The 2003 federal budget assumes economic growth of 3.2% this year and 3.5% in 2004, with inflation hovering around 2% and the unemployment rate dropping to 7% next year from 7.6% in 2002. This is based on U.S. growth of 2.7% this year and 3.6% in 2004.

It assumes three-month treasury bills will average 3.3% this year and 4.5% in 2004, while 10-year government bond rates come in at 5.4% and 5.9%, respectively.
Budgets are sensitive to economic growth, inflation and interest rate assumptions:

  • A one-percentage-point lower growth rate would decrease the budgetary balance by $2.5 billion in both the year it occurs and the following year. This would be due to both lower tax revenues — as personal income and corporate profits are lower than expected — and higher expenditures related mainly to increased unemployment insurance claims. A 1% higher growth rate would have positive impacts of the same magnitude.
  • A one-percentage-point lower inflation rate would pull the budgetary balance down by $1.4 billion in Year One and $1.3 billion in Year Two. The decline in tax revenues as a result of lower-than-expected personal income and corporate profits would be greater than the savings on the expenditure side due to a lower increase in costs.
  • A 100-basis-point decrease in interest rates would have a positive impact on the budgetary balance, pushing it up by $800 million in the first year and $1.3 billion in the second.

Usually a change in economic developments affects all three indicators, so the impact on the budget balance becomes difficult to calculate.

For example, slower economic growth this year — a possibility given the mixed signals from the U.S. — would probably be accompanied by lower interest rates.

As a result, some of the negative impact from slower growth would be offset by lower debt charges.
Because of this sensitivity to economic developments, Canadian budgets usually include a contingency reserve to cover unexpected expenditures or revenue shortfalls, as well as an “economic prudence” allowance to allow for weaker economic growth.

The contingency reserve is $3 billion. Economic prudence increases the longer the period forecast, so it’s $1 billion for the first year, $2 billion for the second, $3 billion for the third, $3.5 billion for the fourth and $4 billion for the fifth.

In recent years, the government has been using all the fiscal room it has, forecasting balanced budgets should the contingency reserve and economic prudence be needed. In fact, the economy has done better than expected and surpluses have resulted. Some of these have been used for extra spending while the rest has gone to reducing the debt.