Budget 2012: Lower deficit, stronger economy giving Flaherty flexibility

The question is whether Flaherty will use the unexpected bounty to curtail some of the more extreme calls for austerity coming from elements of his party and cabinet.

Last week, the minister stressed that government cuts — expected to range between $4 billion and $8 billion above previously announced measures — will be “modest,” but did not define the term.

RBC’s analysis Monday shows the better fiscal track reduces the need for overly aggressive action and that Ottawa would be able to eliminate the deficit one year, perhaps even two years, prior to its 2016-17 target, while still keeping cuts at the low end of the range.

“The $4-billion mark is now likely given that we are tracking well ahead of plan,” said Craig Wright, RBC’s chief economist.

“Although this will allay some of the earlier fears of extreme austerity, holding spending growth to a slower path will still imply some components of government could still potentially see out-right declines,” he added.

Some of the savings could be “re-allocated” to high priority new initiatives, such as improving Canada’s productivity record.

Signals sent by Flaherty, the prime minister and other ministers point to the upcoming budget being a transformational document, with an eye to the aging baby boomer generation just entering retirement years, rather than something focused on the next year.

There will almost certainly be no new major tax reductions, Ottawa having already fulfilled its goal of taking the corporate rate to 15%.

The budget is expected to usher in long-term changes to Old Age Security, including raising age of entitlement to 67 from 65, a new approach to funding research and development to improve productivity, relaxing the environmental review processes to speed up resource development and trimming the size of government by about 30,000 workers.

In a speech Monday, Natural Resources Minister Joe Oliver confirmed that “streamlining of the approval process for major economic projects across the country will be a key focus” of the budget.

On the fiscal issue, Ottawa has already tackled a major budget headache by capping future health-care transfers to the growth in the economy, meaning its commitment in they key service will climb roughly in tandem with revenues.

Wright estimates the anticipated change to OAS has the potential to save Ottawa $8 billion in 2020 — the first year of likely implementation — rising to $20 billion annually by 2040.

And Flaherty is already well ahead of the game in terms of his quest to return to balance around the next time the Conservatives will have to face the electorate in October of 2015.

That would not only buttress the Harper Conservatives’ boast of being good economic stewards, but allow them to fulfil to high-profile election pledges made last spring. During the campaign, he promised the government would bring in limited income splitting and double the limit on tax free savings accounts to $10,000 once the deficit is eliminated.

The RBC analysis shows the government’s deficit could be eliminated in 2015-16, or even for the 2014-15 fiscal year.

The bank notes that the first nine months of the current fiscal year shows the deficit will come it at about $20 billion — although late-year adjustments could push that number to about $25 billion — well south of the $31 billion Ottawa had calculated in November.

With three-quarters of the year’s numbers in, government revenues have been coming in above expectations, while expenses have been well below.

“If nothing changes in the final three months, then you could get in around that $20-billion mark, but there are still economic uncertainties out there,” explained Wright for favouring the conservative estimate.

When the minister met economists earlier this month, they advised him that the risks to the global recovery had diminished, mostly because Europe had begun dealing with its debt crisis and U.S. growth had resumed.

Since then, they have told Flaherty to plan for the economy growing by 2.1% this year and 2.4% next year.

While risks remain, Wright said they have diminished. It’s almost certain Flaherty won’t need the $3.0 billion he put on reserve during this year, which means it’ll come off the deficit bottom line. With the risk of a reversal of fortune lessening, the $4.5 billion reserve for the 2012-13 fiscal period also appears to be icing on Flaherty’s fiscal cake.

The importance of the past year’s better than planned for performance is that the government’s books begin subsequent years closer to the balance, sort of like starting a 100-metre race from the 10-metre point.

“It’s still very unlikely they could beat their balanced budget target by two years, but it is within the realm of possibility if all lot of things go well,” agreed economist Douglas Porter of the Bank of Montreal.

Porter said the deficit is becoming less of a concern for the Ottawa and will likely use Thursday’s budget to set out a path for the future. He notes the critical debt-to-GDP ratio, already the best in the Group of Seven big economies, is on a downward trajectory.

“This budget will be more about setting priorities over the medium and long term,” he said. “Frankly, Canada’s fiscal situation at the federal level isn’t much of an issue for the financial markets.”