Skip to main content

1 - The Challenge of Canada's Debt and Deficits

With his February 1995 Budget, the Minister of Finance put Canada's finances on a new track. The budget set in place the measures that will progressively reduce the federal deficit to 3% of gross domestic product in 1996-97 and 2% the year after. The budgetary decisions, which the public through this Committee played a significant role in shaping, fundamentally altered the structure of Canadian government spending. Because of that, and the progressively greater impact the budget's measures will have on the country's fiscal health in the following years, it is widely and rightly considered the most significant budget in Canada's post-war history.

The task of the Committee this year was shaped by the success of that budget. Fundamentally, the Committee's task was to build on the progress that has been made and, in the new framework the budget established, provide Canadians again with the opportunity to help the government develop its next budget.

The Committee found continuing concern about annual deficits and the federal government's accumulated debt. It is worthwhile to recall at the outset some facts about the national debt.

The Debt Conundrum

For most of us, debt at the level of personal experience is a fairly simple story. However, the story of Canada's debt is far from simple and quite beyond personal experience. The essential facts of our predicament are not in dispute:

However, even these numbers do not convey the extent of the challenge we face. A multitude of factors - economic, social, political, some home-grown and others global - brought us to our current dilemma. It will require determination and continuing national commitment to solve it.

The Mathematics of Debt Interest

"The fundamental problem of economic policy is not the deficit, nor the deficit-to-GDP ratio; it's the level of the debt relative to our abil ity to finance the debt. Everybody seems to recognize this. This was very clear in the report from your committee last year. ... The ap propriate highest-profile target for fiscal policy should be changed. In stead of targeting a 3% deficit-to- GDP ratio in 1996-97, we should be giving highest profile to target ing a debt-to-GDP ratio in the 55% to 60% range several years later. In the upcoming budget, we should identify as the next high-profile target a debt-to-GDP ratio of 71% for 1997-98."
Dale Orr, Chair of the Economic Policy Committee of the Canadian Chamber of Commerce.
In his 1994 report to Parliament the Auditor General wrote the following about the essential arithmetic that governs Canada's debt: ``The volume of Canada's debt is growing faster than the income base the government draws on to generate its revenues''. Since 1977, annual federal deficits have never fallen below 4% of GDP and have risen as high as 8.7% (in 1985). Even during the boom years of mid-1980s, the national economy (GDP) never grew faster than the debt. This mathematical relationship persists today. Net federal debt is about three-quarters the size of our annual economic output.

The impact on budget-making is inescapable. It is not enough to ensure that revenue equals program spending. The total debt will continue to grow. Even if tax revenues exceed program spending, i.e. we have an operating surplus, the debt will continue to grow until revenues equal total spending (i.e. we balance our budget).

Mathematics has still another lesson for governments: procrastination costs. The longer one waits to take the steps necessary to alter the debt path, the more draconian the eventual measures will have to be in order to correct the problem. The inescapable need to head Canada in a new fiscal direction was a key factor in the measures the Committee recommended in its report one year ago, and which were implemented in the 1995 budget.

International Debt Comparisons

Canada is not the only country with a large debt, but our situation has some unique characteristics which may call for unique remedies. Canada has the second largest deficit and debt relative to GDP among the G-7 countries. Italy has the highest debt to GDP ratio of the G-7 nations. Its interest rates on long-term bonds exceed 11%. Canada has, by a large margin, the highest level of foreign held debt relative to GDP among the G-7 nations. Canada's high and rising international indebtedness means that more and more Canadian income must go to foreigners to service our external debt, resulting in a lower standard of living.

A. The Maastricht Criteria

Canada's fiscal situation ranks poorly according to a variety of benchmarks, one of which is the Maastricht deficit and debt criteria for countries of the European Union that are to be met as of January 1, 1997. The fiscal criteria are: deficits of the government sector are not to exceed 3% of GDP, and the net debt of the total government sector is not to exceed 60% of GDP. Canada, like most EU countries, does not meet either criteria. Fiscal measures announced in the past two budgets, and likely to be announced in the upcoming budget, will soon allow Canada to meet the deficit criterion. We are, however, so far away from meeting the 60% of GDP debt criterion that compliance with that target would take many years.

B. Canadian vs. American Targets

The Minister of Finance has announced that the government's deficit target for the fiscal year ending March 31, 1998 will be 2% of GDP. At that level, federal financial requirements (i.e. the extent to which it must borrow from financial markets as opposed to financing it through internal sources such as employee pension funds) would be less than 1% of GDP. It is this measure, namely financial requirements, that most countries including the United States use as their deficit measure.

The current United States budgetary agreement envisages that the deficit will fall from its current level of 3% of GDP to zero in the year 2002. While under present measures, Canada's deficit is being reduced more quickly than that of the United States, this reflects our greater need for fiscal restraint. We have accumulated about 50% more debt relative to our economic size than the Americans and, at 37 cents per dollar of revenue, debt service charges consume about twice as much of our tax dollars as they do in the United States.

Reducing Canada's Debt - Increasing Canada's Choices

As the Committee noted a year ago, the government has not embarked on this admittedly painful deficit reduction exercise merely for the purpose of meeting some theoretically satisfying fiscal benchmark. The government, supported by the Committee, is convinced that Canada's fiscal problems represent a clear and present danger to Canadians' way of life.

Canadian Debt Held Offshore

One result of our massive debt is our current dependence on foreign savings. The net debt of all Canadians held by non-residents now exceeds $300 billion, of which more than $110 billion is foreign-held federal government debt. At 46% of GDP, Canada has a much higher foreign-held debt than any of the three other G-7 countries that are net borrowers (Italy at 11%, the United States at 9% and France at 1%).

The reason for the exceptionally high reliance on borrowings from off-shore is that domestic savings are now insufficient to meet the total borrowing needs of Canadian governments and the private sector. From 1980 to 1985, the personal savings rate averaged 14.8% of personal disposable income. From 1986 to 1993, the savings rate fell to an average of about 10%. In 1994 it was only 7.9%.

Adverse consequences arise from this reliance on foreign capital. The first is that interest payments flow abroad rather than continuing to circulate in Canada. The second is that interest paid on federal and provincial debt to non-residents, unlike interest paid to Canadians, is not subject to Canadian taxation. Thirdly, decisions regarding Canadian fiscal and monetary measures must be made not only on the basis of domestic requirements but also to respond to international economic forces which we cannot control.

The Added Burden of Provincial Debt

The federal government is not the only villain in accumulating a large debt. As of March 31, 1996, the combined net debt of the federal and provincial governments should reach $826 billion, equalling 105% of GDP; $248 billion of this will represent provincial debt.

Provincial debt grew sharply in the first half of the 1990s. However, the pace of provincial debt accumulation slowed markedly as several provinces have acted to balance their budgets. Prince Edward Island, Newfoundland, New Brunswick, Manitoba and Saskatchewan have all predicted budgetary surpluses for the fiscal year 1995-96. Alberta, while predicting a deficit for this year, will likely achieve a surplus for the second year in a row. Total provincial deficits in 1995-96 are expected to be some $13 billion lower than three years earlier, more than a 50% reduction. Unlike earlier budgets where a number of provinces increased taxes, these provinces have most recently employed spending cuts as the primary means of deficit control. Government operations and transfers to municipalities, institutions and persons bore the brunt of most of the cuts.

"The Government of Ontario is tak ing $8.3 billion out of the provin cial economy of Ontario over the next three years. I can assure you, when you reduce government spending in Ontario by 2% or 3% of provincial GDP and add the fed eral government reduction as a per centage of GDP, you will destroy jobs."
Arthur Donner, Consultant.
However, four provinces, British Columbia, Ontario, Quebec and Nova Scotia, have been slower than the others to come to grips with their fiscal problems. In 1994-95, Ontario and Quebec still ran deficits of $9.6 billion and $5.7 billion respectively. These deficits were well above those of other provinces when measured on a per capita basis (Ontario $878 and Quebec $785) or as a percentage of gross provincial product (Ontario at 3.2% and Quebec at 3.4%). British Columbia has not relied on expenditure cuts, placing its faith instead in economic growth.

Ontario has undertaken significant measures, however, since the election of the new government in June, announcing spending cuts of between $4.5 billion and $5.5 billion. Despite this, the budget is not expected to be in balance until the fiscal year 2000-01.

No such measures are yet evident in Quebec. In 1994-95, it had the highest net provincial debt per capita at $10,228 and the third highest debt expressed as a percentage of gross provincial product, namely 44.6%.

Debt vs. Deficit Targets

A number of witnesses, as well as the Auditor General, have challenged the ongoing practice of the Committee and the Minister of setting and meeting deficit targets, be they expressed in dollar terms or as a percentage of GDP. To the contrary, they have expressed the need for the government to now move to debt as opposed to deficit targets.

"As we see it, the fundamental problem of economic policy is not the deficit or the deficit-GDP ratio; it is a level of debt relative to our ability to finance this debt. There fore, the appropriate highest profile target for fiscal policy should be changed. Instead of targeting a 3% deficit-GDP ratio in 1996-97, we should be giving the highest profile to targeting a debt-GDP ratio in the 55% to 60% range several years later. ... The ultimate objective of fis cal policy is to get the government into a position in which it can once again have the flexibility to be re sponsive to the needs of the public. This day will not arrive until the debt-GDP ratio has fallen signifi cantly from its current level."
Greg Sherloski, Committee Member, Saskatoon Chamber of Commerce.
Those who favour debt targets do so because past governments have reduced annual deficits, but not sufficiently to prevent an increase in the debt to GDP ratio. The previous government reduced the deficit from 8.7% of GDP in 1985 to 6% in 1993. At the same time, however, the debt grew from 46% to 67% of GDP, vastly increasing at the same time the annual cost of servicing the debt.

In addition, the proponents of changing the focus to debt argue that, in themselves, deficit targets have little if any significance. They point out that corporations and individuals, just like governments, can spend in any one year more than they take in, thus creating a deficit. The real issue, however, is the actual amount of debt they can sustain at any one time. A person or government can obviously sustain a greater debt load if income is high.

The 3% of GDP target is the significant target in terms of the deficit. Once we achieve it, our ability to service the debt should then grow more quickly than the debt itself. Thereafter, deficit targets of less than 3% of GDP will be significant only insofar as they relate to the rate by which Canada's overall debt burden is reduced as a percentage of our gross domestic product.

RECOMMENDATION

As Canada should meet the critical 3% of GDP deficit target by the end of the next fiscal year, the Committee agrees with the Auditor General and others who say that future budgetary policy should focus less on the level of the annual deficit and more on the relative level of our national debt.

;