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analysis

Canada’s Deputy Prime Minister Chrystia Freeland addresses a crowd at the Empire Club of Canada in Toronto on June 16.Cole Burston/The Canadian Press

The Tax and Spend newsletter will return on July 11

In the run-up to the Allied invasion of Normandy in 1944, U.S. General George Patton was assigned to command a phantom army in the southeast of England, complete with plywood trucks and tank-shaped balloons.

It was an elaborate ruse designed to confuse enemy aerial reconnaissance and deceive the Germans into thinking a large force was being assembled to invade the Pas-de-Calais.

The politics of Canada’s defence spending are a little bit like Gen. Patton’s phantom army: Often a lot is made of comparatively little.

Ottawa has, in recent years, taken some small steps in that direction, but it has also used accounting moves to inflate the importance of those actions. That phantom effort takes place against the backdrop of continued pressure from the U.S. for Canada (and other NATO countries) to boost defence spending to the agreed-upon threshold of 2 per cent of each country’s national economy.

That pressure intensified during the Trump administration and has continued, although in less aggressive terms. U.S. Senator Dan Sullivan called this country a freeloader last month, and U.S. ambassador David Cohen described the $8-billion boost to defence spending in the April budget as a “little disappointing.

Defence Minister Anita Anand crisply outlined the Liberal government’s position in a news conference last week in Trenton, Ont., as she unveiled details of increased funding for continental air defence. She pointed to three moves: a 70-per-cent increase in spending under the 2017 policy Strong, Secure, Engaged; $8-billion in additional funding in the April budget; and an additional $4.9-billion over six years for NORAD modernization.

Ms. Anand misspoke on that $4.9-billion; as her office quickly noted, those funds were included as part of the extra funding in the budget, and were not in fact an additional increase.

But that slip-up isn’t really the problem. The bigger issue is the Liberals’ insistence on refusing to commit to meeting the 2-per-cent goal, and in using superficially impressive accounting in an attempt to create the impression that they are serious about boosting defence spending substantially.

To begin with, there is the putative 70 per cent. It’s true that the 2017 defence policy included an increase in spending to $32.7-billion in fiscal 2027 from $18.9-billion in 2017. But that is an increase over 10 years; throw in the effect of inflation and that 70-per-cent figure becomes much less impressive. On top of that, procurement delays have pushed billions of dollars in spending into later years, the Parliamentary Budget Officer has noted.

Then there are the accounting adjustments Canada made in 2017 that pushed up the proportion of GDP spent on defence. Those changes, allowed under NATO accounting rules, wrapped in the cost of military pensions and military-related spending from ministries outside of Defence. Without those changes, defence spending as a percentage of GDP would have barely budged during the Liberals’ time in office through to 2020. Virtually all of the progress since 2014 toward meeting NATO’s target of 2 per cent can be ascribed to that accounting change.

And lastly, there is the $8-billion in higher defence outlays in the April budget. That’s real money, to be sure, although the U.S. ambassador did venture that the increase was less than impressive when set against the lofty rhetoric from the government before the budget.

Even for those added funds, there are question marks. Some of the $4.9-billion for NORAD modernization will be spent on quasi-military ventures such as a science and technology centre; the government has not yet provided a detailed breakdown.

Despite the acknowledgment of the immediacy of the strategic threat posed by next-generation intercontinental missiles, the Liberals’ spending plan is no blitz: Nearly half of the $4.9-billion is to be spent in the sixth year; together, the fifth and sixth years account for more than three-quarters of the NORAD outlays.

And then there is the ever-present stumbling block of procurement. Ms. Anand insisted last week that her department is making progress. It will need to; the PBO has already flagged the possibility of even more delays as spending plans outstrip domestic procurement capacity.

Without significant improvement on that front, even Ottawa’s circumscribed boost to military spending could end up just being reinforcements for a phantom army.

Taxing questions

Responding to last week’s Tax and Spend on the federal Liberals’ plan to help ease the financial pinch from surging inflation, one reader wondered about the effect of rising interest rates on the federal government’s debt – and when the Liberals will start talking about paying it off.

Rising interest rates do increase Canada’s debt servicing costs, but that effect is relatively small, particularly on an accounting basis. The April budget contains a sensitivity analysis that details the fiscal ripples resulting from a rate increase. An increase of one percentage point in interest rates would add $5.1-billion to the deficit (or reduce the surplus, if ever there were a surplus) in the first fiscal year. That extra cost would rise to $5.9-billion in the second year, and to $6.9-billion by the fifth year. That’s a net expense, reflecting both higher debt servicing costs as well as the small revenue boost Ottawa would get on its interest-bearing investments.

However, that net expense does not include what would be a large positive impact from rising rates: the cost of the federal government’s pension obligations for its employees. Higher rates mean that the estimated cost of future pension payments is lower. That is an accounting adjustment, but it still means billions of dollars in lower projected expenses, offsetting the rise in debt servicing costs initially.

Even without including pension savings, there is only a relatively modest rise in debt costs for a net federal debt exceeding $1.3-trillion. Part of the reason: The federal government moved to lock in the low rates of 2021 by issuing longer-term debt instruments.

As for when Canada might pay off the debt, that is unlikely to happen, at least under the Liberals. True, Finance Minister Chrystia Freeland did appear to say the opposite in her speech last week to the Empire Club of Canada. “Our pandemic debt must—and will—be paid down,” she said.

However, it’s clear that Ms. Freeland was actually referring to shrinking the size of the debt relative to the size of Canada’s economy (a task made easier by galloping inflation). What she calls the government’s fiscal anchor isn’t too much of a constraint: just a commitment to keep the ratio of net federal debt to GDP on a downward trajectory. Ongoing deficits, and a rising dollar value of debt, are consistent with that anchor. Paying off or paying down the debt – if the plain meanings of those words are used – is unlikely under the current government.

Line Item

In-the-red rankings: Canada was second only to Japan among 33 industrialized countries in running up the national debt during the pandemic, but had only middling economic growth to show for it, says a new study from the Fraser Institute.

The Fraser study uses gross national debt (which excludes the assets of the Canada Pension Plan and Quebec Pension Plan) rather than the federal government’s preferred measure of net debt. Canada’s ratio of gross debt to gross domestic product jumped to 112.1 per cent in 2021 from 87.2 per cent in 2019. Meanwhile, Canada placed 24th out of 33 countries for GDP growth in 2020, and performed only slightly better in 2021, with a 22nd-place ranking.

Of course, those two statistics are intertwined: if economic growth had been higher, the debt ratio would not have risen as much.

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