Marc Lévesque
The Federal government is in need of a new fiscal anchor. If there is one thing the current crisis has revealed on the fiscal policy front, it is that the debt-to-GDP ratio alone cannot adequately play that role. As a result, additional fiscal rules that allow potentially large deficits during recessions while ultimately balancing budgets over the cycle will be needed to keep the country’s finances on a sustainable path.
The dramatic increase in Canada’s fiscal deficit and the sharp jump in the level of public debt during the pandemic – the inevitable result of the government’s response to the crisis – has brought the issue of fiscal rules back to the forefront of public policy discussions. According to the most recent assessment by Canada’s Parliamentary Budget Officer, the country’s fiscal deficit is already on track to reach an unprecedented $343 billion during the current fiscal year, or close to 16% of GDP, which would push the debt-to-GDP ratio to 49.1% of GDP from 31.1% prior to the crisis. These numbers do not reflect the additional measures that will enacted in future to support the economic recovery, and so there is every reason to believe that the debt will climb much higher.
It is against this backdrop that many have started to point to the need for a fiscal anchor to ensure that the government’s fiscal position remains sustainable and will not send the country into the kind of painful adjustment that was required during the mid-1990s.
Until the beginning of the crisis, the government did have an anchor – its commitment to keep the debt-to-GDP ratio on a downward path. However, in the absence of additional fiscal rules, the debt-to-GDP ratio cannot serve as a true anchor because it is bound to lead to one of two things: either fiscal policy becomes pro-cyclical or the anchor is abandoned the moment the economy slows in any meaningful manner. Obviously, when the economy is growing, there is ample room for the government to spend and run significant deficits if it so desires without pushing the debt-to-GDP ratio higher, and the faster the economy grows, the more leeway it has. However, when GDP growth slows or the economy contracts, the budgetary balance deteriorates under the strain of slower revenue growth and increased cyclical spending pressures. As a result, the debt-to-GDP ratio moves higher.
The only way to keep it from rising is to constrain the pace of spending or to raise taxes – exactly the opposite of what fiscal policy should be doing during an economic slowdown. Since no government would want to be seen as pursuing fiscal austerity during a recession, the anchor is ignored – which is exactly the current situation. And, an anchor that is only of use when the economy is growing, but is discarded when it slows, is not much of an anchor.
In sum, a falling debt-to-GDP ratio is not enough. If it wants to be serious about adding discipline to the budget process, the federal government needs to commit to a more credible and responsive fiscal rule.
Does that mean that the debt-to-GDP ratio is of no use whatsoever as a fiscal anchor? Not at all. After all, it does provide useful information as to the long-run sustainability of the government’s fiscal path. But it needs to be supplemented with other rules. On that front, the literature has identified a number of well-defined criteria for the choice of a fiscal rule.[1] Aside from sustainability, it needs to allow automatic stabilizers to play their role, and easily allow for counter-cyclical changes in taxes and expenditures – which implies some degree of flexibility. It should not need to be abandoned after a shock or a downturn. Targets should be well-defined and compliance easy to verify. And it must be easy for the general public to understand and for governments to follow.
A simple annual balanced budget rule obviously does not give that needed flexibility. Instead, the government should commit to balance the budget over the course of a business cycle, while being flexible enough to allow governments to run deficits during a downturn. That’s a responsive and a responsible fiscal rule worth considering.
Québec’s balanced budget legislation ticks all of those boxes. The conditions under which a government can run a deficit are well defined. The time allowed for governments to bring the budget back into balance after running a deficit is clearly spelled out. During good economic times surpluses are squirreled away in a stabilization fund to be used when the going gets tough. And the province has a trust fund dedicated to reducing the debt to which specific sources of revenue must be invested on an annual basis. While Quebec’s framework has come under some strain as a result of the current crisis, highlighting the need for some adjustments, it nonetheless provides a good example of how a set of fiscal rules can work.[2]
[1] The IMF has produced a good primer on fiscal rules.
[2] Luc Godbout’s presentation at a recent conference on Quebec’s finances provides details as well as some of the important issues.
Canada Needs a New Fiscal Anchor. (Québec Has One to Offer.)
By adminMarc Lévesque
The Federal government is in need of a new fiscal anchor. If there is one thing the current crisis has revealed on the fiscal policy front, it is that the debt-to-GDP ratio alone cannot adequately play that role. As a result, additional fiscal rules that allow potentially large deficits during recessions while ultimately balancing budgets over the cycle will be needed to keep the country’s finances on a sustainable path.
The dramatic increase in Canada’s fiscal deficit and the sharp jump in the level of public debt during the pandemic – the inevitable result of the government’s response to the crisis – has brought the issue of fiscal rules back to the forefront of public policy discussions. According to the most recent assessment by Canada’s Parliamentary Budget Officer, the country’s fiscal deficit is already on track to reach an unprecedented $343 billion during the current fiscal year, or close to 16% of GDP, which would push the debt-to-GDP ratio to 49.1% of GDP from 31.1% prior to the crisis. These numbers do not reflect the additional measures that will enacted in future to support the economic recovery, and so there is every reason to believe that the debt will climb much higher.
It is against this backdrop that many have started to point to the need for a fiscal anchor to ensure that the government’s fiscal position remains sustainable and will not send the country into the kind of painful adjustment that was required during the mid-1990s.
Until the beginning of the crisis, the government did have an anchor – its commitment to keep the debt-to-GDP ratio on a downward path. However, in the absence of additional fiscal rules, the debt-to-GDP ratio cannot serve as a true anchor because it is bound to lead to one of two things: either fiscal policy becomes pro-cyclical or the anchor is abandoned the moment the economy slows in any meaningful manner. Obviously, when the economy is growing, there is ample room for the government to spend and run significant deficits if it so desires without pushing the debt-to-GDP ratio higher, and the faster the economy grows, the more leeway it has. However, when GDP growth slows or the economy contracts, the budgetary balance deteriorates under the strain of slower revenue growth and increased cyclical spending pressures. As a result, the debt-to-GDP ratio moves higher.
The only way to keep it from rising is to constrain the pace of spending or to raise taxes – exactly the opposite of what fiscal policy should be doing during an economic slowdown. Since no government would want to be seen as pursuing fiscal austerity during a recession, the anchor is ignored – which is exactly the current situation. And, an anchor that is only of use when the economy is growing, but is discarded when it slows, is not much of an anchor.
In sum, a falling debt-to-GDP ratio is not enough. If it wants to be serious about adding discipline to the budget process, the federal government needs to commit to a more credible and responsive fiscal rule.
Does that mean that the debt-to-GDP ratio is of no use whatsoever as a fiscal anchor? Not at all. After all, it does provide useful information as to the long-run sustainability of the government’s fiscal path. But it needs to be supplemented with other rules. On that front, the literature has identified a number of well-defined criteria for the choice of a fiscal rule.[1] Aside from sustainability, it needs to allow automatic stabilizers to play their role, and easily allow for counter-cyclical changes in taxes and expenditures – which implies some degree of flexibility. It should not need to be abandoned after a shock or a downturn. Targets should be well-defined and compliance easy to verify. And it must be easy for the general public to understand and for governments to follow.
A simple annual balanced budget rule obviously does not give that needed flexibility. Instead, the government should commit to balance the budget over the course of a business cycle, while being flexible enough to allow governments to run deficits during a downturn. That’s a responsive and a responsible fiscal rule worth considering.
Québec’s balanced budget legislation ticks all of those boxes. The conditions under which a government can run a deficit are well defined. The time allowed for governments to bring the budget back into balance after running a deficit is clearly spelled out. During good economic times surpluses are squirreled away in a stabilization fund to be used when the going gets tough. And the province has a trust fund dedicated to reducing the debt to which specific sources of revenue must be invested on an annual basis. While Quebec’s framework has come under some strain as a result of the current crisis, highlighting the need for some adjustments, it nonetheless provides a good example of how a set of fiscal rules can work.[2]
[1] The IMF has produced a good primer on fiscal rules.
[2] Luc Godbout’s presentation at a recent conference on Quebec’s finances provides details as well as some of the important issues.