Canada: Economic Developments and Policies

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

Abstract

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

XIV. Illustrative Fiscal Policy Simulations 1/

1. Introduction

This paper discusses the main properties of the Canadian block of MULTIMOD, the IMF’s policy simulation model, with reference to a set of standard fiscal scenarios. The focus of the note is on the effects of fiscal policy shocks in the Canadian model. 2/

2. Fiscal policy and distortionary taxes in MULTIMOD

The IMF’s macroeconomic policy simulation model, MULTIMOD, has been recently extended to include a simple model of the labor market and to illustrate some of the distortionary effects of taxation. The revised version of the model now incorporates a richer set of fiscal instruments, namely: government direct spending, transfers from the Government to households and to firms, a consumption tax, a labor income tax, and a capital income tax. 3/

Fiscal policy affects the demand side of the model directly in the case of changes in government consumption, and indirectly by affecting the wealth of households and firm’s cost of capital, which in turn influence private consumption and investment decisions, respectively. In addition, indirect taxes also affect private sector decision-making by driving a wedge between consumer and producer prices. The Government’s fiscal instruments affect the supply side of the model through the assumption of a simple tax-augmented forward-looking model of the labor market.

The long-run properties of the model generally conform to those of intertemporal neoclassical public finance models. For instance, monetary policy is neutral and unemployment converges to its natural rate in response to demand shocks in the long run. The model also assumes that government transfers to the private sector adjust endogenously to ensure that government debt converges to a target fraction of GDP.

For example, deficit reduction implemented by a cut in government expenditure initially lowers the debt/GDP ratio. Subsequently, government transfers to the private sector gradually adjust to allow the debt/GDP ratio to return to its target level. If the debt/GDP target ratio also is assumed to fall after the initial shock, a further adjustment to government spending or revenues is required to accommodate the reduction in debt service. The simulations below generally assume that labor and capital income taxes adjust to accommodate changes in debt service resulting from changes in the target debt/GDP ratio.

Some of the sharp predictions of neoclassical public finance models are weakened, though, by the model’s allowance for market imperfections and short-run rigidities. For instance, households are assumed to be liquidity-constrained in the short run, and they discount future income flows at a rate higher than the market interest rate.

Under these circumstances, the model does not exhibit full Ricardian equivalence: changes in taxes--even if nondistortionary--affect aggregate demand in the model. A tax cut expected to be offset by a subsequent tax increase, for instance, is viewed by households as increasing their net wealth. This leads them to raise current consumption at the expense of current investment, which has the effect of reducing future potential output. Also, a reduction in the steady-state level of government debt will lead to a reallocation of demand from consumption to investment if the debt-service savings are used to lower capital income taxes.

MULTIMOD assumes that labor supply is inelastic in the long run, so that changes in indirect taxes are fully accommodated by changes in post-tax real wages. However, in the short run wages adjust sluggishly so that higher indirect taxes raise pre-tax real wages and the unemployment rate. Consistent with empirical results on the effects of labor taxes on the natural rate of unemployment, MULTIMOD also assumes that labor taxes raise the long-term unemployment rate. Similarly, MULTIMOD recognizes that firms are partly equity-financed, so that taxes on firms’ profits are only partly offset by debt payments, and higher capital taxes depress investment. 1/

Finally, the short-term effect of specific fiscal policies will depend on a country’s openness, the magnitude of the response of the exchange rate to exogenous shocks, and the pass through of exchange rate changes to inflation and real money balances. This is especially the case when short-run price rigidities increase the response of exchange rates to exogenous shocks. For very open economies such as Canada’s, the external sector may well be the primary channel through which fiscal policies are transmitted to private demand and supply in the short run.

3. Illustrative fiscal shocks

The effects of using different fiscal instruments to achieve fiscal consolidation are reviewed in the simulations below. Specifically, it is assumed that the fiscal deficit is lowered by 3 percent of GDP for six years by cutting transfers, reducing government consumption, or raising taxes. After the sixth year, transfers to households are assumed to gradually increase until the debt/GDP ratio stabilizes at a new steady-state level about 25 percent of GDP lower than the baseline.

An important assumption in the simulations described below is that a fall in government debt-service costs that results from a lowering of the target debt-ratio permits a reduction in the tax on capital and labor income. 1/ As a result, fiscal consolidation that permanently reduces the debt/GDP ratio has the effect of reducing the pressure of distortionary taxes.

In each of the scenarios described below, monetary policy is assumed to remain passive on impact in response to the fiscal shock, in the sense that the central bank maintains its money supply target at its baseline level in the first year of the shock. In subsequent years, however, the money supply is assumed to adjust endogenously so as to target a constant rate of domestic absorption inflation (which moves very closely with CPI inflation). The results of the simulations are summarized in the Annex tables.

a. Temporary reduction in transfers to households

This scenario assumes a decrease in current transfers to households to achieve a temporary reduction in the deficit of 3 percent of GDP. The reduction in the deficit is subsequently reversed by an increase in transfers that exactly matches the earlier decrease in present value terms. This experiment illustrates the non-Ricardian effect of fiscal consolidation in MULTIMOD. 2/ Even though the simulation involves an intertemporal shift in what are essentially lump-sum transfers, current consumers attach greater weight to a decline in current transfers than to their subsequent (offsetting) increase because they anticipate death with a positive probability. Hence, deficit reduction lowers current households’ wealth, which leads to a decline in consumption (Annex Table XIV-1). The resulting increase in savings lowers the interest rate over the medium-to-long run, thereby stimulating investment. In the new long-run equilibrium, resources are shifted from (public) consumption to (private) investment, causing the capital stock and output to exceed their baseline values.

However, the output effects resulting from a deficit reduction of 3 percent of GDP achieved by nondistortionary means is estimated to be small--approximately 0.3 percent of baseline GDP at the end of ten years. 1/ Furthermore, the short-run effect of the fiscal contraction is to reduce output, reflecting the fact that negative demand effects dominate over shorter horizons: the fall in consumption demand, amplified by the reduction of disposable income for liquidity-constrained consumers, depresses output by about 0.2 percent of its baseline in the first year of the simulation.

The fall in domestic consumption is partly offset by a rise in net exports caused by the decline in the real effective exchange rate (i.e., a depreciation). The effect of the fiscal consolidation on the exchange rate and on interest rates reflects the effect of the improved saving/investment balance. Interest rates, in particular, fall marginally below their baseline value despite the inflationary impact of the depreciation (and the resulting fall in real money balances).

b. Permanent cut in government consumption

This scenario assumes a permanent, unanticipated cut in government consumption expenditure, combined with a gradual reduction in the debt/GDP ratio of 25 percentage points. The retirement of public, debt and the resulting decline in debt-service costs is assumed to allow the Government to reduce the burden of income taxes on employment and investment.

The reduction of government debt by 25 percent of GDP results in debt service and income taxes being reduced by about 1 1/4 percent of GDP each (Annex Table XIV-2). This promotes employment and investment, and raises potential and actual GDP above their baseline levels by about 1 percent in the long run. In response to the lower relative demand for domestic output (owing to reduced government consumption) the Canadian dollar eventually depreciates by about 7 percent in real effective terms. The large drop in domestic demand offsets the improved trade balance and causes short-term interest rates to fall, even in the first several years of the simulation.

c. Permanent cut in transfers to households

This scenario illustrates the effects of debt reduction implemented by reducing nondistortionary transfers, assuming (as above) that the fall in debt-service costs is used to reduce income taxes. Qualitatively, a cut in transfers to households has a similar effect as the previous example of a cut in government consumption, in that it contributes to shifting resources from consumption to investment in the long run. However, the effects of a cut in government consumption on domestic demand are stronger and more immediate since total domestic consumption is affected directly, whereas the effect of the reduction in transfers to households is partly offset by a drop in private savings.

Accordingly, while most macroeconomic aggregates display the same qualitative behavior as in the previous scenario, their response to the deficit reduction is weaker (Annex Table XIV-3): output falls by 0.2 percent of baseline in the first year and rises by just under 1 percent of baseline within 11 years. Prices and interest rates are affected only slightly, and the real effective exchange rate falls immediately by about 2 1/2 percent.

d. Permanent cut in transfers to firms

Transfers to firms act primarily as investment incentives by increasing the market value of each unit of existing capital. A cut in transfers to firms causes investment to fall on impact, and to remain depressed in the long run with respect to its baseline value. Consumption also falls in response to a decrease in transfers to firms because households, as shareholders, ultimately consume the profits of firms. The decline in the capital stock reduces the productivity of labor and labor income, thereby providing an additional channel for a decline in demand.

As in all other scenarios, the real depreciation of the Canadian dollar spurs higher net exports, but their contribution is not sufficient to prevent a fall in aggregate demand and output (Annex Table XIV-4). In the long run, the reduction in debt-service costs permits a decline in the tax rates on labor and capital income, which partly offsets the adverse effect of the fall in direct transfers to firms. In the new steady state, however, the capital stock and output are all lower than their baseline values.

e. Permanent increase in consumption taxes

MULTIMOD assumes that the long-run supply of labor is fixed, an assumption that is consistent with a significant amount of empirical evidence. 1/ Under these circumstances, indirect taxes do not distort labor market decisions in the long run, as they are borne--eventually--solely by consumers. In the short run, however, workers resist declines in real wages, and indirect taxes are partly shifted forward to prices, thereby leading to a fall in demand and output.

In this framework, an increase in indirect taxes has the same long-run expansionary effects as a reduction in transfers to households, including the beneficial effects of lower debt-service costs (Annex Table XIV-5). In the short run, however, higher indirect taxes raise prices and reduce demand. In this particular case, a 5 percent increase in the consumption tax (corresponding to tax revenues of 3 percent of GDP), causes GDP to fall on impact by about 3/4 percent, the GDP deflator to rise by about 1 percent, and the absorption deflator to rise by 1 1/2 percent. The increase in prices reduces the real money stock and causes a small increase in interest rates in the short run.

f. Permanent increase in labor taxes

In MULTIMOD, higher labor taxes affect investment and the external sector only indirectly, through a decline in firms’ revenues and in the fiscal deficit. However, labor taxes have direct economic effects through their impact on households’ disposable income (thereby leading to a fall in consumption), and through their negative effects on short-run and steady-state unemployment. 1/ Assuming a two-thirds labor share of income, an increase in labor tax rates of about 4 1/2 percentage points is required to raise tax revenues by 3 percent of GDP on impact.

This shock has an immediate contractionary effect on output, only partly offset by higher net exports (Annex Table XIV-6). Unemployment responds slowly, gradually adjusting to its new (higher) steady-state value. The reduction in debt-service costs gradually allows a partial reduction of the labor tax rate and a reduction of the capital tax rate. The new steady-state equilibrium exhibits a higher unemployment rate (about 1 1/2 percentage points above baseline), a somewhat larger stock of capital, and lower potential and actual output.

g. Permanent increase in capital income taxes

The investment and output implications of a rise in the capital tax rate are similar to those of a decline in transfers to firms, 2/ The implications for consumption and exports are different, however. A decline in transfers to firms acts as a tax on households’ wealth, thereby causing consumption to fall, and net exports to be crowded in by the real depreciation of the exchange rate. In contrast, a capital income tax acts as a tax on saving, thereby causing current consumption to rise and crowd out net exports.

The effect of a capital income tax on the economy’s convergence to its new steady state is also different: liquidity effects dominate on impact, causing disposable income, consumption, and aggregate demand to fall (Annex Table XIV-7). Subsequently, consumers respond to stronger incentive to consume (rather than save), thereby sustaining a short-lived recovery. Eventually, the consumption boom erodes the capital stock, and the economy converges to a lower level of investment, capital, and output in the steady stat.

h. Decline in the interest rate premium

Finally, Annex Table XIV-8 illustrates the effect of a permanent 1/2 percentage point fall in the real risk premium on Canadian debt. This shock could be viewed as capturing an aspect of investors’ behavior that is difficult to model empirically--namely, the responsiveness of portfolio choice to uncertainty about the economic and fiscal climate. Underlying this simulation is the assumption that investors’ desire to hold Canadian financial assets reflects uncertainty about future policy actions, and this uncertainty is likely to be greater for higher levels of government debt. For instance, debt reduction may reduce uncertainty regarding the timing of or the instruments used to meet the Government’s intertemporal budget constraint, or reduce the risk of a financial crisis.

While usually imprecise, estimates of risk premia of up to 1 percent for industrial countries seem to be the most common in the literature. The illustrative scenario assumes a decline in the risk premium of 1/2 percentage point. The main effects of greater investors’ willingness to hold Canadian assets include a lower interest rate and a rise in the value of the Canadian dollar. The fall in Canadian interest rates leads to higher human wealth and asset accumulation, and hence to a rise in both consumption and investment demand. Greater demand for Canadian dollars causes an appreciation of the Canadian dollar, but the resulting fall in net exports is eventually more than offset by the sharp rise in domestic absorption. The net effects of the shock, therefore, is a long-run increase in the capital stock and output.

4. A fiscal adjustment scenario

It is apparent from the experiments performed above that the effects of a fiscal contraction depend crucially on the mix of fiscal instruments used: if relatively distortionary taxes on factor income are used to reduce the deficit, output losses may persist in the long run. However, debt reduction implemented through relatively nondistortionary means can promote output and increase welfare. In practice, however, deficit reductions usually involve a broad range of fiscal instruments, and it may be useful to illustrate the effects of a fiscal consolidation package that relies on a combination of the instruments discussed above.

For example, it is assumed that the fiscal deficit is cut by 3 percent of GDP beginning in 1995 for six years using a combination of the fiscal instruments described above. Reductions in transfers to households are assumed to contribute four-fifths of the decline in the fiscal deficit, while the remaining fifth is achieved by a reduction in government consumption expenditure. After six years, the deficit is assumed to rise gradually to a level that is consistent with a debt/GDP ratio that is about 25 percentage points below baseline by increasing nondistortionary transfers to households. The reduction in interest payments that results from the fall in government debt is assumed to permit a reduction in labor and capital income taxes in proportion to the capital and labor income shares (roughly 30 percent and 70 percent, respectively).

As in the cases above, monetary policy is assumed to partially accommodate the price effect of the fiscal shock in the first year of the simulation, by targeting money supply at its baseline value in the first year, but to target absorption inflation (or roughly CPI inflation) thereafter. To illustrate the potential for fiscal stabilization to enhance economic growth, the additional possibility is considered that the fiscal consolidation leads to a permanent fall in the risk premium on Canadian bonds by 1/2 and 1 percentage points, respectively.

The results of these scenarios are summarized in the tabulation below (see also Annex Table XIV-9.) 1/ The results indicate that the debt-reduction initiative would be associated with a relatively modest loss of output in the first year, while output would rise above baseline from the second year of the simulation. By the eleventh year, output would exceed its baseline by about 1 percent, and the unemployment rate would be about 3/4 percentage point lower than in the baseline. The debt-reduction plan would lead to a moderate real depreciation of the Canadian dollar, and net exports would increase. The decline in real interest rates would promote investment and raise longer term output.

Simulated Effects of Fiscal Adjustment

(Percent deviations from base line)

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Consistent with the discussion in Section 3, the debt-reduction initiative would lead to even more significant gains if it caused a reduction in the premium required by international investors to hold Canadian assets. For example, assuming that a permanent decline in the debt/GDP ratio by about 25 percentage points would lead to a fall in the risk premium of 50 basis points (roughly half the current differential of long-term Canadian rates with respect to U.S. rates). In this case, output would fall below its baseline in the first year (by a similar amount as in the fiscal adjustment scenario described above), and would rise above baseline by about 1 1/2 percent by 2005. The primary engine for higher output would now be private investment, with Canada’s competitiveness remaining broadly unchanged throughout the horizon. A larger fall in the risk premium on Canadian bonds would mean a larger increase in output and greater shift from foreign to domestic demand.

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ANNEX

Table XIV-1.

Canada: Temporary Cut in Transfers

(Percent deviation from baseline)

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Percentage point change.

A positive number implies an appreciation.

Table XIV-2.

Canada: Permanent Cut in Government Consumption

(Percent deviation from baseline)

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Percentage point change.

A positive number implies an appreciation.

Table XIV-3.

Canada: Permanent Cut In Transfers to Households

(Percent deviation from baseline)

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Percentage point change.

A positive number implies an appreciation.

Table XIV-4.

Canada: Permanent Cut in Transfers to Firms

(Percent deviation from baseline)

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Percentage point change.

A positive number implies an appreciation.

Table XIV-5.

Canada: Permanent Increase in Consumption Tax

(Percent deviation from baseline)

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Percentage point change.

A positive number implies an appreciation.

Table XIV-6.

Canada: Permanent Increase in Labor Income Taxes

(Percent deviation from baseline)

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Percentage point change.

A positive number implies an appreciation.

Table XIV-7.

Canada: Permanent Increase in Capital Taxes

(Percent deviation from baseline)

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Percentage point change.

A positive number implies an appreciation.