Spending cuts and debt reduction should be top priorities for Canadian governments

With the United States credit rating recently being downgraded and some European countries teetering on the verge of debt crisis, Canadians can rightly be proud of the country’s AAA credit rating.

That said, Canadians should not get too complacent. With growing concerns about a slowing global economy, Canadian politicians should put forth genuine plans to restore balance to the nation’s finances.

Consider that the federal government and all provinces (save Saskatchewan and Newfoundland) are currently borrowing to spend. Specifically, the federal government’s deficit will hit nearly $30 billion in 2011-12, while the provinces will collectively borrow another $25 billion. As a result, the federal debt has increased by more than $120 billion since 2008-09 and will reach $611 billion by 2015-16.

Likewise, provincial debt has increased by nearly $145 billion since 2008-09 and stands at $487 billion. When combined, total federal and provincial debt is more than $1 trillion.

While plenty of empirical evidence shows a negative relationship between government debt levels and economic growth, a close look is warranted at Public Debt and Growth. The recent International Monetary Fund study examined the relationship between public debt and economic growth for a group of advanced and emerging countries over almost four decades. It found that an increase in a country’s debt-to-GDP ratio leads to a decrease in per-person income growth.

Another important recent study, Growth in a Time of Debt, by University of Maryland professor Carmen Reinhart and Harvard University professor Kenneth Rogoff, found much of the same: persistent deficits propel public debt to levels that impede economic growth.

The problem is that while most Canadian governments have plans to balance their budgets, most are still planning deficits for the foreseeable future. For example, it will take B.C. three years to balance its budget, five years for the federal government and seven years for Ontario.

Additionally, the budget plans of many Canadian governments do not adequately account for risks that could worsen their position.

Take the federal government’s plan to balance its books in five years. To get there, the Conservative government projected revenue to grow at a robust average rate of 5.6% over the next five years with plans to hold program-spending increases to an average rate of 2%.

A plan to balance the budget that relies on strong revenue growth is one with significant downside risk and little to no upside potential. Lower than forecasted revenue growth could result in larger deficits for a much longer time period and significantly more government debt.

That’s what happened in the 1980s and early 1990s when successive federal governments failed to balance the budget by trying to slow the growth in spending while hoping for higher revenue. The result was ongoing deficits, mounting debt and, ultimately, a downgrade in Canada’s credit rating in 1994.

Unfortunately, history could repeat itself as current governments are facing similar risks with signs of a slowing global economy that would negatively affect government revenue and plans to slay deficits.

To reduce the frailty of current fiscal plans, Canadian governments must quickly close their budget deficits. The best deficit-reduction strategy, according to research, is to cut spending.

In a recent study entitled Large Changes in Fiscal Policy: Taxes Versus Spending, renowned fiscal policy expert and Harvard professor Alberto Alesina examined data from 21 countries (including Canada) from 1970 to 2007. He found that large reductions in budget deficits that were driven by spending cuts were much more effective than tax hikes for reducing government debt and avoiding economic downturns.

If our Canadian politicians want to stimulate economic growth, they should rein in spending, reduce deficits and bring down debt.