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The Liberals have pointed to the falling cost of public debt this year as part of their reassurance that the large deficits forecast for much of this decade don’t present a long-term threat to Canada’s financial stability.

But that reassurance only goes so far.

In the economic update released on Nov. 30, the government said “historically low interest rates have ensured Canada’s debt is affordable and sustainable,” going on to note that public debt charges are projected to be more than $3-billion lower in the 2020-21 fiscal year than was forecast in the fiscal update in December, 2019, despite an estimated deficit of at least $381.6-billion.

While broadly correct, that assertion glosses over the fact that the biggest source of those savings on public debt costs has nothing to do with the interest the government pays on its market debt and instead stems from an accounting adjustment related to the pensions and benefits of federal civil servants. And the trumpeting of lower debt costs ignores the flip side of falling interest rates: large actuarial increases in the government’s liability for those pensions and benefits.

It is certainly true that there is broad agreement that this year’s decline in interest rates is likely to reverse only slowly and that, as a result, the costs of the government’s debts will be lower than previously forecast. In July, the government issued a forecast for fiscal 2021 as part of its limited update showing a sharp drop in public debt costs from previous estimates, shown in the chart below.

The outlook was broadly similar in the November, 2020 fiscal update, with public debt costs for fiscal 2021 projected at $20.2-billion, below the $23.7-billion forecast made in December, 2019. It’s that decline that the government was referencing when it talked about public debt charges being “more than $3-billion lower.”

The federal Parliamentary Budget Officer arrived at similar conclusions in an economic and fiscal outlook issued in September. Indeed, the PBO decided to assume lower interest rates than did the government from fiscal 2022 onward, resulting in lower forecasts for public debt charges in outlying years. For fiscal 2021, the PBO had a slightly higher projection, at $22-billion. But the overall picture is similar: Public debt charges decline in fiscal 2021 from the previous year and are well below the estimates in the December, 2019, fiscal update.

However, the PBO’s projections also make it clear that most of that decline does not result from lower interest payments on government bonds and other market debt. Rather, the majority of the decrease in public debt charges is driven by a decrease in “other debt charges.” For the most part, that category of other debt charges is an accounting adjustment made to the deflated cost of the government obligation to pay the pensions and benefits of federal civil servants in the future (which is called, appropriately enough, the future value).

But the government, using standard accounting principles, presents a calculation of its current liability for those pension and benefit payments years down the road, using what is called a discount rate to reduce the future value of those costs to a smaller present value. The higher the discount rate, the greater the reduction in that future value.

In essence, it is a compound-interest-rate calculation in reverse: If you want to have $1,000 in your bank account in 10 years, how much should you deposit today? The answer will depend on what you believe interest rates will be during those 10 years. If you assume that interest rates will be high, the amount you deposit today can be relatively small, since the principal will grow quickly. If you assume rates will be low, your initial deposit will have to be larger.

That logic holds true for the government’s pension and benefits obligations. A high discount rate makes today’s liability – the equivalent of an initial deposit – commensurately smaller, while a low discount rate means that the present value of the liability is larger.

Over time, that discount gets reversed. Each year, the government adds a bit to the discounted present value of its pension and benefit obligation to reflect the passage of time; eventually, the present value equals the future value. That yearly addition is what makes up those “other debt charges.” Even though it’s called an interest expense in the federal budget, it’s really an accounting adjustment; no dollars are paid out as a result.

But the size of that adjustment is very sensitive to the assumptions that the government makes about where interest rates are headed, stemming from the move three years ago to use prevailing long-term interest rates as the discount rate for the government’s unfunded pension liabilities.

If the projection for interest rates decreases, as was the case this year, then the present value of those liabilities increases. That also means that there is less of a gap between the present value of the liabilities and their future value. So, the annual adjustment also falls, since there is a smaller gap to make up.

As a result, projections for “other debt charges” should fall. The government would not provide a breakdown between market debt charges and other debt charges. But the PBO has produced its estimates of such a breakdown, which show that “other debt charges” account for just over three-fifths of the overall decrease in public debt charges (as shown in the chart below). Market debt charges, or the interest payments made on government bonds and other instruments, accounted for just under two-fifths.

The PBO’s forecast has public debt charges declining to $21-billon in fiscal 2022, in line with the government’s projection of $20.3-billion. According to the PBO forecast, however, market debt charges will rise by $1.5-billion, edging up to $17.2-billion that year from $15.7-billion in fiscal 2021. That rise is more than offset by the $2.5-billion decline in other debt charges. The same pattern holds in fiscal 2023, with market debt charges rising but the overall cost of public debt charges declining.

Parliamentary Budget Officer Yves Giroux said he believes that the government’s characterization of public debt charges is fair, since those who are aware of the intricacies of discount rates and government accounting standards understand that there is a distinction between public debt charges and market debt charges. But he acknowledges that the distinction is likely lost on the general public. “I don’t think it’s clear at all,” he said.

For the moment, the assumption that falling public debt charges simply mean less interest paid to bondholders could benefit the government, to the extent it eases worries about Canada’s debt burden. But Alexandre Laurin, director of research at the C.D. Howe Institute, sounded a cautionary note, saying that any uptick in projected interest rates would reverse that dynamic, with large increases in “other debt charges” magnifying a less-pronounced rise in market debt charges. At that point, the government would be left to make the case that its actual interest expenses were smaller than its public debt charges.

“The debt charges do look really small,” he said. “But they can increase really fast too.”

Tax and Spend examines the intricacies and oddities of taxation and government spending.

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