What the Federal Economic Statement Did Not Highlight

 

Well, the Federal Fall Economic Statement for 2023 is out and soon to be relegated to the collections of fiscal and economic history.  There is a lot out there summarizing the economic and fiscal situation facing the federal government. Briefly, for 2023-24 it looks like revenues of $456 billion and expenditures of $489 billion for a deficit before actuarial losses of $32.5 billion and a deficit with actuarial losses of $40 billion.  Inflation this year will be about 3.8 percent and next year the outlook is for 2.5 percent while real GDP growth in 2023 is now forecast to end up at a lower 1.1 percent and for next year at a paltry 0.4 percent.  On the bright side, there are measures to create more housing, but they add up to perhaps 300,000 homes by 2031 which given the country apparently needs 3.5 million means the housing shortage is going to be around for some time to come. 

 

Two things the numbers on the fall statement do not highlight.  First, when one factors in population growth going forward at about 2.5 percent annually and the government's inflation and GDP growth forecasts, real per capita GDP is going to continue declining over the next five years.  As Figure 1 shows, by 2028, inflation adjusted output per person by 2028 will be lower than it was in 2014.  Given the anemic business investment in Canada and the resulting weak productivity performance of the Canadian economy and its inability to grow faster than population, falling real GDP per person means a declining standard of living.  We are looking at essentially a lost decade or more if nothing happens to ramp up growth.

 

 

 

Second, a fiscal anchor or guardrail set as a deficit to GDP ratio of 1 percent means that there will be perpetual deficits for years to come of at least 30 billion dollars.  Put more starkly as Figure 2 illustrates, federal revenues and expenditures will continue to grow in tandem like ships traveling alongside in the night but never actually meeting.  This will result by 2028 in a net federal debt of almost $1.5 trillion and debt service costs of about $60 billion annually which as a share of federal revenue will account for about 10 percent of revenue.

 

 

 

Needless to say, it is not surprising that these types of projections are not front and centre from the perspective of a government facing slowing growth and rising spending.

Interest and Debt

 

Wednesday's Bank of Canada rate increase reminds us once again that the era of cheap money is over not just for consumers and business but also governments. One of the notable features of the pandemic response in Canada was the enormous amount of federal fiscal stimulus injected into the economy.  Federal spending rose from $363 billion in fiscal 2019-20 to reach $639 billion in 2020-21 – an increase of 73 percent.  It then began to subside going down to $480 billion as reported in Budget 2023 but is set to resume an upward trend and reach $556 billion by 2027-28.  As of the 2022-23 fiscal year, federal spending is 37 percent higher than going into the pandemic meaning an average annual increase in spending of about 12 percent.  This has been funded by deficits which in turn have increased the federal net debt dramatically going from $813 billion in 2019-20 to $1.3 trillion by 2022-23 and is expected to reach just over $1.4 trillion by 2027-28.

 

The long-term implications of this spending and debt surge are of course debt service costs. As a result of recent interest rate increases, they are about to become in nominal terms the largest, they have ever been.  Using data from the federal Fiscal Reference Tables and Budget 2023, Figure 1 plots both the total annual amount of federal debt charges paid as well as the annual percent increase for the period 2000 to 2022 and then as forecast until 2028.  What is evident at a glance is that until 2021, annual debt charges had been on a downward trend falling from nearly $44 billion in 2011 to $20.4 billion in 2021.  Since then, they have soared growing 20 percent in 2022 and forecast at 41 percent and 27 percent growth in 2023 and 2024 respectively before subsiding.  Indeed, by 2028, annual debt service costs are anticipated under the current forecast to reach over $50 billion which surpasses even the peaks reached in the 1990s. 

 

 

 

Now of course, as a share of total federal government spending, these debt charges may seem less alarming as at less than ten percent of total expenditure, they are modest relative to peaks of nearly 30 percent or more in the 1990s and 1930s. However, it should be noted that the share of total federal government spending going to debt service more than doubled between 2021 and 2023 rising from 3.2 to 7.2 percent and is expected to keep rising to just over 9 percent by 2028.  Nothing to worry about you might think?  However, it all depends on what happens to interest rates.  The fact remains that not surprisingly there is a strong correlation between the growth rate of federal debt charges and the effective interest rate on the net federal debt.

 

 

 

Figure 2 plots the annual percent change in federal debt charges against the effective interest rate on the net debt since 1867 (calculated as debt charges divided by net debt) using data from A Federal Fiscal History, the federal Fiscal Reference Tables and Budget 2023.  With a linear trend fitted, there is a definite positive correlation that has a bigger impact than you might think.  On average, a one percentage point increase in the rate of interest is associated with a nearly two percent increase in debt charges.  Given such sensitivity, it is not a surprise that debt charges have doubled since 2021.  And the current situation is anything but average given the enormous stock of nominal debt meaning that even with the staggering of long-term government bond debt issue, small interest rate increases can have large increases in government debt interest costs.  Moreover, with the anemic real GDP growth forecasts and an increase in interest rates, the long-term sustainability of the federal fiscal position becomes more of an issue.  We are in for interesting times.

Revisiting the Federal Finances

 

In the wake of the Federal 2023 spring budget, it is useful to take a look at the historical picture to see how the present and the immediate projected future fits into the long-term pattern of federal spending.  The key defining issue of recent public finance and government spending was of course the pandemic and the enormous amount of federal fiscal stimulus that was injected into Canada’s economy.  Federal spending rose from $363 billion in fiscal 2019-20 to reach $639 billion in 2020-21 – an increase of 73 percent.  It then declined reaching $480 billion as reported in Budget 2023 but is set to resume an upward trend and is expected to reach $556 billion by 2027-28.  As of the 2022-23 fiscal year, federal spending is 37 percent higher than going into the pandemic meaning an average annual increase in spending of about 12 percent.  This has been funded by deficits which in turn have increased the federal net debt dramatically going from $813 billion in 2019-20 to $1.3 trillion by 2022-23 and expected to reach just over $1.4 trillion by 2027-28.

 

A key feature of the pandemic is what appears to be a dramatic reversal of the decline in federal program spending as a share of Canada’s GDP – the so-called “federal fiscal footprint”.  Figure 1 uses data I compiled for my 2017 federal fiscal history with updates from the federal Fiscal Reference Tables and Budget 2023 to look at the program expenditure to GDP ratio for Canada from 1867 to 2022 and then projected forward to 2028. Fitting a simple linear trend shows that over time, there has been an expansion of federal program expenditures relative to GDP rising from about 5 percent in the 1870s to about 15 percent by the 1980s and with the COVID expenditure bump approaching 17 percent. 

 

 

 

Of course, there have been ebbs and flows around this linear trend with notable spikes during WWI and WWII.  It is noteworthy that the COVID spending spike represents the second highest federal program expenditure to GDP share with World War II as the highest.  After the spike and drop of the war era, the post WWII period saw a gradual rise in the federal fiscal footprint that saw it rise from about 10 percent in 1948 to peak at nearly 19 percent in 1982 and then decline, reaching 11 percent by 2000.  Since 2000, it has risen with a spike in 2021 at the height of the pandemic that brought the program expenditure share of GDP to 23 percent.  It has since declined to about 15 percent.  However, going into the pandemic it was just under 14 percent, up 1 percentage point since 2014 and the forecast of 15 percent means the federal footprint has returned to the size it had in the late 1970s to mid 1980s. 

 

Of course, we all know what happened after that.  There was a rise in the federal debt as a result of accumulated deficits and high interest rates that at first squeezed out program spending – note the decline into the 1990s even before the federal fiscal crisis – and then of course the transfer cuts and program expenditure reductions of the federal fiscal crisis. This of course makes the role of debt charges and interest rates of particular interest and Figure 2 plots two series: federal government debt charges as a share of total federal government expenditures and the effective interest rate on the federal net debt (defined as debt charges divided by net debt).  

 

 

 

The period from 1870 to WWI saw a decline in interest rates and not surprisingly a decline in the debt charge share of federal spending.  What surprises most people is that as a result of all the provincial debt the federal government took on at the dawn of Confederation, about 30 cents of every federal dollar of expenditure was going to service the debt in 1867.  Spending on nation building infrastructure such as railways saw debt levels and debt charges accumulate in the 1870s and 1880s but then came the great boom of prairie settlement after 1896 .  World War I saw an accumulation of debt and a rise in interest rates and with the budgetary and economic shocks of the Great Depression, debt charges as a share of total federal spending remained at over 25 percent.  Indeed, there is probably an interesting economic history thesis in explaining why there was a federal fiscal crisis in the 1990s but not the 1920s. 

 

The post WWII era saw a rise in interest rates that surpassed even the rise of the pre-WWI era and as significant budget deficits and debt began to accumulate after the mid-1970s, debt charges as a share of total spending began to rise.  However, with the positive budgetary balances of the post fiscal crisis era as well as the decline in interest rates, both interest rates and federal debt charges as a share of total spending hit historic lows.  In 2021, federal debt charges as a share of total federal spending was just below 5 percent and the effect interest rate on the net debt was about 1.8 percent.  Those numbers will be ones for the economic history books in the years to come as the debt service share of federal spending approaches 10 percent and the effective interest rate is just under 4 percent.  At least, that is what is currently forecast.

Federal Finances and Fiscal Projections

 

The Federal Fall 2022 Economic and Fiscal Update is now economic history and for 2022-23 it projects budgetary revenues of $446 billion, program expenditures of $438 billion, public debt charges of $35 billion, a deficit (including net actuarial losses) of $36 billion and a net federal debt of  $1.283 trillion.  By 2027-28, revenues are expected to rise to $542 billion with total expenses including actuarial losses of $537 billion meaning that a budget surplus is anticipated within five years. 

 

While total spending in 2022-23 is actually down from 2021-22 as a result of the COVID-19 unwind, it remains that compared to spending in 2018-19 of $346 billion just prior to the pandemic, "reduced" federal spending in 2022-23 is expected to be one third higher and projected to rise to $487 billion in 2023-24.  In other words, over a five-year period, the federal fiscal footprint after the COVID-19 unwind expanded at an average annual growth rate of 8 percent.

 

Despite the economic uncertainty currently present with respect to inflation, interest rates and the potential of a recession, the federal forecast is remarkably upbeat with both its  ‘downside’ and ‘upside’ forecasts for growth, unemployment, and the federal finances remarkably close to one another.  This of course means that the deficit forecasts that range from $36 to nearly $50 billion are also in a sense somewhat optimistic and hinge on economic conditions and in particular the impact of any downturn on federal revenues.  When it comes to forecasting the fiscal future, the greatest source of uncertainty is apparently not on the expenditure side – which is more in the hands of the federal government – but the revenue side which is in the hands of the economy.

 

A case in point is illustrated in figure 1 which presents federal estimates for revenue and expenditure for the 2021-22 fiscal year starting with the spring budget pf 2021.  What is remarkable moving forward to the final numbers for 2021-22 as released in the public accounts and also presented in the Fall 2022 update is the remarkable stability of the expenditure estimates and the constant revisions on the revenue side.  Compared to the initial budget forecast in 2021, expenditures went down slightly from $497.6 billion to $493.3 billion by fall 2022 – less than 1 percent variance.  On the other hand, revenues appear to have been significantly underestimated as the economy did better than expected and inflation helped pump up federal revenues from an original estimate of $355 billion to $413 billion – a 16 percent variance.  As a result, the deficit estimate also fell from $143 billion to eventually $90 billion.  This was not the result of fiscal restraint – expenditures stayed pretty much stable.  It was purely from the revenue surge.

 

 

 

Why does this matter?  What goes up can also come down.  Expenditures over the next five years are projected to rise steadily recession or not and one suspects based on past performance that barring a sudden policy shift those estimates will be close to the mark.  Meanwhile, while revenue growth is a function of the economy.  The economy rebounded better than expected and as a result revenues did too. However, while revenue was underestimated over the last couple of years, it could easily be overestimated going forward which means the optimistic deficit reduction scenario with a surplus by 2027 is as uncertain as economic forecasting in general.   

 

Despite the public pronouncements that there is now more frugality at the federal level, that is not the case.  The federal government is projecting average annual revenue growth from 2023 to 2027 at an average of 4.7 percent while expenditures (after the drop in 2022-23) will rise at 2.6 percent.  The federal government is banking on the revenue surge of the last couple years to continue and keep revenues growing faster than spending.  A severe recession could upset that optimistic projection.

Redesigning Representation in Northwestern Ontario

 

In the wake of every Canadian Census, there is a redistribution of populations and representations for federal elections and the current census is no exception.  Much to the angst of many, the Federal Electoral Boundaries Commission is recommending the Kenora riding be merged into Thunder Bay-Rainy River, creating a new and more widely spread-out Kenora-Thunder Bay-Rainy River. riding  A new riding of Kiiwetinoong-Mushkegowuk has also been proposed to represent Ontario’s far north while Thunder Bay-Superior North remains relatively unchanged under the proposal. 

In the end, the ten federal northern Ontario ridings would go down to nine as Algoma-Manitoulin-Kapuskasing in the northeast is going to be eliminated and split between two neighbouring ridings. While its provincial representation for northern Ontario has been fixed for some time at eleven seats, there is fear that this decision may also be reversed down the road in the wake of these federal proposals thereby also weakening representation at the provincial level.

To provide a cohesive and distinct representative voice to the part of Ontario approximately north of 60 – which one thinks is part of the intent of this proposal - the result is somewhat lopsided ridings in Northwestern Ontario in terms of population.  The Kenora-Thunder Bay-Rainy River riding seems to clock in at about 101,000, Kiiwetinoong-Mushkegowuk at just over 36,000 and Thunder Bay-Superior north grows a bit to 99,035.  Given the competing needs to ensure adequate representation that considers geographic spread, low population densities and population size, the Federal Electoral boundaries commission no doubt feels this is a suitable compromise to deal with the exceptional circumstances of the Far North of Ontario.

In the end, northern Ontario  is the victim of a changing population distribution given that its population is growing more slowly than the rest of the country.  Over the last decade, the North only grew about two percent - much of that in areas with more Indigenous population - while the rest of Ontario grew by well over 10 percent.  The geographic size of two of these riding is such that one will not envy the MP elected to serve those constituents and current MPs have already brought this up. Indeed, how an MP can adequately be familiar with the needs of constituents spread across a riding the size of several European countries combined and effectively represent them is a valid concern.  One will also probably not envy residents of Kenora or Dryden who will be put in a riding where Thunder Bay voters are the majority, and their issues and needs could potentially overwhelm the rest of the riding – more than they already do. 

Indeed, a resolution by Fort Frances City Council reflects that concern as they are asking The Federal Electoral Boundaries Commission consider creating a separate, single urban riding encompassing the City of Thunder Bay.  That is, the ask seems to be for a rural Thunder Bay Superior North Riding, a rural Thunder Bay-Rainy River Riding and an urban City of Thunder Bay riding – along with the new Kiiwetinoong-Mushkegowuk one presumes.  Thunder Bay City Council not surprisingly has responded to the proposal with a request for the status quo- that is to maintain current representation.

These proposals are both unlikely to fly with the Commission given that it means either no change or four ridings instead of the proposed three as the overall population of the entire region obviously is slated for three ridings.  Thunder Bay voters and issues already dominate northwestern Ontario given that the city dominates the region with half of its population.    One could easily make the case for only two ridings in Northwestern Ontario – Greater Thunder Bay stretching approximately in a rectangle from the Town of Nipigon, north along highway 11 to Macdiarmid, west to Ignace and then directly south to the US border taking Atikokan along –Greater Northwest Ontario - the rest of Northwestern Ontario including the new Kiiwetinoong-Mushkegowuk riding.  Indeed, if the region does not start to pick up the pace of economic development and population growth, in a decade the redistribution may indeed have to consider how to divide the Far North and the Northwest into just two ridings.

Thunder Bay itself has had the historical fortune of once being two cities and two riding with a substantial national economic role and that parlayed itself into a continuation of two ridings with expanded boundaries.  It has therefore enjoyed representation out of proportion to population size and influence for decades but has not always wielded it very effectively.  In the end, the last real heavyweight powerhouse Minister the region had at the federal level was C.D Howe and frankly given the general calibre of representation in recent decades it probably would not matter that much if Thunder Bay had two federal representatives or one.  The best case for either the status quo or even four ridings in place of the current proposal is an effective marshaling of the case that really large geographic ridings in rural remote regions do not provide for effective representation of the needs of their constituents. 

 

 

The Shape of Federal Fiscal Things to Come: Chrystia Freeland’s 1 Percent Solution

 

Yesterday’s Federal Fall Economic Statement is actually quite a remarkable document. On the one hand, given the expectations being raised that the deficit for 2020-21 might reach $450 billion, coming in an $381.6 billion has probably caused many to heave a sigh of relief.  That was probably the intention. Of course, that $381.6 billion figure is the lower bound estimate given economic assumptions and could be as high as just under $400 billion.  Moreover, none of the scenario deficit projections were factoring in the $70-$100 billion in stimulus spending that was to be spread over 3 years once the pandemic was brought under control.

 

The Fall Economic Statement appears to be as much a political as it was an economic and fiscal document in that it continues federal spending and support for the pandemic as well as positions the government for substantial spending announcements of stimulus spending in the spring probably in advance of a federal election once the pandemic appears to be under control – which it currently is not. 

 

If one takes the base case scenario, revenues for 2020-21 will be $275.4 billion and spending $641.6 billion for a deficit (after actuarial adjustment of federal liabilities – the recent twist in federal finance reporting) of $381.6 billion.  For 2021-22, revenues are expected to rise to $335.9 billion and spending decline to $441.5 billion for a deficit of $121.2 billion.  After that, deficits will continue to decline reaching $24.9 billion by 2025-26 and returning us to the deficit range of the 2018 to 2019 period.  This period of deficits will take the federal net debt from $772.1 billion in 2018 to reach $1.494 trillion by 2025.

 

The document is quite clever because it lays out a fiscal plan with a target – which critics have been clamouring for – without actually stating there is a fiscal target.  The pandemic is essentially a dis-equilibrium situation for the federal government’s finances and the federal government hopes to return to its version of equilibrium finances by 2025 at which point revenues will be higher at $417.3 billion and spending at $484.4 billion.  

 

 If one takes their GDP growth forecasts into account, the deficit to GDP ratio for 2020-21 is actually just over 16 percent but will decline to 5 percent the year after and then essentially reach 1 percent.  Prior to the pandemic, a deficit to GDP ratio of 1 percent was what the federal government saw as perfectly reasonable given low interest rates and GDP growth rates and that is what they want to get back to.  It is the 1 percent solution.

 

To place all of this in very long term visual perspective, data from the Jorda-Schularick-Taylor MacroHistory Data Base, Statistics Canada, my federal fiscal history and the 2020 Fall Economic Statement is used to generate figures 1 and 2 below. Figure 1 shows real per capita federal revenues and spending from 1870 to 2018 and then forecasts from 2019 to 2025.   

 

 

 

If all pans out as forecast, then the surge in spending and revenue collapse of the pandemic will subside with real per capita revenues and spending eventually up 2.5 percent and 3.4 percent respectively from their 2018 amounts.  That will be viewed as a perfectly acceptable growth when spread over 5 years. Figure 2 presents the deficit to GDP ratio with the pandemic showing the second largest deficit to GDP ratio in history but with a return to roughly where it was just prior to the pandemic.

 

 

 

This is the shape of federal fiscal things to come, assuming the federal government’s vision pans out.

 

 

 

 

A Brief History of Federal Budgets

The following op-ed appeared in the Waterloo Region Record, March 16^th, 2017 and the New Brunswick Telegraph-Journal, March 13^th, 2017.

The upcoming federal budget comes in Canada's 150th year — an important milestone for what is perhaps the most successful country in the world. The evolution of federal finances since 1867 reflects a changing economy and offers important lessons regarding the perils of persistent deficit spending and growing indebtedness.

Canada's federal government has indeed grown. In 1867, it had a budget of $14 million, an expenditure-to-GDP ratio of approximately five per cent, a net debt of $75.7 million, and a net debt-to-GDP ratio of 20 per cent. Transportation, communications and economic development accounted for a quarter of federal spending, and transfers to other governments 20 per cent. Meanwhile, debt service charges were 27 per cent due the newly formed federal government assuming provincial debts. There were no transfers to persons.

By comparison, total federal government spending in 2017 is estimated at $331 billion with an expenditure-to-GDP ratio of nearly 16 per cent and a net federal public debt of $760 billion, resulting in a debt-to-GDP ratio of 36 per cent. Assorted transfers to persons and other levels of governments now account for nearly two-thirds of federal government spending.

Until the First World War, customs duties dominated federal government revenue. The war effort sparked the search for new revenues leading to the creation of the first personal and corporate incomes taxes and the first federal sales tax. Over time, the importance of these three new revenue sources grew, and in 2017 it's anticipated that the personal income tax alone will make up 51 per cent of federal government revenue, with corporate taxes comprising 13 per cent and commodity taxes (GST, excise taxes and customs duties) making up 17 per cent.

The 150 years since Confederation have seen the federal government's primary focus transition from the active economic development of a country grounded in liberal economic principles to an activist role partly aimed at bringing about a more egalitarian society via social spending. Despite the benefits, expanded federal spending in the post-Second World War era — given the subsequent slowing of economic growth, rising interest rates and the absence of more concerted fiscal discipline — ultimately resulted in the 1990s federal debt crisis.

Prudent government spending is useful, such as the construction of the transcontinental CPR railway where subsidies encouraged the building of a risky transportation project. However, the same strategy also saw over-subsidization of the CPR and substantial subsidies to two other less-successful rail lines. More government spending is not always better, and that also applies to deficit financing.

Over the period 1867 to 2017, Canada's federal government ran a deficit nearly three-quarters of the time, with the largest deficits-to-GDP ratios during the two world wars and the great divergence between revenues and spending leading to the 1990s debt crisis. Large deficits and interest rates greater than the economy's growth rate during the 1970s and 1980s lead to a rising debt-to-GDP ratio and the federal fiscal crisis of the early 1990s.

The important policy decisions when it comes to spending are when to spend, what to spend, how much, and how to pay for it. The wrong answer to any of these questions has negative fiscal implications.

Given the surge in federal deficit financing in the wake of the 2016 budget, one wonders if the lessons of the 1990s have already been forgotten. While interest rates remain at historic lows, economic growth is also low, making a case for fiscal prudence given the dynamics of deficits and debt. The progress made in reducing the federal net debt-to-GDP ratio below 40 per cent will be largely squandered if we allow debt to once again grow uncontrollably.

Livio Di Matteo is a senior fellow at the Fraser Institute and professor of economics at Lakehead University. He is the author of “A Federal Fiscal History: Canada, 1867-2017.” Distributed by Troy Media