2016 FEDERAL BUDGET. TD Economics. Trudeau and Morneau make their mark

2016 FEDERAL BUDGET TD Economics Trudeau and Morneau make their mark Highlights As anticipated, the federal government announced that budget deficits of about $30bn (1.5% of GDP) are in store. This is about $11bn higher than revealed in the February Update. The larger deficits relative to the Update largely reflect the implementation of commitments outlined in last year s election campaign. Chief among these promises are additional infrastructure spending, changes to employment insurance and support for indigenous peoples. However, speculation that capital gains taxes would be raised did not materialize. Deficits of more than 1% of GDP persist for the next several years, but the federal debt burden remains relatively low and stable. Revenue projections include a sizeable margin of prudence, appropriate in light of the longer-term headwinds to Canadian growth. Recent weeks have seen calls to run even larger deficits to support economic growth. We feel that the moderate deficits announced today strike a good balance between injecting short-term stimulus, generating long-term benefits through infrastructure enhancement, and maintaining a credible longer-term fiscal path. Given that today s announcements were fairly well telegraphed in advance, we expect little market reaction. In terms of economic impact, we calculate that the blend of transfer payments, tax changes, and additional infrastructure spending will deliver a boost to the economy of about 0.1 percentage points this year, rising to 0.3 percentage points in 2017. This does not represent a massive game changer, but does provide a nice boost to an economy that appears to be increasingly benefitting from rising exports. All told, today s budget is consistent with a growth outlook that will see the Bank of Canada on hold well into 2017. Telegraphed for some time, today s budget makes many rumours and promises concrete albeit with little in the way of major surprises. The government is projecting a budgetary shortfall that will peak at around $30 billion in fiscal 2016/17 before narrowing moderately over the next several years (Chart 1). Today s new deficit estimates mark an $11 billion upward adjustment to those presented in the government s recent February Update. Within this expanded fiscal box, the government has moved to implement many of the promises outlined during last year s election campaign, with infrastructure, affordable housing, measures to support families with children, and help for the disadvantaged taking top billing. After moving quickly late last year to legislate changes to personal income taxes, newlyannounced revenue measures featured far less prominently, with emphasis instead on new spending. Some pre-budget speculation of a hike in capital gains taxation or taxes on stock options did 5 0-5 -10-15 -20-25 -30-35 CharT 1. additional SPendinG ProMiSeS PuSh deficits Wider February Update Budgetary balance ($ billion) Budget 2016-2.3-5.4-18.4-15.5-29.4-29 -22.8-17.7-14.3 2015/2016 2016/2017 2017/2018 2018/2019 2019/2020 2020/2021 Source: Department of Finance Canada. Derek Burleton, VP & Deputy Chief Economist, 416-982-2514 Brian DePratto, Economist, 416-944-5069 @TD_Economics

Table 1: economic assumptions for Canada Annual, percent change (unless otherwise indicated) Calendar Year 2016 2017 2018 2019 2020 real GdP February 2016 Update 1.4 2.2 n/a n/a n/a March 2016 Budget 1.4 2.2 2.2 2.0 1.9 nominal GdP February 2016 Update 2.4 4.6 n/a n/a n/a March 2016 Budget 2.4 4.6 4.3 4.2 4.1 nominal GdP ($ billion) February 2016 Update 2,036 2,129 n/a n/a n/a March 2016 Budget 2,036 2,129 2,221 2,313 2,408 3-Month T-Bill rate February 2016 Update 0.5 0.7 n/a n/a n/a March 2016 Budget 0.5 0.7 1.6 2.4 2.7 10-Year Gov't Bond Yield February 2016 Update 1.6 2.8 n/a n/a n/a March 2016 Budget 1.6 2.3 3.0 3.4 3.6 Source: Department of Finance Canada not materialize. We find that today s blueprint strikes a good balance between providing near-term support to economic growth, generating some longer-term benefits to Canada s economy and maintaining a credible longer-term fiscal path. While the persistence of deficits remains a longer-term challenge facing the government, as a share of GDP (1.5% and falling) they remain quite manageable, especially stacked up against the 4-9% shortfalls recorded in the 1980s and early 1990s. Lastly, the steady deficits are not expected to materially worsen the government s low debt burden. Much has changed since the spring So much has changed since the spring 2015 federal election campaign. At the time, the government had campaigned on running small deficits of no more than $10 billion over the next few years and return to balanced budgets within four. However, a deepening oil price shock has halved the outlook for nominal GDP growth for 2016 (Table 1). The weaker economic backdrop was in large part responsible for the $18 billion baseline 2016-17 deficit reported in the government s February 2016 Update. Importantly, the government s February baseline had also included some $2.3 billion in campaign promises (notably the middle class tax cut ) that had already been legislated, as well as a higher buffer to safeguard against unforeseen economic risks (i.e., prudence). Traditionally, past federal governments have incorporated annual prudence cushions of roughly $3 billion into budget forecasts, but the government has opted to double this contingency set-aside to $6 billion annually. This amount is primary incorporated into the revenue projections by using a lower GDP assumption than the private-sector consensus. In today s budget, the government has maintained this prudence margin while increasing the flow of red ink through a combined $11 billion in additional measures for fiscal 2016/2017. The split between new spending and tax initiatives is skewed to the former, although factoring in the already-implemented middle-income tax cut would result in a more equitable balance (roughly a 60/40 split). In the next section, we provide some highlights of the key budget measures. Table 2 reveals that although revenue growth is projected to slightly outpace spending over time, given the sizeable initial gap, deficits are likely to be persistent over the next 5 years. While many analysts have flagged the notable caution built into revenue projections as unnecessarily high, we believe it to be appropriate. Forecasters have been serially over-predicting growth in recent years not just for Canada but in the U.S. and other advanced economies. Some of this over-estimation could boil down to an overly optimistic view on longer-term potential growth in light of an aging workforce. Indeed, the government s nominal GDP forecast to 2020 after deducting the prudence is close to our below-consensus call. The magnitude of the deficits over the next five years is at the low end of the range bandied about in public circles in the run-up to Budget 2016. Indeed, there were some calls for shortfalls as large as $40 billion or $50 billion to provide support to the Canadian economy. Recent improvements in Table 2: March 2016 Federal Budget Forecast Summary (C$ billion, unless otherwise specificed) 2015-16 2016-17 2017-18 2018-19 2019-20 Budgetary revenues 291.2 287.7 302.0 315.3 329.3 % change 3.2-1.2 5.0 4.4 4.4 Program expenses 270.9 291.4 304.6 308.7 314.2 % change 6.7 7.6 4.5 1.3 1.8 Public debt Charges 25.7 25.7 26.4 29.4 32.8 % change -3.4 0.0 2.7 11.4 11.6 Total expenditures 296.6 317.1 331.0 338.0 347.0 % change 5.8 6.9 4.4 2.1 2.7 Budgetary Balance -5.4-29.4-29.0-22.7-17.7 Federal debt 619.3 648.7 677.7 700.5 718.2 % change 1.1 4.7 4.5 3.4 2.5 Per cent of GdP Budgetary Revenues 14.6 14.4 14.5 14.5 14.5 Program Expenses 13.6 14.6 14.6 14.2 13.8 Public Debt Charges 1.3 1.3 1.3 1.3 1.4 Budgetary Balance -0.3-1.5-1.4-1.0-0.8 Federal Debt 31.2 32.5 32.4 32.1 31.6 Source: Department of Finance Canada. 2

the economic data, including solid export figures and continued strength in the manufacturing sector have shown that the economy has entered 2016 on a more solid footing. As such, the focus of the budget could hone in on better positioning Canada to deal with the longer-term challenges that it faces. Infrastructure to get a major boost The government plans to follow through on its promise to spend $120 billion on infrastructure over the next 10 years, but the mix of infrastructure spending has shifted somewhat and the bulk of the spending is not forecast to occur until 2020 onwards. Included are commitments for transit, green infrastructure and indigenous infrastructure; Roughly $4.6 billion has been earmarked over the first two years for public transit and municipal infrastructure, while federal and indigenous infrastructure spending is expected to total roughly $4.3 billion; Significant support has been earmarked for indigenous communities totaling about $1.8 billion over the next two fiscal years. Roughly 2/3rds of the funds are earmarked for housing, health, and education facilities, with the remainder going towards water, wastewater, and waste management on reserves. The government will also create of an infrastructure bank which allows municipalities to borrow funds at the federal government s cost of borrowing. The reduced cost should lower the return threshold for projects, resulting in additional projects becoming economic, thereby providing economic stimulus through the municipal system. Support for low income families a high priority The government s centerpiece tax cut was already implemented ahead of today s budget. On January 1st, personal income taxes were reduced for earners within the $44,700 to $89,401 bracket. This cut will be funded partially through the creation of a new tax bracket with a rate of 33% on incomes above $200K. The net cost to the government is expected to be about $1.2 billion per year. Other measures announced today are primarily aimed at helping those Canadians of modest and low income: A number of tax exemptions, including the universal child care benefit (UCCB), are being phased out, and replaced with the new, income-tested Canada Child Benefit (CCB). At the same time, income-splitting for families with children will be eliminated. The net impact of the CCB is expected to be a reduction in revenues of about $4.3bn on an ongoing basis. Changes to employment insurance, including reduced waiting periods, expanded access, and extended benefits. Net spending increases by $1 billion in 2016/2017, rising to about $1.5bn in the following fiscal year. A number of other spending programs, including jobs and training support, enhanced programs for veterans, expanded supports for arts and culture, and additional funds for programs that support Canada s indigenous peoples. New spending for these areas totals $2.1bn in fiscal 2016/2017, rising to roughly $3.2bn thereafter. The qualifying age for Old Age Security payments will be moved back to 65 it had been scheduled to increase to 67 in 2023. This has no immediate impacts on expenditures, but does increase the government s future liabilities, creating an eventual budget gap of about 0.2 per cent of GDP. Innovation and business support The budget provides significant support for public research, including funds for improving university infrastructure, as well as budget increases for academic research grants through bodies such as the Natural Sciences and Engineering Research Council. More than $1.4 billion in support through these and other programs is pledged by fiscal 2017/2018 New measures to support business research and innovation directly are smaller in scale, totalling $334 million over the next two fiscal years. Spending is aimed at fostering innovation networks, supporting tourism efforts, and a number of specific segments such as optics and photonics. CHART 2. SPENDING MIX TILTED TOWARDS SOCIAL AND GREEN INFRASTRUCTURE Public Transit, $3.4 bn Green Infrastructure, $5.0 bn Social Infrastructure, $3.4 bn Source: Department of Finance Canada. Sum of next three fiscal years presented. 3

34 32 30 28 26 24 22 20 CharT 3. debt To GdP on a downward TraJeCTorY Federal Debt, % of GDP The small business tax rate of 10.5% on the first $500,000 of income will be maintained, with previously legislated reductions in this rate deferred indefinitely. There had been talk ahead of the budget that changes may be in store for the taxation of option grants and capital gains. In the event, these rumours proved to be unfounded as these tax rates were left unchanged. Other budget highlights November Update Budget 2016 Budget with TD Growth Projections 15-16 16-17 17-18 18-19 19-20 20-21 Source: Department of Finance Canada, TD Economics. Spending on the clean growth economy of up to $1.7 billion over the next two years is planned. This includes investment in alternative transportation infrastructure, measures to ensure international co-operation on environmental issues. The largest share of these funds is earmarked for the creation of a Low Carbon Economy Fund to support provincial greenhouse gas emission reductions. Budget measures also result in a planned decline in the EI premium rate to $1.61 in 2017, down from its current rate of $1.88, and slightly lower than the $1.65 premium envisioned in the election platform. A muted market reaction likely in store for a progrowth budget Although sizeable deficits are now on the horizon, financial market reaction is likely to be muted given that today s announcements were fairly well-telegraphed in advance, and rumours of capital gains tax changes proved unfounded. The increase in gross bond issuance of about $41 billion relative to the 2015-2016 pace may be on the high side of expectations, but while the level of federal debt will rise through time, Canada will still enjoy an enviably low debt burden when compared with our international counterparts. Indeed, the raw level of debt in and of itself is not terribly important, and some level of government debt is generally considered useful for the functioning of financial markets. More important is the ratio of debt-to-gdp while upward movement in the ratio is not necessarily concerning, persistent growth often indicates structural problems with government finances. This does not appear to be the case for Canada. Although debt rises as a share of GDP in the near-term, the ratio appears likely to trend lower through time (Chart 2). In fact, given the sizeable prudence built into the government s GDP figures, even when benchmarked against our fairly conservative growth outlook the debt/gdp ratio rises only modestly helped in part by the positive near-term economic momentum that we have incorporated into the 2016 forecast and is slightly below its 2014/2015 level by fiscal 2020/2021. Unless growth is continuously weaker than our already conservative forecast, the debt path appear sustainable under the 2016 budget assumptions. Perhaps more important than the changes in debt is how the proceeds are used. The impact on economic growth of government spending varies depending on the state of the economy, the type of spending, and other factors. The impacts are summarized by fiscal multipliers which measure the growth impact of each dollar of government spending. These vary dramatically depending on the type of government spending/revenue change (Table 3). Looking through the details of the 2016 budget, we estimate that it will have a modest, but positive impact on near-term growth. GDP growth is likely to be boosted by about 0.1 percentage points this year, largely via tax changes and spending measures. 2017 will receive the largest boost to growth, of 0.3 percentage points, as infrastructure projects make their way to the action phase, where multipliers are Table 3: Fiscal Multiplier Summary Estimated GDP increase per $ gov. spending Spending Type est. Multiplier direct Spending: infrastructure 1.1 direct Spending: other 1.0 Personal Tax Changes 0.4 Business Tax Changes 0.1 Transfer Payments 0.8 Source: TD Economics. Average of year one and year two multipliers presented. 4

largest. We would note that although we use similar fiscal multipliers to the Department of Finance, we incorporate a delayed impact of infrastructure spending, consistent with the practicalities of translating funding into action and the experience of the 2009/2010 Economic Action Plan. The result is thus a modest but positive fillip to Canadian growth in coming years, helping offset the ongoing adjustment process to lower commodity prices. The size of the economic impact will help quicken the pace at which economic slack is absorbed, but not significant enough to accelerate rate hikes from our current forecast timetable of early 2018. Indeed, in the January Monetary Policy report, the Bank of Canada pointed to the budget as the missing piece of their projection, which at the time did not include inflation returning to target over the two year policy horizon. The larger concern for the Bank of Canada is likely to be the recent rise in the Canadian dollar. Another sharp leg up could put the nascent recovery in exports at risk. Bottom Line New governments often try to make their mark with their first budget, and today s is no exception. Consistent with election promises, the budget is filled with changes to the tax system, increased spending, and tweaks to a number of programs. Although budget deficits are the order of the day, there appears to be a credible path back to balance. The additional stimulus will help provide some impetus to growth, but is not likely to spur any reaction from the Bank of Canada. This report is provided by TD Economics. It is for informational and educational purposes only as of the date of writing, and may not be appropriate for other purposes. The views and opinions expressed may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The report does not provide material information about the business and affairs of TD Bank Group and the members of TD Economics are not spokespersons for TD Bank Group with respect to its business and affairs. The information contained in this report has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. This report contains economic analysis and views, including about future economic and financial markets performance. These are based on certain assumptions and other factors, and are subject to inherent risks and uncertainties. The actual outcome may be materially different. The Toronto-Dominion Bank and its affiliates and related entities that comprise the TD Bank Group are not liable for any errors or omissions in the information, analysis or views contained in this report, or for any loss or damage suffered. 5