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economy lab

Minister of Finance Jim Flaherty answers questions in the House of Commons after delivering the federal budget on Monday.Adrian Wyld

Yesterday's budget was an implicit admission of a problem whose existence the Conservatives had spent quite some time denying: the federal government is running a structural deficit that will not go away on its own when the economy fully recovers from the recession. If the deficit were purely cyclical -- that is, if the deficit could be completely explained by recession-induced increases in spending and reductions in revenue -- then the government wouldn't be in a position where it would feel obliged to commit to large, unspecified spending cuts in order to balance the budget.

Many commentators have suggested that the structural deficit was created by increased spending, so spending cuts are the appropriate remedy. I don't see how this hypothesis fits the data, and the fact that the necessary spending cuts have yet to be specified suggests to me that there's no expensive new program that can be blamed for the structural component of the deficit.

It's much easier to tell a story ( here and here) in which the cuts to the GST are the cause of the federal structural deficit. It certainly fits the timing: the beginning of the federal government's slide into deficit in early 2008 coincides with the cut in the GST rate from 6 per cent to 5 per cent; see this graph from last week.

As far as I can tell (more here), the Conservatives inherited a structural balance of approximately zero when they came to power in 2006: the structural surplus of the Chrétien years had been distributed to the provinces when the Martin government increased the Canada Health Transfer.

But the actual government balance in 2006 was a surplus on the order of 1 per cent of GDP. In hindsight, it seems fairly clear that this surplus was a purely cyclical phenomenon produced by an overheating economy. This was by no means clear at the time: I don't recall many people voicing concerns that the Conservatives' plan to cut the GST would send the federal government into deficit. So even though the GST cut did end up creating a structural deficit, I'm inclined to be generous on this point: it was a mistake based on a misreading of very noisy data.

If it weren't for the politics involved, reversing the decision that created the problem would seem like an obvious solution. But politics has a way of transforming obvious solutions into unthinkable heresies.