Thursday, September 14, 2006

Bernard Lord to cut income taxes?

As promised, here is my post on Lord's 20th of 20 promises: an 8% tax cut.

It has been brought to my attention that it may not even be a tax cut but, we'll cover that later. First, I want to explain why I think a tax cut is just about the worst possible thing we could do in New Brunwick right now.

First of all, Bernard Lord has been cutting income taxes modestly since he took office. However in order to make up the difference he rasied gas taxes (which he now promises to cut by more than he raised them in the first place) and radically increased fines and fees.

If he plans to lower gas taxes and income taxes how is he going to make up the difference? Double our fees again? Slash spending in departments? What if the economy, which has been chugging along with unprecedented growth for over a decade slips? What about contingency planning? Bernard Lord used to keep a "rainy day fund" but he already used that up in to keep the books barely black a few years ago.

Lord's definition of balanced budget operates over a four year cycle. So, he can run deficits in as many as three consecutive years, if he can manage to post a surplus greater than the sum of those three deficits in the fourth year. I think that this is wreckless financial management because you can never predict for sure that you'll get a surplus in the future because many aspects of the economy and revenue generation are outside of your control.

Anyway, as Lord hasn't completed a second four year cycle, we have some difficulty determining whether or not he is in a surplus by his four year measure.

Let's look at Lord's record (from the Office of the Comptroller):

Net Debt for the Province of New Brunswick:
  • 2000: $6.9353b

  • 2001: $6.7820b

  • 2002: $6.6036b

  • 2003: $6.7129b

  • 2004: $6.8161b

  • 2005: $6.7783b

  • 2006: $6.6557b
o there are two ways of looking at this.

1. Lord has lowered the net debt by, and therefore ran a cumulative surplus of, $279.6 million. Not too bad, though that is only an average surplus of $46.6 million which is a bit thin in my view. Lord himself used to want to set aside $100 million per year for contingencies, something that has long since gone out the window.

2. After a good couple of years in office, Lord blew it big in 2002-2003 and 2003-2004, though he has managed to improve since then, his last four years in office show a cumulative deficit of $52.1 million. It is Bernard Lord's own Fiscal Responsibility and Balanced Budget Act that talks about "the objective of the Government of New Brunswick that, in respect of each fiscal period, the total amount of expenses for that fiscal period not exceed the total amount of revenue for that fiscal period" where most fiscal periods are "a period consisting of 4 consecutive fiscal years". The act however, starts with a "first fiscal period" which " means the period of 3 fiscal years commencing on April 1, 2004 and ending on March 31, 2007". The logical here was to get these fiscal periods in sync with fixed four year elections. However, it would be unfair to judge a new government on the sins of its predecessor and the spirit of the law is clearly to run a balance over the four year period leading up to an election, something Lord has failed to do here.
I am not going to get into a semantic war of words about whether or not Lord has run a balanced budget over a course of several years. We know he has run four balanced budgets and two deficits. That is, on par, not too bad after all.

However, I am using these numbers to illustrate a point. Despite a rosy economy, the years of Bernard Lord have given us budgets bordering right on the line between red and black. Through these years he raised gas taxes and fees in order to maintain budgets in the black most of the time.

Now he is pledging to cut gas taxes and cut income taxes, even if the economy continues to go well, it looks as though it would become impossible to balance the books. This is not something I could support.

SO, if Bernard Lord is telling the truth and he intends to make these cuts, it is probably bad for New Brunswick BUT, then we get into the question of whether or not it is actually is a tax cut he is proposing.

What do I mean? Lord has confirmed that all he is promising is that the income tax rate for someone making $50,000 per year will be 8% less in 2010 than it is today. That will probably happen anyway due to the good piece of public policy the Tories brought in to fight bracket creep by indexing tax brackets.

I quote from none other than the Times & Transcript of September 13, 2006:

The province delivered its provincial budget this year on March 28. In it Finance Minister Jeannot Volpé announced a commitment to lower personal income taxes by five per cent. So the new offer is really an increase of three per cent over something the government is already committed to. But even then, the premier's quote requires closer inspection.

Volpé said -... the provincial income tax credit amounts and tax brackets will continue to be indexed to protect against inflation, "..."

The inflation factor used in 2006 is 2.2 per cent applied to the 2005 numbers. If one assumes that inflation will continue at two per cent for the next four years, you'd believe that pure arithmetic would take the voter to eight per cent with the budget already presented.

So what does that commitment mean? While no one knows the way the inflation factor is really going to unfold, take the current 2006 figures and factor in an indexation of two per cent until the end of 2009. Then calculate the provincial Basic Personal Amount difference between over the four-year period - $666 - and then multiply it by the lowest provincial tax rate - 9.68 per cent. You end up with a tax savings of $65. Then take the difference between the first tax threshold limit over the same period - $2,767 - and then again multiply it by the lowest tax rate and you have additional savings of $268 for a combined total of $333. If we subtract this amount from what the taxpayer remitted in 2005, you'd have a net tax due for 2009 of $4,377.

If we approach the problem from a different perspective and discount last year's tax bill by eight per cent, the amount due in 2009 will be $4,333 - or within $50 - and the reality is that inflation will probably be closer to 2.5 per cent than two in our projections.

Lastly, if we take the $50,000 and plug it into commercial tax software and allow for the standard deductions, it looks like the tax liability is $4,235 in 2009.

In this context the tax commitment appears to be easily achievable. One of the interesting things to point out is that the indexing seems to suggest that a taxpayer continues to get a break as there is an allowance for inflation.

But what if the taxpayer experiences a raise equal to the same inflation increasing factors as in our example? The 2005 income increases from $50,000 by 2.2 per cent in 2006 and 2 per cent through 2009. Our model taxpayer is now earning $54,227. Interestingly enough, the tax bill increases to $4,861 up from $4,710 in 2005 - even though all we've done is increased the brackets, credits and income by the same percentage.
And from the Times & Transcript of September 14, 2006:

Still, one expert says the Liberals and Conservatives seemed to be adopting similar policies.

Roger Haineault, a Moncton-based tax expert and a Times and Transcript columnist, said both parties are simply committing to indexation as well as offering several tax credits.
The Liberals have long been on the record in favour of tax bracket indexation and it appears that Lord is either pledging to maintain bracket creep or to axe it and replace it with a nominal tax cut that will give the same effect with a bit more fanfare.

So in summary, either Bernard Lord is irresponsible in promising a tax cut that will send New Brunswick into a deficit in violation of his own laws or Bernard Lord is dishonest and is trying to mislead New Brunswickers into believing he is promising either the status quo or a new measure which will result in the same effect as the status quo.

Neither sounds very good to me. Here is what Shawn Graham said:

I love income-tax cuts, every New Brunswicker would love to have the ability to pay no tax, bBut we also have a responsibility to invest in our children with our education programs, we also have a responsibility to fund a public health care system and that's why we have to take a prudent approach.

As we continue to grow our economic base and generate the revenues to build a self-sufficient province, then there will be capacity within the budget to look at income-tax cuts, but we have to achieve the first goal and that is to build the economy, build our education system and that's what I'm committed to do.
That sounds like reasonable and sound public policy. What do you think?


Anonymous said...

Keep in mind that other increase: property tax. That's worth looking into, its been awhile but I remember doing a study on NB and NS and noticing that while one depended more highly on property taxes, the other depended more highly on income taxes. I would think NB would be the latter, but its been awhile and I'm tired of looking at numbers. I'd be surprised if they increased their reliance on pt is they were already quite high, but that may be a result of not getting enough from income taxes.

herringchoker said...

Fair point on indexation as the only true argument against it is that it is inherently inflationary. In times of modest growth, indexing tax brackets doesn't mean much, as government has time to respond to bracket creep with adjustments to tax brackets. However, as we discovered in the 70s & early 80's, when growth is stronger indexation can fuel government spending (& taxation) as the gov't is continually playing catch up with taxation to pay for revenue lost through indexation. Its the vicious, rather than virtuous, cycle.

However, my main point in writing is to comment on your observation about net debt. You've actually wandered onto my territory there. The biggest driver of provincial debt since 2001 (approx) hasn't been provincial spending (although they have managed to spend handsomely), its been recognizing past debt. One of the hangovers from the previous government was more than $1.5 billion in US denominated debt. This was money borrowed in the early to mid-90s, beginning when our dollar was in the 85 cent range. Although that might have seemed wise then, the story of the dollar between 1993 & 2003 was its weakness against the greenback. In fact, it was made worse as the Dept of Finance kept reporting this US debt in nominal terms (ie. not adjusting for the change in exchange rates). Despite very modest changes in debt levels, debt servicing grew substantially in the late 1990s, a period of modest interest rates.

When the Lord crowd took over they took a decision long avoided by the previous crowd. They opted to get rid of any non-loonie-denominated debt. As public policy, this was perfectly sound; its folly to assume debt in a currency that is appreciating against that of your tax revenues. The result was a series of debt swaps between 2000 & 2004, converting $US debt into loonies. It actually worked reasonably well until the loonie began rising in 2003. After that the media started reporting that the province was speculating in the currency markets, which wasn't even close.

However, the impact of these swaps are laid out in your charts. Whenever the province converted its debt, it had to start reporting it at the converted rates (which really were closer to fair market rates). Prior to that, they had been fudging. Its why Moody's took such a dim view of provincial bonds back in the 90s.

In any event, the benefits of these swaps can be seen in the main estimates. Between 02/03 & 06/07, servicing the provincial debt has fallen by $110 million a year.

01/02 - $654 million
02/03 - $685 million
06/07 - $575 million

Over the same period interest rates have actually doubled (2.25 to 4.5%).

So, if you want to look at this objectively, you have to allow that, in fact, debt management under the current crowd has been far more transparent than under their predecessors. If PNB had been forced to use GAAP when reporting its debt, provincal debt in the final McKenna & Theriault years would have choked off a lot of investment. As it turned out, they only put off recognizing the debt until it was someone else's problem.

Anonymous said...

I have some questions. Why is holding debt in american dollars not transparent? Isn't it illegal to account for debt without showing the exchange rate?

If you have debt in american dollars, why is it 'prudent' to convert your debt while your dollar is rising in value? Very little debt is floating, most is debentures, so if they still had that debt in american funds, with the exchange rate we'd have far less debt. Or am I missing something?

herringchoker said...

Yep, your missing something. Gov'ts don't apply GAAP to their books. This allows them to record assets and debts at their book (nominal) value, rather than their market value. The reasoning is that gov't bonds are long-term debt and, given that exchange rates fluctuate a lot, rapidly converting debt on the books could create an improper impression of a gov't's financial health. Who knows, over forty years, this might be sound policy.

In the near term though, say over a decade, exchange rates can play real havoc with debt service costs. During the nineties, the dollar fell from the mid-eighties into the low sixties twice, and once again in 2002. Meanwhile, the McKenna gov't issued US denominated bonds, because they had lower interest rates throughout the early nineties. The result was that, when the dollar dipped, debt service costs, which are regularly paid in greenbacks, went through the roof.

When Lord came in, he was faced with debt that had to be paid in US dollars, and revenues in Canadian dollars, which were falling against the greenback. Enter the currency swap. From 2000 onwards, NB Finance unloaded its US debt at a discount, so it could pay off the debt in Canadian dollars, at a constant (rather than a fluctuating) rate. In terms of money management, this is considered prudent because, for the most part, gov't revenues come in at a constant rate (unless you have a lot of oil) so it makes sense to pay off your debts at a constant rate.