International

Canada’s Growing Debt Problems Amid Runaway Government Spending

People are silhouetted in front of the Canadian national flag at the Palais des Congres in Montreal, Quebec, Canada October 21, 2019. (Stephane Mahe/Reuters)
With the highest unemployment rate in the G7, Canada is running massive deficits with no signs of slowing down, causing Canada's debt to be downgraded and yields to rise.

Many countries have turned to government spending to mitigate the effect of the coronavirus pandemic on their economies. The methods used have varied — ranging from wage subsidies to checks — but they have one thing in common: They have been primarily financed with substantial amounts of new government debt.

Canada may be among the first to see the negative consequences of the new debt binge. In June, Fitch downgraded Canada’s sovereign debt, revoking its prized AAA status. Unlike the U.S. which saw its sovereign debt downgraded from AAA by S&P in 2011, Canada does not enjoy the luxury of a reserve currency. The U.S. dollar’s reserve-currency status helps the U.S. maintain demand for its debt, giving it more fiscal room than other countries, and (in theory, if not necessarily in practice) makes a default highly unlikely. Technically, the U.S. could always pay that debt by printing more dollars (albeit with inflationary consequences). Whether it would be able to attract new lenders is an entirely different question.

Canadian finance minister Bill Morneau recently revealed that Canada’s projected 2020 deficit is now C$343 billion, a whopping 16 percent of GDP. Canada’s 30-year government bond yield rose by 0.1 percent due to the announcement alone (higher government interest rates also mean that interest rates on mortgages and consumer debt go higher). The Trudeau government was previously keeping information about the country’s finances out of the public eye despite calls for transparency. Perhaps it’s easy to understand why.

Canada Federal Government Surplus-To-GDP Ratio
Source: Government of Canada

The Trudeau government now finds itself in a quandary over how to get to grips with its increased government spending. It recently agreed to continue sending Canada Emergency Response Benefit (CERB) stimulus checks to Canadians in the amount of C$2,000 per month for a maximum of six months, amounting to C$12,000 in total per person (or almost $9,000 U.S. dollars). Canadians on employment insurance (EI) can also get a top up so their total benefits equal the same dollar amount of C$2,000 per month. By comparison, the U.S. has only sent one round of checks in the amount of $1,200 (known as Economic Impact Payments or “EIP”) as part of the CARES Act.

Approximately 8.2 million Canadians, out of a population of 37.6 million, have applied for such CERB stimulus checks. Unlike the $1,200 one-time EIP checks, which begin to phase out gradually at incomes over $70,000, Canadians lose 100 percent of the entire CERB paycheck benefit once they find work making $1 more than $1,000 per month (or $12,000 annually), effectively creating a massive marginal tax rate and a major disincentive for individuals to return to work. A gradual phaseout of some sort would have been smarter policy (making the program more like a negative income tax). For instance, the Government of Canada could have followed the precedent set by the U.S. Treasury’s Economic Impact Payment (EIP) phaseout schedule from $75,000 to $99,000 for individuals. The longer Canadians stay unemployed (in part due to bad incentives), the more calls there will be for more stimulus and therefore even more debt.

Canada also has a program to help small businesses called the Canadian Emergency Wage Subsidy — roughly analogous to the Paycheck Protection Program (PPP).  It helped employers stay in business amid government-imposed lockdowns but added to Canada’s mounting debt.  It was also slow to arrive.

The COVID-19 crisis hit Canada in March, but, after passing legislation in April, it wasn’t until May that the government of Canada was able to send the first Canada Emergency Wage payments to firms. It delivered the wage subsidy through the tax system, in contrast with the bank-mediated PPP, which helped deliver the subsidy faster but also resulted in disparities in which companies received PPP first, if at all. At the outset of both wage-subsidy programs in the US and Canada, I would have recommended using the payroll tax system (adopting a negative payroll-tax scheme as Art Laffer and I have advocated) as a faster delivery mechanism instead.

With unemployment in Canada standing at 12.3 percent, the highest level anywhere in the G7, it’s quite possible that the Canadian government will agree to another round of CERB stimulus checks (the current program is set to end in October), which would take the government’s debt levels still higher. When the COVID-19 pandemic first hit Canada, the Trudeau minority government was given unlimited spending powers for six months. This autumn will mark the first time since March that other parties in Canada besides Trudeau’s liberals will have a say in COVID-19 spending matters, and the Conservative Party of Canada will doubtless be focusing more attention in the growth in the debt than has hitherto been paid.

This won’t be the first time that Canada has had to wrestle with its federal debt, and there is no obvious way out of the mess. (And no, I don’t think that Modern Monetary Theory [MMT], a false theory, provides any realistic solution.) Perhaps unsurprisingly, there has been speculation that the Trudeau government is now looking to institute a controversial federal housing-equity tax on primary residences (Canada already applies capital-gains taxes to second and third homes), which would almost be akin to removing the exemption on capital gains (up to a certain limit) on the disposal of a primary residence in the U.S., and would significantly hurt middle-class homeowners.

Canada now has high middle-class tax rates and, if federal and provincial taxes are combined, a top marginal tax rate of over 53 percent in the most populous province, Ontario. Raising taxes even higher is not, I suspect, politically feasible.

Simply printing money to pay for Canadian sovereign debt is probably not on the cards either. The Bank of Canada is fortunately independent and under the helm of economist Tiff Macklem, who called for fiscal prudence in the 1990s, another time of deep concern about the size of Canada’s deficit and debt. He is well aware that, one way or another, printing money is almost certain to trigger inflation, possibly to dangerous levels. As governor of the Bank of Canada, he also has recently committed to keeping Canadian interest rates low and to continuing quantitative easing only as long as inflation remains below 2 percent (in what some would refer to as Odyssean forward guidance).

There is always the possibility that the Canadian economy could grow to a size at which its debt becomes manageable, but at the moment this looks like a tall order. Canada’s energy-driven economy faces headwinds in the world of low oil prices brought about by the fracking technological revolution of the 2010s (in 2015 and 2016, Canadian GDP growth slowed to 0.7 percent and 1.1 percent respectively).

In fairness to Trudeau’s liberals, Canada’s COVID-19 lockdowns have effectively acted as a regressive tax on those who cannot work remotely (who tend to be among the lower paid), as well as, of course, a massive blow to the economy. Instituting a temporary fiscal boost in response is reasonable. What’s lacking for now is any obvious policy path to return the country to economic normality and restore a semblance of control to the nation’s finances.

It is quite possible that a future Canadian conservative federal government will cut spending just as former prime minister Stephen Harper did in the 2010s (even following the Great Recession), a process that eventually saw the government’s finances move closer to a balance, including one surplus in the 2014-2015 fiscal year. Here’s hoping, but I have a feeling that ultimately it will be the younger generations such as my own that will get stuck with the bill of continued high taxes for decades to come.

Jon Hartley is a master’s student at the Harvard Kennedy School and a Visiting Fellow at the Foundation for Research on Equal Opportunity. He formerly served as a senior policy adviser to the Congressional Joint Economic Committee.

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