Those days are over, of course. Dealing with the deficit will - or should - be a theme of the upcoming federal budget. So it's worth spending some time thinking about just how the policy decisions of the current and previous governments managed the trick of transforming that indestructible surplus into what looks to be a stubbornly persistent defict.

In the early years of the millenium, the federal government ran what appeared to be an indestructible series of budgetary surpluses. No matter how many tax cuts were implemented, it ended each year with a sum of money so large that its biggest fiscal policy challenge was to find legal ways to spend it.

Update : See this follow-up post , which corrects some mistakes made below. I've added comments pointing out which parts needed revision.

Many or most of the numbers you'll see on public finances use annual data, but I've found it useful to keep track of the monthly numbers published in the Fiscal Monitor . The most recent annual data are for the 2009-10 fiscal year that ended last March, the latest Fiscal Monitor release is for December. The downside with these numbers is that there are strong seasonal cycles in many of the components of revenues and expenditures, so I'll be working with 12-month moving sums (when expressed as shares of GDP, they will be 4-quarter moving sums). With these numbers, it's easier to pick up turning points and inflection points in revenues and spending.

Here are the basic numbers; debt service charges are included in the expenditures series:







I should add that I've removed the one-time transfer of $7.2b made to the provinces in March 2005. This was an extraordinary event that would otherwise obscure the trends in the moving sums: a sharp jump followed by a sharp reduction a year later.

Of course, the proper scale for the size of government is as a share of GDP, so here are the same numbers as a per cent of GDP:

The numbers after 2009 are driven by the recession, but my point is that the seeds of future deficits were sown by policy decisions made before then. Let's zoom in on 2003-2008:







During the three years before 2005, the federal government ran surpluses on the order of 1% of GDP, based on expenditures and revenues that were fairly stable. Then something - many things, actually - happened. Here are the questions for which I've been trying to find answers:

Why did revenues rise in 2005? Why did revenues level off over 2006-7? Why did expenditures rise in 2005? Why did expenditures level off over 2006-8? Why did revenues fall in 2008?

1. Why did revenues rise in 2005? It looks like the answer is simply strong economic growth, led by personal income tax revenues:

It should be noted that the 2005-06 jump in PIT revenues is quite impressive when put in context:

The sharp reductions after 1999 are due to the Chrétien-era cuts to personal income tax rates.

I haven't gone that deeply into the PIT numbers, but it seems to me as though the story behind the 2005-06 surge involves a working-age population that was still growing, an employment rate that was hitting an all-time high and strong wage growth. If I've missed something, please let me know in the comments. [eta: The answer is that I missed a data redefinition; see the follow-up post]

2. Why did revenues level off over 2006-07? It's clear from the second-last graph that the answer is not that all sources of tax revenues leveled off. PIT revenues continued to increase in 2006 and then fell in 2007, but other sources had the reverse pattern: the result was a wash.

Here's what was happeniing in those other sources:

The newly-elected Conservative government cut the GST by one percentage point in July 2006, and this brought about a drop in non-PIT revenues. But this was a one-time effect; by 2007, the growth in corporate tax revenues was enough to bring non-PIT revenues up.

Once again, it's useful to put those GST and CIT revenue swings in perspective:







So the apparent stability of revenues over 2006-07 is a bit misleading; there were many important shifts in PIT, GST and CIT revenues that just happened to cancel each other out.

3. Why did expenditures rise in 2005? Here is a thing that I had heard, but which I really hadn't appreciated until I started looking more closely at the numbers: for the most part, the federal government is in the business of writing cheques and running the armed forces. In the fiscal year 2009-10, these activities cost the federal goveernment $216.6b. The cost of operating all of the other ministries and agencies was $58.2b - and in 2009-10, that latter number was inflated by the government's stimulus program. Any discussion of government expenditures that focuses on operating expenses of the non-defence ministries is going to miss the point by a wide margin.

So it's probably not surprising that the surge in expenditures came from transfer payments:







Interestingly enough, the increase in transfers was fairly evenly distributed between transfers to persons and transfers to provinces:



I don't have a short answer for just where those increases came from. A longer answer would include the Canada Health Transfer and the Universal Child Care Benefit, but a complete answer would be beyond the scope of this post. What does matter for the purposes of this post is that these increases were the result of policy. The major transfer that is driven by the business cycle - Employment Insurance payments - were declining over this period. [eta: The increase in transfers to persons is part of the data redefinition problem; see the follow-up post]

The last graph also answers the next question:

4. Why did expenditures level off over 2006-8? The growth rates of transfer payments to persons and the provinces were matched by the growth rate of GDP.

5. Why did revenues fall in 2008? It's important to note that revenues were falling before the recession started:







Personal income tax revenues were stable in 2008; the decline was due to the fall in GST revenues following the reduction of the GST rate from 6% to 5% at the beginning of 2008, as well as a return of CIT revenues back to its previous trend:

Here are the policy decisions made between 2005 and 2008 that generated that swing in the pre-recession budget balance:

Transfer payments increased by roughly 1% of GDP. [eta: Make that 0.5%]

The GST cut reduced revenues by roughly 0.75% of GDP.

Put the two together, and we get a trend towards a deficit even before the recession hit.

In a subsequent post, I'll go into the reasons why exiting the recession won't be enough to restore the federal budget balance.

title('Nominal GDP and CPI: UK and Canada')