Tuesday, November 8, 2011

Canada’s looming fiscal squeeze


EDITOR’S NOTE: The following is an edited version of  the executive summary from the Macdonald-Laurier Institute’s recently released study, Canada’s Looming Fiscal Squeeze, by Christopher Ragan.
MONTREAL, QC, Nov. 8, 2011/Troy Media/ – Macdonald-Laurier’s report, Canada’s Looming Fiscal Squeeze, assembles a collection of increasingly familiar demographic projections and draws the not-so-familiar implications for the fiscal challenges to be faced by future Canadian governments.
It emphasizes the rising share of national income that will need to be devoted to publicly provided healthcare and seniors’ benefits, resulting in an increase in public debt if future governments do not adjust their spending programs or tax rates. In order to avoid a return to the high-debt situation of the mid 1990s, Canadians and their governments must soon begin thinking in a systematic and critical way about their long-term fiscal priorities.
Baby boom to baby bust
During the baby boom that followed the Second World War, the average fertility rate in Canada was 3.6 children per woman. Partly due to the increase in women participating in the Canadian labour force, Canada’s fertility rate dropped to 1.7 children per women by 2007. This change in the fertility rate is expected to continue to slow the population growth rate. Thanks to healthier lifestyles and improved technology, the average life expectancy of a Canadian has risen from 68.5 years in 1951 to 80.5 years in 2006. The combination of fewer younger people entering the population and the current population living longer will act together to increase the average Canadian’s age over the next few decades.
The aging of the baby boom resulted in a significant increase in the working-age share of the population, from 58 per cent in 1962 to about 69 per cent in the early 1980s. The youngest baby boomers came of age in the early 1980s, and in the subsequent three decades there were no significant changes in the working-age share of the population. But the oldest baby boomers reached 65 in 2011, and so for the next 20 years there will be an inexorable decline in the working-age share of the population, a decline that roughly mirrors the increase from 30 years earlier.
With the ongoing aging of Canada’s baby-boom generation, a growing fraction of the population will fall into these older age categories, thus reducing the economy’s overall labour force participation rate. The overall participation rate is projected to decline from over 67 per cent today to below 61 per cent by 2040, even with the assumption that age-specific participation rates increase by up to four percentage points between now and 2030, and remain constant thereafter.
The falling labour force participation rate will cause a decline in the future growth rate of average living standards, as measured by real per capita Gross Domestic Product (GDP) This leads to two policy conclusions:
1) Productivity growth is likely to account for more than 100 per cent of growth in real per capita GDP over the next few decades, meaning that Canadians and their governments must take seriously the issue of increasing productivity.
2) The reduction in the labour force participation rate, taken by itself, will reduce the growth rate of real per capita GDP (for any assumed productivity growth rate) and thus reduce the growth rate of Canadian governments’ per capita tax base.
The aging of the Canadian population will force Canadian governments to face a significant two-part fiscal challenge:
1) It will lead to a slowing of national income, the primary tax base for governments, thus slowing tax revenues.
2) Key Canadian public spending programs will become more costly as a share of GDP, especially those providing healthcare and income support for the elderly, even as the tax base slows considerably.
This fiscal challenge will likely create political tensions between provincial and federal governments and will force governments at all levels to make some difficult fiscal decisions.
As spending demands rise faster than tax revenues, future Canadian governments will be faced with three broad choices:
1) They can attempt to reduce the growth rate of overall spending.
2) They can attempt to increase the growth rate of revenues through increases in tax rates, or
3) They can choose to increase their public borrowing.
Of course, the third option is not a permanent solution since the debt eventually needs to be repaid and such repayment ultimately requires a command over resources, which in turn requires either spending reductions or increases in tax revenues. In the hypothetical situation in which future governments choose to not make any adjustments in spending or taxation but merely increase borrowing, the cumulative borrowing is expected to equal 52.5 percentage points of GDP over 25 years.
Hitting the debt wall
The net public debt-to-GDP ratio was approximately 92 per cent in 1996, and Canada was then seen by the International Monetary Fund (IMF) and others as having a serious fiscal problem. The failure to tackle the problem would have meant hitting the “debt wall”, with implications for declining access to global capital markets and rising domestic interest rates, just as we are now seeing in some European countries. But the federal and provincial governments embarked on programs of significant fiscal consolidation. which quickly turned large annual budget deficits into modest budget surpluses. These, combined with a healthy economic recovery, produced a rapidly declining debt-to-GDP ratio.
By the beginning of the 2008/09 financial crisis, the overall debt ratio was 37 per cent of GDP and, as of the fall of 2011, it appears that most Canadian governments are on paths back to budget balance.
To avoid a future “debt wall”, this report examines five non-fiscal solutions to Canada’s looming fiscal squeeze: increasing the immigration rate, increasing the retirement age, increasing the fertility rate, restraining the growth of healthcare spending, and increasing the growth rate of productivity.
Immigrants, of course, also age over time, which leads to eventual lower labour force population and higher demands on public programs, and the immigration rate would have to at least double in order to merely continue the 2008 rate of growth of the Canadian labour force. This is politically unfeasible.
And even an aggressive increase in the retirement age could not offset the impact of the large numbers of aging baby-boomers, who will inevitably drop out of the labour force and continue to require more health care.
As for the fertility rate, it could likely not be raised from the current level of 1.7 children per woman to a level that would make a significant difference, and the programs required to marginally increase fertility would be prohibitively expensive.
Restraining the growth of health care spending, however, may be possible but, given the magnitude of the underlying demographic forces, Canadian governments must recognize that even in an optimistic view of the future there will be a significant increase in the share of national income devoted to public healthcare spending.
Finally, faster productivity growth cannot be engineered by policy and would only help to lessen the fiscal squeeze if policy actions could somehow prevent the faster income growth from creating a similar expansion in the number or generosity of public spending programs.
An inconvenient truth
The inconvenient truth that Canadians and their governments must face is that the demographic forces in play and the fiscal implications that follow are so large that governments will need to respond by making fundamental adjustments to their fiscal frameworks. As is always the case, the simple arithmetic of government budgets implies that there are only two broad fiscal choices available to address the coming fiscal squeeze: spending programs can be reduced or eliminated or taxes can be increased. There is nothing else.
Government spending can be restrained in many ways, with some programs being reduced in scope while others are eliminated altogether. But such cuts are politically very difficult; one needs only to glance at the highly-charged political debates going on in the United States and Europe to be reminded about how unpopular it is to consider reductions in public spending, especially if the cuts fall on important social programs.
Governments also have many choices when it comes to raising tax revenues, including personal and corporate income taxes, expenditure and sales taxes, and product-specific excise taxes. Apart from the general unpopularity of higher taxes, an important choice would need to be made concerning which taxes would be raised and by how much.
Since government debt is often incurred to provide current goods and services, but is serviced and repaid in the distant future, public debt usually involves a redistribution of income away from future generations toward current generations. In general, the more the policy changes are delayed through time, the more debt will be incurred before those adjustments take place and thus the more the burden of the fiscal adjustment will ultimately fall on Canadians who are currently young.
Conversely, the more immediate are the changes in spending and taxation, the less debt will be incurred and thus the more the overall burden of adjustment will fall on the same baby boomers whose aging is the fundamental cause of the looming fiscal squeeze. Which generation pays for the rising age-related expenditures of the baby boomers will be determined by the fiscal policy choices Canadian governments make in the coming years.
The government machine built over the past half-century was constructed during a time when the demographic forces were very advantageous: a young and fast-growing population. The implications were rapidly advancing living standards and the ability to easily fund many government programs. But as the oldest baby boomers reach 65 this year, and these demographic forces move into reverse for the next three decades, there will be a need to adjust this machine of government.
The adjustment can occur primarily on the spending side or primarily on the revenue side – or indeed can occur on both. But some adjustment will be necessary. There will be a Canadian tendency for this debate about overall fiscal priorities to become focused on the division of fiscal capacity between different levels of government. But a focus on the “fiscal imbalance” rather than the more general “fiscal squeeze” should be avoided, as it will both cloud the central issues and needlessly politicize a debate that will in any event be fraught with difficult decisions. Canadians and their governments at all levels need to recognize that addressing Canada’s looming fiscal squeeze will require a careful and transparent examination of our fiscal priorities.
Christopher Ragan is a professor of economics at McGill University.