Andrew Pyle
March 29, 2023
Copying your neighbour is never a good way to budget
Three years ago, the world was torn apart by a virus and government finances were thrown for a bit of a loop. Yet, from a point where many felt the deficits and debt created by the pandemic would take us down a dark rabbit hole, economies started to grow and revenue coffers filled. Last autumn, the federal government proclaimed that not only had there been progress in reducing the deficit, but that a surplus was in sight. Well, this week we had a peak back inside the rabbit hole following the latest budget and it is a tad winding and dim.
If there was indeed a revenue relief party after the pandemic, I would call this the hangover budget. The recoil effects from Covid showed up in higher inflation, rapidly rising interest rates, and a less “global” trade environment (aka make things at home). With respect to the latter, there has also been significant peer pressure in terms of making investments in clean energy.
The White House’s introduction of the Inflation Reduction Act, in addition to the Bipartisan Infrastructure Law and the CHIPS & Science Act represented a multi-facet approach at stimulating domestic economic activity through increased investment in clean energy (including carbon capture and hydrogen), domestic manufacturing, and health care. Adding the three initiatives together we arrive at a plan that is almost $2 trillion in size, yet is supposed to reduce federal deficits by $237 billion over the next ten years according to the Congressional Budget Office (CBO).
Why do we talk about US initiatives in the context of a Canadian budget? Mainly because Ottawa felt it had no choice but to offer up something similar to Canadians. So much so that the down-the-road budget surplus that was touted back in the Fall has been replaced with an infinity pool of red. The deficit for this year is now estimated at $43 billion and in 5 years it is projected to come in at almost $16 billion. If aiming for a balanced budget was like putting for the hole, the government may want to call this a gimme, though businesses and investors may have a different take.
The budget just for this fiscal year proposes an additional $8 billion in new spending and the 5-year total adds up to $60 billion. Roughly half of this goes to health transfers to the provinces and a top-up to the national dental program that the Liberals promised to the NDP. That program is now going to cost more than $13 billion over 5 years. There is also a one-time grocery rebate for low-income families that amounts to about $2.5 billion. On the clean energy front, the budget offers up a 15% refundable tax credit for investments in what is referred to as non-emitting power generation and a 30% refundable tax credit for investments in equipment that is geared toward manufacturing clean technologies (including the recycling of critical minerals).
What was completely missing from this budget was any real recognition or remedy for the massive housing shortage in Canada. Following on our discussion last week, this problem is going to get worse given the record-high growth in the population, labour and material shortages and ridiculously long building permit times. The capital for increased housing formation will largely come from the private sector (especially if the public coffers are stretched thin), yet there was no major announcement to support investment. Indeed, tax measures (discussed later) could work against it.
Based on the old 10-1 rule (where the US economy is generally seen as being 10 times the size of Canada’s), it would seem that the Trudeau government didn’t exactly go and match what the Biden Administration unveiled in 2021-2022. That would have been a spend of about $200 billion. It came close though, given that the current proposals call for $60 billion over 5 years and the tax incentives on clean energy initiatives have the potential of inflating to a price tag of $80 billion from about $20 billion in this budget.
Speaking of inflating, the government had said that this budget would not exacerbate the inflationary pressures already present in the economy. It has been quite some time since my first year economics course, but I distinctly remember the professor saying that deficit spending was inherently inflationary.
The reality is that inflation is still well above the Bank of Canada’s target and the economy is beginning to show stress fractures. Economists are in unity around a slowdown call, if not recession, and that does not bode well for government revenues. The budget suggests that there are “efficiency” gains of roughly $15 billion, including 3% cuts to department spending and reduced government travel.
And if that doesn’t work, there is always increased taxation on individuals and companies. As expected, the budget introduces a 2% tax on corporate share buybacks (in excess of $1 million) starting in 2024. It also proposes that dividends received by financial companies in the regular course of business be treated as business income (versus having the benefit of a dividend tax credit). This is purely arbitrary opens up a potential pandora’s box in whether other forms of income tax treatment can be altered for other entities. The bigger issue is that income earned as a result of investment in the shares of a company ultimately increases capital formation, investment and the foundation for enhanced productivity, employment and overall economic health. Canada has not had a great track record on productivity and now faces a challenging economic climate, with higher government debt servicing costs, and no plan for a balanced budget.
But let’s bring this back home to the financial impact on Canadians – their investments and financial planning. Yet again, the govenrment side-stepped any major changes to personal taxation on higher net worth individuals or families. There has been speculation for years that the capital gains inclusion rate would be adjusted and, once again, there was no change. Trust me, it has been probably been batted about, but the government instead went for something a little more stealthy.
The Alternative Minimum Tax (AMT) was raised to 20.5% from 15%. This tax calculation is used when someone derives income from capital gains, dividends, stock option deductions, investment tax credits, losses and deductions and other special items. In other words, items that are not commonly seen on a tax return. A somewhat translucent calculation is done which allows for a comparison between the tax owed under standard rules and AMT. So, there are going to be some of you that will likely pay more tax under this proposal. What is unclear is whether this measure will influence investor behaviour to the same extent as simply a change to the capital gains inclusion rate. This will depend on the advice being provided by one’s tax professional and how much analysis is done on the individual’s present situation relative to the proposed changes.
What I do know is that we now have a projected net government debt load of $1.4 trillion for the fiscal year ending 2027 and no budgetary balance anticipated. For now, international investors have either given the budget a passing nod or simply were too distracted by ongoing activities in the US banking sector or Gwyneth Paltrow’s court hearing. The Canadian dollar actually moved higher on Wednesday, though oil prices have also been staging a comeback. The near-term implications for Canadian markets or investors will likely be negligible from this budget, though we could see some support for equities in the renewables space. It is not clear how the Bank of Canada will view the initiatives in this budget as being ultimately deflationary (as the government would have us believe) or adding more fuel to the inflation fire.
Longer-term consequences from a lack of fiscal restraint in an environment of higher interest rates will probably be more impactful. Unfortunately, there is no quick solution. Lower rates would come from weaker economic activity (lower inflation), which would negatively affect government revenues. On the other hand, persistently high rates will permeate deeper into the government’s debt structure and potentially create a structural deficit problem. Once upon a time, we copied Washington on this front as well.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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