Restoring sustainability to public finances would require permanent policy actions amounting to 2.7% of GDP

Government finances are not sustainable over the long term, says Canada’s Parliamentary Budget Officer in a new report released Thursday.

The report sets out the PBO’s assessment of the sustainability of the federal and provincial-territorial governments’ fiscal structure, which concludes that they are “not sustainable over the long term.”

It estimates that addressing the projected fiscal gap and restoring sustainability to public finances would require permanent policy actions amounting to 2.7% of gross domestic product, either through higher taxes, reduced overall program spending, or some combination of both. The PBO notes that this represents $46 billion of fiscal actions in 2011-2012, and says the amount of these actions, in dollar terms, would increase over time in line with GDP.

The PBO’s assessment of fiscal sustainability involves projecting government debt relative to the size of the economy over the long term based on assumptions about current program commitments and taxes, given projected demographic and economic trends.

Those assumptions include projected real GDP growth of 2.5%, on average, over the 2011 to 2016 period, while potential GDP is projected to rise by 2.1% over the same period. The excess capacity in the economy that built up following the 2008-2009 financial crisis is projected to be gradually absorbed by 2016, after which real GDP is projected to grow in line with PBO’s estimate of potential GDP growth.

The report stresses that these long-term projections are “best viewed as illustrative ‘what if’ scenarios that attempt to quantify the implications of leaving a government’s current fiscal structure unchanged over long periods of time”, and they should not be interpreted as predictions of the most likely outcomes.

While these projections include many uncertainties, one of the big factors that is fairly well-established that will stress government finances in the years ahead will be population aging. Assuming that the pace of labour productivity growth over the last 34 years continues over the long term, the PBO projects that slower labour force growth will reduce annual average real GDP growth from the 2.6% observed over 1977-2010 period to 1.8% over the 2011-2086 period.

Slower economic growth will, in turn, put downward pressure on government revenues, it notes, and, at the same time, aging will put upward pressure on programs such as health care and elderly benefits. “Assuming that once the economy fully recovers and revenue grows in line with nominal GDP, population aging along with increased spending on health care and elderly benefits – adjusted for inflation and ageing – are projected to result in a deterioration in the operating balance from surpluses over the medium term to sizeable deficits over the long term,” it says.

The report also finds that implementing the required fiscal actions may be delayed until the economy has fully recovered without unduly increasing the size of the fiscal gap. However, it warns that significant delays in implementing the required actions substantially increase the amount of corrective measures. For example, delaying fiscal actions by five years increases the fiscal gap from 2.7% to 3.0% of GDP; and, delaying by 10, 20 and 30 years increases the fiscal gap to 3.4%, 4.4% and 5.8% of GDP, respectively.

While the PBO projects federal and provincial-territorial budgetary deficits over the medium term, achieving budgetary balance over this horizon significantly reduces – but does not eliminate – the fiscal gap, it notes. Even if both federal and provincial-territorial governments balance their budgets by 2015-2016, a fiscal gap of 1% of GDP would persist, it says.

Higher than expected real GDP growth (+0.5 percentage points) or than forecast lower interest rates (-50 basis points) over the long term would also reduce, but not eliminate, the federal and provincial-territorial fiscal gap. Higher real GDP growth would reduce the fiscal gap to 2.4% of GDP from 2.7%. Whereas lower interest rates would reduce the fiscal gap to 2.6% of GDP from 2.7%.

IE