Why Other Nations Should Follow Canada’s Lead on Spending

IBJ Budget surplus_000034159510_Large

When it comes to new spending in government budgets, politicians are typically damned if they do and damned if they don’t. The release of Canada’s latest spending plan is a case in point.

Leaving aside the fact that getting Ottawa out of the red required Finance Minister Joe Oliver to deploy some skillful manoeuvers, not to mention seek a little help from contingency funds, the budget delivered in mid-April clearly demonstrated spending restraint that is not as common as one might expect in today’s economic environment.

Keep in mind that many households, corporations and politicians around the world are out of control on the spending front, which is why world debt has jumped US$57 trillion since the so-called Age of Austerity started in 2007, according to the McKinsey Global Institute. Governments have been the worst offenders, accounting for US$25 trillion of the extra liabilities. So Oliver deserves at least some credit for setting this nation apart from the over spenders.

In addition to showing restraint in a re-election budget, Oliver managed to deliver enough goodies to seniors and families to allow critics to call his budget an exercise in vote-buying while claiming it does nothing substantial for the national economy. Oliver was also criticized for announcing plans to cut the small business tax rate because the move will widen the gap between what small businesses and large businesses pay in taxes. “The awkward reality for Mr. Oliver is that large companies are Canada’s engines of growth, not small ones,” noted a Globe and Mail column by Barrie McKenna, adding that the budget “may be unintentionally creating a perverse incentive for companies to stay small, just to get the tax break.”

Now, you can argue that any incentive for small businesses to stay small is a non-issue in the greater scheme of things. Either way, Oliver actually delivered a relatively good budget for business.

The manufacturing sector, for example, gained some significant tax relief in the form of a 10-year extension of the accelerated capital cost allowance (ACCA) provisions. As noted in a Maclean’s commentary by Ivey Business School Assistant Professor Mike Moffatt, who was in the budget lockup, “manufacturers did quite well—especially given that we have a government devoted to balancing the budget.”

Furthermore, public spending restraint itself is good for all businesses, especially big healthy ones.

You don’t need a doctorate in public finance to understand that there are good reasons for rating risks associated with government debt. All you have to do is open a newspaper and read about the European Union’s woes with Greece. But believe it or not, when a downgrade on sovereign debt is issued by rating agencies, they often trigger additional private-sector downgrades that penalize a nation’s healthiest businesses.

In a paper entitled “The Real Effects of Credit Ratings: The Sovereign Ceiling Channel,” Ivey Assistant Professor Felipe Restrepo explains (with coauthors Heitor Almeida, Igor Cunha and Miguel A. Ferreira) how this situation stems from a policy originally designed to ensure no private firm in a particular country received a credit rating higher than the one warranted by the state. Although so-called sovereign ceilings are no longer strictly applied, a troublesome link remains between the downgrades of national debt and the debt of private-sector firms with the same debt rating level as the target government—or even a better one.

In other words, a nation’s strongest companies tend to get hit with a lower rating following a sovereign downgrade faster and more often than firms with ratings that were worse than the state. And this disproportional effect leads to a greater reduction in investment for a nation’s healthiest firms while increasing their cost of capital by pushing up bond yields.

“Our research has uncovered a disturbing issue,” Restrepo noted in an article published by Ivey’s Impact magazine. “Keep in mind that when a nation has its debt downgraded it really needs the private sector to put its best foot forward to stimulate the economy and create jobs. But the very act of downgrading government debt actually chills the economic activity of the healthiest players in a targeted nation’s private sector. Meanwhile, relatively speaking, many of the weaker firms in a downgraded nation almost look like better credit risks than they actually are because of this system that doesn’t treat them the same as the market’s cream of the crop.”

When Paul Martin was finance minister, Canada — once described by comedian Robin Williams as an apartment above a great party — ditched its honorary membership in the Third World by showing budget restraint. But that only happened after sovereign debt downgrades moved the Wall Street Journal (in an editorial headlined “Bankrupt Canada”) to suggest that the International Monetary Fund might have to come to our nation’s aid. And that’s why companies big and small stand to benefit from Canada’s return to surplus.

 

Leave a Reply

Your email address will not be published. Required fields are marked *