The sensitivity of fiscal projections to economic shocks
PBO periodically provides estimates of the sensitivity of the fiscal outlook to key economic indicators that drive our federal fiscal projection: real GDP growth, GDP inflation and interest rates. PBO estimated the impacts of shocks to these economic indicators relative to its October 2022 fiscal outlook.
PBO periodically provides estimates of the sensitivity of the fiscal outlook to key economic indicators that drive our federal fiscal projection: real GDP growth, GDP inflation and interest rates. [^1]
In this note, we estimate the fiscal impacts of three key economic shocks:
A permanent 1 per cent decrease in real GDP driven equally by lower productivity and employment. [^2] A permanent 1 per cent decrease in the GDP price level, assuming the Consumer Price Index moves in line with the decrease in the GDP price level. [^3] A permanent 1-percentage-point (100-basis-point) increase in all interest rates. [^4] Each of these shocks is assessed independently. In constructing our sensitivity estimates, we assume that changes in nominal GDP are proportional across income and expenditure components. Further, it is important to note that these economic shocks are illustrative and simplifications of a complex and endogenous system. As such, these estimates should be considered stylized rules of thumb.
The economic shocks begin in the second quarter of 2023 (the first quarter of fiscal year 2023-24) and are assumed to be permanent over the projection horizon.
The fiscal impact of a 1 per cent decrease in real GDP
A permanent 1 per cent decrease in the level of real GDP reduces the budgetary balance by: $5.8 billion in the first year; $6.3 billion in the second year; and, $5.6 billion in 2027-28 (Table 1).
Total budgetary revenues are $4.5 billion lower in 2023-24, largely due to income taxes. Personal income tax revenues are reduced as the underlying tax base of household income is lower. Corporate income tax revenue is lower as the underlying tax base of corporate profits is reduced. Excise taxes and duties is the third largest contributor, which is impacted by lower consumer spending.
Revenue from Employment Insurance (EI) premiums decline in the first three years due to lower earnings. However, starting in 2026, there is an increase in the EI premium rate, which adjusts to offset the increase in EI benefits such that the EI Operating Account balances over time.
A rise in expenses further contributes to the reduction in the budgetary balance. The main driver to higher expenses is major transfers to persons and public debt charges (due to a lower budgetary balance). This is partially offset by lower direct program expenses and major transfers to other levels of government, as the growth in certain programs is linked to the growth in nominal GDP.
The fiscal impact of a 1 per cent decrease in the GDP price level
A permanent 1 per cent decrease in the GDP price level reduces the budgetary balance by: $3.0 billion in the first year; $2.5 billion in the second year; and, $2.0 billion in 2027-28 (Table 2).
Total budgetary revenues are $4.4 billion lower in 2023-24. Lower revenues are mainly driven by income taxes. A decrease in the price level results in lower personal income tax revenue as the underlying tax base of household income is reduced. Corporate income tax revenue is also lower as the underlying tax base of corporate profits are reduced. Excise taxes and duties are impacted by lower consumer spending.
Offsetting some of the lower revenues is a reduction in federal expenses. This is due to lower spending on elderly benefits and Employment Insurance (benefits linked to CPI and wages decline). There is also lower spending on the Canada Health Transfer and Equalization (due to lower nominal GDP).
The fiscal impact of a 1-percentage-point increase in interest rates
A permanent 1-percentage-point increase in interest rates decreases the budgetary balance by: $4.2 billion in the first year; $2.7 billion in 2024-25; and, $5.5 billion in 2027-28 (Table 3).
Higher interest rates raise budgetary revenues through the government's interest-bearing assets (recorded as other revenues). This impact is partially offset as the increase in interest rates reduces the Bank of Canada’s profits given its outstanding purchases of government bonds during the COVID-19 pandemic. Previously, higher interest rates would result in increased revenue from student loans, however, given the 2022 Fall Economic Statement measure, student loans are now (permanently) interest-free. [^5]
Offsetting higher revenues, total expenses reduce the budgetary balance by $4.3 billion in the first year and by $6.9 billion in 2027-28. Higher interest rates directly impact public debt charges which are partially offset by lower valuations of public service employee pension and benefit obligations.