Why Finance Ministers are still sweating it

by Avery Shenfeld

Ordinarily, a Canadian federal or provincial finance minister wouldn’t be sweating about their budgets when the country’s jobless rate sits at only 5.7%. You have to go back to 1974 to find a year in which the average unemployment was any lower. So why will this year still see many finance ministers struggling to contain deficits and borrowing needs?

In part, it reflects a less impressive employment rate, with an aging population leading to fewer tax payers. Yours truly also bears part of the blame, as I participate in surveys of private sector forecasts that Ottawa and many provinces use in their fiscal plans. Sluggish growth forecasts will feed into soft revenue projections. But there are less obvious factors making for a challenging budget season.

For one, inflation, has turned into the finance minister’s enemy rather than friend. Back in 2022, inflation had been a winner, boosting nominal revenues from sources like sales taxes or resource royalties. But as of 2023, it’s turned into more of a negative, with inflation hitting government operating expenditures more than it’s lifting nominal GDP, given the gap between the deflators on those two elements of the national accounts (Chart). Much of that reflects catch-up wage increases granted to public sector employees in the past year, and multi-year settlements could carry into 2024/25 while inflation in other parts of the economy abates.

Second, the growth we have seen in Canada’s economy in the past couple of years has been facilitated by immigration-fueled population increases. That has created more taxpayers, but has also added to the head count for health care, education, transportation and other public services. Look for upcoming budgets to cite the crush of more people as a source of operating and capital spending growth.

That would be more manageable if the additional population growth was also leading to a commensurate acceleration in economic output, and therefore, in revenues. But in recent years, that hasn’t been the case, although it’s tougher to prove that the fall in output per hour owes to less-productive newcomers. Whatever the cause, weak productivity growth has held back the output, and therefore tax revenues, that finance ministers can tap into.

There’s also the productivity of government workers themselves. Measuring the real output of public administration workers isn’t as easy as counting cars rolling off an assembly line. But the ratio of public sector employment to population has never been higher than in recent years.

We’ve yet to see evidence on what’s driving those headcount increases, which have been particularly steep at the federal level. Is it a work-from-home issue? Greater per capita needs for public sector programs? Perhaps it’s the so-called Baumol effect, in which public service jobs tend to have slower productivity growth than others, and the result is that these areas will need faster employment growth relative to other parts of the economy. Whatever the cause, it might be timely to assess whether there are efficiencies available in how we deliver government services.

There’s one final reason why finance ministers are worried, despite polls showing that voters haven’t put much weight on budget deficits. That’s because one rapidly escalating source of spending growth doesn’t win any votes at all: interest payments. Higher debt service costs already showed up in provincial budget projections released to date, and we’ll be watching for the same trend elsewhere. Large pandemic-era debt build-ups, and now rising rates on refinancing debts, make debt servicing costs a very good reason to sweat the details on budget balances this year.