Facing Newfoundland and Labrador’s Fiscal Challenges

Don Drummond and Louis Lévesque unpack why Newfoundland and Labrador have highest debt burden of all provinces and the difficult choices the province faces to get back on track.

The Newfoundland and Labrador 2020 Budget revealed the expectation of a huge deficit of $1.8 billion and of a net debt-to-GDP ratio set to reach 55.7 per cent by the end of fiscal year 2020-21. As in other Canadian jurisdictions, COVID-19 is to blame for a good part of this fiscal deterioration as it is requiring additional spending and hitting revenues hard. However, the situation of Newfoundland and Labrador stands out as uniquely difficult among provinces. Prior to the pandemic, Newfoundland and Labrador already had the highest debt burden of all provinces as a percentage of GDP, but, just as ominously, the province’s debt burden was also rising very fast.

As a matter of fact, the above still probably understates how unusual the fiscal situation of Newfoundland and Labrador is among Canadian provinces. Its government debt measures do not include the debt associated with the Muskrat Falls project which officially stands on the books of Nalcor, a provincial crown agency. However, whether it is as rate payers or taxpayers, it is individuals and businesses in the province who will ultimately have to bear the impacts of the project’s large cost overruns. Newfoundland and Labrador is also home to an older and declining population, a situation which is translating into both slower revenue growth because of declining labour-force participation and into more intense pressures on health-care costs.

Spending Decisions Amid Oil Riches

To understand how Newfoundland and Labrador’s fiscal situation became so bleak we need to go back about 20 years. As Figure 1 shows, strong economic growth in the 2000s together with the budgetary surpluses that emerged around 2008 allowed the province to bring its net debt-to-GDP ratio down to 26 per cent by 2012-13, which suggested fiscal stability. However, there was a big catch. All of this had been achieved because historically high oil prices had propelled revenues from offshore royalties to as high as $2.8 billion a year. The province should have considered the volatile nature of that revenue stream. Instead, it went on a spree of program spending (total spending less debt-service payments). More civil servants and employees in the health and education sectors were hired and they were granted higher wages. In doing so, the province created an important financial mismatch between permanent increases in spending on the one hand, and high but volatile resource revenues on the other.

Figure 1
Net Debt and Public Debt Charges

As of 2013, Newfoundland and Labrador’s budget appeared set to stay roughly in balance, but that was predicated on offshore royalties remaining very high. They did not. Global oil prices declined significantly in 2014 and have hovered around a much lower level ever since. As a result, offshore royalties accruing to Newfoundland and Labrador have declined to $1.1 billion in 2019-20 and are expected to be only $0.5 billion in 2020-21. Yet program spending not only was not reduced as offshore royalties plunged, it continued its upward march.

Interprovincial comparisons shown in Figure 2 provide a better grasp of the extent to which spending levels in Newfoundland and Labrador got progressively further out of line with those in other Canadian provinces. In the early 1990s, Newfoundland and Labrador’s program spending per capita was similar to the Canadian average. Starting in the mid-1990s and especially after 2005, the province allowed its spending to grow much faster than in other provinces. As a result, for the 9 years up to 2018-19, the gap with spending in other provinces reached 32.3 per cent on average. For the last 15 years, spending in Newfoundland and Labrador has in fact exceeded that of Alberta, the richest province in the country over that period. Newfoundland and Labrador’s spending has also been much higher than that of the Maritime provinces, which in many respects share similar economic characteristics and yet have been able to keep their spending and debt levels close to the national average.

Figure 2
Per Capita Program Spending
(Percentage of Provincial Average)

 

Financial Sustainability Requires Strong Action

While fraught with uncertainty, fiscal projections are critical to ascertain fiscal dynamics and help provide a rigorous frame for discussions about spending and revenue decisions. We first built a status-quo fiscal outlook for Newfoundland and Labrador that factors in the expected economic recovery when the pandemic settles down and there is an unwinding of the associated spending. Such a scenario does not suggest status quo policies will produce much improvement to the financial health of the province. The projection features a deficit of $0.8 billion in 2025-26 and a debt burden of 59.4 per cent, higher than what is expected this year. One in seven dollars of revenues will need to be allocated to paying interest on the public debt.

Clearly, the Newfoundland and Labrador fiscal situation is unstable and continuation of the status quo carries enormous risk. An ever-declining fraction of taxpayers’ money would be available to fund the goods and services residents need. Higher debt loads could further exacerbate the situation by leading to challenges in borrowing and higher interest rates. Ultimately, draconian fiscal action would likely be needed and this would be highly disruptive to the province’s economy and the well-being of residents. In contrast, if action is taken now to put the province on a sustainable fiscal path, the adjustment will be challenging but manageable.

On the revenue side, sluggish world growth and ample global oil supplies lead us to expect only a modest recovery in oil prices that will raise royalties only marginally to $0.7 billion by 2025-26. In the status quo outlook, we also assume program spending continues to rise at the historical pace. Hence, Newfoundland and Labrador remains in the unstable fiscal structure of high spending that is no longer supported by high offshore royalties.

We then built an alternative fiscal projection which features a balanced budget by 2025-26. Under this scenario, the debt burden would reach 51.6 of GDP per cent by the end of 2025-26, showing some reduction from the high level this year. The province would be on track toward a much more secure fiscal future but would need to extend its fiscal adjustment efforts beyond mid-decade. If annual surpluses of $1.0 billion were recorded 2026-27 through 2030-31, the debt burden would decline to 35.9 per cent, a much more fiscally secure place.

In keeping with the analysis above, our scenario to produce a balanced budget by 2025-26 puts the emphasis on spending reductions because it is high spending that is the main reason behind the current unsustainable fiscal situation (Figure 2). In 2020-21, program spending is expected to peak at $7.9 billion, notably due to pandemic-related expenditures. We expect that these will be unwound once the economic impact of the pandemic subsides. We focus more on the spending base of 2019-20 when program spending was $7.4 billion. To achieve a balanced budget by 2025-26, spending would have to be reduced to $7.0 billion, down $0.4 billion from that 2019-20 base.

Difficult Choices Ahead

Our proposal for an alternative fiscal scenario based on spending reductions is mindful of the difficulty of reducing the level of spending when there are invariably upward pressures, especially from health care, where ageing alone is adding 1.2 percentage points of spending growth in this domain. In theory, the declining population might facilitate reductions in spending, but it also lowers the labour force and weakens growth prospects. We also note that the required spending reduction at about 5 per cent is not huge and that other provinces have been able to put in place similar initiatives in the past.

More importantly, our approach is predicated on the fact that overspending on programs remains far more important than any other factor, including Muskrat Falls, in terms of explaining the province’s current difficult fiscal situation. For instance, it is easy to calculate that had Newfoundland and Labrador limited its excess annual program spending compared with the Maritimes at 15 percent (about the level prior to 2005), the province would have saved more than $10 billion, before interest costs, cumulatively from 2000 through 2017-18. A look at the federal transfers for Newfoundland and Labrador also demonstrates that the deterioration of the province’s fiscal situation occurred despite levels of federal financial support being much higher than those provided to other provinces for decades before 2012.

Higher taxes could augment the contribution of spending restraint in the quest for fiscal stability. In the short term, however, we are concerned that higher taxes may have more negative impacts than spending reductions on the post-COVID economic recovery. We also note that the province’s tax burden is not particularly low relative to other jurisdictions. Should the decision be made in later years to fill a portion of the fiscal gap with higher taxes, care should therefore be taken to ensure that the taxes causing the least damage to the economy are chosen, such as the HST.

Asset sales could also play a role, but they tend to give one-off fiscal benefits, while the Newfoundland and Labrador fiscal challenge is structural and long term. Care should also be taken to ensure that any asset sales do not unduly reduce revenue streams associated with the asset.

As noted above, the large cost overruns at the Muskrat Falls project could make the fiscal situation of Newfoundland and Labrador even more difficult in the years to come. The province can afford neither the doubling of electricity prices that might be required to fill the shortfall nor a replacement large tax increase. The province should reduce the target rate of return it is expecting from the asset. We believe that the federal government should also go beyond the recent hint of some relief on the timing of debt payments and relieve the province of a portion of the debt, reflecting the federal government’s role in enabling the project through loan guarantees. We also believe that the above discussion on spending clearly suggests that it would be appropriate for federal relief for Muskrat Falls to be contingent on strong actions on the part of the province to bring its spending significantly closer to that of other provinces.

A Norwegian Lesson

Achieving fiscal stability in Newfoundland and Labrador will be difficult, but it is feasible. The freshly re-elected Liberal government will need to explain the challenges, consult with all stakeholders on possible approaches, and form a plan. The Economic Recovery Team chaired by Dame Moya Greene can play a role in improving public understanding of the situation, formulating policy recommendations and helping to build consensus around the need for strong actions.

If and when the province returns to a more stable fiscal path, it must forever be mindful of the main lesson to be drawn from its current fiscal challenges—the need to match recurrent spending commitments with predictable and recurrent revenues. In other words, the proceeds from the sale of non-renewable resources with highly volatile prices should not be viewed as recurrent revenues that can fund new annual spending, especially not expenses like wages and salaries which tend to be fairly permanent. A large portion of the proceeds from non-renewable resources should be used to pay down debt or set aside as savings in a fund.

This approach would first help reduce the economic and fiscal booms and busts associated with the volatility of resource prices. Over time, a growing pool of capital in such a fund could also provide a reliable source of revenues to the province. This is in part the scenario that former Alberta Premier Peter Lougheed envisaged for his province by creating the Heritage Fund. Unfortunately, his successors decided, as did their counterparts in Newfoundland and Labrador, to use most of the proceeds from resources as current revenues. It is Norway that followed the prudent approach of putting the large proceeds it received from the production of North Sea oil into an investment fund, instead of using them to pay for current spending. Norway’s approach has paid off handsomely; the country’s GDP per capita is one of the highest amongst developed countries and it also owns the largest sovereign wealth fund in the world.

 


About the Authors

Don Drummond is the Stauffer-Dunning Fellow in Global Public Policy and Adjunct Professor at the School of Policy Studies at Queen’s University. In 2011-12, he served as Chair for the Commission on the Reform of Ontario’s Public Services. Its final report, released in February 2012, contained nearly four hundred recommendations to provide Ontarians with excellent and affordable public services. 

Drummond previously held a series of progressively more senior positions in the areas of economic analysis and forecasting, fiscal policy and tax policy during almost 23 years with Finance Canada. His last three positions were respectively Assistant Deputy Minister of Fiscal Policy and Economic Analysis, Senior Assistant Deputy Minister of Tax Policy & Legislation and most recently, Associate Deputy Minister. In the latter position he was responsible for economic analysis, fiscal policy, tax policy, social policy and federal-provincial relations and coordinated the planning of the annual federal budgets.

He subsequently was Senior Vice President and Chief Economist for the TD Bank (2000-2010), where he took the lead with TD Economics’ work in analyzing and forecasting economic performance in Canada and abroad.  For Canada, this work was conducted at the city, provincial, industrial and national levels. TD Economics also analyzes the key policies which influence economic performance, including monetary and fiscal policies. 


Louis Lévesque began his economist career in 1983 with the Quebec Government, first with the Crop Insurance Board and later with the Department of Finance. He joined Finance Canada in 1991 and moved up the ranks in economic development, tax policy and federal-provincial relations, leading to his appointment as Associate Deputy Minister of Finance in 2004.

He was promoted to Deputy Minister in 2006 with responsibility for intergovernmental affairs in the Privy Council Office. He was appointed as Deputy Minister of International Trade in 2008, as Canada’s Sherpa and personal representative of the Prime Minister in 2010, and as Deputy Minister of Transport Canada in 2012.

Mr. Lévesque left the public service in July 2015 and later joined the International Forum of the Americas as Chief of Operations for the Montreal Conference. In April 2017, he was appointed as Chief Executive Officer of Finance Montreal, the cluster of financial institutions in Quebec.

Born and raised in Quebec City, Mr. Lévesque obtained a first degree in Mathematics and a Masters in Economics from Laval University.

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