Canada: Selected Issues
Author:
International Monetary Fund
Search for other papers by International Monetary Fund in
Current site
Google Scholar
Close

This Selected Issues paper for Canada presents comprehensive and broad-based analysis of the role of domestic and external shocks. Canada’s economic history illustrates the important role played by external as well as domestic macroeconomic disturbances. Canada’s economy slowed in 2001 because of the global slowdown, although by less than in many other countries. In 2003, the recovery has been interrupted by a series of shocks that moderated growth. Fluctuations in Canadian real GDP are explained by external and domestic cycles.

Abstract

This Selected Issues paper for Canada presents comprehensive and broad-based analysis of the role of domestic and external shocks. Canada’s economic history illustrates the important role played by external as well as domestic macroeconomic disturbances. Canada’s economy slowed in 2001 because of the global slowdown, although by less than in many other countries. In 2003, the recovery has been interrupted by a series of shocks that moderated growth. Fluctuations in Canadian real GDP are explained by external and domestic cycles.

PART II: FISCAL ISSUES

III. Jam Today or More Jam Tomorrow? On Cutting Taxes Now Versus Later22

A. Introduction

1. The Canadian fiscal framework adopted in the mid-1990s has led to a rapid reduction in government debt in recent years. The federal objective of budget balance or better has resulted in seven consecutive years of fiscal surpluses and by far the largest reduction in debt across G-7 countries (see the discussion in Box 1 of the accompanying Staff Report). Fiscal prudence, together with reforms of the public pension system that have put it on an actuarially sound basis, have left Canada relatively well prepared to cope with the fiscal pressures from population aging.

2. This paper uses the Fund’s Global Fiscal Model (GFM) to examine the long-term benefits from reducing government debt by delaying tax cuts as well as issues of tax spillovers. GFM has been recently developed at the Fund to examine fiscal policy issues. The simulations in this paper examine the consequences of foregoing immediate tax cuts in response to reductions in government spending so that government debt falls, allowing larger tax cuts in the future. In addition, the impact of tax rate changes in the rest of the world on Canada is also examined.

B. The Model and Calibration

3. The Fund’s GFM model is a micro-founded model that has been developed specifically to examine fiscal issues. It is part of a suite of models with similar underlying structures adapted to look at different macroeconomic issues.23 These models share important characteristics, including a firm grounding in microeconomic theory—consumers maximize utility and firms do the same with profits—ensuring that the long-run properties of the model conform to those predicted by theory. As the underlying parameters correspond to assumptions about underlying behavior (such as the elasticity of substitution of hours worked with respect to real wages or consumption with respect to the real interest rate) these models are well designed to analyze how simulations depend on key behavioral assumptions, while real and nominal rigidities generate realistic dynamic responses. Finally, these models allow for more than one country, and hence can examine international linkages, a major theme of Fund work.

4. Several features of GFM make it particularly well suited to examine fiscal issues:

  • The private sector is impatient. More specifically, the discount rate used by the private sector is higher than the real rate of interest. In the absence of such impatience, the private sector fully anticipates the future costs of tax changes, leading to the Ricardian result that movements in aggregate demand from changes in taxes or transfers have no impact on spending. Additionally, the model assumes that a certain proportion of wages accrue to “rule-of-thumb” individuals who vary their consumption one-for-one with their post-tax income. Finally, tax rates also distort relative prices, and hence the allocation of resources.24

  • Markets are not fully competitive. Firms and workers have some monopolistic power, implying that prices are above their perfectly competitive levels. The most important consequence of this is that a corporate income tax affects not only the return to capital, but also the economic rent firms are able to extract from their monopolistic power. As a result, corporate income taxes are less distortionary than in the case where these rents do not exist.

  • The remainder of the model can be briefly summarized as follows. Consumption and production are characterized by constant elasticity of substitution utility/production functions. There are two factors of production, labor and capital, which can be moved across sectors to produce traded or nontraded goods. Investment is driven by a Tobin’s Q-relationship, in which firms respond sluggishly to differences between the future discounted value of their profits and the market value of their capital stock. Perfect capital mobility implies that real interest rates in countries are equalized over time.25 Wages and prices are assumed perfectly flexible, which reduces the short-term aggregate demand impact of fiscal policies. Accordingly, the discussion will focus on medium- and long-term results. This paper uses a two-country version of the model.

5. The impact of a tax cut on real activity depends on the response of aggregate supply and demand. The supply-side effects come through the increase in equilibrium hours worked (as a drop in the wage tax rate raises take home wages) or the capital stock (as a cut in the corporate income tax rate increases post-tax rates of return). The increase in aggregate demand depends on the extent to which individuals view a larger fiscal deficit as an increase in their permanent income, which, in turn, depends on nominal rigidities, the level of impatience, and the proportion of rule-of-thumb consumers. Over the longer-term, these effects spill over to other countries as the global real interest rate rises to re-equilibrate aggregate demand and supply.

6. The model was parameterized to reflect the macroeconomic features of Canada and the rest of the world. The latter is based on the United States, Canada’s main trading partner. Canada is about one-tenth of the size of the rest of the world, and hence its policies have only a limited impact on the global rate of interest. The ratios relative to GDP of consumption, investment, government spending, wage income, and income from capital correspond to those in Canada and the United States. Canadian exports and imports as a ratio to GDP are set at current values. Tax rates on capital, labor, and consumption have been calibrated to reflect current yields across the two economies.26

7. A number of other key behavioral parameters are set equal across the two economies.27 In addition to those characterizing real rigidities in investment and the markups of firms, simulations examine the impact of changing the values of the following key parameters:

  • The Frisch elasticity of labor supply, which measures the sensitivity of labor supply to real wages. In the baseline, this is set at 0.04, in the mid-range of values produced by microeconomic studies. Alternative simulations assume values of 0.08 and 0.01, around the upper and lower limits of these estimates.

  • The elasticity of substitution between labor and capital in the production function. In the baseline, this is set at -0.8, while alternative simulations use values of -0.6 and -1 (the latter is the familiar Cobb-Douglas case, which implies constant shares of income accruing to labor and capital).

  • The intertemporal elasticity of substitution of consumption, which measures the sensitivity of consumption to changes in the real interest rate. This is set at -0.33 in the base case, with a lower and upper level of -0.25 and -0.5, again broadly covering the range of microeconomic estimates.

  • The impatience of forward-looking consumers. This parameter has not been subject to significant microeconomic analysis. One approach is to consider the gap between interest rates charged to consumers on credit card debt, the main source of unsecured loans in which the lender takes the full risk that consumers may be unable to repay, and government debt. Given the substantial margins seen in this comparison, the private sector discount rate was set some 10 percentage points above the real rate of interest, while simulations are also reported with wedges of 5 percentage points and 15 percentage points.

  • The proportion of wages associated with “rule-of-thumb” consumers. In the base case, this parameter was set at 10 percent, being raised to 20 percent and set to zero in alternative simulations. At the macroeconomic level, consumption is known to be relatively sensitive to changes in disposable income, although some of this comes from the impatience of forward-looking consumers discussed above. In the base parameterization, the assumptions about impatience and rule-of-thumb consumers imply a multiplier of around one-fourth for temporary tax cuts or changes in income, broadly in line with other empirical work.28

C. Results of Cutting Transfers and Lowering Taxes Immediately or Later

8. This section compares the consequences of matching a cut in transfers with an immediate tax cut versus a larger tax cut that occurs later. The simulations assume that room for tax cuts is provided by a permanent cut in lump-sum transfer payments of one percentage point of GDP. 29 The results compare the following two policy responses: (i) immediately implementing a permanent cut in tax rates so as to reduce tax revenues by the same amount as the cut in transfer payments; and (ii) leaving tax rates unchanged for 10 years, followed by a larger permanent cut in tax rates made possible by the lower level of interest costs due to the intervening fall in the government debt ratio. In the second scenario, the government ends up with permanently lower tax rate and levels of government debt, but at the cost of not offsetting the negative short-term impact of the cut in transfers on aggregate demand. While such scenarios are clearly stylized—in practice, the main reason for reducing government debt at present is to prepare for the future pressures on government spending from population aging—they help illustrate the effects of choosing to cut taxes or reduce debt in a simple and intuitive manner.30

9. Results for the base parameterization suggest that there are significant long-term benefits to delaying a cut in wage taxes, but there are also costs to not offsetting the fall in transfers in the short term (Figure 1). Immediately replacing a one percentage point of GDP reduction in lump sum transfers with a cut in wage taxes leads to a 0.3 percent increase in real GDP. About two-thirds of this boost occurs relatively rapidly, as the reduction in taxes leads to a boost in hours worked, while the remainder accumulates more slowly as the capital stock rises. Delaying the cut in wage taxes by 10 years results in a small fall in real GDP after 5 years as the impact on aggregate demand of the reduction in transfer payments is not offset, but also leads to an eventual tax rate reduction that is one-and-a-half times larger than when taxes are cut immediately. Once implemented, the larger tax cut leads to real GDP gains that rise gradually from double to triple those with an immediate tax cut.

Figure 1.
Figure 1.

Effects on Real GDP of Reducing Transfers and Cutting Wage Tax Immediately and with a Delay

(percent deviation from baseline)

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A003

Source: Fund staff calculations.

10. Cuts in corporate income taxes produce larger benefits that accumulate more slowly over time, while delaying cuts produce a similar ratio of losses and benefits (Figure 2). Replacing an immediate cut in wage taxes with a cut in corporate income taxes leads to a similar gain in real GDP after 5 years and a much larger gain over time as capital is accumulated. The larger long-term benefits from a cut in corporate income taxes compared to wage taxes reflects the fact that the corporate tax is more distortionary as the supply of capital (which can be easily reproduced) is more elastic than that of labor—a standard result in the literature. 31 Delaying the cut in taxes for 10 years again implies forgoing significant benefits to real GDP over the first 5 years in return for reaping benefits that are of the order of double the base case beyond ten years.

Figure 2.
Figure 2.

Effects on Real GDP of Reducing Transfers and Cutting Corporate Income Taxes Immediately and with a Delay

(percent deviation from baseline)

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A003

Source: Fund staff calculations.

11. A key advantage of a model such as GFM with well-defined microeconomic foundations is that the implications of alternative behavioral assumptions can be examined. Figure 3 reports the change in real GDP after 5 years, 15 years, and 40 years when wage taxes are cut immediately, after 10 years, and the difference between these two values for a range of parameter values. The results after 5 years can be interpreted as the medium-term effect of the cut in spending and (if implemented) the tax cut, those after 15 years represent the medium-term impact of a delayed tax cut, while the results after 40 years represent the long-term impact of alternative scenarios.

Figure 3.
Figure 3.

Effects of Alternative Parameterizations on Impact of a Cut in Transfers and in the Wage Tax Rate on Real GDP

(percent deviation from baseline)

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A003

Source: Fund staff calculations.

12. The results indicate that the Frisch elasticity of labor supply largely determines the overall size of the wage tax distortion. The benefits from immediate cuts in wage taxes vary approximately proportionally with the value of the Frisch elasticity of labor supply, for example, approximately doubling when it is raised from 0.04 to 0.08. This is because the elasticity determines the response of hours worked to changes in post-tax real incomes and hence the distortion to labor supply. No other parameter has a significant effect on the impact of an immediate cut in wage taxes.

13. The Frisch elasticity also has a proportional impact on the dynamic benefits of delaying wage tax cuts, while the ratio of short-term losses to long-term benefits rises as consumption becomes less sensitive to the real interest rate. The difference in the changes in real GDP implied by the different timing of tax cuts again vary approximately proportionately with the size of the Frisch elasticity. In addition, the ratio of longer-term benefits from delayed tax cuts to short-term losses rises when consumption is less sensitive to real interest rates as it induces a larger fall in the real interest rate and a greater rise in the capital stock. This occurs when the intertemporal elasticity of consumption is reduced and when forward-looking consumers are made more impatient. Increasing the elasticity of substitution between labor and capital also raises this ratio as it increases the response of the capital stock to changes in labor supply. Finally, changing the proportion of rule-of-thumb consumers had little impact on the path of real GDP (and is not reported).

14. The key parameter for a corporate income tax is the elasticity of substitution between capital and labor, while changes in the sensitivity of consumption to real interest rates again matter for the dynamic responses (Figure 4). The higher the elasticity of substitution between labor and capital, the greater the incentive for firms to respond to a tax cut by raising the capital stock, and hence the larger the benefits of a delayed tax cut. In addition, the larger impact on the real interest rate from reducing the sensitivity of consumption to the real interest rate again raises the dynamic benefits of a tax cut. By contrast, changes in the Frisch elasticity and the proportion of rule-of-thumb consumers have little impact on the simulations.

Figure 4.
Figure 4.

Effects of Alternative Parameterizations on Impact of a Cut in Transfers and in the Corporate Income Tax Rate on Real GDP

(percent deviation from baseline)

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A003

Source: Fund staff calculations.

D. Fiscal Spillovers

15. The model can also be used to examine issues of fiscal spillovers across countries. As in the earlier section, a highly stylized scenario designed to illustrate the impact of tax competition on the Canadian economy is examined. In particular, it is assumed that there is a wage or corporate income tax rate cut in the rest of the world that lowers revenues by a percentage point of GDP and leads to larger fiscal deficits. After 5 years, this tax cut is rescinded and replaced by a permanent tax rate increase that generates sufficient revenues to cover the additional interest costs incurred by the intervening rise in government debt. The simulations first examine the impact on the Canadian economy assuming no response by the tax authorities, and then the results if the Canadian authorities follow the rest of the world in cutting, and then later raising, the same tax rate.

16. The results suggest that fiscal Figure 5. Impact of Tax Spillovers from spillovers from tax cuts in the rest of the world can be significant and rise over the Rest of the World Temporary Cut in Wage Tax in the Rest of the World time (Figure 5). A temporary cut in wage taxes in the rest of the world equivalent to a one percentage point of their GDP is followed by subsequent increase of the order to one-quarter of this amount. The loss to Canadian and global GDP is of the order of three-quarters of a percent after 15 years. The losses accumulate gradually over time, as global real interest rates rise by around a half percentage point and crowd out investment in response to the 8 percentage point of GDP increase in rest of the world government debt.32 The resulting losses to real GDP for equivalent changes in corporate income taxes are somewhat larger, reflecting the fact that corporate tax rate increases are more distortionary, but the basic mechanisms are similar.

Figure 5.
Figure 5.

Impact of Tax Spillovers from the Rest of the World

Citation: IMF Staff Country Reports 2005, 116; 10.5089/9781451806984.002.A003

Source: Fund staff calculations.

17. The Canadian government can mitigate the medium-term effects of fiscal spillovers by matching foreign taxes cuts, but only at the cost of larger long-term costs to real GDP. These results broadly mirror those found earlier about the benefits and costs of immediate and delayed tax cuts. However, as the main effect on Canada occurs through the global rate of interest, rather than differences in tax rates across countries, Canada’s own tax policy has only a limited impact on the long-term losses in output. This observation applies more to wage tax cuts than corporate income tax cuts, as the latter involve larger domestic distortions.

18. These results reflect a range of assumptions about the structure and behavior of the global economy. It should be emphasized that the impact of fiscal policies in individual countries would be smaller for the rest of the world, as they would have a lesser impact on global debt and real interest rates. In addition, the size of fiscal spillovers is an area of considerable controversy, and these simulations are only one approach to answering this question.33

E. Conclusions

19. The conclusions of this analysis can be summarized as follows:

  • There are significant potential benefits to reducing government debt by delaying tax cuts. In the base case, delaying tax reductions 10 years at the costs of short-term losses in output doubles the medium-term gains to real GDP of the eventual tax cut and the long-term benefits can be even larger.

  • A corporate income tax cut provides significantly greater benefits over time than a wage tax cut. This is because capital is a more mobile factor of production, and hence more responsive to changes in incentives.

  • The key parameters that determine the benefits of delaying tax cuts are the Frisch elasticity of labor supply for a wage tax and the elasticity of substitution between labor and capital for a corporate tax cut. In addition, the ratio of losses and benefits to real GDP rise as the response of consumption to real interest rates is reduced or consumer impatience rises, as this boosts the long-term impact on the capital stock.

  • International fiscal spillovers can be significant, with much of the impact coming through the global rate of interest, rather than differences in tax rates across countries. This limits the effectiveness of Canadian policies in reducing these spillovers, particularly for wage taxes.

References

  • Bayoumi, T., 2004, GEM: A New International Macroeconomic Model, IMF Occasional Paper No. 239 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Botman, D., and D. Laxton, 2004, “The Effects of Tax Cuts in a Global Fiscal Model,Box 2.2 in World Economic Outlook, April (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Botman, D., D. Laxton, D. Muir, and A. Romanov, 2005, “A New-Open-Economy-Macro Model for Fiscal Policy Evaluation,” Unpublished Manuscript (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Elmendorf, D.W., and N.G. Mankiw, 1999, “Government Debt,n Handbook of Macroeconomics, Vol. 1c, edited by J.B. Taylor and M. Woodford (Amsterdam: Elsevier Science).

    • Search Google Scholar
    • Export Citation
  • Finance Canada, 2004, “Taxation and Economic Efficiency: Results from a General Equilibrium Model,in Tax Expenditures and Evaluations 2004 (Ottawa: Department of Finance Canada). Available on the Internet at http://www.fin.gc.ca/taxexp/2004/TaxExp04_e.pdf.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund (IMF), 2004, “The Global Implications of the U.S. Fiscal Deficit and of China’s Growth,World Economic Outlook, April (Washington).

    • Search Google Scholar
    • Export Citation
  • Laxton, D., and P. Pesenti, 2003, “Monetary Rules for Small, Open, Emerging Economies,Journal of Monetary Economics, Vol. 50, pp. 110946.

    • Search Google Scholar
    • Export Citation
22

Prepared by Tamim Bayoumi and Dennis Botman (FAD).

23

See Bayoumi (2004) for a discussion of the overall modeling effort and Botman, et al. (2005) for a description of GFM.

24

The model is not useful, however, for analyzing issues of intergenerational equality.

25

Lower levels of international capital mobility would raise the beneficial effects of debt reduction for the Canadian economy, while lowering spillover from tax policy in the rest of the world.

26

Rather than try to model the complexities of actual tax systems, it is assumed that taxes are levied on the relevant base as a single marginal rate, so there is no difference between average and marginal tax rates. Were taxes assumed to be progressive, this would lead to small reductions in tax rates and hence distortions.

27

See Laxton and Pesenti (2003) for a more detailed discussion of evidence on parameter values.

28

For a discussion of current evidence on fiscal multipliers, see IMF (2004).

29

Lump-sum transfers have no impact on incentives, and hence allow a focus on the distortions caused by tax rates.

30

The baseline also does not take account of future fiscal pressures from population aging. However, as the model is approximately linear, the results would not be significantly altered if the baseline was changed.

31

For a Canadian application, see Finance Canada (2004).

32

This is broadly consistent with results reported in IMF (2004), which finds that a percentage point rise in the U.S. fiscal deficit raises interest rates by up to ½ percentage point (i.e. recalling that the United States represents about one-third of global GDP at market prices), as well as the rule of thumb of Elmendorf and Mankiw (1999), that are rise in government debt lowers the capital stock by an approximately equal amount.

33

See IMF (2004) for a discussion of these issues.

  • Collapse
  • Expand
Canada: Selected Issues
Author:
International Monetary Fund
  • Figure 1.

    Effects on Real GDP of Reducing Transfers and Cutting Wage Tax Immediately and with a Delay

    (percent deviation from baseline)

  • Figure 2.

    Effects on Real GDP of Reducing Transfers and Cutting Corporate Income Taxes Immediately and with a Delay

    (percent deviation from baseline)

  • Figure 3.

    Effects of Alternative Parameterizations on Impact of a Cut in Transfers and in the Wage Tax Rate on Real GDP

    (percent deviation from baseline)

  • Figure 4.

    Effects of Alternative Parameterizations on Impact of a Cut in Transfers and in the Corporate Income Tax Rate on Real GDP

    (percent deviation from baseline)

  • Figure 5.

    Impact of Tax Spillovers from the Rest of the World