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Provincial fiscal perspective.

There has been an appreciable increase in the size of Canada's public-sector fiscal deficit in recent years. Since the late 1980s, this deficit has increased 70 percent with much of the gain taking place in the last two years as the economic downturn slowed revenue growth and generated upward pressure on spending, particularly in the area of social services. At the same time, however, here has been a fundamental shift in the structure of the budgetary imbalance in Canada's public sector, with provincial government deficits becoming a much more significant component of the imbalance. As seen in Exhibit 1, the provincial element of the deficit increased from 16 percent in 1988-89 to 41 percent by 1992-93 of the public sector's fiscal gap. Small reductions in provincial deficits are budgeted for in the current 1993-94 fiscal year, but in most cases, not without a combination of spending controls and significant tax increases.

Many factors contributed to this shift in the public-sector deficit profile. For instance, comprehensive budgetary reforms within the provincial sector were in earlier stages of both conceptualization and implementation than they were at the federal level. A complicating factor for the provinces' revenue situation was that some of the measures the federal government undertook to control its own deficit consisted of restricting the growth of major transfer payments to provincial governments. In some of the poorer provinces, these transfers account for as much as 45 percent of the revenue base.

On the expenditure side, the provinces have had to deal with spending pressures arising from the economic downturn, as has the federal government. However, the situation at the provincial level was compounded by ongoing structural cost pressures in major spending areas which fall under provincial jurisdiction, such as health care and social services. Among the many sources of structural pressures on the expenditure base of provincial governments are the aging of the population, the advent and acceptance of new medical technologies, ongoing or new social problems, and rigidities in government employee benefit packages.

Another important change reflected in the new deficit profile of the public sector is the major shift in fiscal direction in Ontario, which began in the late 1980s. The widening of Ontario's deficit from 1990-91 through 1992-93 accounts for more than half of the total deficit increase of the provincial government sector. The increase in Ontario's deficit reflects the severity of the economic downturn in central Canada, years of large base budgetary expenditure growth and the sheer size of the province in relation to others.

1992-93 Deficits

As in the case of the federal government, budgetary estimates released by provincial governments indicate that the budgetary imbalance in the provincial sector was noticeably larger last fiscal year than projected during the 1992-93 budget season. According to official projections, the aggregate budgetary deficit for the provinces is now estimated to have reached C$24.9 billion, up 22.7 percent from the estimates that were put forth in the spring of 1992. Despite provincial efforts to reduce the deficits from the levels reached last

year, the latest estimates indicate that there was deterioration. As a result, the ratio of the deficit to the gross domestic product (GDP) was marginally higher this year than the level recorded in the 1991-92 fiscal year.

Exhibit 3 illustrates for 1992-93 the fiscal gap relative to the revenue base, which reflects budgetary deficiencies in both the operating and capital accounts. More important, however, is that the 20 percent deficit-to-revenue ratio for the provincial sector suggests that the imbalance has a structural component which--unlike the cyclical portion--will not recede as economic performance recovers. Exhibit 3 also shows that the fiscal challenge is national in scope: only Newfoundland's deficit-to-revenue ratio is under 10 percent.

The deviation in the deficits from budget estimates was caused by several factors, which vary in their significance from one province to another. The one commonality of the factors is that the bulk of unanticipated pressures came from the revenue side of the ledger as opposed to the expenditure side. A weaker-than-expected economic recovery across Canada dampened growth in major tax revenue items, such as personal and corporate income taxes, as well as consumption tax items.

Shortfalls arising from lower-than-projected growth in income tax receipts were compounded further last fall when the federal government adjusted the 1991 provincial tax base estimates downward. The federal government collects provincial income taxes and remits them to the provinces, except Quebec where they are levied directly by the provincial government. A growth projection is added to the 1991 collection estimates to compute 1992 income tax receipts. As a result of the reduced 1991 collection, the TABULAR DATA OMITTED computation for 1992 revenue was lowered. The reduced estimates for 1991 also meant that the provinces had received income tax overpayments last fiscal year, which must now be reimbursed to the federal government, adding further pressure to the revenue situation of the provinces for the previous and current fiscal years.

A deviation in revenue collected from traditional tax sources has been particularly evident in Alberta, Quebec, Ontario and British Columbia.

Ontario's income and sales tax revenue shortfalls have been the most significant, reflecting the severity of the most recent economic downturn. Even after accounting for a technical upward adjustment in federal transfers for health and education, total budgetary revenues for Ontario are now projected to be nearly 4 percent below budget.

Shortfalls in sales and corporate income taxes account for the revenue slippage in Quebec, currently estimated to be 2.2 percent below budget. Unlike many other provinces, reduced personal income tax receipts have not been a predominant factor in Quebec.

In Alberta's case, the decline in traditional income and other tax revenues is projected to be offset partially by an increase in resource-based revenue, as production values will get a boost from the weaker Canadian dollar, higher spot market prices for natural gas and recent reforms in the province's royalties from the energy sector.

In British Columbia, the magnitude of the revenue shortfalls--particularly in the area of personal income tax--is somewhat unexpected given the comparatively superior economic performance of the province.

Pressures on the revenue side in the smaller provinces also can be traced to shortfalls in tax revenue. The situation for the smaller provinces was complicated further, however, by the technical downward adjustment in fiscal equalization payments received from the federal government, mainly as a result of narrowing disparities in economic performance among regions. The fiscal equalization program provides payments to provinces that have revenue-raising capacity below the national norm.

The weaker-than-expected economic performance of the provinces also generated higher expenditures in social and other counter-cyclical support programs. Despite these expense pressures, the most recent estimates indicate that, overall, spending at the provincial level was essentially on target with the budget projections. In a concerted effort to contain the widening of their deficits, most provinces implemented cost-cutting measures last year, ranging from temporary salary and hiring freezes to program cuts and reductions in the level of program benefits. Expenditure control measures implemented in Ontario, Saskatchewan and Newfoundland were quite extensive. Measures taken in other provinces, such as Alberta and British Columbia, did not fully offset cost overruns; as a result, revised expenditure estimates for the year widened their budgetary imbalances.

Looking Ahead

Most of Canada's provinces have released budgets for fiscal year 1993-94 as of this report. While a reduction in deficits is expected, the aggregate provincial sector reduction from budget to budget is very small, given the amount of slippage which occurred in 1992-93. While deficit reduction measures vary across Canada, they fall into the general categories of strict expenditure growth controls (mainly wages and benefits) and significant tax increases. A few provinces have introduced measures to reduce the base of expenditures. Given the rates of provincial spending growth during the late 1980s and the magnitude of budgetary imbalance now faced, this is likely the most effective tool for deficit reduction.

The provinces of Ontario and Quebec have introduced processes to reduce the cost of their direct and indirect civil service, restructuring somewhat the role of provincial and local governments. Other provinces also are restructuring local government services through education and health care reforms. The success of many of these reforms, however, hinges upon the completion of fruitful negotiations with public-sector unions, concerning both work force complements and compensation. Failure to reach a negotiated settlement in some cases, may result in legislated reductions to the expenditure base.

Across Canada, the range of provincial tax measures includes increased income tax and income surtax rates, increased consumption tax rates, or a broadening of their base of collection, and the closing of many tax exemptions and credits. With the exception of British Columbia, which continues to experience above average economic performance, most of the provincial tax increases were implemented in order to offset slippage in the budgetary revenue base which occurred from a combination of the economic downturn's effects, and the federal revenue adjustments discussed above. Since the tax increases were significant in many provinces, it will be interesting to see if they dampen the already modest economic recovery.

In the authors' opinion, fiscal year 1994-95 will see a more measurable improvement in the financial performance of Canada's provinces. Three factors help explain why this progress will take a period of years. First, economic data released recently by Statistics Canada point to a recovery taking hold, but the positive effects of improved economic growth on the financial position of the provinces will lag somewhat. On the expenditure side, continuing high unemployment levels across the country this year will likely delay the realization of significant savings in social support and other counter-cyclical programs for individuals. Finally, a significant component of the current imbalance at the provincial level is structural in nature and will require a multi-year process of fiscal reforms before it can be greatly reduced or eradicated.

WILLIAM STREETER is a vice president and assistant director of Canadian Ratings for Moody's Investors Service. YVES LEMAY is an assistant vice president of Canadian Ratings for Moody's Investors Service.
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Title Annotation:Canada's public-sector fiscal deficit
Author:Streeter, William; Lemay, Yves
Publication:Government Finance Review
Date:Aug 1, 1993
Words:1670
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