Federal budget keeps inflation low, productivity high

(March 2008) By now, every advisor will have determined which parts of the federal government budget apply to their practice. The majority of the headlines have focused on the 2009 introduction of the tax-free savings account, enhancements to registered education savings plans and proposals to increase flexibility in freeing up locked-in federally legislated pension funds, but there are other parts of the budget that could, more subtly, affect your clients’ fortunes.

Inflation is one key area that can determine a person’s financial well-being. Of course, a low and stable inflation rate will do much less damage to purchasing power over the 25 or 30 years of retirement than a high, unpredictable inflation rate.

Now, achieving low and stable inflation isn’t the primary role of federal budgets — the Bank of Canada has the central responsibility for keeping inflation under control — but ill-considered government tax and spending policies can contribute to inflation, and have done so in the past. Fortunately, the present government is carrying on the tradition established in the late-1990s of maintaining a balanced budget or a surplus. In addition, spending plans seem to be appropriately restrained at a time of economic uncertainty. The bottom line is that nothing in the 2008 budget is likely to get in the way of the Bank of Canada doing its job of controlling inflation. This may seem like faint praise for the budget, but inappropriate spending and tax policies can be a big hindrance to the central bank.

Productivity growth is another area that advisors should pay attention to. The positive effects of productivity growth seem indirect — a complex mix of economic policies is required to get productivity moving, and investments in productivity can take a long time to pay off. Partly because of this, politicians and policymakers don’t always view productivity-enhancing policies as their favourites. The 2008 budget does make a modest contribution to future productivity gains by making the contribution from the gas tax fund available to municipal governments to help address local infrastructure issues. As well, the federal government will contribute $500 million toward public transit. Infrastructure — roads, bridges, airports, telecommunication links — is usually the responsibility of governments; however, the budget included a provision to encourage public–private partnerships, which may help infrastructure get built faster in the future. Another contribution to future productivity gains came in the form of additional funding for graduate students at Canadian universities and for research and development.

One of the more difficult questions that governments face is whether they should try to help individual industries or companies. There is a big difference between a public and private investment in a company. Companies and investors make investment choices about the future of individual industries and companies on a regular basis. They understand the potential risks and rewards. If the investment pays off, the investors are rewarded. If the investment fails, the investors lose part or all of their investment.

At least two things change when governments become investors. One is that taxpayers generally don’t take kindly to failed investments by governments because taxpayers are rarely consulted about whether the investment should have been made in the first place. Even when investments by governments are successful, taxpayers don’t usually see much in the way of a direct reward.

The second problem is that governments don’t seem particularly adept at picking the right investments. Sure, the comparison with the record of private-sector investments may be a little unfair because public-sector-related investment failures often come under much closer media scrutiny than private-sector ones, but this sort of comparison has made governments much less eager to pick winners in recent years.

So is there anything a government can do? Fortunately, yes, and the budget contains a couple of examples. One is aimed at helping manufacturers adjust to the high Canadian dollar and weakening demand from the United States. It’s an extension of the temporary accelerated capital cost allowance for investment in manufacturing or processing machinery and equipment.

A second initiative, which is more narrowly focused on the automobile manufacturing sector, includes $250 million for research into creating more environmentally friendly cars. The point here is that the government has seemingly found a way to invest in and support a broad and important future trend while avoiding the potential stigma of backing the wrong manufacturer. It is a much better bet that covers a wider range of companies than just the vehicle assemblers, and will ultimately help provide additional investment opportunities to individual investors.

It is pretty clear that the broad policies discussed above don’t have the near-term effects of the investment/savings/pension provisions of the budget, but they are equally important. All the investment, savings plans and pension provisions in the world would do very little if there isn’t low inflation, high productivity and a healthy economy to support them.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in retirement in Canada today. He can be reached at peter.drake@fmr.com.

(03/25/08)