How Have Canadian Federal Governments Responded to Budget Deficits?

Summary

• The objective of this study is to investigate, based on econometric modelling using time-series data from 1868 to 2021, how Canadian federal governments have responded to budget deficits.
• The fiscal responses of Canadian federal governments to budget deficits have depended on the ratio of net debt to GDP and the ratio of interest payments to revenue. When the federal government has a debt-to-GDP ratio exceeding 37.1% or ratios of interest payments to revenue above 12.5%, they have responded to budget deficits by reducing program spending and raising revenue. When debt or interest-cost ratios have been below these thresholds, governments have postponed fiscal adjustments.
• According to this classification, Canada is currently in a fiscal environment with a high debt ratio and low interest-cost ratio. The Liberal government has postponed deficit reduction in its recent budgets, which indicates that its fiscal policies are based more on the ratio of interest payments to revenue than the ratio of net debt to GDP.
• Postponing fiscal adjustments and incurring greater deficits results in higher interest payments. In the future, the fiscal adjustment will require deeper cuts in program spending and larger increases in tax rates that will have substantial economic and social costs.
• We find that a short-term increase in program spending is only partially offset by future spending restraint and about 30% of the adjustment involves increases in future taxes. This is consistent with the spend and tax hypothesis—that higher program spending ultimately leads to higher tax burdens.
• We also find that a short-term increase in revenues is followed by an increase in the present value of future program spending. This is consistent with the tax-and-spend hypothesis—that is, revenue increases lead to increases in program spending.