in billions of dollars)

Using my surplus/deficit calculator, I plugged in the Consensus Economics real GDP forecasts of 1.1% for 2015 and 2.1% for 2016. I also reduced the 10-year bond rate by 30 basis points for each of 2015 and 2016 (1.4% from 1.7% in 2015, 2.2% from 2.5% in 2016) to reflect the decline in economic conditions. The calculator estimates that this reduces the budgetary outlook by $3-4 billion a year:

Fiscal Year Contingency S/D Budget 2015 S/D Revised Change
15-16 1.00 1.40 -1.32 -2.72
16-17 1.00 1.70 -1.57 -3.27
17-18 2.00 2.60 -0.90 -3.50
18-19 2.00 2.60 -1.19 -3.79
19-20 3.00 4.90 0.98 -3.92

If we apply the entire contingency fund to the budget, this creates small deficits in 2015-16 and 2016-17 and small surpluses in following years. I believe the actual impact of the current economic decline will be somewhat larger than the calculator predicts, partly because my forecast for 2016 GDP growth is smaller than 2.1% and partly because of the nature of the current shock. An oil price decline has a disproportionately larger impact on corporate profits than the typical downturn, with a disproportionately smaller impact on EI expenditures. Put it altogether, I would estimate that the budgetary hole is closer to $5-6 billion, but $3-4 billion is reasonable.

What none of this takes into account is the fact that since the end of the Great Recession, federal budgets have greatly overestimated future economic growth. That is not a criticism of the federal government, as those forecasts are provided by Canadian private sector forecasters. This is also not as a criticism of Canadian private sector forecasters, since a similar phenomenon has taken place across the developed world. Forecasts for the four-year 2011-2014 period have overestimated the three economic indicators in our calculator by the following amounts:

RGDP GDP Inflation 10 Year Bond Rate
1 Year Out 0.10 0.18 0.40
2 Years Out 0.60 0.13 1.18
3 Years Out 0.65 0.18 2.23
4 Years Out 0.70 0.18 2.70

These numbers would be even more dramatic if the economic downturn of 2015 were included. Interestingly, the only year in the sample that forecasters largely got right was 2014, despite the unexpected decline in oil prices.

Let’s consider the scenario where this trend continues over the next four years. By downwardly adjusting RGDP, GDP inflation and the 10-year bond rates for 2016-2019 in the calculator to estimate the impact on government budgets, we get the following results:

Fiscal Year Contingency S/D Budget 2015 S/D Revised Change
15-16 1.00 1.40 -1.39 -2.79
16-17 1.00 1.70 -2.38 -4.08
17-18 2.00 2.60 -3.76 -6.36
18-19 2.00 2.60 -6.12 -8.72
19-20 3.00 4.90 -6.34 -11.24

Even with the drastically reduced debt financing costs from lower interest rates, our calculator forecasts a series of deficits for the next five years. The size of the deficits grow over time due to a compounding effect, as one year of slower-than-anticipated economic growth follows another.

Of course, the actual deficit (or surpluses) experienced in future years will likely deviate significantly from these estimates for three reasons:

  1. Governments can alter the size of a deficit (or surplus) by changing their taxation and spending plans.
  2. The surplus/deficit calculator provides only rough estimates of the impact of economic shocks on the federal budget.
  3. Although forecasters have consistently overestimated economic growth over the last five years, that does not necessarily have to hold in the future.

Despite those caveats, I would advise whoever forms the next federal government to develop a contingency plan for a continuation of the economic underperformance we have seen since 2011, as such a decline would put a large strain on federal budgets.

Mike Moffatt is an assistant professor in the Business, Economics and Public Policy group at the Ivey Business School. He has worked with Canadian politicians and policymakers of all political stripes to craft more effective public policy, including his most recent role as an outside economic adviser to Liberal Leader Justin Trudeau. Follow @MikePMoffatt on Twitter.

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