The 2021 federal budget was a disappointment to the Investment Industry Association of Canada (IIAC) and its member firms. In a pre-budget submission late last year, the IIAC recommended the budget be placed within a multi-year fiscal plan. A detailed plan helps guide spending and tax decisions to keep public finances stable and restrained, and guards against unexpected economic downturns and sudden increases in interest and inflation rates.
The advice the IIAC offered was largely ignored, although the government imposed a loose 50% debt-to-GDP ratio for the medium term. The disregard for a formal fiscal plan is puzzling, given the recent acceleration in government spending to provide economic support from the devastating impact of the pandemic and a rapid runup to unprecedented levels of public debt. In light of the current state of the economy — which includes a struggling energy sector, weak levels of investment spending and modest infrastructure spending — a detailed fiscal framework would have made sense.
A robust pace of investment spending is the critical ingredient to ignite a sustained economic recovery across the country, which will help bring federal finances into better balance. The high levels of social program spending and pandemic support programs are not sufficient to provide stimulus.
The federal government needs the policy groundwork to re-vitalize business investment spending and confidence. Over the past three years, average business spending has fallen steadily right across the corporate sector. Further, spending in the small business sector is needed to start new businesses and expand existing small businesses decimated by the pandemic. According to statistics from the Canadian Federation of Independent Business, 58,000 businesses were inactive in 2020, and another 181,000 are anticipated to close this year. A fiscal plan would encourage investment spending and signal better control of public finances and confidence in stable tax rates.
The IIAC had recommended a Canadian version of the U.K. Enterprise Investment Scheme by providing a personal tax credit for purchasing shares of small businesses in the manufacturing, technology and service sectors across the country. This program is highly successful in the U.K., attracting small investors to purchase shares of operating businesses in their local communities. A resurgence in investment in the small business sector, driven by an effective market incentive, could create a vitally positive impact to economic recovery. Unfortunately, the IIAC’s advice was ignored.
It is likely that without a detailed fiscal plan, program spending and budget deficits will exceed the currently projected unprecedented levels. This is particularly relevant if the pandemic is prolonged, the pace of business investment stays sluggish and the anticipated surge of pent-up spending falls short of expectations. At some point, near in the future — even without rising bond rates — the government will likely be forced to raise corporate tax rates and investment tax rates to limit the weakening of public finances. An increase in these tax rates would be a significant blow to direct investment, further spurring net capital outflows and depressing investor participation in retail markets.
One possible explanation for the government’s reluctance to implement a detailed fiscal plan is that the markets don’t foresee rapid increases in interest rates and inflation. This view stems from recent history that suggests inflation and high interest rates have somehow disappeared, caused by factors inherent to a globally integrated economy and massive advances in technology. As a result, some may believe that past financial crises resulting from plunging bond and currency markets — and a corresponding need for massive spending cutbacks and deficit reductions — are a thing of the past.
However, there is reason to expect a negative market reaction from the chronic deterioration in public finances. Responsible fiscal policy must be grounded in a detailed fiscal plan to manage finances, whatever the uncertainties about the future course of inflation rates and interest rates. Increased spending should be prudent and focused on needed economic support, giving scope for some incentive to encourage small business investment spending. Just when you think things have changed, another financial crisis may be waiting around the corner.