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tax and spend

The former Bank of Canada at 10 Toronto Street, with its four Ionic columns, resembling a Greek temple, on Jan. 28, 1959.John Boyd/The Globe and Mail

Canadian soldiers were slowly fighting their way up the Italian peninsula, with the Normandy landings a year distant, when Ottawa last amassed debt at the rate it is now.

That year, 1943, Canada’s borrowing accelerated, part of a six-year spree to fight fascism that resulted in the national debt more than tripling. But over the three decades after the end of the Second World War, those massive debts shrank in relation to the economy. Pent-up demand, the start of the baby boom and the relative strength of manufacturing all helped the Canadian economy expand at a rapid clip year after year, and in the process, made the large debts of 1946 comparatively smaller.

Some economists, and media analyses, have pointed to Canada’s fiscal record in the postwar period as a reason not to be greatly concerned about the large and growing bills to fight the coronavirus. But a look back through Ottawa’s finances in the 1940s and 1950s shows that many of the factors that allowed the debt burden to fall so rapidly are either absent in today’s economy, or pulling in the opposite direction. Even with sustained economic good fortune, years of fiscal discipline were needed to tame the debt.

There was a lot of taming to do. In 1943, the ratio of debt to gross domestic product, roughly akin to measuring a household’s debt against its annual income, shot up to 54 per cent from 38 per cent the year before, on its way to a peak of 109 per cent in 1946, as the chart below shows.

Even with the heavy borrowing spurred by the coronavirus, Ottawa has not come close to matching that record. The forecast $343-billion deficit for fiscal 2020-21 will push the debt-to-GDP ratio to 49 per cent, up 16 percentage points from last year. It would take another four years of similar deficits for Canada’s debt burden to exceed the postwar peak.

Those debts began to recede quickly, at least as measured against the economy. By 1952, the debt-to-GDP ratio was below its pre-war levels, on its way to a nadir of 18.5 per cent in 1974.

For some economists, that experience is proof that today’s substantial (but relatively smaller) debts are not a great concern. “We know from the experience of World War II (when Canada’s debt-to-GDP rose above 100%) that we can emerge from a crisis and successfully manage high levels of government debt gradually while the economy grows,” argued economist Alex Hemingway in a policy note for the Canadian Centre for Policy Alternatives.

Mr. Hemingway and others make that point as part of a broader argument for higher spending and taxes, large deficits and much more federal debt in the next few years.

Yet, Ottawa’s experience in the postwar period points in the opposite direction. As the chart below shows, fiscal discipline played an important part in allowing the federal government to reduce its debt burden. Enormous wartime deficits evaporated as Ottawa demobilized the military, and returned the economy to a peacetime footing. For the next six years, the federal governments ran surpluses as the economy boomed. Even after deficits reappeared, they were relatively small. The reduction in the debt-to-GDP ratio slowed after the mid-1950s, but it did not stop falling until 1974, the end point of nearly three decades of fiscal discipline.

Mr. Hemingway notes that tax rates on corporations and individuals were much higher in the immediate postwar period than they are today. Yet, the size of the federal government shrank in the 1940s and 1950s (as measured by the ratio of revenues to GDP). High taxation was not the vehicle that reduced the debt burden, although maintaining rates at high levels may very well have helped.

Instead, relatively slow spending growth was key, as the chart below shows. Ottawa’s per capita spending, adjusted for the effect of inflation, shows that restraint. Unsurprisingly, per capita inflation-adjusted spending dropped sharply after the end of war, bottoming out in 1948. Spending then jumped in the next four years, in part because of increased military outlays as the Cold War took root and the Korean War broke out. But through the rest of the 1950s, per capita real spending barely budged – it had increased by less than 1 per cent by 1960. (But by the late 1960s, in the first administration of Pierre Trudeau, that spending restraint had begun to dissolve, setting the stage for large and persistent deficits through to the mid-1990s.)

Livio Di Matteo, a professor of economics at Lakehead University, says that many of the factors that drove the postwar expansion are absent today. North American manufacturing was in its heyday, trade liberalization was boosting exports and productivity, and the baby boom fuelled consumption. Today, protectionism is on the rise, and the aging of the baby boomers poses significant long-term problems for labour productivity.

Mr. Hemingway agrees that the parallels between the postwar era and today are limited, most notably because Ottawa won’t be able to depend solely on economic growth to reduce its debt burden. He says the federal government will need to “look at ramping up the revenue side.” Stepped-up enforcement against tax evasion, an annual wealth tax and higher corporate income tax rates are needed, he says.

Both economists say there is one similarity, at least, between Canada’s fiscal situation eight decades ago, and the present: low interest rates. Indeed, in its limited July fiscal update, Ottawa said its debt costs will be $4-billion lower than what it had forecast last December, even with hundreds of billions in additional spending, because of an expected long-lived drop in interest rates.

But Prof. Di Matteo warns of depending on low rates to keep a high federal debt burden under control, saying that as governments around the world continue to borrow heavily, interest costs are bound to rise. “At some point, the price of money has to come up. You can’t have free money forever.”

Tax and Spend is a weekly series that examines the intricacies and oddities of taxation and government spending.

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