The budget deficit is slain – now what?

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Last week's federal budget clearly illustrated how close the government is to restoring a balanced budget. Six years after the bottom fell out during the global financial crisis and recession, the 2014-15 budget signals the end to a tough but necessary period of fiscal consolidation. Current expectations are for a surplus of $6.4-billion in 2015-16, plus a contingency reserve of $3-billion; there is finally some room to manoeuvre in the years ahead.

This projection sets the stage for a different kind of budget – one that has scope to invest in Canada's economic future. Resetting fiscal priorities should take place within a framework of balanced budgets, a declining debt-to-GDP ratio and built-in prudence. Once surplus funds start to become available, there are essentially three ways to use them: reduce public debt; cut taxes; and/or invest in growth to strengthen the economy.

The last of these choices – investing in growth – should now be the priority.

Canada is about to enter a period of sustained slower economic growth that will squeeze valued public services such as health care unless Canada can find a way to shore up its growth potential. While Canadian economic growth is expected to pick up a bit in 2014 and 2015, to almost 2.5 per cent annually, that uptick won't last. After 2016, the Conference Board of Canada projects that Canada's economic growth will fade to 2 per cent annually – a full percentage point slower than a decade ago. Growth will be faster in the West, average in Ontario, and even slower in Quebec and Atlantic Canada.

Canada's growth potential is slowing principally because of the aging of our society and declining labour force growth. Tightening labour markets are already affecting the available work force and creating skills gaps, most notably in Western Canada, but also in pockets across the country. Immigration can help fill some of the holes, but the demographic forces at play are powerful and irrepressible, as seen in other aging industrial countries in Europe and Japan.

Stronger productivity growth (usually measured as output per hour worked) could offset the impact of aging demographics, but Canada's productivity track record is feeble. Business innovation and a solid physical infrastructure are foundational to a well-functioning economy, and foster productivity growth. But Canada ranks at the back of the pack on innovation among rich industrial countries, and our public infrastructure is in serious need of repair and modernization.

The federal government alone cannot solve these problems – but it can address certain key aspects. A top budget priority in the years ahead should be to increase federal investment in education and skills, in order to equip the Canadian work force with the right knowledge, skills and capacities to offset the impact of retiring boomers, to boost productivity and to feed innovation.

Budget 2014 provided some solid analysis on the existing labour market skills gaps and misalignments. It took some cautious steps in the right direction in terms of investing in skills development and education, but much more is needed. Alignment with the provinces on labour market issues and skills development is critical; we cannot afford to be pulling in separate directions.

As a nation, we have systematically underinvested in public infrastructure for decades, and first have to catch up. The past two budgets began to commit greater federal funding for public infrastructure investment. Investing much more in infrastructure would modernize the productive capacity of the economy and underpin private sector productivity growth.

What about tax cuts? Our existing tax system is complicated and uneven, and simply cutting tax rates in this imperfect environment is not the best way to proceed. The next federal budget should commit to undertaking a broad reform of the tax system. The priorities for reform include shifting the burden of taxation to improve incentives for investment and innovation, simplifying the tax code to reduce compliance costs and revenue leakages, and ultimately creating a more level playing field. Adopting these principles for reform would create room to cut tax rates in many areas. Tax reform will be a long journey, but it starts with a first step.

In short, the next federal budget presents an opportunity to declare victory on fiscal consolidation, and to shift gears by investing in Canada's future.

Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada. He will present the Canadian Outlook with the Chief Economist webinar on Friday, Feb. 21.