I. Introduction ^1/

The recovery of the Canadian economy from the cyclical trough in the first quarter of 1991 was initially hesitant, but it has strengthened considerably during the past two years. While the economy still appears to be operating below its potential, economic slack is being taken up at a rapid pace. This report reviews recent economic developments and discusses some of the challenges and opportunities that the present situation presents for the fiscal authorities. The paper also builds on the earlier work carried out by the staff, which was included as background for previous Article IV consultations (Table I-1).

Table I-1.

Canada: Recent Staff Studies on Economic Issues and Policies

Table I-1.

Canada: Recent Staff Studies on Economic Issues and Policies

1.	Recent Economic Developments (SM/92/25)
	a. The Natural Rate of Unemployment in Canada
	b. Fiscal Impulse measures for Canada
2.	Selected Papers on the Canadian Economy (SM/93/45)
	a. Labor Market Aspects of Industrial Restructuring in Canada
	b. Simple measures of the Output Gap in Canada
	c. The Natural Rate of Unemployment in Canada Revisited
	d. A Forecasting Equation for the Canadian-U.S. Dollar Exchange Rate
	e. The Canada-U.S. Free Trade Agreement: A Retrospective on the Agreement and the Canadian Experience
	f. Balance Sheet Risk, Credit Supply, and Their Impact on Real Economic Activity
3.	Economic Developments and Policies (SM/94/97)
	a. Federal-Provincial Fiscal Relations
	b. Aging Populations and Canadian Public Pension Plans
	c. Labor Market Policies
	d. Current Account Model

View Table

Table I-1.

Canada: Recent Staff Studies on Economic Issues and Policies

1.	Recent Economic Developments (SM/92/25)
	a. The Natural Rate of Unemployment in Canada
	b. Fiscal Impulse measures for Canada
2.	Selected Papers on the Canadian Economy (SM/93/45)
	a. Labor Market Aspects of Industrial Restructuring in Canada
	b. Simple measures of the Output Gap in Canada
	c. The Natural Rate of Unemployment in Canada Revisited
	d. A Forecasting Equation for the Canadian-U.S. Dollar Exchange Rate
	e. The Canada-U.S. Free Trade Agreement: A Retrospective on the Agreement and the Canadian Experience
	f. Balance Sheet Risk, Credit Supply, and Their Impact on Real Economic Activity
3.	Economic Developments and Policies (SM/94/97)
	a. Federal-Provincial Fiscal Relations
	b. Aging Populations and Canadian Public Pension Plans
	c. Labor Market Policies
	d. Current Account Model

Chapters II-VI focus primarily on recent economic developments. Chapter II reviews aggregate output and price developments, with an emphasis on the labor market. In particular, this chapter discusses the factors that have allowed economic activity to accelerate in recent years while keeping inflation pressures relatively subdued. Chapters III and IV review in more detail estimates of the degree of economic slack in labor and output markets, respectively. Although such estimates are subject to a high degree of uncertainty, the econometric evidence suggests that economic slack was taken up rapidly during 1994.

Chapters V describes developments in Canada’s balance of payments. The chapter notes that the effect of the depreciation of the Canadian dollar since 1991, the increase in world commodity prices, and the cyclical recovery in the United States have contributed to an improvement in Canada’s external current account. Chapter VI assesses monetary and exchange market developments. Since mid-1990 Canadian monetary policy has generally sought to ease monetary conditions in support of economic recovery, while at the same time ensuring that the inflation rate remains within the official target range, set in 1991. However, during 1994 and early 1995 the conduct of monetary policy was complicated by periods of substantial downward pressure on the Canadian dollar, which resulted an increase in short-term interest rates vis-à-vis the United States.

The subsequent chapters concentrate on fiscal issues. Chapter VII describes the deterioration in the federal fiscal situation during the late 1980s and early 1990s, which resulted in the federal deficit rising to an average of 6 percent of GDP in 1992/93 and 1993/94, and federal net debt reaching 72 percent of GDP at the end of 1993/94. The provincial fiscal situation deteriorated at the same time, and on a national accounts basis the general government fiscal deficit averaged about 7 percent in 1992 and 1993. Recent federal and provincial deficit-reduction initiatives--including the Federal Government’s February 1995 budget--are described.

Chapters VIII-X review the three major federal spending programs: federal-provincial transfers, unemployment insurance, and elderly benefits. Chapter VIII suggests that transfers to the provinces may have contributed to inefficient and excessive provincial spending on health, education, and social assistance. It notes that only the first step toward reform of the transfer system appears to have been taken as part of the Government’s February 1995 budget, and that the modalities for determining the size and distribution of transfers still need to be determined.

Chapter IX reviews the operation of the unemployment insurance system in Canada, and suggests that many of its current features have contributed to its use as long-term income assistance and to its adverse effect on labor market flexibility. The chapter reviews suggested reform options, including the withdrawal of enhanced benefits for high-unemployment regions and the reduction of cash benefits to the long-term unemployed. Chapter X describes the system of public support for the elderly and the fact that demographic trends suggest that the system is substantially underfunded. The chapter notes that these trends mean that action will need to be taken soon to scale back public pension benefits or to raise contribution rates. Similar pressures will cause federal transfers to the elderly to rise significantly in the future. The chapter suggests that in light of the current fiscal situation and the longer-term prospects for these transfers, there may be scope for reducing the generosity of these transfers, especially for high-income seniors. Chapter XI discusses federal spending on government operations and defense, and the prospects for achieving further cuts in these areas.

Chapter XII and Chapter XIII discuss various federal tax issues. In particular, Chapter XII reviews the performance of the federal Goods and Services Tax (GST)--a value added tax--since its inception in 1991. The chapter notes that an important drawback to the GST has been the administrative and compliance costs that have resulted from the lack of harmony between it and provincial sales taxes, and describes the options for the reform of the GST. Chapter XIII describes a number of major tax incentives and preferences--so-called “tax expenditures”--in the federal direct and indirect tax systems, and discusses some of the issues that would be involved in their reduction.

Chapter XIV presents illustrative fiscal policy simulations using the Fund’s macroeconomic policy simulation model--MULTIMOD. In particular, the Chapter explores the effect of policies to achieve a substantial reduction in the Government’s deficit and debt. The results illustrate that the effects depend substantially on the instruments chosen to achieve this objective. For example, fiscal consolidation that is achieved by raising relatively distortionary taxes--such as labor income or capital income taxes--tend to adversely affect output in both the short and long runs. However, deficit reduction that is accomplished by cutting government consumption, raising consumption taxes, or cutting transfers to households is estimated to have only a modest adverse effect on output in the short run, and would tend to increase output in the longer term. The simulations also suggest that beneficial effects of deficit reduction could be enhanced if investors reduce the risk premium required on Canadian assets.

Finally, Chapters XV and XVI describe developments in Canada’s international development assistance and trade policies.