Interest payments on government debt a painful reminder that there are no free lunches

With the holiday season now behind us, the oncoming flood of credit statements to Canadian households is a powerful reminder that there are no free lunches. Borrowing to pay for current consumption brings interest payments, and ultimately, the need to pay off principal balances. Most Canadians are intimately familiar with this reality when it comes to their household finances. But this same reality also applies to governments. As taxpayers, Canadian families are also responsible for interest on government debt. And these payments are significant.

In recent years the federal and most provincial governments have been running deficits, meaning they are spending more than the revenue they collect. These annual deficits accumulate and contribute to increased government debt. The most common measure of government debt is total debt minus financial assets held by governments like cash. On this measure, the combined debt of the federal and provincial governments has increased from $778.7 billion in 2007-08 to $1.1 trillion in 2012-13 a 42.7 per cent increase in just five years or 30.8 per cent after adjusting for the effects of inflation. As a share of the Canadian economy, total federal and provincial government debt has grown from 49.7 per cent to 61.1 per cent over this period.

Increased government debt can have a number of consequences. Aside from the potential for higher debt to be a drag on economic growth, the debt also requires interest payments that consume government resources. Debt servicing costs, as they are referred to by governments, can be substantial and can displace other spending on things that Canadians care about such as health care, education and tax relief.

To put debt servicing costs into perspective, consider the following illustrations from Canada's three largest governments.

At the federal level, debt servicing is projected to be $29.5 billion or 11.1 per cent of total revenue in the current year. Meanwhile, the federal government will collect $29.7 billion in revenue from the GST, transfer $30.3 billion to the provinces for health care, and spend $32.4 billion on Old Age Security for Canadian seniors. In other words, debt servicing consumes considerable resources compared to some of the federal government's largest and most important spending programs.

In Ontario, where government indebtedness is a well-documented problem, the province estimates debt servicing costs in 2013-14 will total $10.6 billion or 9.1 per cent of overall revenue. This means that almost 10 cents of every dollar in revenue that the government collects will go to paying interest on the provincial debt. That's money not spent on important public programs. And that's not all: last year's provincial budget anticipated that interest payments on the debt will grow, on average, by 5.5 per cent per year between 2012-13 and 2015-16, making it by far the government's fastest-growing expenditure (health care and education will grow annually by 2.0 per cent and 3.4 per cent over the same period, respectively).

In Quebec, Canada's second most populous province and its most indebted (relative to the size of its economy), government interest costs are projected to consume 12.3 per cent of total revenue this year. In fact, its 2013-14 interest payment of $8.6 billion is greater than the $7.8 billion transfer the province is receiving from the federal government for equalization and is only slightly less than the $9.5 billion the government plans to spend per year on public infrastructure going forward.

These three examples illustrate the tangible and immediate costs of government debt and deficits. It's clear that growing public debt and the interest payments that follow can consume a significant share of revenue and limit a government's ability to spend in key areas or lower taxes.

Importantly, debt levels alone do not determine the magnitude of interest payments; the interest rate, or the cost of borrowing, also has an impact. Governments are currently borrowing at historically low rates. If interest rates rise, borrowing costs would rise accordingly and impose even further pressure on government budgets.

Just as Canadian households have to deal with the reality of interest payments on debt-financed consumption, so do governments. Ultimately, however, it is taxpayers who pay when governments borrow. The burden of debt servicing costs is a painful reminder to us all that there are no free lunches with government debt.