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Tuesday, 22 October 2013

Can balanced budget legislation really work in Canada?

by Stephen Tapp

Three things to know about fiscal rules:

1.   The federal government now wants to introduce a balanced budget rule. The idea is to adopt a law that requires balanced budgets in normal economic times. Under this law, the federal government could run occasional deficits, but only when growth is very slow and a timeline to return to balance is given.

2.   Since the early 1990s, Canadian governments have increasingly relied on formal rules to guide fiscal policy. Other countries do this too. Enforcement of these rules is increasingly being delegated to independent budget offices. 

3.      My research finds a robust positive correlation between stronger fiscal rules and better fiscal outcomes on average. This result applies only to selected rules over a selected time period, namely, balanced budget and debt rules in Canadian data from 1981-2007 — i.e., before the global recession. Conversely, I find that spending or revenue rules were generally ineffective in this same period.

Three common misconceptions about fiscal rules:

Myth #1:  Fiscal rules are basically homogeneous and are readily copied from other jurisdictions.

The reality:  The details of fiscal rules matter; they differ and are jurisdiction and context specific. Canadian governments have used rules of various types and strengths. In the early-1990s there was early experimentation with debt, spending and budget balance rules, typically used on their own.  By the mid-1990s as fiscal pressures intensified, several provinces adopted more wide-reaching rules that combined various targets, with balanced budget and debt rules becoming the most common. 

The stringency of rules also varies. Some provinces have had no formal rules (Newfoundland and Labrador and Prince Edward Island), whereas Alberta and Manitoba have historically had the strongest fiscal rules in Canada.

Myth #2:  When fiscal rules are legislated they are set in stone, and thus act as a permanent constraint on future governments.

The reality: As used in practice, fiscal rules are better thought of as moving targets that policymakers generally aim for, but adjust at irregular intervals in response to economic and political developments (such as recessions or changes in governments).

Myth #3:  Examples where a government missed a fiscal target show that fiscal rules don’t work.

The reality:  The natural instinct is to simply compare the target (balance the budget!) and the outcome (balance the budget?). In fact, the correct comparison (the so-called counterfactual) isn’t the target, but what would have happened without it. (Of course, this can’t be observed because it didn’t happen, so it must be inferred with statistical techniques). So just because a government failed to balance its budget, doesn’t mean that it didn’t have a smaller deficit than without the rule in place.  In the same vein, seeing one driver run a red light doesn’t disprove the notion that traffic lights generally make roads safer.

Continue the IPAC Impact discussion on balanced budget legislation by reading Dr. Wayne Simpson's post, "Is federal balanced budget legislation a meaningful step?"

Stephen Tapp is a Research Director at the Institute for Research on Public Policy (IRPP). Before joining the Institute, he was a senior economist and adviser on economic, fiscal and tax issues for Canada's first Parliamentary Budget Officer. You can e-mail him here; follow him on Twitter (@stephen_tapp); and connect with him on Linkedin.  

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