Business and Economics Growth Related Questions

New Fiscal Programmes in the US and Canada Author(s): Ali Al-Eyd and Dawn Holland Source: National Institute Economic Review, No. 188 (April 2004), pp. 16-20 Published by: Cambridge University Press Stable URL: https://www.jstor.org/stable/23876682 Accessed: 27-01-2021 04:08 UTC

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I 6 National Institute Economic Review No. 188 April 2004

New Fiscal Programmes in the US and Canada

United States

Following the surge of 2 per cent growth in the third quarter of 2003, US output rose by a further 1 per cent in the final quarter of the year, bringing output in 2003 to a level 3.1 per cent higher than in 2002. Private sector investment was the driving force behind this expansion, with housing investment exhibiting exceptionally strong growth of 7.5 per cent in 2003. Business investment has also recorded strong growth since the second quarter of 2003, following nine quarters of decline. The level of business investment, however, remains 6.3 per cent below its level at the end of 2000. We expect business investment to continue to expand faster than GDP for the next several years, allowing investment to regain its pre-recession level by the end of next year.

Housing investment has been fuelled by the rapid growth in house prices, which have increased by 7-8 per cent per annum since 2000. The recent rise in house prices also had an important sustaining impact on

Table 5. United States

2000 2001 2002 2003 2004 2005 2006-2010

Consumption 4.7 2.5 3.4 3.1 3.6 2.2 2.0

Investment : housing 0.8 0.3 4.9 7.5 5.8 4.0 1.5 : business 8.7 -4.5 -7.2 3.0 3.7 5.9 5.3

Government: consumption 1.7 2.8 3.6 3.8 5.2 1.7 2.4 : investment 3.6 2.5 5.0 1.4 5.3 2.0 2.4

StockbuildingM -0.1 -0.9 0.4 -0.1 0.0 0.0 0.0 Total domestic demand 4.4 0.7 2.8 3.3 4.0 2.6 2.4

Export volumes 8.7 -5.2 -2.4 2.0 8.3 10.6 8.1

Import volumes 13.1 -2.6 3.3 4.0 4.6 4.7 5.4

GDP 3.7 0.5 2.2 3.1 4.3 3.1 2.7

Savings ratio 2.4 1.8 2.4 2.1 2.3 2.9 2.2

Average earnings 6.4 3.5 2.6 2.9 3.8 4.1 4.6

Private consumption deflator 2.5 2.0 1.4 1.8 2.5 2.3 2.3 RPDI 4.6 1.8 4.1 2.9 3.8 2.8 1.9

Unemployment, % 4.0 4.8 5.8 6.0 5.6 5.6 5.5

General Govt balance as % of GDP 1.6 -0.1 -3.3 -4.8 -5.9 -5.0 -3.6 General Govt, debt as % of GDP 58.0 58.0 59.8 61.3 63.6 65.7 67.5

Current account as % of GDP -4.2 -3.9 -4.6 -4.9 -4.9 -4.4 -3.9

Net Overseas Assets as % of GDP -15.9 -22.7 -24.5 -27.1 -31.2 -35.6 -41.0

household spending throughout the 2001 recession, and continued to support consumer spending in 2002 and 20033.

Consumers have also received a strong boost from tax cuts, with real disposable incomes rising by nearly 3 per cent in 2003. Rising equity prices will give an additional boost to consumers this year, and we expect consumer spending to rise by 3 Vi per cent in 2004. There has been a further erosion of the savings ratio, which dropped to 2.1 per cent in 2003. It seems unlikely that the savings ratio can fall much further, especially in light of the widening current account deficit, and we are therefore projecting more modest rises in consumer demand over the medium term, of about 2 per cent per annum.

As we discuss in the previous section, there appears to have been a structural shift in labour demand since

2001, which has kept employment growth weaker than

percentage change

Note: (a) Change as a percentage of GDP.

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The World Economy 17

expected. We expect to see the unemployment rate stabilise at current levels of just over 5Vi per cent throughout our forecast horizon. The impact of weak employment growth on the economic outlook depends on its source. If this can be accounted for entirely by a permanent rise in the rate of technical progress, trend growth in the US should rise. However, we have assumed that the shock is a temporary one, and expect the rate of technical progress to return to trend levels this year. As such, we expect output growth in the US to slow to about 23A per cent per annum from 2006-10. This is somewhat below consensus projections, but is consistent with our discussion of a temporary shock to the rate of technical progress.

Inflationary pressures in the US have started to rise, suggesting that the recent exchange rate shock is gradually feeding through import prices to consumers. In the first three months of 2004, consumer prices increased at a seasonally adjusted annual rate of 5.1 percent. The rise in oil prices and other commodities has put upward pressure on prices, while exceptionally strong growth in the second half of 2003 allowed the output gap in the US to close in the first quarter of 2004 (Chart 8). However, wage pressures remain relatively subdued in light of the weak labour market performance, and we are projecting inflation of about 2lA per cent per annum from 2005, following slightly higher inflation in 2004. We continue to expect an inflation differential relative to the Euro Area of roughly

Vi per cent per annum for the next several years, as the 25 per cent shift in the bilateral exchange rate since early 2002 gradually feeds into consumer prices.

Net trade had a small negative impact on output growth in 2003, while the US current account deficit widened by 1.5 per cent of GDP. This occurred despite the sharp drop in the US$, which is consistent with our assumption that the recent depreciation is in part due to a shift in the rate of technical progress in the US. Long-term sustained improvements in the US current balance would have to be associated with changes in government borrowing or private sector net saving. Since 2000, the US government deficit has worsened by 6.4 per cent of GDP, whilst net private sector saving4 increased by about 5Vi per cent of GDP (although it remains negative). The current account worsened by the difference between these, as shown in Chart 9. An improvement in the current account could come from a rise in net private sector saving (this requires less investment or less consumption for the same level of income), which would be accompanied by slower growth. It could also come from a reduction in the government deficit. In both cases a correction to the current account through lower absorption would reduce growth for some years.

Chart 10 plots NIESR's projection of the US deficit in April of each year since 2001. The shift in the government deficit since 2000 is primarily attributable to tax cuts, which reduced revenue by approximately

Chart 8. US Output Gap

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Chart 9. Sectoral Savings

1

2000 2001 2002 2003 2004 2005

□ External ■ Private □ Government

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I 8 National Institute Economic Review No. 188 April 2004

Chart 10. NIESR's projection of US deficits

^ ^ ^ ^ ^ ^ ^ Apr-01 Apr-02

" - - Apr-03 Apr-04

$350 billion in the 2001-2003 fiscal years. In addition, spending has been higher than anticipated, primarily due to the cost of the wars in Afghanistan and Iraq. Government spending on defence was 25 per cent higher in 2003 than in 2000.

Cyclical factors have made a relatively small contribution to the rising deficit. We estimate that cyclical factors had a negative impact of about 0.9 per cent of GDP on the US deficit in 2001, 0.2 per cent in 2002 and a small positive impact in 2003.

The US general government deficit reached $522.4 billion in the calendar year 2003, or 4.8 per cent of GDP. This is the highest deficit relative to GDP that the US has seen since 1993. The general deficit is due to widen significantly next year to nearly 6 per cent of GDP, the highest level since at least 1960, the first year shown in the Bureau of Economic Analysis data set.

The Bush administration released its 2005 budget proposals in February 2004. These include a number of measures that will reduce revenue over the next 10

years, as well as some expenditure cuts in the first five years relative to 2004. The main revenue measures involve the permanent extension of a number of expiring tax provision from previous budgets. This has a small negative impact on the budgets for 2005-10, and a substantial impact after 2011. The fall in expenditure arises from the dissipation of the $87 billion supplemental budget enacted at the end of 2003,

Chart 11. Impact on Deficit and Output

u

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0.4 --

0.2 --

0 --C

-0.2 --

-0.4 --

-0.6 --

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-I --

1 I Deficit (percentage point shift relative to GDP)

GDP (% difference from base)

primarily for reconstruction and military operations in Iraq and Afghanistan. If the supplemental appropriations for 2004 were excluded from the comparison, discretionary funding would rise by 4.2 per cent, rather than fall by 5.7 per cent.

The current policy proposals have yet to be negotiated and adopted by Congress, and so do not form part of our central forecast scenario. We have undertaken a model

simulation to investigate the impact that the budget proposals would have on our projections. This involves an income tax cut worth $20 billion in 2005 and a further $8 billion in 2006, while the lifting of sunset clauses in 2011 will cut tax by a further $93 billion. Corporate tax receives a small cut worth $3 billion in 2005, as the research and experimentation tax credit is extended permanently. Other revenues fall by $11 billion in 2009 and $46 billion in 2011 with the extension of temporary policies for estate and gift taxes and tax rates on dividends and capital gains. Government spending falls by $29 billion in 2005 relative to our baseline scenario, and by a further $17 billion and $19 billion in 2006 and 2007, respectively. There is also a rise in expenditure worth $12 billion in 2012 related to the extension of expiring provisions from previous budgets.

The measures would improve the deficit by 0.3 per cent of GDP by 2008, but in the longer term the deficit falls below base, by about 0.6 per cent of GDP (Chart 11). The modest initial fiscal contraction has a negative

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The World Economy 19

impact on output, matched by a slight rise in output following the expansion of 2011. While our projections do not see the deficit falling to half of its 2004 level after 5 years, as suggested by the US administration, this is partly a distinction between the federal and general budget deficits. In 2003, the federal deficit accounted for 84 per cent of the general deficit, with net state and local shortfalls accounting the remainder. We have assumed a broadly neutral path for state and local deficits going forward.

The new Bush package has been widely criticized by budget analysts as it does not allow for any reform of the alternative minimum tax (AMT) past 2006, which has not kept pace with recent income tax cuts, nor does it allow for any costs to US taxpayers of peacekeeping operations in Iraq beyond 2004. It is therefore unlikely that a final budget will pass that includes both the tax cutting measures proposed and an improvement in the US deficit position over the next five years.

Canada

After stumbling on a series of negative shocks in 2003 — including SARS, BSE, Ontario's power cut, and massive forest fires — and growing at a mere 1.7 per cent, the Canadian economy is well placed to regain its momentum in 2004 and 2005. However, a return to

sustained GDP growth will come mainly on the heels of strengthened private domestic demand since the rise in the Canadian dollar will continue to hamper growth in net exports even as global economic activity rebounds.

Canadian GDP growth recovered in the fourth quarter of 2003, exceeding 3.7 per cent on an annualised basis, up from 1.2 per cent in the third quarter, bringing total growth in the year to 1.7 per cent. Fourth quarter growth was buoyed by a surge in exports and increased inventory investment despite a drop in private consumption. However, in line with the rise in the Canadian dollar, imports also surged in the fourth quarter largely offsetting the rise in exports. Our current projections see the Canadian economy expanding moderately in 2004 by 2.8 per cent, reaching 3.5 per cent growth in 2005. A strengthening US economy and domestic stimulus supported by three consecutive interest rate cuts since January will continue to drive investment and boost domestic demand over the course

of this year. Strong employment figures boosted by higher participation rates and a surge in first quarter consumption growth to an annual rate of 3.1 per cent complement a series of recent tax cuts and will lend further support to economic growth. Increasing global activity and new export markets, notably from emerging economies such as China and India, will also contribute to stronger growth.

Table 6. Canada percentage change

average 2000 2001 2002 2003 2004 2005 2006-2010

Consumption 4.0 2.6 3.4 3.3 3.2 3.4 2.5 Private sector investment 5.9 3.3 -0.3 4.8 5.6 4.0 2.6

Government expenditure 2.7 4.4 4.1 3.4 2.4 2.9 3.1 StockbuildingM 0.1 -0.2 0.1 0.0 0.0 0.0 0.0 Total domestic demand 4.2 2.9 2.9 3.6 3.5 3.4 2.6

Export volumes 8.8 -3.1 -0.1 -2.1 6.3 7.9 5.7 Import volumes 8.0 -5.0 0.6 4.0 8.3 7.9 5.7

GDP 5.3 1.9 3.3 1.7 2.8 3.5 2.7

Private consumption deflator 2.2 1.8 1.9 1.7 1.5 1.9 1.9 Unemployment, % 6.8 7.2 7.6 7.6 7.3 7.0 6.2

Govt, balance as % of GDP 3.0 1.4 0.8 1.2 I.I 0.9 0.6 Govt, debt as % of GDP 80.0 81.7 76.0 72.4 67.7 64.0 54.0

Current account as % of GDP 2.9 2.4 2.0 2.1 2.7 1.9 2.3 Net Overseas Assets as % of GDP -18.2 -17.1 -15.5 -12.6 -11.6 -11.7 -8.0

Note: (a) Change as a percentage of GDP.

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20 National Institute Economic Review No. 188 April 2004

Despite the 15 per cent rise in the Canadian dollar (in real effective terms) since the fourth quarter of 2002, export volumes are expected to grow strongly this year at an annual rate of 6.3 per cent, up significantly from the 2.1 per cent contraction last year. The net impact on GDP growth, however, will be muted as import volumes will continue to rise more rapidly on the strength of the domestic currency and increased capital investment in cheaper foreign machinery. Import growth is expected to peak in 2004 at 8.3 per cent before falling to 7.9 per cent in 2005 matching export volumes in that year.

In view of low inflation, the current level of the exchange rate, and weaker than expected GDP growth in 2003, monetary policy remains accommodative. On April 13th the Bank of Canada reduced its target rate by a further 25 basis points to 2 per cent, which will support domestically led growth and help to facilitate the required adjustment by firms and businesses to meet an increasing global demand. Annual inflation is expected to remain subdued over the rest of this year, at just 1.5 per cent, significantly below the officially targeted rate of 2 per cent and down from last year's pace of 1.7 per cent. Lower rates of inflation and excess supply - as indicated by a negative but narrowing output gap - provide scope for further monetary easing later in the year should it be required. However, current projections show inflation rising to 1.9 per cent in 2005, nearing the official target as the current monetary stimulus feeds through the economy and excess supply is shed.

The Canadian budget for 2004/05 released in March reinforces the government's commitment to a balanced budget and a continued downward path for the debt-to-GDP ratio. Notwithstanding substantial increases in transfers for public health care systems and learning to the provinces, total general government expenditure growth will remain moderate in 2004. Annual expenditure will grow by 2.4 per cent, down one full percentage point from last year. In view of an immediate freeze on all major capital projects (announced in December 2003), weak tax revenues, and a review of current expenditures, the short-run fiscal outlook has worsened. Indeed, there is little room for fiscal manoeuvre over the coming year and any further economic stimulus will have to come from monetary policy.

The current outlook for the Canadian economy is favourable. However, risks remain on the downside. In particular, questions over the effects of the appreciation of the Canadian dollar and the sustainability of the current US expansion continue to cloud growth

Chart 12. Canadian Equity Prices

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projections. Moreover, domestic demand has been fuelled by steep declines in the Canadian personal savings rate, raising questions over the capacity of private consumption to support economic growth. However, recent gains in household net wealth, driven mainly by rising equity prices, have provided consumers with the impetus to finance current consumption without eroding personal sector balance sheets, tempering a less sanguine view of domestic demand (Chart 12). In the medium term, the economy is expected to gain momentum and, as the effects of current economic stimuli wane, it is likely that savings and investment rates will adjust to more sustainable levels.

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