Tuesday, May 24, 2016

Perry: Defence Budget (not as bad as you think)

© 2016 FrontLine Defence (Vol 11, No 3)

Budget 2016 provided a mix of good news, pleasant surprises and disappointing news for Canada’s military. Despite the scant discussion of the Department of National Defence (DND), the budget actually contained several noteworthy defence related items. DND received some modest new money for infrastructure upgrades, incremental funding for its operations in Syria and Iraq, its planned (but unmentioned) 2% increase to its defence escalator, and the third major deferment of DND’s budgeted procurement money in three years.

The latter measure has attracted by far the most attention, and coloured overall perceptions about the impact for DND. But if the 2016 Budget provides a window into the current government’s thinking about defence, it reflects, on balance, a slightly positive signal. The government kept the big budgetary promise it made during the campaign (the good news), introduced a spending review smaller, thus far, than pledged (some uncertainty), provided some unexpected, albeit small, cash infusions (the pleasant surprises), and continued a trend of deferring procurement funds (the disappointing news), but actually demonstrated how difficult it would have been to actually use the money.

The Good News

Despite pre-budget speculation to the contrary, there was no outright cut to DND’s budget in 2016. While two weeks prior to Budget day it was reported that there would be a $400 million reduction to the DND ‘budget’, this reference was to the cash-based spending in the Estimates. The Report on Plans and Priorities for 2016/2017 showed that final, year-end spending for Fiscal Year 2015/2016 was just over $19 billion, whereas the spending requested in the 2016/2017 Main Estimates was $18.64 B.

While the requested funding for 2016/17 is less than for the previous year, this is largely the result of DND asking for less money for Capital equipment funding than the year before, rather than an actual budget cut.

The requirements for Capital funding vary from year to year, so reductions in the amount requested do not equate to an actual cut to this funding.

Notwithstanding the slight year after year budget reductions, DND actually saw an increase to its baseline Vote 1 (Personnel, Operations and Maintenance) operating budget – as planned.

National Defence has a unique funding arrangement, whereby an automatic annual increase to its budget (known as the defence escalator) is built into the fiscal framework. This funding arrangement means that the department automatically receives a budget increase every year, unless otherwise indicated. While Budget 2016 made no mention of this funding, Department of Finance officials in the budget lock-up confirmed that this escalator was in fact provided.

Under the terms of the Canada First Defence Strategy (CFDS) funding arrangements, DND’s escalator increases by 2% each year. That is, each year, the amount by which the National Defence budget increases is 2% larger than the increase of the year before. Of note, this does not mean that either the defence budget (on an accrual basis) or defence spending (on a modified cash basis) actually increases by 2% annually. In fact, the impact of the annual increase to the defence escalator is less than a 2% rise in either the defence budget or defence spending. Nonetheless, the escalator does provide the department with a predictable funding increase, so long as no other cuts or freezes are applied to the defence budget.

The Harper government’s 2015 budget included a pledge that the annual escalator will increase to 3% annually for 10 years (between 2017/2018 and 2026/2027). In its campaign platform, the Liberal Party of Canada pledged to “maintain current National Defence spending levels, including current planned increases.” The additional $361 million DND received for 2016/2017 is evidence that the new Liberal government has stuck to that campaign commitment thus far.

The total absence of any mention that this campaign promise had been kept, however, is curious. What this means about future defence budgetary intentions, and whether DND will see its escalator increase by 3% in 2017, remains to be seen – will this migrate from the “good news” category to “uncertain” or “disappointing”?

Some Uncertainty

The Budget did provide an indication that the government will conduct a spending review – another campaign promise. Whereas the Liberal Party campaign platform had pledged roughly $3 billion in spending efficiencies, the 2016 Budget announced government-wide “annual reductions of $221 million in professional services, travel and government advertising.” This was described as “a first step” in the spending review, with a pledge that other changes would be forthcoming to “better align government spending with priorities.” The Finance officials in the federal budget lock-up were unable to provide any assessment of the impact of the measures announced so far to DND, however, since National Defence accounts for a fifth of Direct Program spending, it is unlikely that defence spending will be spared. So far, however, the spending review is far less aggressive than what had been discussed in the platform.

The Pleasant Surprises
Two modest budget measures were unforecasted good news for defence. First, DND received an unexpected increment for addressing its infrastructure requirements. The $200.5 million over two years is a modest boost for a department with tens of thousands of buildings and works across dozens of bases nationwide. It is nonetheless a welcome infusion of money in an under-resourced sector of its budget. The funding, to be dispersed across upgrades to jetties, air fields, ranges, housing units, reserve armouries and northern operating infrastructure, represents investments DND will no longer have to fund within its own budget.

The budget also contained incremental funding for the mission in Syria and Iraq. For most of the past decade, the Canadian military has funded some or all of its incremental expeditionary mission costs out of its existing budget envelope. For example, during the mission in Afghanistan, DND had to absorb over $3 billion dollars in operational costs out of its existing budget. Redirecting funding in such a manner to offset unforeseen contingency operations makes it difficult to conduct sound long term budget planning. If this indicates a return to the previous practice of providing DND with incremental funding for the bulk of its operational costs, it will be a welcome change. In recent years, the $306 million provided in Budget 2016 would have been redirected from other planned DND budget items.

The Disappointing News
The aforementioned items were all positive news for DND’s Operations and Maintenance, Personnel and Infrastructure funds. In contrast, the outlook for its Capital Equipment purchases wasdisappointing, as some of the funding that had been set aside in the fiscal framework for procuring Capital equipment was removed.

A total of $3.7 billion in DND’s accrual space that had been set aside in the fiscal framework between 2015/16 and 2020/21 was removed and redistributed evenly between 2021/22 and 2044/45. The accrual space is a budgeting construct that had been introduced with the CFDS in 2008. It set aside a portion of DND’s budget to account for the annual amortization expenses associated with the purchases of major defence equipment.

The funding construct is somewhat analogous to a home mortgage in the sense that, for most Canadians, the purchase cost of your home does not count against your monthly budget, and instead only your mortgage payment does. To relate this back to the Capital Equipment funding dynamic, while the Bank (in this case Finance Canada) has to pay the seller in full for the cost of your house (or for DND, Irving or Seaspan for naval ships), you only pay the Bank your monthly mortgage payment (for DND, its annual amortization charges for the ships). While you might have the money set aside to pay your monthly mortgage payments, if your real estate agent can’t actually close a deal for you to buy a house, you don’t actually have to pay your mortgage (even though you could have, financially).

The 2016 budget made clear by publishing a table depicting both the previous and revised profile of the accrual space that this basic dynamic explains why DND could not use all the money set aside.

The CFDS created the accrual space construct for DND in 2008 on the premise the DND could immediately start recapitalizing all of its combat fleets. To make full use, right away, of all the accrual space set aside for this recapitalizaiton would have required several 10s of billions worth of purchases and delivery of major equipment, in just a few years. While some progress has been made, the full scope of planned reinvestment simply has not happened on schedule, because the procurement system cannot move the money fast enough.

As a result, the Department of Finance is moving the money into the future, not to prevent purchases, but because DND has been unable to buy equipment.

In doing so, the funding was redistributed evenly over the subsequent 25 years, increasing the annual budget allotment for Capital equipment. This will actually provide defence with a small degree of additional flexibility to account budgetarily for additional equipment purchases in future years.

The reaction to the defence portions of Budget 2016 has been largely pessimistic, particularly within the defence industry, due to the reprofiled Capital funding. The defence section placed by far the largest focus on that budget measure, understated the impact of the infrastructure and operational funding, and did not mention the escalator increase at all, so this reaction is understandable. This sentiment also likely reflects a widely held expectation that the Liberals would reduce defence spending. For those expecting that outcome, the Budget certainly lent itself to that interpretation.

The Future

It is impossible to know, at this point, what the future intentions are. This Liberal government inherited a situation where the procurement system remains unable to make full use of the funding available. Realistically, the new government could have done little to fix that situation in only five months in office. After all, the previous government was unable (or unwilling) to do so in the decade they were in power. Thus, the government may have been happy, or not, to remove this funding from the fiscal framework and punt it into the future. It does not seem as though they had much choice. Whether they choose to fix this situation to prevent it from happening again in 2018 will be the true test of whether they were happy to save the money in this budget, or actually would have preferred to spend it.

Dave Perry is the Senior Analyst of the Canadian Global Affairs Institute.

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