...against fictions and other tall tales

Saturday, 21 May 2011

The right way to balance the budget: target the corporate surplus, not the government deficit

Deficit reduction is back on the agenda in Canada. And according to recent statements made by Tony Clement, the minister assigned the task of balancing the federal budget, it appears likely that significant cutbacks in public sector spending will occur in the next few years.

This is most unfortunate. At a time when household debt is at a record high and the personal saving rate is near the 40-year low (see chart 1), slashing government budgets is the last thing Canadians need right now. Think about it: for every dollar of reduction in government expenditures, there is one less dollar of income earned in the economy (similarly, if the funds are spent on imports such as US-made fighter jets, the money leaves the domestic economy). The same goes for any tax increase used to balance the budget: each dollar of taxes collected by the government represents one less dollar in private sector bank accounts.

In other words, it is impossible for the government to decrease its deficit in isolation, and any reduction in government spending or tax increase will have an impact on the private sector. In fact, there is a strong argument to be made that the decline in the personal saving rate and the overall weakness in the household sector's financial position during the last two decades is partly the result of the deficit reduction efforts of the federal and provincial governments in years past.

As I've shown elsewhere, public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports. The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

Chart 1 (double click to enlarge) proves that this basic principle is supported by the facts*. As you can see, whenever Canada's government sector (all levels of government combined) is in a deficit, the private sector runs a surplus (or reduces its deficit). The relationship is so close to being perfect that it looks as though each financial balance is a mirror image of the other. If you take into account net imports, you get perfect symmetry (see chart 2).

Chart 1

Chart 2

The Corporate Surplus

A much more sensible approach to balancing the federal budget would take into account the fact that Canada right now has a massive corporate sector surplus (see chart 3). The reason for this large accumulation in corporate savings is that during the last decade the corporate sector significantly reduced its share of productive investment in the economy in favour of short-term investments and speculative activity (Baragar and Seccareccia, 2008).

Chart 3

Based on official statistics (and my own calculations), Canada's corporate sector ran on average a net surplus of 3.7 percent of gross domestic product since 2001. This is a huge jump from the previous 40 years when the corporate sector maintained an average deficit of 1.3 percent. If corporations were to invest these funds in productive, job-creating initiatives, the deficits of both the government and household sectors would shrink significantly without the need to make contractionary cuts to public expenditures.

A good way to achieve this would be for the government to encourage firms to undertake productive investment by imposing a small, yet noticeable tax on retained earnings or on the turnover of corporate financial instruments, as suggested last year by Yves Smith and Rob Parenteau in relation to the case of the US. Marshall Auerback also makes an excellent case here in favour of imposing a tax on the corporate sector to achieve this purpose. As for the idea of a financial speculation tax, economist Dean Baker recently explained the benefits of this policy here.**

According to Smith, Parenteau and Auerback, these measures would create incentives for firms to reinvest their profits in business operations by increasing the cost of speculating with profits.

In a context where the potential for large export growth is weak (due to the current strength of the Canadian dollar and the challenges facing the US, Canada’s major trading partner), enticing firms to increase productive investment is likely to be the only way to balance the federal budget without further causing the household sector’s deficit to grow. 

So next time you're concerned over the size of the federal government's budget deficit, keep in mind that the more pressing matter at the moment is to reduce the massive corporate surplus. Such a policy would not only help to reduce the size of the federal government's deficit, but it would also go a long way in eliminating the current financial deficit of the household sector.

Baragar, F. and M. Seccareccia, Financial restructuring: Implications of recent Canadian macroeconomic developments, Studies in Political Economy, Vol 82 (2008).

* All charts were produced using official Statistics Canada sector accounts/net lending data and my own calculations. 

** This sentence was added on May 28, 2011.


  1. Hi circuit
    Great article, but corporates wont buy this. The mission of the corporation is not to substitute for Govt. Let Govt keep the programs that have public and economic effects and trim down on the civil service size. Obviously dont get rid of tghe good people, but get rid of the consultants and hand-outs etc.
    Dont get me wrong. I like your idea and admire your courage...the NDP and the Liberals in canada should hire you. But the model you're professing is somewhat outdated. You are begging the question when you point out the data indicates the solution. Why ARE CORPORATES KEEPING THE CASH....that is the new corporate reality...take my cash away and I am gone.
    So, as long as you dont increase taxes, keep the incentives that attracted us here and allow me to do what I want with my cash including paying dividends,increasing dividends, bonuses for management and increased board honorariums....I'm all for beneficial govt intervention. That's what corporates think.

    I dont think like them, but i am getting cynical about corporate social responsibility...

  2. Anon, thanks for your comments. The underlying point I'm trying to make is that deficit reduction is not a particularily good policy objective. I'll I'm doing here is to suggest, as Milton Friedman liked to say, the "least bad" means to achieve that end.

    Recall also that I'm not talking about raising the corporate income tax. The proposal would simply impose a small tax on accumulated undistributed earnings. Therefore, shareholders would continue to receive the dividends they're entitled to, and firms that decide to re-invest into business operations wouldn't have to bear costs of the incentive tax.

    As for your question on why corporates are keeping the cash, I suppose you're saying that businesses are essentially calling the shots. Perhaps. But I doubt they would go to the trouble of moving their operations because of low-rated tax (as is proposed). Such a scenario can easily be mitigated by setting the proposed tax rate at a level that isn't too onerous yet high enough to act as a disincentive to save.

  3. Circuit. Your commentator's point is not inappropriate. If you exclude the probability that corporate sovereigns will not pullout their assets-something inconceivable 30 years ago, but recently being acknowledged tacitly (corporate sovereigns vs national sovereigns) by many (see work by Rondinelli, embryonic discussions in the 60's by Chuck KJindleberger and George Ball, best is the work by International Law theorists (Trimble is a reference).

    If you exclude the above action by fickle Footloose Corporate Sovereigns who disengage themselves of social responsibility, with the exception of corporate units that pull-out under threats of expropriation or nationalizations or unfair practices, then your analysis is not only illuminating but revelatory of a solution that right-of-centre governments can assess. Some MMters may not like the direction you suggest. Republicans would not deliberate the option.
    Certainly, the figures you have configured for Canada suggest that your proposal is legitimate and warrants further reflection. However, your commentator raises the spectre that is damning for an entire generation of economists and politicians-corporate units that posit corporate interest above national interest. I imagine Hans Morgenthau is rolling in his grave.

  4. your proposal is reactionary. You've just terminated a cycle of deregulation/regulation and now you want the IRS to step up as a watchdog. Is the next step corporate boards benched by government officials

  5. Anon 2 is a poor alarmist, but a great ironist. Austerity is not the way to go. Krugman's column and Ed Hugh a couple of days ago confirm the dangers. Europe is on the verge of an abyss...so let's stick with a proposal such as yours which is actually centrist. Jorge is right-it will involve political concessions, and since I don't know much about canadian politics, I will pass comments. Anon 1 has a good point, leave the MNE's alone-they are strange partners...when you think you've sealed it, they slip out. These days, as Jorge says, they,re evolving/devolving towards new identities. They can taste "sovereign" power- but they're not yet Leviathans.
    I,ve been following your blog and your calls got balls. You do very well for a solo.

  6. Jorge Thanks for your nod. You mention Rondinelli. Can you be more specific as to the reference. Secondly, I assume your expression 'Footloose' corporates is literal.
    Anon 1, thanks for your nod also. Unfortunately, you can't leave them alone...they'll take everything they can. And I don't think corporates want to be left alone, they remind me of Koalas feeding off the money tree...

    Oh i'm anon 1

  7. Circuit here (I'm having problems with my browser)

    Anon @17:36, the use of taxation to achieve social or economic purposes is not new. Think customs duties, sumptuary and sin taxes, etc.

    Jorge, I see where you and first Anon are going but I'm not really convinced that all businesses can just get up and go, especially given that Canada has mainly a service-based economy now (but don't interpret this as me saying I'm glad about this state of affairs - IMO, it's shameful how Canada's policymakers stood by while the country's manufacturing base shrunk). Also, I'd venture that resource extraction is another area where operations can't be accomplished elsewhere. Perhaps other readers know more about this topic. Obviously, it's likely to be an important factor in the effectiveness of the proposal.

  8. I'm back...for now. I was a bit pressed in my last reply because of the problems I'm having.

    Jorge, thanks for the references. I'll have a look at them. As for my comment about the economy being mainly service-based, I'm not trying to say it precludes corporate exit, as I realize there are many services that can be done elsewhere (call centers, engineering firms, etc). I'm just saying the argument is a very convenient one from the standpoint of the corporates, as it seems to create policy paralysis to their benefit.

  9. Circuit...interesting read. You have good intentions. The point of govt is not to force market behavior, but rather to create incentive. Instead of imposing a tax, even though small yet noticeable, more appropriate strategy would be to permit a tax deduction for these types of productive investments. This way, corporations are in win-win situation with respect to how they employ their money.
    Anon 4.

  10. Anon 1-Rondinelli is a Business Strategy Review article 2003, issue? Footloose is literal nomenclature in the trade...Circuit...Alan Rugman -90's should be checked with reference to service industry impact...Anon refer to Reinert, rajan, glass 2009...a practical lexicon in the trade.
    Circuit-no qualm about the contingency on primary industry, Canada is a good showcase for the breadth of your proposal. I like your use of policy paralysis. I associate it with bureaucratic risk aversion or neutralizing risk parameters..
    Anon 4...tax deduction is interesting...great for the corporates, but it's not a win-win for the government, it actually increases the deficit. The issue if I follow circuit is to create jobs and not anchor productive assets.

  11. Jorge I understand that it's not a win-win for government but the problem to paraphrase Reagan is that the government is not the solution. We are in the era where sovereignty is an impediment with respect to efficient and effective government regulation of corporate citizenship, the deduction will create incentive for the sovereign corporate citizen to enter into arrangements and partnerships with the government to invest their cash into more productive use. The way I see it the government is no longer in the position to dictate the rhythm of the waltz. While you are correct that the deduction may actually raise the deficit, the fact of the matter is that this more productive use of capital will create jobs and indirectly bring money back into the government's purse.
    Anon 4

  12. Hi, sorry for reviving an old post. But I'm curious about your definition of 'savings' here:

    "The reason for this large accumulation in corporate savings is that during the last decade the corporate sector significantly reduced its share of productive investment in the economy in favour of short-term investments and speculative activity (Baragar and Seccareccia, 2008)."

    Wouldn't there still be a large accumulation of corporate saving even if corporations chose "productive" investments, i.e. in tangible assets like production machinery? So, the relationship between corporate financial assets and tangible assets would be different, but total savings would still remain the same (less depreciation).

    S = change in tangible assets + change in net financial assets | = investment + delta NFA.

    1. Thanks for your comment. Since writing this post, I'd put it a bit differently (but I still think it stands). Basically, there's been a big shift in the financing of business investment. Especially since the slow growth performance in recent years, the corporate profit rate has soared to levels not seen since the 1960s. Businesses are holding onto that income as retained earnings instead of using it to finance additional investment. In a sense this means the average return to corporate capital is high, but the expected return on marginal additions to capital investment is regarded as low. The outcome of this is that since the recovery began, businesses are now net suppliers of funds to other sectors thus creating a shift in the balance of net lending. In previous decades, the business sector was a net borrower of funds from households in order to finance its investments. In many ways, this change is a consequence of the weak recovery of investment but the real issue to highlight is the huge jump in corporate profits during a downturn (followed by a period of slow growth) and low utilization of existing capacity.

  13. Quoting Reagan is supposed to be like quoting the Bible or something? Conservative supply side economics is not sacrosanct. It has points but it's full of its own fallacies and unexplained Paradoxes that come with the simplified assumptions that government is always bad and business is always good and that the two don't work work one another, ie it takes two to tango. This Reagan stuff, with the flawed laffer curve and all that is basically the starting point of neoliberal austerity driven economics, never mind the fact that Reagan enormously increased the government deficit.

    That all said, it's funny when MMTers side step neoliberal doctrine to appear to maintain impartiality. I think MMT is great but it's just amusing how MMTers sometimes try to present their models as being equally applicable to the right and the Left,even though it is comes from a left wing school of economics on post Keynesianism.

    1. Some typos but whatever. Ie "work with", not "work work". And second, "in post Keynesianism" not "on post Keynesianism"