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Chapter 7
Sound Financial Management

Highlights

• The Government is committed to sound financial management, including delivering balanced budgets or better through prudent budget planning, reducing the burden of the federal debt, and improving expenditure efficiency and oversight.

• After accounting for the fiscal impact of proposed new initiatives, Budget 2005 projects balanced budgets or better in 2004–05 and in each of the next five fiscal years. 2004–05 will mark the eighth consecutive balanced budget achieved by the Government of Canada, the first time this has happened since Confederation. According to the Organisation for Economic Co-operation and Development (OECD), Canada was the only Group of Seven (G-7) country to record a total government budget surplus in 2004, for the third consecutive year, and is projected to be the only country in surplus again in 2005 and 2006.

• The 2005 budget maintains the annual $3-billion Contingency Reserve. It also includes an additional amount for economic prudence to provide greater assurance that the balanced budget targets will be met. If not needed, the amounts set aside for economic prudence will be released to fund government priorities. The Contingency Reserve—if not needed to deal with unforeseen circumstances—will go each and every year to reduce the federal debt (accumulated deficit).

• This budget reaffirms the Government’s objective set out in the 2004 budget to reduce the federal debt-to-GDP (gross domestic product) ratio to 25 per cent by 2014–15. As a result, debt-servicing costs will absorb a smaller share of revenues, placing the Government in a better position to deal with the fiscal pressures of an aging population.

• The federal debt (accumulated deficit) as a percentage of GDP is projected to fall to 38.8 per cent in 2004–05, down from its peak of 68.4 per cent in 1995–96. With the commitment to balanced budgets in each of the next five fiscal years, and based on the average private sector forecast for nominal GDP growth, it is estimated that the federal debt-to-GDP ratio will decline to about 30.6 per cent in 2009–10.

• Five-year projections are presented in this budget. This is for greater transparency, reflecting the fact that the vast majority of the commitments made in this budget extend beyond the traditional two-year budget horizon.

• The Cabinet Committee on Expenditure Review (ERC) has identified cumulative savings totalling almost $11 billion over the next five years. These savings have been reinvested in core responsibilities of the Government. The work of the ERC constitutes a significant first step toward a culture of ongoing reallocation and is complemented by other measures to improve financial accountability and management.

• The federal revenue-to-GDP ratio is projected to decline from 15.3 per cent in 2003–04 to 14.5 per cent by 2009–10, reflecting one-time revenue gains last year as well as the impact of the tax reduction measures announced in this and previous budgets.

• The ratio of program expenses to GDP will increase to 12.2 per cent in 2004–05, reflecting the substantial increase in transfers to provinces for health care and Equalization. For the remainder of the planning period, the ratio is projected to be 11.9 per cent.

Introduction

Sound financial management is at the core of the Government’s strategy. Prudent fiscal planning, maintaining balanced budgets or better, and keeping the debt-to-GDP ratio on a clear downward track help foster economic growth. A lower debt burden and stronger economy provide the means to invest in programs that are the foundations of a secure society and allow Canada to meet its global responsibilities.

Sound financial management is not just about ensuring that the books are balanced. Responsible stewardship of taxpayers’ money also entails a continuous quest for ways to improve the efficiency of government and to ensure that resources are allocated in a way that reflects the priorities of Canadians. This is why the Government established a new Cabinet committee in December 2003 to conduct a comprehensive review of federal spending with the view to identify savings that could be redirected to new priority areas of the Government. This review has identified cumulative savings of almost $11 billion over the next five years by reducing procurement costs, increasing program efficiency, and reducing and eliminating lower-priority programs.

This chapter sets out the Government of Canada’s approach to budget planning and the benefits of that approach. It updates the fiscal projections for 2004–05 and the next five fiscal years, and reports on the results of the expenditure review and how the savings resulting from the review will be reinvested.

Approach to Fiscal Planning

The Government’s approach to budget planning involves a number of important elements. The first element involves the use of private sector economic forecasts.

• The Department of Finance conducts surveys of private sector economic forecasters. About 20 forecasters are surveyed on a regular basis, following the release of the quarterly National Income and Expenditure Accounts by Statistics Canada.

• Each fall, the Department of Finance conducts extensive consultations with an economic advisory group, which includes the chief economists of Canada’s major chartered banks and leading economic forecasting firms, to determine the economic assumptions appropriate for fiscal planning. The group was recently expanded to ensure representation from all regions of the country.

The second element involves using these economic assumptions to develop status quo fiscal projections for the regular fall Economic and Fiscal Update.

• Major private sector economic forecasting firms develop detailed fiscal projections, on a National Accounts basis, based on current tax and spending policies. These forecasts are then translated into Public Accounts projections by the Department of Finance, in consultation with the private sector economic forecasting firms, and presented in the fall Economic and Fiscal Update.

The third element involves updating the status quo projections presented in the fall Economic and Fiscal Update for the budget and adjusting these projections for prudence.

• Based on the most recent survey of private sector economic forecasters and the most recent financial results, the fiscal projections are updated by the Department of Finance.

• Fiscal projections are adjusted for the Contingency Reserve and economic prudence to derive the fiscal surpluses for budget-planning purposes. The annual Contingency Reserve is set aside to guard against unforeseen circumstances. If not needed, it is used to reduce the federal debt (accumulated deficit). Economic prudence is built into the planning framework to provide further assurance against falling back into deficit. If the economic prudence is not needed, these funds can be directed to increased spending in priority areas, tax cuts or further debt reduction.

• This budget presents five-year fiscal projections, reflecting the fact that the vast majority of the commitments made in this budget extend beyond the traditional two-year horizon. The Contingency Reserve is set in this budget at $3.0 billion for 2004–05 through 2009–10. Economic prudence is set at $1 billion in 2005–06, $2 billion in 2006–07, and rises to $4 billion in 2009–10, reflecting rising uncertainty over the planning horizon.

The key elements of the current approach to budget planning were established following an independent review of the Government’s forecasting methods in 1994. Much has changed since then—the elimination of the deficit, the Government’s commitment to a balanced budget or better, each and every year, and the adoption of full accrual accounting.

To ensure that the Government of Canada is using the most up-to-date economic and fiscal forecasting methods, a comprehensive third-party review of the Government’s economic and fiscal forecasting is currently underway. Leading this new review is Dr. Tim O’Neill, Chief Economist and Executive Vice-President of BMO Financial Group. As part of this forecasting review, the International Monetary Fund is conducting a comparative analysis of the budgeting practices and experiences in Canada and other major industrialized countries for its annual Article IV review of Canada. This report will be shared with Dr. Tim O’Neill to inform his review.

The Minister of Finance has asked Dr. O’Neill to offer specific recommendations with respect to:

• Improving the accuracy of the economic forecasts.
• Improving the preparation and accuracy of the fiscal forecasts.
• Addressing ways of dealing with the uncertainties in economic and fiscal forecasting.

The review is expected to conclude in the spring of 2005. The recommendations from this review will be referred to the House of Commons Standing Committee on Finance, which has also been asked to make recommendations relating to the provision of independent fiscal forecasting advice for parliamentarians.

Canada Is the Only G-7 Country Expected to Maintain a Financial Surplus

The strength of Canada’s current approach to fiscal planning has been clearly demonstrated. Since 2001, when a global economic slowdown put considerable pressure on the finances of all major industrialized countries, Canada has been the only G-7 country to record budgetary surpluses for the total government sector. According to the latest OECD forecast, Canada is expected to be the only G-7 country in surplus in 2005 and 2006 (further details on Canada’s federal/provincial-territorial fiscal situation as well as Canada’s fiscal situation compared to that of other countries are provided in Annexes 1 and 2).

Setting a Goal for Lowering the Debt-to-GDP Ratio

The achievement of seven consecutive annual budgetary surpluses, coupled with sustained economic growth, has resulted in a substantial reduction in the federal debt-to-GDP ratio—from a post World War II peak of 68.4 per cent in 1995–96 to 41.1 per cent in 2003–04.

Nevertheless, the federal debt-to-GDP ratio remains well above average historical levels. A high debt burden leaves any country vulnerable to fluctuations in global interest rates. High levels of debt also mean that a large portion of the revenue that the Government collects from taxpayers must go towards debt-service payments rather than to fund programs and services and reduce taxes.

While public debt charges as a percentage of budgetary revenues have come down significantly from the peak of 37.6 per cent observed in the first half of the 1990s, they remain relatively high compared to levels in the mid-1970s. Federal debt charges consumed 19 cents of every dollar of revenue in 2003–04, compared to 11 cents 30 years ago. These revenues, which are going to service the debt, are not available to fund priorities of Canadians.

Reducing the debt burden, and hence the burden of interest charges on public debt, is made even more necessary in light of the economic and fiscal pressures that will result from population aging. The aging of the population will reduce the employment-to-population ratio over the coming decades, which in turn will slow the growth of government revenue. Simultaneously, the growing proportion of the elderly population will put pressure on government programs such as health care and pension benefits (further information on the challenge posed to Canada by population aging is contained in Annex 3).

In Budget 2004, to ensure that the federal debt burden continues to fall, the Government of Canada set the objective of reducing the debt-to-GDP ratio to 25 per cent within 10 years. This will bring the federal debt-to-GDP ratio back to where it was in the mid-1970s. By 2009–10, the end of the planning period for this budget, the debt-to-GDP ratio will be just above 30 per cent. Reducing the federal debt-to-GDP ratio to 25 per cent would mean that about 12 cents of every revenue dollar would go to service the debt, compared to 19 cents in 2003–04.

Improving Financial Accountability and Expenditure Efficiency

Sound financial management must go beyond ensuring that the Government’s books are balanced. Sound financial management also means that tax dollars are managed responsibly and directed to the highest priorities of Canadians. Government programs should be cost-effective and efficient. It also means greater discipline and rigour to financial management as well as greater transparency and better information on the performance of programs and services.

Financial Management and Accountability

The federal public sector is the largest and most complex organization in Canada. Rapid technological change, social and demographic changes, and the evolving expectations of Canadians are all putting pressure on the public sector to reform and modernize its operations.

To address these challenges, the Government has established an ambitious agenda to strengthen and modernize public sector management. This agenda will deliver concrete results in four key areas: accountability, financial management, service delivery and internal efficiency, and human resource management.

The Government has already made substantive progress in its efforts to achieve these goals through the introduction of full accrual accounting, the re-establishment of the Office of the Comptroller General of Canada, investment in Government On-Line, and the passage of the Public Service Modernization Act.

In November 2004, the Government received an award for excellence in reporting from the Canadian Institute of Chartered Accountants recognizing its leadership in adopting full accrual accounting in the 2003 Public Accounts of Canada—a full three years ahead of the new standard’s effective date—and with an unqualified opinion from the Auditor General. As a result, Canada has joined a small group of national governments, including New Zealand and Australia, that have moved to full accrual accounting in recognition that it provides improved information for decision making and accountability, and a more comprehensive picture of government finances.

The Government also recently outlined a number of measures to strengthen the governance and accountability of Crown corporations, which are an important part of the public sector, with combined assets of more than $70 billion and 73,000 employees. Key recent measures include clarifying the relationship between responsible Ministers and Crown corporations, clarifying the accountability regimes, making the appointment process more transparent, bringing the governance of Crown corporations in line with reforms in the private sector, strengthening the audit regimes, and making activities and operations of Crown corporations more transparent.

Through Government On-Line, the federal government now has a world-class Secure Channel Infrastructure to support on-line service delivery. This has created a rich set of common services capable of supporting most Internet service delivery strategies. Through these efforts, the Government has a strong foundation on which to move forward with internal and external service delivery transformation.

Building on these achievements the Government will:

• Develop a more rigorous approach to capital planning, leading to a proposal to Parliament to consider multi-year appropriations for those departments with good capital plans and a good track record of managing their capital assets. Better long-term capital plans will also enable the Treasury Board Secretariat to fulfill its oversight responsibilities.

• Move forward with a service transformation strategy to improve internal and external service delivery by rethinking and integrating service offerings, by using a shared service approach for corporate and administrative services and common applications across departments.

• Consult with parliamentarians in the coming months to develop a blueprint for improved parliamentary reporting. The blueprint will include the Estimates and related documents, government-wide reporting, ad-hoc reporting from many individual government entities, and options to deliver on-line access to performance information. Through these consultations, the Government will determine how best to provide parliamentarians with more timely, understandable and accessible information on program spending and results, thereby enhancing Parliament’s ability to hold the Government to account on behalf of all Canadians.

Improving labour relations and the management of human resources is a priority of the Government. In keeping with the spirit of the Public Service Modernization Act, the Government will introduce a provision to allow for the establishment of a shared governance entity to oversee the administration of the Public Service Health Care Plan. This plan covers over 500,000 members of the public service and separate employers, and pensioners. The plan costs approximately $500 million annually. The shared governance entity will be a not-for-profit corporation. It will oversee the administration of the plan and ensure that the needs of plan members and the Crown are met. At the same time, it will ensure that there is a proper accountability framework to both the Government and plan members.

Taken together, these initiatives will build on and support the Government’s ongoing efforts to modernize public sector management, enhance accountability, strengthen financial management, and invest in the skills and capacity of the public service needed to deliver better value-for-money to Canadians. More details are contained in the Strengthening and Modernizing Public Sector Management booklet, which has been tabled with this budget.

Improving Expenditure Efficiency

On December 16, 2003, the Government of Canada launched an extensive exercise to review government spending and to shift expenditures from low-priority areas to high-priority areas. A new Cabinet Committee on Expenditure Review (ERC) was created to undertake a rigorous review of all government programs and expenditures. Its mandate was to undertake a rigorous review of federal spending, testing for relevance, efficiency and excellence, and to submit its first set of recommendations to the Prime Minister prior to Budget 2005.

The work of the ERC, however, is also a mechanism to ensure that future spending is consistent with the social and economic goals of Canadians. Savings identified in the course of expenditure review can provide the Government with further funds to invest in today’s priorities and tomorrow’s opportunities. This means that, by systematically rooting out waste and inefficiency, and reallocating funds to areas that matter most to Canadians, expenditure review is a win-win process.

Budget 2005 incorporates the ERC’s first review of federal spending. Over a four-month period, the ERC undertook a detailed, bottom-up review of federal spending both horizontally—government-wide activities—and by individual department. This process resulted in measures that will transform the way the Government operates and provide savings of almost $11 billion.

• Government purchasing will be streamlined, consolidated and made more efficient.

• Property management within the public service will increasingly follow modern management principles.

• The delivery of federal services and programs to Canadians will be improved with "one-stop shopping" by implementing the Service Canada initiative.

• Departments will ensure that their programs are as efficient as possible, and the overhead costs minimized to the extent possible—consistent with improved quantity or quality of service where feasible. Programs that do not work will be eliminated.

• Investments that need to be made to achieve this transformation will be undertaken, and are included in determining the savings to be delivered.

• The expenditure review package will be implemented by the Treasury Board.

Combined with the reinvestment of these savings in the federal government’s core responsibilities to Canadians—being announced in Budget 2005—the expenditure review exercise makes substantial strides in pushing forward the much-needed process of reallocation.

Taking into account attrition rates and opportunities for retraining and relocation within the federal public service, the net reduction in federal government employment will be about 1 per cent. Employees losing their jobs will be entitled to assistance and financial support under existing workforce adjustment programs.

Looking ahead, expenditure review will continue, consistent with the objectives stated in Budget 2004.

Table 7.1
Sources and Uses of the Expenditure Review

The ERC savings will be invested in the Government’s core responsibilities. Examples of programs to which the ERC savings have been directed in this budget include national defence and security, the environment, support for Aboriginal Canadians, support for research and development, and investment in federal infrastructure and programs.

About $2.3 billion of the total savings will be achieved through improved efficiency in the employment insurance (EI) program, and a further $155 million in the Canada Pension Plan (CPP). The Government is committed to maintaining EI premiums equal to program costs. Therefore, savings related to the administration of the EI program will be used to either enhance future benefits or reduce future premiums. Savings related to the CPP program will contribute to ensuring the ongoing soundness of the public pension system.

The ERC is not a one-time exercise, but the beginning of a new management culture in the Government of Canada. Further information on the expenditure review is provided in the Expenditure Review for Sound Financial Management booklet, which has been tabled with this budget.

Fiscal Outlook Before the Measures Proposed in the 2005 Budget

The November 2004 Economic and Fiscal Update presented fiscal projections for 2004–05 and the next five fiscal years. These projections were based on private sector economic forecasts available at the time and the fiscal results for the first six months of the current fiscal year. In this budget, these projections have been updated to reflect the revised private sector economic forecasts following the release of the third-quarter National Income and Expenditure Accounts, as summarized in Table 7.2 (see Chapter 2 for details), and the monthly financial results through December 2004.

Table 7.2
Average of Private Sector Economic Forecasts: December 2004 Survey

Table 7.3 shows the impact of these changes on the budgetary surplus for planning purposes on a "status quo" basis—that is, before including any measures proposed in this budget. The budgetary surplus for planning purposes as presented in the November 2004 Economic and Fiscal Update was derived after subtracting the $3-billion Contingency Reserve and amounts for economic prudence.

In the November Update, based on the financial results for the first six months of 2004–05, the budgetary surplus for planning purposes was estimated at $5.9 billion for 2004–05. The fall Update projection of the planning surplus is restated here to reflect the accounting for the wait times reduction funding in 2004–05. In the fall Update a notional profile was provided for wait times reduction from 2004–05 through 2008–09 to address current backlogs.

There have been several other developments since the November Update forecast that have affected the financial projection for 2004–05.

• Personal and corporate income tax receipts are projected to be somewhat higher than at the time of the November Update, reflecting stronger underlying tax receipts to date than at the time of the Update.

Table 7.3
Changes in the Status Quo Fiscal Outlook Since the November 2004 Economic and Fiscal Update

• Goods and services tax (GST) receipts are projected to be up about $700 million from the November Update forecast, reflecting stronger-than-expected gross GST receipts to date.

• Non-tax revenues are projected to be about $500 million higher than previously predicted, reflecting upward revisions to the forecast of enterprise Crown corporation revenues, particularly for Export Development Canada. Other components of revenues are largely unchanged compared to estimates presented in the November Update.

• Program expenses are projected to be $700 million higher relative to the November Update, reflecting somewhat higher elderly and EI benefits, and higher transfers to other levels of government due to re-estimates of the cost of extending the repayment period for recoveries under the Equalization program.

As a result of these changes, the budgetary surplus for planning purposes for 2004–05 on a status quo basis (after deducting the $3-billion Contingency Reserve but before deducting the cost of initiatives proposed in this budget) is now estimated at $3.3 billion.

Starting in 2005–06, the status quo fiscal projections incorporate the impact of the revised private sector economic outlook as summarized in Table 7.2. The private sector forecasters expect somewhat weaker economic growth in 2005 from that expected at the time of the November Update. In addition, revisions to Statistics Canada National Accounts data have resulted in a slight shift in the composition of GDP growth in the near-term, with somewhat more growth coming from the corporate sector.

These changes, combined with the changes to the fiscal outlook for 2004–05, explain most of the variation in tax revenues in relation to the November 2004 Economic and Fiscal Update. The one exception is the change in EI premium revenues, which reflects revisions to the cost of EI benefits. EI benefits are somewhat higher, as the ratio of unemployed qualifying for benefits is expected to rise slightly over the projection period, while the private sector forecasts used in the November Update suggested that this ratio would decline.

The other components of program expenses, on a status quo basis, are largely unchanged from the November Update. Elderly benefits are up slightly, reflecting revised projections of the elderly population, while statutory transfers to other levels of government are slightly lower.

Private sector forecasters have significantly lowered their projections for short- and long-term interest rates. This change results in lower public debt charges than those assumed in the November Update. Public debt charges are now expected to be $0.8 billion lower in 2005–06, $1.4 billion lower in 2006–07, and $0.8 billion lower per year thereafter.

As a result, before accounting for measures announced since the November Update, the planning surplus for 2005–06 is now estimated at $3.0 billion, $2.5 billion higher than the estimate at the time of the November Update. The budgetary surplus is projected at $4.3 billion for 2006–07 and rises to $14.4 billion by 2009–10.

Fiscal Outlook: Risks and Sensitivities

Fiscal projections are inherently uncertain. The sources of uncertainty are two-fold. First, the fiscal projections can vary as a result of uncertainty regarding the timing of tax receipts and refunds as well as fluctuations in the revenue that individual tax bases yield. Second, the fiscal projections are also sensitive to changes in economic assumptions, which affect the size of projected tax bases and expenditures that are sensitive to economic factors, such as EI benefits and public debt charges.

Risks Related to 2004–05 Outcome

The fiscal projections for 2004–05 are based on financial results through December 2004. Results for the remaining three months must be extrapolated based on year-to-date results. Accrual adjustments necessary for producing final year-end results are based on 2004 tax returns assessed by the Canada Revenue Agency as of May 31, 2005. Based on these tax assessments, work on finalizing year-end revenue payables and receivables and on adjustments to expenses will take place during the summer months of 2005. Final results will appear in the Annual Financial Report of the Government of Canada in mid-September to mid-October.

Uncertainties regarding the outcome for 2004–05 relate to the financial results in the months of January through March and the end-of-year accrual adjustments. Financial results can be difficult to predict in the last few months of the year for corporate income tax receipts and GST revenues.

Corporate income tax remittances throughout the year are strongly weighted toward the latter four months of the fiscal year. On average, between 45 and 55 per cent of net corporate income tax receipts are received during the December to March period of the fiscal year. This is because of remittance procedures, whereby corporations’ monthly instalments can be based on their previous year’s tax liability or the current year’s estimated liability. In addition, provisions of the Income Tax Act allow corporations to smooth income and losses from year to year, implying that corporate tax payments for a year can differ substantially from corporate profits in that same year. These two factors combined make forecasting year-end corporate income tax receipts extremely difficult.

The remaining federal revenue sources are also subject to varying degrees of uncertainty related to how much revenue their associated tax bases will yield. The GST, for example, is a value-added tax with gross taxes collected, and refunds paid out, at each stage of the production-consumption chain. Within a fiscal year, normal timing delays can result in gross GST receipts growth either leading or lagging the growth in GST refunds. However, over the course of a full fiscal year, these differences tend to lessen, and net GST receipts grow broadly in line with the underlying consumption base. To date in 2004–05, net GST receipts are up nearly 10 per cent. This is well above growth in consumer spending and reflects weak growth in refunds. Through the remainder of the fiscal year, the growth in GST refunds is expected to pick up to more closely match that of gross receipts, so that the growth in net receipts is more in line with the growth in taxable consumption.

The level of personal income tax revenues is affected by factors such as registered retirement savings plan (RRSP) contributions, capital gain and loss realizations, transfers to the Provincial Tax Collection Account (which reflect the fact that the federal government collects personal income taxes on behalf of 9 of the 10 provinces) and transfers to the Canada Pension Plan. The last two alone, which are collected along with personal income tax withholdings from taxpayers’ paycheques (the basis for monthly financial results for personal income tax revenues) total some $63 billion, equivalent to one-third of total federal budgetary revenue. Due to the magnitude of these revenues, even small percentage variations in the monthly estimates of any one of these factors can cause year-end revenues projected on the basis of monthly results to differ significantly from the final, audited year-end outcome.

The following chart shows the year-end accrual adjustments that have been made to personal income taxes. Since 2001–02 (the first year for which these adjustments are available on a full accrual basis of accounting) these adjustments have ranged from a reduction in revenue of $5 billion in 2001–02 (reflecting capital losses as a result of the stock market correction) to an increase in revenue of $3.1 billion in 2003–04. These variances are due, among other things, to overall economic conditions, capital gains and losses, and the investment decisions on the part of individual taxpayers with respect to RRSP contributions. The true magnitude of these net receivables, and of all other factors that affect final accrual personal income tax revenues, is not known until the associated tax returns have been filed and assessed, which does not take place until several months after the end of the fiscal year. The actual outcome for personal income tax revenue for 2004–05 will vary depending on the magnitude of the year-end accrual adjustments.

On the expenses side, the two key sources of uncertainty are the liabilities that the Government recognizes in its financial statements and the size of departmental lapses. Both can vary significantly from year to year. The size of departmental lapses has varied by over $1 billion in recent years.

Risks Related to 2005-06 and Future Years

The fiscal projections over the next five years are sensitive to changes in economic assumptions—particularly to changes in real economic (GDP) growth, inflation and interest rates. Table 7.4 illustrates this sensitivity to a number of economic shocks.

These sensitivities are generalized rules of thumb that assume any decrease in economic activity is proportional across GDP income components. The actual fiscal response to an economic shock will also be influenced by the degree to which specific income components of GDP are affected, such as if a slowdown were concentrated more in the corporate rather than personal or investment income sectors. The sensitivities shown below also differ somewhat from those presented in Budget 2004 due to changes in the estimated income composition of GDP and to changes in the levels of the respective revenues and expenditures themselves.

Table 7.4
Estimated Change in Fiscal Position¹

A decrease in the growth of real GDP (through equal reductions in employment and productivity) would lead to lower federal government revenues through a contraction in various tax bases and an increase in spending, primarily due to higher EI benefits. The impact would lower the budgetary balance by $2.5 billion in the first year, $2.7 billion in the second year and $3.4 billion in the fifth year.

A 1-per-cent reduction in the growth in nominal GDP resulting solely from a one-year decline in the rate of GDP inflation would lower the budgetary balance by $1.6 billion in the first year and by $1.5 billion in year two. Most of the impact would be on budgetary revenues, as wages and profits would be lower, as well as the price of goods and services subject to sales and excise taxes. Somewhat offsetting the reduction in revenues would be the fall in the cost of programs that are indexed to inflation, such as elderly benefit payments. The budget balance would be lower by $1.7 billion in the fifth year.

A sustained 100-basis-point decline in all interest rates would improve the budgetary balance by $1.0 billion in the first year, rising to $1.4 billion in year two. By the fifth year of the reduction, the budgetary balance would improve by $1.8 billion. This improvement comes solely from the reduction in public debt charges, which reduces overall budgetary expenses. Expenses would fall by $1.4 billion in the first year, $2.0 billion in year two and $2.7 billion in year five, as longer-term debt matures and is refinanced at the lower rates. This impact is slightly larger than that presented in previous years, reflecting the reduction in the fixed-rate portion of the market debt in order to lower debt-servicing costs. Moderating this impact are lower interest earnings on the Government’s interest-bearing assets, which are recorded as part of non-tax revenues.

Impact of Measures Since the 2004 Budget on the Budgetary Balance

Table 7.5 summarizes the impact of the measures proposed since Budget 2004 on the fiscal surplus for planning purposes.

The measures proposed in this budget amount to $3.0 billion in 2004–05, to $3.4 billion in 2005–06, rising to $16.6 billion in 2009–10. Cumulatively, the spending and tax measures proposed in Budget 2005 amount to $48.9 billion. This cost is net of amounts previously set aside in the fiscal plan for international assistance, climate change and other environmental initiatives. The Government is committed to increasing the International Assistance Envelope by 8 per cent per year. Consistent with this commitment, the status quo fiscal projections incorporate growth of 8 per cent in international assistance. This budget also allocates the remaining amounts set aside in the 2003 budget for the Climate Change Action Fund ($470 million in 2005–06, $450 million in 2006–07 and $500 million in 2007–08) and the remaining amounts set aside in the 2004 budget in support of new environmental technologies ($100 million in 2006–07, $250 million in 2007–08, $250 million in 2008–09 and $200 million in 2009–10).

After deducting the cost of initiatives proposed in this budget and adding the ERC savings, balanced budgets or better are expected each year over the projection period.

Table 7.5
Fiscal Outlook Including February 2005 Budget Measures

Summary Statement of Transactions

Table 7.6 provides the summary statement of transactions, including the impact of all the measures proposed in this budget.

Five-year projections are presented in this budget. This is for greater transparency, reflecting the fact that the vast majority of the commitments made in this budget extend beyond the normal two-year budget horizon.

A balanced budget is projected for 2004–05. This will mark the Government’s eighth annual consecutive balanced budget or better. Balanced budgets or better are projected for the next five years. The balanced budget projections are backed by inclusion of the $3-billion Contingency Reserve and amounts for economic prudence—$1 billion in 2005–06, rising to $4 billion by 2009–10. If not needed to deal with unforeseen circumstances, the Contingency Reserve will be applied to reduce the federal debt.

Assuming a balanced budget over the next five years, and based on the private sector projection of nominal GDP which increases, on average, by about 5 per cent per year, federal debt as a percentage of GDP is projected to decline from 41.1 per cent in 2003–04 to just above 30 per cent in 2009–10.

Table 7.6
Summary Statement of Transactions (Including February 2005 Budget Measures)

Outlook for Budgetary Revenues

Budgetary revenues are expected to increase 5.2 per cent in 2004–05 (Table 7.7), reflecting modest growth in personal income and strong growth in corporate profits. Over the planning period, budgetary revenues are expected to increase more slowly than the growth in the economy. In 2004–05, this reflects lower EI premium revenues due to the drop in EI premium rates; the impact of the implementation of the final phase of the Five-Year Tax Reduction Plan via the increase in the income thresholds to which statutory rates apply; and the 2-percentage-point reduction in the general corporate income tax rate in 2004. It also reflects an unusually high level of corporate income tax revenues in 2003–04 related to the revaluation of U.S.-dollar-denominated liabilities in the financial services industry. In 2005–06, budgetary revenue growth slows to 2.3 per cent, reflecting the one-time impact of the sale of the Government’s remaining shares in Petro-Canada in 2004–05 and lower expected enterprise Crown corporation revenues. Beyond 2005–06, budgetary revenues continue to grow slightly below growth in nominal GDP, reflecting the incremental effect of tax reductions announced in previous budgets as well as additional tax reductions proposed in this budget.

Personal income tax revenues are projected to increase 5.5 per cent in 2004–05. This increase is dampened somewhat by the implementation of the final phase of the Five-Year Tax Reduction Plan. From 2005–06 to 2009–10, the change in personal income tax revenues reflects growth in the underlying increase in the tax base (personal income), mitigated by the impact of the tax reduction measures proposed in this budget.

Corporate income tax revenues are expected to increase 3.6 per cent in 2004–05, after increasing 23.4 per cent, or $5.2 billion, in 2003–04. The strong growth in corporate income tax revenues in 2003–04, which was substantially stronger than the 10.0-per-cent growth in profits, reflected a one-time increase of about $2.5 billion in tax revenues stemming from the revaluation of U.S.-dollar-denominated liabilities in the financial services industry, which boosted profits in that sector. Once the impact of this one-time gain in 2003–04 is removed, the expected underlying growth in corporate income tax revenues in 2004–05 is more consistent with the predicted growth in profits in the year. Between 2002–03 and 2004–05, the 27.9-per-cent growth in corporate income tax revenues is broadly in line with 29.6-per-cent growth in corporate profits over the same period. Corporate income tax receipts are projected to increase 2.6 per cent in 2005–06 and then remain fairly stable through 2007–08. This stability in corporate income tax receipts reflects an expected decline in the share of corporate profits in total national income to levels more in line with historical experience. The proposed elimination of the corporate surtax and the reduction in the general corporate income tax rate are projected to reduce corporate income tax receipts by about 8 per cent in total over the last two years of the projection period.

Excise taxes and duties are expected to increase 4.9 per cent in 2004–05, after remaining flat in 2003–04. GST revenues are expected to increase 6.9 per cent in 2004–05, after recording virtually no change in 2003–04. For the remainder of the projection period, GST revenues increase, on average, 4.9 per cent per year, in line with forecast growth in consumption over the planning period. Customs import duties are expected to increase 4.5 per cent in 2004–05, after falling 11.9 per cent in 2003–04 due to the impact of the appreciation of the Canadian dollar. Energy taxes and other excise taxes and duties are expected to remain flat in 2004–05, with increases in alcohol and tobacco-related taxes offsetting declines in energy taxes. The Air Travellers Security Charge is expected to fall 9.8 per cent in 2004–05 and 8.1 per cent in 2005–06, reflecting the proposed reduction in the charge in the 2004 budget and further proposed reductions in this budget.

Over the projection period, EI premium revenues are assumed to match EI program costs (including administration costs), which is consistent with the principles outlined in the 2003 budget. EI premium revenues are expected to decline 2.5 per cent in 2004–05. This reflects the impact of the premium rate reductions for both 2004 and 2005, which more than offset the increase in the number of Canadians employed and therefore paying premiums. The employee premium rate for 2004 was $1.98 per $100 of insurable earnings, down from $2.10 in 2003. For 2005 the employee rate is $1.95.

Other revenues include Crown corporation revenues, return on investments, foreign exchange revenues and revenues from the sale of goods and services. Other revenues are expected to increase 16.2 per cent or $1.9 billion in 2004–05, reflecting the inclusion of the net proceeds ($2.6 billion) from the sale of the Government’s remaining shares in Petro-Canada. Other revenues are expected to fall by 17.5 per cent in 2005–06, reflecting the one-time nature of these gains. For the remainder of the planning period, other revenues increase, on average, about 5 per cent per year.

Table 7.7
The Revenue Outlook (Including February 2005 Budget Measures)

Revenue Ratio Lowered Due to Tax Cuts

A useful perspective on movements in budgetary revenues can be obtained by examining the "revenue ratio"—federal revenues in relation to total income in the economy (or GDP). This represents an approximate measure of the overall federal "tax burden" in that it compares the total of all federal revenues accrued to the size of the economy.

There is a cyclical element to the revenue ratio. It tends to decline during economic downturns and to increase during recoveries, reflecting the progressive nature of the tax system and the cyclical nature of corporate profits and capital gains. It is also affected by the impact of tax policy changes.

The revenue ratio dropped significantly after 2000–01 due to the tax reductions that came into effect in January 2001 as part of the $100-billion Five-Year Tax Reduction Plan.

The revenue ratio is projected to decline from 15.3 per cent in 2003–04 to 15.1 per cent in 2004–05, reflecting lower EI premium revenues; the impact from the implementation of the final phase of the Five-Year Tax Reduction Plan via the increase in the personal income thresholds to which statutory rates apply; the 2-percentage-point reduction in the general corporate income tax rate in 2004; and the one-time increase in corporate income tax revenues in 2003–04 related to the revaluation of U.S.-dollar-denominated liabilities in the financial services industry.

The decline in the revenue ratio in 2005–06 primarily reflects the impact of the one-time nature of both the $2.6-billion gain from the sale of the Government’s remaining shares in Petro-Canada in 2004–05 and the higher revenues from enterprise Crown corporations in 2004–05. The decline also reflects slower growth in corporate receipts in 2005–06, reflecting a projected decline in the growth of corporate profits in 2005 from the very strong rates posted in 2004. Over the remainder of the projection period, the revenue ratio is projected to further decline to 14.5 per cent by 2009–10, reflecting the tax reduction measures announced in this and previous budgets, including the increases to the basic personal amount, higher RRSP limits, the elimination of the corporate surtax, and reductions in the general corporate income tax rate.

Outlook for Program Expenses

Table 7.8 presents the program expenses outlook to 2009–10. These projections include the costs of policy measures announced since Budget 2004, including the measures proposed in this budget, and reflect the savings identified by the ERC. Total program expenses are expected to increase by 11.9 per cent in 2004–05. This largely reflects higher transfers to other levels of government as a result of the recent First Ministers’ agreements on health, Equalization and Territorial Formula Financing and, in particular, the proposed $4.25-billion payment for wait times reduction and the $700-million payment for early learning and child care. A number of other one-time initiatives, including relief for Asia and debt forgiveness for African countries, have contributed to this increase.

Program expenses are projected to increase by only 2.0 per cent in 2005–06 from 2004–05 levels, primarily reflecting the impact of the one-time measures in 2004–05. Program expenses growth is expected to be around 5 per cent in 2006–07 and 2007–08. In the last two years of the planning period, it is projected to average about 4.5 per cent per year. Average annual growth in program expenses over the 2005–06 to 2009–10 period is projected to be around 4 per cent, slightly below expected average annual nominal GDP growth.

Table 7.8
The Program Expenses Outlook (Including February 2005 Budget Measures)

Major transfers to persons are projected to increase, reflecting both higher elderly and EI benefits. The growth in elderly benefits is largely determined by the growth in the elderly population and average benefits, which are fully indexed to quarterly changes in consumer prices. This component includes the increased payments to Guaranteed Income Supplement recipients proposed in this budget.

The growth in EI benefits reflects the projected increase in the number of people eligible for benefits and increases in average benefits.

Major transfers to other levels of government include cash entitlements to support health and other social programs, fiscal arrangements, Alternative Payments for Standing Programs, the Atlantic offshore accords, and transfers to the provinces for early learning and child care and for Canada’s cities and communities.

At the First Ministers’ Meeting in September 2004, the Government and all provincial premiers and territorial leaders signed the 10-Year Plan to Strengthen Health Care, which will provide $41.3 billion over 10 years to the provinces and territories. As a result, transfers in 2004–05 for health and other social programs will be $27.8 billion. This includes $4.25 billion for the Wait Times Reduction Fund, which will be accounted for in 2004–05, subject to passage of authorizing legislation. Transfers for health and other social programs fall slightly in 2005–06, reflecting the one-time payment for wait times reduction in 2004–05. Between 2005–06 and 2009–10 transfers in support of health and other social programs increase almost 25 per cent.

The major programs under fiscal arrangements are Equalization and transfers to the territories. The federal government provides Equalization payments to less prosperous provinces so they can provide their residents with public services that are reasonably comparable to those in other provinces, at reasonably comparable levels of taxation.

In October 2004, the Government committed to increasing Equalization and Territorial Formula Financing by more than $33 billion over the next 10 years relative to Budget 2004 levels for 2004–05. Over the planning period, this agreement will increase transfers to provinces and territories by $14.1 billion.

Fiscal arrangements are expected to total $13.3 billion in 2004–05, an increase of about $4.0 billion or 42 per cent over 2003–04. This is a result of increased expenses related to Equalization and Territorial Formula Financing related to the new framework mentioned above, including an adjustment to account for the extension of the repayment period on certain Equalization overpayments. Other fiscal arrangements consist of the Youth Allowance Recovery Program and statutory subsidies. Fiscal arrangements are forecast to drop slightly in 2005–06, before increasing by about 3 per cent every year thereafter.

Alternative Payments for Standing Programs represent recoveries of federal tax point abatements under contracting-out arrangements. These arrangements allow provinces to assume the administrative and financial authority for certain federal programs. In turn, the Government of Canada provides provinces with tax points, the value of which are netted against total entitlements and accordingly recovered from cash transfers. These recoveries reflect the growth in the value of the tax points.

The Government of Canada recently reached agreements with Nova Scotia and Newfoundland and Labrador to enhance the benefits that these provinces receive from offshore resource revenues. Up-front payments of $830 million for Nova Scotia and $2.0 billion for Newfoundland and Labrador are proposed to provide the provinces with immediate flexibility to address their unique fiscal challenges. The budgetary impact of the agreements will be recorded in the years in which the protection from reductions in Equalization is triggered.

This budget delivers on the Government’s commitment of $5 billion over five years in support of a national Early Learning and Child Care initiative under development in cooperation with provinces and territories. As an initial step, Budget 2005 is making $700 million available through a third-party trust. The funds will be accounted for in 2004–05, subject to the passage of authorizing legislation. Provinces will have the flexibility to draw down the funds as they require through the end of 2005–06.

This budget also delivers on the Government of Canada’s commitment to share a portion of the revenues from the federal gasoline excise tax to support environmentally sustainable infrastructure, and will provide $5 billion over five years. Beginning in 2005–06 this will provide cities and communities with $600 million, and when fully implemented in 2009–10 will provide $2 billion per year.

Direct program expenses consist of subsidies and other transfers (such as assistance to farmers, students and Aboriginal peoples and for international and regional development), payments to Crown corporations and the operating expenses of departments and agencies, including National Defence. They include $182 million in 2004–05 for the extension of Veterans Independence Program benefits to veterans’ widows widowed before 1980. This budget also provides additional funding of $150 million per year to be managed by the Treasury Board to deal with critical federal infrastructure and program needs.

Program Expenses-to-GDP Ratio

The program expenses-to-GDP ratio has declined significantly, from about 16 per cent in 1993–94 to 11 per cent in 2000–01. This decline was largely attributable to the expenditure reduction initiatives announced in the 1995 and 1996 budgets aimed at eliminating the deficit and strong economic growth in 1999 and 2000.

Since 2000–01 the ratio has increased to an estimated 12.2 per cent in 2004–05. The year-over-year increase in 2004–05 is attributable to commitments made under the 10-Year Plan to Strengthen Health Care and the new framework for Equalization and Territorial Formula Financing, in particular funds provided for wait times reduction, which are accounted for in 2004–05. In the absence of these commitments, the ratio would have been 11.6 per cent in 2004–05, unchanged from its 2003–04 level. For the reminder of the planning period, the ratio is projected to be at 11.9 per cent.

Public Debt Charges

Public debt charges are forecast to decrease by $1.1 billion in 2004–05 as a result of a decline in the average effective interest rate on interest-bearing debt. Over the 2005–06 to 2007–08 period, public debt charges are forecast to increase by a total of $1.7 billion due to expected increases in short- and long-term interest rates. For 2008–09 and 2009–10, public debt charges are expected to be relatively unchanged.

Public debt charges as a percentage of government revenues are estimated to have declined from their peak of 37.6 per cent in 1995–96 to just under 18 per cent in 2004–05. This means that in 2004–05 the Government spent just under 18 cents of each revenue dollar on interest on the federal debt.

This ratio is expected to continue to decline, falling to about 17 per cent in 2006–07 and to 15.2 per cent by 2009–10.

Debt Management

Effective management of the federal debt is important to all Canadians, as the annual debt-servicing cost is the largest single federal government expense. One of the Government’s key objectives in managing the debt is to strike the appropriate balance between low financing costs and cost stability over a medium-term horizon. The Government maintains a prudent debt structure to protect its fiscal position from unexpected increases in interest rates and to limit annual refinancing needs. The main measure is the share of the debt that pays a fixed rate of interest, compared to a floating rate of interest. Debt that matures within the next year is considered floating, as it will be refinanced at prevailing market rates.

Over the past seven years, Canada’s economic and fiscal position has strengthened. Canada has enjoyed the best employment growth and real GDP growth record in the G-7 since 1996, low and stable inflation, a significant decline in net foreign debt as a percentage of GDP, and a substantially reduced public debt burden.

This sharply improved economic and fiscal situation has made Canada less vulnerable to world interest rate fluctuations and other external or domestic shocks. This has contributed to the restoration of Canada’s triple-A credit rating.

As a result of these positive developments, the Government announced in the 2003 budget that it would reduce the fixed-rate portion of the market debt in order to lower debt-servicing costs, while maintaining a prudent level of cost stability. The target for the fixed-rate portion of the debt is being reduced from two-thirds to 60 per cent. The reduction is being implemented in an orderly and transparent manner over the next few years to allow the market time to adjust. The Government will be examining potential changes to the structure of the debt programs, in consultation with market participants, to help ensure a well-functioning market for Government of Canada securities is maintained in future years.

Further details on the outlook for 2005–06 borrowing programs and the Government’s debt structure will be provided in the 2005–06 Debt Management Strategy, to be released in late March.

Market debt consists of debt issued on credit markets, including Government of Canada bonds, Canada Savings Bonds and Treasury bills. The decline of $38.6 billion in market debt since 1996–97, coupled with sustained economic growth, has resulted in a decline in the market debt-to-GDP ratio from 58.2 per cent in 1995–96 to 36.1 per cent in 2003–04, a decline of 22.1 percentage points. This decline mirrors the rapid fall in the federal debt-to-GDP ratio.

The Government of Canada is also taking steps to reinforce the soundness of its financial management practices to ensure that value is provided to taxpayers. In this regard, the prudent and cost-effective management of the Government’s international reserves portfolio, the Exchange Fund Account, will be enhanced by modernization of the Currency Act. Modernizing the Act will improve the flexibility in managing the portfolio by allowing investment in asset classes with lower risk and potentially higher returns. It will also reduce the risk of legal issues arising from antiquated and unclear drafting of some sections of the current legislation. More information on the investment policy and guidelines are published in the annual Report on the Management of Canada’s Official International Reserves (available at http://www.fin.gc.ca/toce/2004/oir04_e.html).

Financial Source/Requirement

The budgetary balance is presented on a full accrual basis of accounting, recording government liabilities and assets when they are incurred or acquired, regardless of when the cash payment or receipt is made.

In contrast, the financial source/requirement measures the difference between cash coming in to the Government and cash going out. This measure is affected not only by the budgetary balance but by the cash/source requirement resulting from the Government’s operating activities, primarily through the federal employee pension accounts, changes in non-financial assets, its investing activities through loans, investments and advances, and changes in other financial assets, liabilities and foreign exchange activities. These activities are included as part of non-budgetary transactions. The conversion from full accrual to cash accounting is also reflected in non-budgetary transactions.

Table 7.9
The Budgetary Balance, Non-Budgetary Transactions and Financial Source/Requirement

With a balanced budget and a requirement of $2.7 billion in non-budgetary transactions, a financial requirement of $2.7 billion is estimated in 2004–05, compared to a financial source of $6.2 billion in 2003–04. This deterioration is largely a result of a $4.8-billion transfer of Canada Pension Plan assets to the Canada Pension Plan Investment Board. Another $2.7 billion is to be transferred in 2005–06, contributing to the requirement of $5.3 billion. Financial sources are expected in 2006–07 and 2007–08. A financial balance of zero is projected in 2008–09 and a requirement of $1.2 billion in 2009–10, largely due to defence-related capital spending included in this budget.

• Pensions and other accounts include the activities of the Government of Canada’s employee superannuation plans, as well as those for federally appointed judges and members of Parliament. Since April 2000 the net amount of contributions less benefit payments related to post-March 2000 service is invested in capital markets. Contributions and payments pertaining to pre-April 2000 service are recorded in the pension accounts. The Government also sponsors a variety of future benefit plans, such as health care and dental plans and disability and other benefits for war veterans and others. In addition, under Bill C-3, An Act to amend the Canada Pension Plan and the Canada Pension Plan Investment Board Act, the Government is transferring the current assets as of March 31, 2004, of about $7.5 billion from the Canada Pension Plan operating balance to the Canada Pension Plan Investment Board. About $4.8 billion will be transferred in 2004–05 with the rest in 2005–06.

• Non-financial assets include the cash outlay for the acquisition of new tangible capital assets, proceeds from the sale of tangible capital assets, the amortization of existing tangible assets, any loss on the disposal of tangible capital assets, the change in inventories, and prepaid expenses. In the calculation of the budgetary balance, the acquisition of new capital assets is not included but the amortization of existing tangible assets is. However, in the calculation of the financial source/requirement, these entries are reversed. A net cash requirement of $0.9 billion is estimated for 2004–05, reflecting a net increase in the acquisition of tangible capital assets. This component is expected to rise throughout the forecast period, largely due to defence-related capital spending included in this budget.

• Loans, investments and advances include the Government’s investments in enterprise Crown corporations, such as the Canada Mortgage and Housing Corporation, Canada Post Corporation, Export Development Canada and the Business Development Bank of Canada. In addition, it includes loans, investments and advances to national and provincial governments and international organizations, and for government programs. The net financial requirements in this component throughout the outlook period are largely attributable to loans under the Canada Student Loans Program.

• Other transactions primarily include the conversion of other accrual adjustments included in the budgetary balance into cash, as well as foreign exchange activities. A net financial source is expected in each year of the outlook period except for 2005–06, when there is a requirement of $1.5 billion.

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