The federal budget – what does it mean for the economy and the markets?

Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets. A podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Ali Jaffery: Thanks for joining us on our latest edition of Eyes on the Economy. I’m Ali Jaffery, a Senior Economist at CIBC and the host for today’s episode. And it’s my pleasure to be joined today by our Chief Economist, Avery Shenfeld, to talk about the latest federal budget and what it means for the economy and markets. So let’s jump right into the discussion, Avery. What’s your overall impression of what the government has done here?

Avery Shenfeld: I’d say that in general, the fiscal plan is on track versus where it was supposed to be looking back at last year’s fall statement. But that said, it’s not as good as it could have been. Because what happened is that since the fall statement, in fact, the economy has picked up in a way that would otherwise have allowed the budget deficits to actually come in a fair bit smaller than what had been planned. Instead, what we’ve done here is we’ve used that to finance additional spending. And on top of that, actually, we added even more spending and offset that with a tax hike on capital gains income. So for those looking for some fiscal restraint, we’re getting what we were originally promised in terms of a budget deficit in the coming year, in the $40 billion range and gradually descending after that, but it could have been better. And if we look further out, into say 2027 for example, we are a fair bit off course once again so by 2027 now the government is promising to have a deficit of just under 27 billion and a year ago that number if you looked at the March 23 budget, the 2027 deficit was supposed to be 14 billion so we’re not making quite as much progress on deficits at a time when provinces are having difficulties dealing with inflation and some of their costs, healthcare costs and so on and their salaries. And so it might’ve been helpful if the federal government had actually used some of the fiscal room that they had to at least stay on track or even perhaps project a lower track for the deficit than they’re in fact doing.

Ali Jaffery: How is the economic backdrop affecting the budget, and what does the budget mean for the Bank of Canada?

Avery Shenfeld: In terms of how the economy impacts the budget itself, they took a survey of private sector economists at a time when expectations for the current year were on the low side. Actually in the weeks since they did that survey, the outlook has brightened a little bit with better than expected news on first quarter growth. So the budget is based on an assumption that real GDP growth this year will be only 0.7%. We think it might be 1%, for example, and similarly nominal GDP could be higher. So they may end up getting more revenues in the current year than they expect. Of course, what they are counting on to get budget deficits falling after this year is a recovery in economic growth, a reasonable one, but they’re basically waiting for better times to kick in order to make real progress on deficits. There’s also a separate issue. Will this budget impact the economy? And in particular, will it boost the economy enough that it delays much needed interest rate relief? On balance, I think if it does, it’s going to be fairly marginal. If we look at the budget deficit, for example, relative to what was predicted in the mid-year fiscal statement last year, which the Bank of Canada would have been using in its projections, we’re only talking a decimal or two in terms of the increase in the budget deficit and therefore net stimulus. Now it might work out a little more because the tax hikes are hitting high income earners who would save the money. Some of the spending is flowing to lower income earners who will spend that money. But you could also argue that they’re creating a little downward pressure, longer term at least, on inflation by stimulating housing supply and opening up childcare spaces that will improve labor force participation. But overall, I don’t think anything in this budget really stands in the way of getting the interest rate relief we expect to see over the latter part of the year.

Ali Jaffery: You call this budget the dance of the seven veils. What did you mean by that? And feel free here to provide people of my generation a bit of a cultural education.

Avery Shenfeld: Well, it used to be that budgets were held in close secret and then you found out everything all at once. What instead has happened is like Solomé’s dance to King Herod in the old play, the government has basically been releasing or unveiling all of its new initiatives one at a time over the past several days in order to get the media attention for that. And that meant that the last act of this dance, which was the one on budget night, really was only about revealing where the tax hikes would come to pay for all that and what other spending reductions might be planned in order to stay within the budget balance. So in this case, the tax hikes are a major tax increase on large capital gains, that is those earning 250,000 or more or corporations earning capital gains, will now have to include two thirds of that as income for tax purposes instead of only one half. That’s going to raise more than six billion dollars in the first year, but not average nearly as much after that. And there were some minor spending adjustments, basically plans to pare back a little bit of the growth in the civil service we’ve seen over recent decades by letting head counts fall with attrition over time and taking some of the money out of other programs. But the other thing we’ve done here, and this is a pattern we’re getting used to now, is that the government announces new programs, but phases them in over several years, so that in the first year, it doesn’t do as much to the budget deficit as you might fear reading all these headlines in the lead up to the budget. The problem is, is that every year we do that. So if you go back and you look at the projections for government spending that were made back in 2020, for example, if you look at where they were expecting spending to be today, we’re much higher than that. We’re talking about tens of billions of increases in spending relative to the previous plan. So I think you have to take with a grain of salt the projections that spending after this year will grow quite slowly because that assumes that there are no new announcements in future budgets that add to spending. And of course, what we see is that, every year. in fact, we do that. In terms of the tax hikes, we didn’t get something that we did fear, which was a corporate tax hike on corporate income for selected companies, the way we saw it on banks and insurance in the previous budget. The capital gains taxes being marketed as a fairness measure that high income earners who get their income from that source don’t pay as much tax as people earning wages and salaries. The problem with that analogy is that people earn capital gains on money that they previously paid tax on and then chose to save rather than spend. So you’re really taxing them a second time on after-tax income that they made the choice to in fact save and also made the choice to put at risk in the economy. And it’s those sort of risky investments that in fact finance people building apartment buildings or people investing in companies that grow over time. So there is a negative impact of taxing capital gains in this fashion and maybe not quite as much of an argument as the government made about fairness.

Ali Jaffery: And what does the budget mean for bond supply in the coming year?

Avery Shenfeld: Well, the deficit doesn’t move up from the prior year. So on the surface, that looks positive that the deficit is actually marginally lower than the prior year. But deficits do not equal borrowing requirements. So for example, this budget is loaded up with some items that require the government to lend money. And in terms of the expenses for the deficit, only loan losses on those loans would really show up. But the government still has to finance those loans somewhere by issuing debt. The government is also buying up Canadian mortgage bonds, part of a new program to reduce the flow to that in the public sector and the private sector rather. So all told, there’s this item called non-budgetary transactions, which also features in borrowing requirements. So if we compare it to last year, last year they needed to raise on net about just under $90 billion. This year it’s about $10 billion higher, but there’s also more maturities that need to be refinanced because we’re starting to see some of the bonds that were issued at the height of the deficits caused by the pandemic. We’re starting to see the need to refinance those. So, in fact, gross borrowing requirements will grow from $447 billion to $523 billion. And that will mean that government bond issuance will grow from just over $200 billion to $228 billion. They’re also going to drain more cash and issue more treasury bills than they did in the past. So bond supply is actually increasing at a faster pace than it did a year ago. Particularly, they’re focusing on increasing the issue sizes for five and 10-year government bonds. And that won’t necessarily stand in the way of interest rates across the yield curve coming down if the Bank of Canada starts cutting short term rates, but it will likely mean it’s just another factor that will mean that five and 10 year interest rates won’t fall nearly as quickly as say floating rates and treasury bill yields might fall as the Bank of Canada eases. I think the bigger barrier to long rates coming down a lot isn’t that though, it’s the much heavier borrowing requirement that the US government faces. So while you’ll hear a lot of talk about Canadian deficits, the federal deficit is a little over 1% of GDP. If you add in the provinces, you’re adding another one or one and a half percent of GDP. But the federal deficit in the US is over five and a half percent of GDP. And it’s really heavy US government borrowing. That’s going to be more a factor keeping North American five and 10 year rates in particular, perhaps a little higher than they would be in an environment where the Bank of Canada will be cutting short-term rates.

Ali Jaffery: Thanks, Avery. And with that, I want to thank our listeners for joining us on today’s podcast. And I hope this provides a view into the key details of the budget and how it will impact the economy. And I hope you tune in again and join us on future episodes of Eyes on the Economy.

Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.

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