Projections of Federal Fiscal Sustainability in Canada

The planned levels of deficits and debt in the latest budgets of the federal and four provincial governments are reasonable projections for the years to FY 2023-24, if governments actually adhere to the spending and revenue plans laid out in those budgets.

Whether these fiscal plans are sustainable over the medium term is clearly questionable for all governments, especially for the federal government. In this supplement to the Bennett Jones Spring 2021 Economic Outlook, we examine the fiscal sustainability issue for the federal government in detail against two key criteria:

1. The debt/GDP ratio should be on a clear downward track over time based on prudent assumptions for future productivity and labour force growth, and for future interest rates which determine costs of debt service.
2. Annual program spending should be restrained so that the projected ratio of debt service costs to revenues (including any tax rate changes) does not rise above 10%, again based on prudent projections for future productivity and labour force growth and for future interest rates.

In order to understand the medium-term fiscal implications for the federal government, we provide projections for key federal fiscal parameters to the end of the decade under three economic scenarios.

The first scenario (Table A.1) is built on the economic and financial projections to FY 2025-26 contained in the Budget documents, extended under "optimistic" assumptions to FY 2030-31. Key to this projection are:

1. robust real economic growth of 1.8% per year from 2025 to 2030;
2. inflation at 2% resulting in nominal revenue growth of 3.8% after 2025;
3. federal revenues over-optimistically rising to 15.3% of GDP after 2024 with no tax increases;
4. the 10-year Government of Canada interest rate rising slowly from 1.5% in 2021 to 2.7% by 2025 and stabilizing at that level thereafter); and
5. nominal program spending growing at 3% per annum in 2025-26 and thereafter.

Under this "reasonably optimistic" projection, deficits would stabilize at about 1% of GDP in the second half of the decade, the ratio of public debt charges to revenue would rise to about 10% by 2030-31 (column 5), and the ratio of debt to GDP would fall slightly from a peak of about 51% in 2021-22 to 45% by 2030-31 (column 6). Under this reasonably optimistic scenario, real per capita spending (in 2012 dollars) would fall slightly each year from the level implied by the budget of $8,492 in 2023-2024 to $8,278 by 2030-31 (column 3), thus leaving no fiscal room for extension or expansion of the new programs currently being put in place over three years. With this scenario, the federal fiscal framework would, in our view, probably be sustainable in that the ratio of public debt charges to revenues does not significantly exceed 10% and the debt/GDP ratio is on a downward track year after year. Note that this sustainability rests on a future policy combination of no planned increase in taxes and a small but steady decline in real per capita spending after 2023-24.

 

The second scenario is built on a more prudent economic scenario from 2024 to the end of the decade (Table A.2). Key to this scenario is weaker productivity and hence only 1.5% real per annum growth which, combined with 2% per annum inflation means an average nominal growth of only 3.5% over the period after 2024. Revenue to GDP ratio would hold constant at 14.9% to 2030-31 with no tax changes, so that revenue growth would also be constant at 3.5% per annum after 2024. Under this scenario, the 10-year bond rate would rise to 3.5% by 2025 and, pessimistically, stay there to 2030. With the 10-year bond rate roughly equal to the growth rate of revenues, as it was in the 1990s, the ratio of public debt charges to revenues steadily rises over the second half of the decade reaching over 14% by 2030-31 (column 5). With nominal spending assumed to grow at the same rate of 3% in the second half of the decade as in the first scenario, real per capita spending falls to $8,278 as in the first scenario (column 3). Unlike the first scenario in which the budget deficit slowly falls to a little over $20bn by 2030-31, in this scenario the deficit rises to over $60bn and the debt/GDP ratio (column 6) remains nearly constant at roughly 50% as additional borrowing is required to plug the gap caused by slower economic growth and higher interest rates.

 

Fiscal policy, in this second more prudent scenario, would not be sustainable over the longer run since the ratio of debt service cost to revenues would have risen well above the sustainable benchmark of 10%, and the debt/GDP would be constant at the high level of 50%. Note that the situation would be even more unsustainable if spending growth were not to be controlled (as in the previous scenario) to ensure that real spending per capita falls slowly during the second half of the decade from its 2023-24 level of $8,492 to $8,278 by 2030-31.

Neither of our projections are forecasts of the future. The evolution of actual economic performance and interest rate developments will be much more volatile than these scenarios suggest. For planning purposes, the average growth rates or median levels of interest rates over the 2024-30 period provide reasonable upper and lower indicators of the likely fiscal outcomes over the decade if, and this is a big if, the federal government constrains average nominal spending growth to 3% after 2024 and maintains the tax regime set out in the Budget.

Since it is doubtful that any federal government would be able to govern from 2024 to 2030 while delivering continuous year after year reductions in the level of real per capita spending, we have constructed a third scenario based on the same economic assumptions as the second scenario but holding real per capita spending constant at 2022-23 levels and raising taxes to achieve a revenue/GDP ratio of 16.5% (Table A.3). This could be achieved by roughly doubling the GST or imposing something like a 25% surtax on personal income or any other equivalent combination of tax increases. We do not suggest that such tax increases are desirable from an economic or social policy perspective nor that maintaining real per capita spending is necessarily desirable. However, what this third projection does indicate is the magnitude of tax increases that would be required just to sustain real per capita federal spending at the 2022-23 level implied by the budget while assuring, based on prudent economic projections, more or less sustainable federal finances.

 

From our analysis of these three scenarios, we conclude that the federal fiscal framework is unlikely to be sustainable if it is judged against a prudent projection of growth and interest rates. Even if economic growth and the revenue yield turn out to be as strong after 2023 as the budget implicitly projects, without tax increases sustainability can only be achieved if real spending per capita is reduced and the government's ambitious spending plans for its own programs scaled back.

Sustainability of National Finances

This leaves open the question of federal transfers to the provinces for health care which receive no mention in the federal budget. At some point, if Canadians’ expectations are to be met, the rising operating and capital costs for health care are going to have to be met from provincial budgets. In examining the four provincial budgets we observe insufficient increases in planned spending to meet current operating costs of the health care system, little additional planned capital spending on health care infrastructure and little additional operating or capital spending to improve the unacceptable conditions in long-term care facilities. We also see no indication in provincial operating budgets of an increase spending on child care to match the federal initiative. Finally, our examination of provincial capital budgets reveals only limited investment in the ecosystems required to facilitate adaptation to climate change, to produce the capital goods required for the production of clean energy, e-vehicles and transport networks, or for the digitalization of production of both goods and services. Our close examination of the budget of the province of Ontario revealed that planned real spending per capita is slated to decline year after year. In particular, our analysis of real operating spending on health care on an age-weighted per capita basis reveals a decline of almost 2% per year between 2021-22 and 2029-30. This spending projection is simply unrealistic. Additional revenue will be required either from provincially levied taxes or from federal transfers to fund a realistic health care budget. Neither the provincial nor federal governments make provisions for significant tax increases to boost revenues. Collectively, federal and provincial governments must publicly acknowledge that if the quality of public services (including income transfers) is to be even maintained, let alone improved or expanded, tax increases will be required.

For national public finances to be sustainable, federal and provincial budgets should be based both on realistic spending projections to meet public needs and on realistic revenue projections from the taxes they are willing to levy. To be sustainable, budgets should provide plans which achieve a downward track in the currently high debt/GDP ratio and keep the projected ratio of debt service costs to revenues at no more than 10%. These are the key parameters for fiscal sustainability, which we conclude that neither the federal nor most provincial governments are fully meeting.  

In the long run, fiscal sustainability depends on economic sustainability, which in turn depends on productivity growth. Productivity growth requires investment. Thus, high levels of government borrowing and rising debt may in fact be sustainable over time only if that borrowing is undertaken to make productivity-enhancing investment. This is the key issue which we address in the closing chapter of our Spring 2021 Economic Outlook.