Lessons From Canada: It Fixed Its Fiscal Problems with 7:1 Ratio of Spending Cuts toTax Increases

Some excerpts from a very lengthy, but excellent Reuters article "Insight: Lessons for U.S. from Canada's "Basket Case" Moment":

"Canada's shift from pariah to fiscal darling provides lessons for Washington as lawmakers find few easy answers to the huge U.S. deficit and debt burden. "Everyone wants to know how we did it," said political economist Brian Lee Crowley, head of the Ottawa-based thinktank Macdonald-Laurier Institute, who has examined the lessons of the 1990s.

To win its budget wars, Canada first had to realize how dire its situation was and then dramatically shrink the size of government rather than just limit the pace of spending growth. It would eventually oversee the biggest reduction in Canadian government spending since demobilization after World War Two. The big cuts, and relatively small tax increases, brought a budget surplus within four years.

Canadian debt shrank to 29 percent of gross domestic product in 2008-09, from a peak of 68 percent in 1995-96, and the budget was in the black for 11 consecutive years until the 2008-09 recession. For Canada, the vicious debt circle turned into a virtuous cycle which rescued a currency that had been dubbed the "northern peso." Canada went from having the second worst fiscal position in the Group of Seven industrialized countries, behind only Italy, to easily the best.

It is far from a coincidence that the recent recession was shorter and shallower here than in the United States. Indeed, by January, Canada had recovered all the jobs lost in the downturn, while the U.S. has hardly been able to dent its high unemployment.  Canada's experience turned on its head the prevailing wisdom that spending promises were the easiest way to win elections. Politicians of all kinds and at all levels of government learned that austerity could win.

Canada's scrape with disaster had been building for a long time. Over a decade earlier, top finance department bureaucrats had begun raising the alarm about the problem of rising debt, a hangover from the big government era of the 1970s. The period before Jean Chretien came to power in Canada is often likened to the situation in the U.S. today. The country was not yet peering over a precipice, but was fast approaching it.

The budget deficit more than doubled between 1980 and 1990, rising to 8 percent of GDP in 1983 and 1984, before shrinking to a still unsustainable 5.6 percent just before Chretien took over, and all the time debt was soaring. The debt-to-GDP ratio shot up to 67 percent in 1993-94 from 29 percent in 1980. The numbers aren't that different to the U.S. today with its deficit of around 9 percent for 2011, and debt-to-GDP ratio at 74 percent, up from 40 percent at the end of 2008.

Drawing a parallel to Washington, Scott Clark, associate deputy finance minister in the 1990s, said Canadian leaders before Prime Minister Jean Chretien paid lip service to the debt problem but did nothing.  "There are no lights blinking saying you're at the edge of the cliff," he said. "The one lesson others can give the U.S. is that the higher that debt-to-GDP ratio goes, the more difficult it's going to be."

The ratio of spending cuts to tax hikes was seven-to-one.  Asked why, then-prime minister Jean Chretien, a Liberal who ended up chopping cherished social programs in one of the most dramatic fiscal turnarounds ever, said simply: "There was more need on one side than the other." That contrasts with proposals this year by President Barack Obama and the Democrats to have a much higher proportion of revenue increases in the deficit-tackling mix.

Canadian ministers were told how much they had to cut and then told to come back with a plan on how to do it. Cuts ranged from five percent to 65 percent of departmental budgets and included controversial cuts in transfers that help provinces pay for health and education, decisions that lengthened medical waiting lists for years to come. In the end, program spending fell by about 12 percent between 1994-95 and 1998-99. The percentage fall was substantially more after adjusting for inflation. The deficit disappeared by 1997 and the debt-to-GDP ratio began a rapid decline - it is now at about 34 percent.

"The entire political class decided to stop treating this as a matter of political contention and started treating it as a matter of national interest," said political economist Brian Lee Crowley.  After wrestling the deficit to the ground, Canada enjoyed what Crowley calls the payoff decade, outperforming the rest of the G7 on growth, job creation and inward investment. From 1997 to 2007, it averaged 3.3 percent economic growth while U.S. growth averaged 2.9 percent.

The final lesson is that you can impose painful spending cuts and still win elections. Chretien went on to win two more back-to-back to form majority governments, a rare feat. He argued that a responsible Liberal who believes the state has a role in reducing poverty can only do so by ensuring a financially healthy government."

Note: Emphasis added.