The sensitivity of fiscal projections to economic shocks – April 2024

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.

In this note, we estimate the fiscal impacts of three key economic shocks:

1.     A permanent 1 per cent decrease in real GDP driven equally by lower productivity and employment.[^1]

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.[^2]

3.     A permanent 1-percentage-point (100-basis-point) increase in all interest rates.[^3]

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 2024 (the first quarter of fiscal year 2024-25) 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: $5.6 billion in the first year; $5.8 billion in the second year; and, $6.5 billion in 2028-29 (Table 1).

Total budgetary revenues are $4.5 billion lower in 2024-25, 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 are also reduced due to lower consumer spending.

This reduction in revenue is somewhat offset by increases in Employment Insurance (EI) premiums starting in 2025-26, due to a higher EI premium rate. This rate 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: $3.3 billion in the first year; $3.0 billion in the second year; and, $2.9 billion in 2028-29 (Table 2).

Total budgetary revenues are $4.6 billion lower in 2024-25. 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 primarily due to lower spending on major transfers to persons, where benefits linked to CPI and wages decline.

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: $2.5 billion in the first year; $1.4 billion in 2025-26; and, $4.4 billion in 2028-29 (Table 3).[^4]

Higher interest rates raise budgetary revenues through the government's interest-bearing assets, and interest and penalty revenue on taxes owing (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. As part of the Bank’s quantitative tightening, the stock of government bonds is anticipated to continue declining as it matures and is not replaced on its balance sheet.

Offsetting higher revenues, total expenses reduce the budgetary balance by $3.1 billion in the first year and by $9.1 billion in 2028-29. Higher interest rates directly impact public debt charges which are partially offset by lower valuations of public service employee pension and benefit obligations.