Flaherty's plan on shaky ground; Finance Minister must ensure spending is returned to pre-stimulus levels by expanding current review

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Appeared in the Financial Post

On Tuesday, the National Post's editorial page celebrated the continuation of Canada's AAA credit rating, in light of the U.S. downgrade to AA+. While there's no doubt our fiscal health is relatively better than the United States and Europe, the recent market volatility combined with declining commodity prices should not make us too complacent.

The Post noted that Canada had learned its lesson years ago. However, the way we see it, we're making the same basic mistakes Canadian governments made years ago: pinning our hopes for a balanced budget on a combination of significantly higher future revenues while trying to slow the growth in spending.

In June, the federal government tabled a plan to balance the budget in five years. To get there, the Conservatives forecast revenues to grow at a robust average rate of 5.6% over the next five years while planning to hold program spending increases to an average rate of 2%.

The problem with this plan is that, while the federal government directly controls the amount it decides to spend - though Canadians should exercise healthy skepticism, as the Conservatives' track record on spending suggests it will be unable to hold the line at 2% - the government is exposed to revenue shocks that are beyond its control.

Hence, a balanced budget plan that relies on robust average revenue growth of 5.6% is one with significant downside risk and little to no upside potential. Lower than forecast revenue growth will mean larger deficits for a much longer time period and significantly more government debt.

As we pointed out on this page after the budget, The same approach failed drastically in the 1980s and early 1990s. Successive federal governments attempted, but ultimately failed, to balance the budget by trying to slow the growth in spending while hoping for higher revenues.

Like the incumbent Conservatives, the Progressive Conservative government in the late 1980s and early 1990s was at least notionally predisposed to lower levels of government spending and balanced budgets. But failure to eliminate the deficit came from the Progressive Conservative's inability to constrain growth in spending, coupled with revenues lower than expected. That ultimately resulted in ongoing deficits, mounting debt, and a loss of Canada's AAA rating in 1994.

And now, just two months after the 2011 budget was tabled, the current government's fiscal plan is facing similar risks, with signs of a slowing U.S. economy and the possibility of a double-dip recession increasing.

Given that Canada's economy is heavily tied to the United States, any material slowdown in the United States will likely have a negative impact on the Canadian economy, federal revenues and the Conservatives' deficit-reduction plan.

Interestingly, the Conservatives' plan is built on the assumption that the U.S. economy will grow robustly at an inflation-adjusted average rate of 3.2% over the next five years - faster than the Canadian economy at 2.7%.

To reduce the frailty of the current fiscal plan and to set Canada apart from the rest of the world, the Canadian government must quickly balance its budget. Finance Minister Flaherty can use the government's fall economic and fiscal update to do just that - balance the books in two years, not five.

First, Flaherty should ensure that program spending is returned to prestimulus levels. This can be achieved by greatly expanding the government's Strategic and Operating Review, currently a one-year review of program spending - excluding transfers to individuals and governments - which proposes to find a mere 2% in savings from the $352.5billion in departmental spending planned from 2012-13 to 2014-15.

The expanded Strategic and Operating Review ought to prioritize spending so that important areas are spared deep cuts while lower-priority areas carry a greater burden of the spending reductions. A good starting point would be to significantly reduce or better yet, eliminate corporate subsidies, which have grown substantially under the Conservative regime.

A two-year balanced budget plan would substantially reduce the risks associated with a revenue shock, like a slowing U.S. economy. Such a plan also provides the Conservative with upside potential. That is, if revenues rebound robustly, the Conservatives could then implement a much needed multi-year plan to reduce personal income taxes.

In the wake of the United States' credit downgrade, the stock-market plunge was an arresting reminder of the risks facing the Canadian economy. The U.S. economy is looking ever more fragile, sovereign-debt concerns are growing in Europe, and commodity prices are beginning to soften; all reasons why Canadians should feel increasingly uneasy about the government's fiscal plan. The Conservative government should use its new majority to implement the type of balanced-budget plan the Prime Minister and his colleagues once championed as members of the opposition.

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