The Canadian Beacon: What Washington Can Learn from Ottawa
DETERIORATING PUBLIC FINANCES at every level are causing grave anxiety among both the public and financial experts. The federal government is plagued by persistent deficits. The national debt is growing at an alarming rate. Interest payments are crowding out spending on programs. The country’s tax competitiveness is deteriorating rapidly. The media and the international community are all predicting a day of reckoning with far-reaching implications.
While this could accurately describe the United States of 2011, it’s actually taken from our analysis of Canada circa the early 1990s when the country faced incredible economic peril.
Fast forward to today, however, and Canada is a beacon for economic prosperity. Before the recent worldwide recession, Canada enjoyed an unparalleled decade of prosperity. The Canadian economy grew at an average rate of 3.3 percent between 1997 and 2007, the highest average growth among G7 countries, including the United States. Canada’s job creation record was nothing short of stellar. From 1997 to 2007, Canada’s average employment growth was 2.1 percent, doubling that of the United States and exceeding employment growth in all other G7 countries. Perhaps most important for future economic prosperity, during the same period Canada outperformed the G7 average almost every year on business investment. Canada outperformed the U.S. on this measure in every year but three over the same period.
And Canada has weathered the recent recession better than most. The housing market experienced a slight blip but has already more than recovered with home prices now exceeding their pre-recession highs and no bank bailouts. Unemployment is trending downwards, standing at 7.2 percent as of July. Investment is rebounding and government finances are once again on the mends—although much more is needed on this latter point.
It’s first important to understand how Canada got off track. Prior to the early 1970s, Canada had a strict political culture, like many countries, which demanded balanced budgets and frugal government spending. Ottawa began to abandon this traditional discipline in the 1960s and ’70s, as federal spending increased from just under 15 percent of gross domestic product in 1965 to 23 percent by 1993. This marked increase in spending was not matched by equivalent increases in taxes but rather financed by borrowing. This phenomenon of increasing government spending unmatched by revenues and financed by debt was observed in many, if not most industrialized countries during this period.
Between 1965 and 1996, there were only four years in which Ottawa booked an operating surplus. Over that period, the real value of the national debt tripled. By the late 1980s, roughly a third of Ottawa’s revenues were being used to pay interest.
Then there were the entitlement programs. The national public pension plan (the Canada Pension Plan), for instance, was increasingly unsustainable because its underlying assumptions, namely a growing population and continuous income growth, proved faulty. Huge premium increases or benefit cuts seemed the only way to carry the program through the looming retirement of Canada’s enormous baby-boom generation.
The problem wasn’t only in Ottawa. Canada’s provinces, whose governments have much greater spending, taxing, and regulatory authority than American states, were also hard at work creating a fiscal mess. As a share of the economy, total provincial spending more than doubled between 1965 and 1993 while provincial debt tripled. The associated interest costs, as a share of revenues, also tripled.
The Canadian public was hungry for change, and in October 1993 the left-of-center Liberal Party of Canada led by Jean Chretien came to power. For the first year, the new government’s promises of reform went largely unfulfilled. The turning point came in the 1995 budget when Finance Minister Paul Martin articulated a new direction for the federal government in his budget: “We are acting on a new vision of the role of government … smaller government … smarter government.” The 1995 budget was nothing short of the most important government document handed down in a generation.
The Liberals’ 1995 budget relied chiefly on spending cuts rather than tax increases to slay the deficit and began the long process of debt reduction. Overall spending was to fall 8.8 percent over two years. Large cuts in transportation, industry, regional development, and scientific support were made. The size of the federal government was to decline from 16.2 percent of GDP in 1994 to 13.1 percent in 1996. Public sector employment was to fall by 14 percent.
The new discipline paid off quickly. Federal government spending as a share of the economy fell even more rapidly than planned. Provincial government spending also decreased significantly from 25 percent of GDP to 20 percent. Federal budget surpluses were consistently reported beginning in 1997. The national debt fell by almost half (to a little over 40 percent of GDP) by 2007.
The quick return to fiscal surpluses coupled with stronger economic performance than anticipated meant Ottawa could cut taxes. Critically, many of the tax cuts introduced by the Liberal government were focused on improving the country’s competitiveness and incentives for investment and entrepreneurship. For instance, the capital gains tax was cut twice and corporate income taxes (federal) were put on a path to be reduced from 28 percent to 15 percent by 2012. Other taxes like personal income taxes, payroll taxes, and the corporate capital tax were also all reduced—though Canada still has a great deal of work to do when it comes to personal income taxes.
Canadian reforms didn’t stop with balanced budgets. Canada went on to tackle and solve two previously untouchable entitlement programs: the Canada Pension Plan (CPP) and welfare.
The CPP is similar to Social Security in the United States. Previously deemed a political third rail, the CPP’s unsustainable finances suddenly became fixable in Canada’s new reform-minded political climate. The federal government and a number of its provincial counterparts seized the opportunity of the public’s willingness to confront long-festering problems and bear the cost of reform.
Nine provinces along with the federal government agreed to a set of reforms to the program that went into effect in 1998. Specifically, the four reforms were: (1) the payroll tax was increased ahead of schedule (but less than anticipated); (2) surpluses began to be actively invested in equities, corporate debt, and other market instruments; (3) benefits were trimmed modestly; and (4) the value of the basic exemption for contributions was frozen, allowing its real value to be reduced over time by inflation. One can quibble with the specific nature and cost effectiveness of the reforms; however, no one can disagree with the results: the financing of the program was placed on a solid footing that will enable it to weather the costs of the retiring baby-boomers.
Like the United States, Canada achieved historic reform of the country’s welfare programs in 1996. Canada’s approach, however, was more decentralized than Washington’s. Ottawa offered an historic deal to the provincial governments, granting them unprecedented freedom to make their own welfare policy. This unleashed a wave of fruitful experimentation and innovation while spending was cut at the national level. The results were stunning. Large numbers of Canadians previously trapped on poorly-designed benefit programs returned to the workforce. By 2000, the number of welfare beneficiaries in Canada had declined by over a million people, from 10.7 percent of the population to 6.8 percent.
Some in Washington dismiss the relevance of the Canadian example to America’s fiscal problems because allegedly its parliamentary form of government made reform easier. We think this is to misunderstand the Canadian experience. Many of the reforms that were put in place required extensive political bargaining with powerful interests, and provincial consent was often necessary. Moreover as part of the reform package, the Liberals in Ottawa directly challenged several of their traditional interest groups, among them the civil service and social welfare advocates, for example.
In fact, circumstances in Ottawa and Washington in the early years of Canada’s reforms showed parallel patterns: The Liberals faced a fiscally conservative Reform Party opposition in parliament, while Democratic President Bill Clinton was under similar pressure from Newt Gingrich’s Congressional majority after 1994. This political alignment proved fruitful in moving both countries in a more fiscally responsible direction, but Canada was able to sustain reform whereas in America it quickly faltered. For example, the duo of the Clinton Administration and Republican Congress began reducing the federal deficit in 1994 until surpluses were finally achieved in 1998. Unfortunately, the habit of over-spending financed with deficits returned in 2002.
What made reform possible was the depth of the crisis Canada faced, the extent to which the Canadian electorate demanded an end to irresponsible public finances and the degree to which the entire political class responded. Governments at all levels then moved on a broad front, making it clear that no established interests would be exempted from contributing to the cost of slaying the deficit, lowering both taxes and the debt and making the Canadian economy a high performer.
Every one of these lessons is applicable to the United States today. Public finances in the United States can and will be fixed when the public demands action and the political class decides to set aside rancorous and extreme partisanship in pursuit of a robust economy, job growth, lower taxes, and focused government.
Mr. Crowley, Mr. Clemens, and Mr. Veldhuis are the authors of the award-winning book The Canadian Century: Moving Out of America’s Shadow published by the Macdonald-Laurier Institute in 2010. This article is an updated version of an article that appeared in Foreign Policy in June 2010. More information is available at www.macdonaldlaurier.ca.