The federal government has not hit a debt wall, yet.
But that wall may have come into view, with the Parliamentary Budget Officer issuing a sobering analysis in late September that shows how narrow a path Ottawa will need to walk to keep the country’s deficit and debt on a sustainable trajectory.
First, the good news. The PBO says that even with the massive spending of the past seven months, the federal government’s finances are in solid enough shape that the ratio of net federal debt to gross domestic product will gradually fall after fiscal 2022-23, as the chart below shows. That means fiscal policy is sustainable over the medium term, the PBO says.
That’s pretty much the end of the good news, because the PBO’s assessment depends on four critical factors all tumbling in Ottawa’s favour. If they don’t, the federal government could be headed to a repeat of the 1970s, when the growth in debt outstripped economic expansion, resulting in debt charges eating up an ever-larger chunk of spending. Canada hit a debt wall two decades later, when Ottawa was forced to significantly curtail spending to get debt costs under control to placate ratings agencies.
“There is a limit to how much governments can borrow, but these limits aren’t known in advance, it depends a lot on market confidence,” Parliamentary Budget Officer Yves Giroux says.
No second wave
The PBO’s conclusions depend in part on there not being a second wave that results in a lockdown or other measures that would impair economic recovery. The agency has built a “slow burn” scenario into its calculations, under which the pandemic would continue for 12 to 18 months, but a vaccine would be developed and be made widely available. The agency prepared its assessment before the sharp uptick in coronavirus cases this month. But Mr. Giroux said in an interview that the situation does not cross the threshold for a second wave.
Low interest rates for years
The interest costs on the national debt are actually projected to fall this year, despite the record $328.5-billion deficit that the PBO projects for this fiscal year. The Bank of Canada’s steep cut to its benchmark rate, along with other measures, has driven down those debt-servicing costs. Indeed, the Liberals have pointed to those low interest rates as a rationale for continued spending.
The PBO assumes that today’s ultralow interest benchmark rate of 0.25 per cent will persist for three more years, through to the end of 2023, and that the Bank of Canada will continue its intervention in bond markets. Over the following two years, the agency is projecting that the Bank of Canada rate will rise only gradually, to 1.25 per cent by the end of 2025. Because of the increased size of Canada’s debt, however, even a relatively small increase in interest rates will add billions to the yearly deficit. An increase of an additional percentage point, to 2.25 per cent, would still leave interest rates at the lower end of what the Bank of Canada calls a “neutral” level, which keeps economic output at its potential and inflation within the central bank’s target.
If the PBO is off by that one percentage point, the deficit would rise by $3.2-billion in 2024-25 and $4.7-billion in 2025-26, an indication of how quickly pressure can build on debt-servicing costs.
No exodus from the work force
In the early days of the pandemic, labour force participation rates for men and women fell sharply as the virus and lockdown sparked mass layoffs and some voluntary departures. Since then, participation rates have rebounded, but for women, there’s still a gap. The PBO is assuming that this is a temporary phenomenon, and that concerns over the safety of child care and schools won’t have a lasting impact on women’s decisions, especially, to return to work.
Ottawa reins in spending
Perhaps the biggest assumption by the PBO is that the Liberal government will return to prepandemic levels of spending rapidly, once the coronavirus is vanquished, as the chart below lays out.
But that scenario assumes that the agenda laid out in the Speech from the Throne last month doesn’t add to permanent program spending. Child care, green initiatives, a modernized employment income support program: All would be continuing and costly. And each would be a step off the path of fiscal sustainability.
Mr. Giroux concedes that it is unlikely that the government will in fact snap back spending and forswear any big-ticket outlays. “We all know it’s not going to happen,” he said.
Mr. Giroux declined to speculate on how the government might offset billions in new spending to keep a lid on debt costs, but did say that an unexpected surge in oil prices, the early arrival of a vaccine or a faster-than-forecast economic rebound could give Ottawa more fiscal breathing room.
Walid Hejazi, a professor of economic analysis and policy at the University of Toronto’s Rotman School of Management, said the government could give itself fiscal manoeuvring room through focusing any new spending on boosting productivity, rather than on income-support programs, as well as a bold deregulation agenda. But he said it is unlikely that the left-of-centre Liberals will embrace such a program.
Prof. Hejazi and other economists point out the obvious: Higher spending means the Liberal government will need to hike taxes, and not just for the wealthy.
“They need to tell people there will be a broad-based tax increase,” said Jack Mintz, president’s fellow at the School of Public Policy at the University of Calgary.
Kevin Page, president and CEO of the Institute of Fiscal Studies and Democracy, agreed that revenue increases should accompany a permanent rise in spending (as opposed to short-term economic stimulus spending).
He said an increase in payroll taxes should be avoided, but a tax aimed at the wealthy or an increase in the GST are both viable options. Another possibility would be to continue to increase the federal carbon tax and spend that revenue, rather than recycle the majority to consumers.
He warned that major new spending without counterbalancing tax increases would undermine lenders’ confidence in the federal government. “It would raise alarm bells for the bond-rating agencies.”
Tax and Spend is a weekly series that examines the intricacies and oddities of taxation and government spending.
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