A memo to the Canadian Government
20 April 2024
Co - Contributors : Julian Greco, Sabyatha and Xintong Xia
Canada faces a pressing issue: rising debt servicing costs are eating into tax revenues, threatening the nation's fiscal stability. Drawing from empirical research and Canada’s fiscal challenges in the 1990s, we propose a strategy to stabilize debt servicing costs.
The 1990s Fiscal Crisis and Budget 1995
Since the 1970s, Canada's federal revenues lagged expenditures, leading to a persistent and growing deficit. Government debt soared from 18.4% of GDP in 1972 to 78.04% in 1994. The 1973 OPEC oil embargo triggered an energy shock, causing global economic slowdown and recession in the 1980s, further damaging Canada’s economy. The Bank of Canada’s steep rise in real interest rates to combat inflation resulted in higher debt servicing charges, eroding revenues and limiting fiscal capacity for growth.
Jean Chrétien’s Program Review in the mid-90s aimed to eliminate the federal deficit through restructuring and eliminating inefficient expenditures. Budget 1995 set significant spending reduction targets, leading to Canada’s first budget surplus in 28 years by 1997/98. Federal debt was reduced from 78.04% of GDP in 1994 to 39.15% in 2006. The success of Budget 1995 was due to its focus on cost reduction rather than increasing taxes, fostering capital investment and economic growth. This virtuous cycle of sustainable fiscal policy helped Canada better withstand the 2008 global financial crisis.
Signs of Runaway Debt in Canada
Recent data from Statistics Canada indicates that Canada has run a budget deficit for the past fifteen years. Combined federal and provincial net debt has doubled from $1.1 trillion to a projected $2.1 trillion in 2022/23. General government gross debt increased from 67% of GDP in 2007 to 107% in 2022, with federal debt interest rising from $24.5 billion in 2021/22 to $46.5 billion in 2023/24. The COVID-19 pandemic spike in government spending significantly increased the deficit, and subsequent inflation prompted the Bank of Canada to raise interest rates from 0.25% to 5.00%.
Without action to eliminate deficits and pay down debt, rising interest rates will further increase debt servicing costs as a proportion of tax revenue. Canada’s current economic situation resembles the challenges of the 1990s, necessitating a revisitation of historical lessons to avoid a looming economic downturn.
A Three-Pronged Strategy to Stabilize Canada’s Debt Servicing Costs
Tiff Macklem (1995) highlighted three channels through which government debt affects economic activity: aggregate demand and crowding out, tax distortions, and risk premia. Persistent and rising deficits lead to future tax increases, reducing household consumption and investment, lowering output growth, and increasing the risk premium on government debt.
Given the recent rise in borrowing costs and sluggish GDP growth, it is unlikely Canada can outgrow its debt. Debt service charges consume a larger portion of the budget, leaving little room for growth-enhancing investments. Stabilizing Canada’s debt servicing costs requires more than reducing the federal budget deficit to zero. The government must run budget surpluses and pay down existing debt. Here is our proposed three-pronged strategy:
Cut Spending and Restructure Pension Liabilities:
Adopt a structured “Program Review” targeting operational inefficiencies and redundant spending.
Reduce public health care expenditure by adopting best practices without compromising care quality.
Enact a temporary freeze or long-term growth limit on government worker salaries.
Reform pensions by raising the retirement age for CPP and OAS benefits to reduce outlays and boost GDP growth.
Implement Pro-Growth Tax Reform:
Shift tax revenue composition from personal and corporate income taxes to consumption taxes like the GST, which are less harmful to economic growth.
Address regressivity of consumption taxes through rebates and progressive transfers.
Implement Pro-Growth Regulatory Reforms:
Cut bureaucratic red tape to incentivize business formation and investment.
Commit to retiring one regulation for every new one added.
Harmonize overlapping regulations to reduce business costs.
Canada’s rising debt servicing costs pose a significant threat to fiscal stability. By drawing lessons from the 1990s fiscal crisis and adopting a three-pronged strategy, Canada can stabilize its debt servicing costs, foster economic growth, and ensure long-term fiscal sustainability.
Figure 1. Budgetary Balance
Figure 2. Canadian Government Debt
References
Federal Reserve Bank of St. Louis. "Total Public Debt for Canada (DEBTTLCAA188A)." FRED, Federal Reserve Bank of St. Louis, 2024.
M. Moss, "Oil and Gas and the New West," in Post-Confederation British Columbia: Chapter 8.10, Open Text BC, 2024.
T. A. Wilson, “Lessons of the Recession,” The Canadian Journal of Economics, vol. 18, no. 4, p. 693, Nov. 1985.
Fraser Institute, "The Budget That Changed Canada," Fraser Institute, 2024.
C.D. Howe Institute, "Title of the Document," C.D. Howe Institute, 2023.
Fraser Institute, "Federal Government Debt Interest Costs Nearly Double in Just Two Years," Fraser Institute, 2024.
Federal Reserve Bank of St. Louis. "Interest Rates, Discount Rate for Canada (IRSTCB01CAM156N)." FRED, Federal Reserve Bank of St. Louis, 2024.
Bank of Canada, "Estimating Potential Output in Real Time: A Practitioner's Guide with Application to Canada," Research Department Staff Analytical Note, no. 95, Bank of Canada, Ottawa, Canada, Jun. 2010.
RBC Thought Leadership, "Governments Face Higher Interest Costs When Straying from Fiscal Anchors," RBC Economics, Thought Leadership, 2024.
Department of Finance Canada, "Debt Management Report 2022–2023," Government of Canada, Ottawa, Canada, 2023.
Fraser Institute, "Canada's Aging Population and Long-Term Projections for Federal Finances," Fraser Institute, Vancouver, Canada, 2024.
I. Joumard, C. Andre, and C. Nicq, “Health Care Systems: Efficiency and Institutions,” SSRN Electronic Journal, 2010.
D. Sutherland, P. Hoeller, and R. Merola, “Fiscal Consolidation: How Much, How Fast and by What Means?,” SSRN Electronic Journal, 2012.
Government of Canada, "2023 Public Accounts of Canada," Public Services and Procurement Canada, Ottawa, Canada, 2023.
Tax Foundation, "What Evidence Tells Us About Taxes and Economic Growth," Tax Foundation, 2024.
The Hub, "Stephen Poloz: Here’s How to Increase Government Revenues Without Raising Taxes," The Hub, 2023.
Canadian Chamber of Commerce, "Death by 130,000 Cuts: Improving Canada's Regulatory Competitiveness," Canadian Chamber of Commerce, Ottawa, Canada, 2018.
Department of Finance Canada. "Annual Financial Report 2022." Government of Canada, Ottawa, Canada, 2022.
Statistics Canada, "Consumer Price Index, March 2024." Statistics Canada, 2024.
