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Former Bank of Canada governor David Dodge in 2007.

Sean Kilpatrick/The Canadian Press

The federal government is underestimating the risks presented by a possible 2023 recession and prolonged high interest rates, says former Bank of Canada governor David Dodge, who warns the Liberals may have a hard time delivering on all their recent political commitments.

Finance Minister Chrystia Freeland has yet to set a date for the government’s 2023 budget, but she faces considerable uncertainty regarding the state of federal finances, as economists debate whether the Canadian economy will slip into recession. At the same time, she and her cabinet colleagues are negotiating a potentially multibillion-dollar deal to increase federal health transfers to the provinces.

The government is also under pressure to deliver an ambitious package of environmental incentives to compete with new programs announced last year in the United States through the Inflation Reduction Act.

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A new report co-authored by Mr. Dodge and released Monday by Bennett Jones and the Business Council of Canada says the government’s most recent fiscal forecast, in its Nov. 3 fall economic statement, now appears to be based on a “plausible but optimistic” set of assumptions about the economy and future interest rates.

The report says there is a “high risk” that the government will not be able to deliver on its spending promises, made in last year’s budget and in the fall update, while maintaining its existing fiscal track. The report presents various alternative scenarios in which the economy would slip into a full recession, the government would fail to curb spending as promised, interest rates would remain high or there would be a combination of all three things.

Under these scenarios, the government could be required to add tens of billions of dollars in new spending to meet its promises while dealing with higher-than-expected borrowing costs as a result of high interest rates.

“You’ve got to align what you’re promising with what you’re actually putting real resources behind,” Mr. Dodge said Monday in a briefing with journalists.

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Mr. Dodge, who is now a senior adviser at Bennett Jones, co-authored the paper with Richard Dion, the company’s senior business adviser. They collaborated with Robert Asselin, senior vice president, policy, with the Business Council of Canada.

Mr. Dodge argues the new interest-rate landscape revives budgeting challenges that finance ministers have not had to deal with in decades. He says the government should consider expanding its fiscal anchor to take into account the impact of higher debt servicing costs.

A fiscal anchor is a target that guides the government’s overall spending plans. While previous Liberal and Conservative governments have used balanced budgets as their targets – meaning they have sought to maintain a budget surplus or to erase the federal deficit by a specific date – the current government under Prime Minister Justin Trudeau has used a different target: the debt-to-GDP ratio.

The government’s official aim is to keep that ratio on a downward trend.

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Ms. Freeland’s fall economic statement forecasts a return to surplus in 2027-28, and says the country’s debt-to-GDP ratio will decline to 37.3 per cent by then, from 42.3 per cent this fiscal year. The update also illustrates a “downside scenario” in which the debt-to-GDP does not decline as sharply and the government’s books remain in deficit.

Monday’s report says that, in addition to focusing on reducing the federal debt-to-GDP ratio, the government should set targets for interest costs as a percentage of revenue. The report says this measure – known as an interest cost-to-revenue ratio, or IC/R – is currently about 7.8 per cent. The authors say if that ratio were to rise above 10 per cent and the federal debt-to-GDP ratio were not declining steadily, that would signal a risk that federal finances were unsustainable.

“The implication of our analysis of the federal 2022 budget as updated in the Fall Economic Statement is that there is a significant risk that both the debt ratio and the interest cost ratios exceed comfortable levels over the remainder of this decade, both because economic conditions will turn out to be more difficult than assumed in the FES 2022 and because the spending budgeted will turn out to be insufficient to achieve the policy goals promised,” the report concludes.