Federal interest costs will increase—perhaps substantially—if interest rates continue to rise

Do Budget Deficits Matter?  Essays on the Implications of Government Deficits and Debt

Budget deficits have become something of a norm recently for many Canadian governments. This is especially prevalent at the federal level, as Ottawa has recorded a deficit every year since 2007/08 and the most recent budget projects this will continue for at least five more fiscal years. While some provincial governments expect to return to balanced budgets in 2022/23, many others are still years away from turning red ink to black. During the COVID pandemic in the past two years, the federal government ran record deficits of $327.7 billion and $113.8 billion, respectively. Given the low interest rates and the lack of visible short-term costs in running budget deficits, some Canadians may likely question whether deficits matter anymore since at first glance there appears to be no cost to them.

However, government deficits and debt are not costless. There are significant risks in continuing the trend of red ink across the country and this is often not widely understood. This essay series identifies and discusses several important implications of government deficits and debt while also encouraging Canadian governments to be more responsible with public finances.

Chapter 1 by Matthew Lau reviews when it is appropriate or inappropriate for governments to record budget deficits. The essay examines three possible justifications for government deficits: the presence of an economic shock or recession, borrowing to build infrastructure, and stimulating economic growth. Lau finds that incurring deficits may be necessary to deal with an economic shock since automatic stabilizers kick in and revenues fall. Borrowing money to build infrastructure can also sometimes be justified, but not in all cases. Increasing government spending and running deficits to stimulate economic growth, however, is inappropriate because it crowds out more productive private sector activity and this deficit-financed spending must be recovered by future taxes.

In Chapter 2, Donald J. Boudreaux illustrates that future generations of Canadians bear the burden of deficits and debt because they will be the ones to repay the borrowed sums of money through the imposition of higher taxes in the long-term. Highlighting the work of the late Nobel-laureate economist James Buchanan, Boudreaux argues that there is a strong temptation to spend more on your own personal consumption if other people will be paying the tab. Indeed, current budget deficits allow today’s taxpayers to spend money belonging to other people (tomorrow’s taxpayers) and encourages excessive government spending. Moreover, politicians have an incentive to frequently run deficits because spending more today without simultaneously raising taxes is a good strategy for winning votes.

When governments run deficits, Canadians incur costs in the form of interest payments to service the debt accumulated, as Philip Cross explains in Chapter 3. Recently, Canadian governments have benefited from low interest rates which have kept their interest payments relatively low. But many Canadian governments were also imprudent with spending and accumulated significant public debt both before and during COVID, which has left government finances vulnerable to interest rate hikes. Even seemingly small changes in interest rates relative to economic growth can have a large impact and damage government finances, leaving fewer resources for other priorities. As an example, Cross points to 1995 when interest payments consumed over 33 percent of federal government revenues.

In Chapter 4, David Henderson highlights the lessons we can take from Canada’s experience during the 1990s. Continuous deficits and high levels of spending can lead to a debt crisis. By 1993, following decades of fiscal mismanagement, federal debt rose to an alarming 67.0 percent of GDP. As a matter of necessity the Chrétien government began re-establishing fiscal discipline in 1995 by prioritizing balanced budgets and reducing both government spending and debt, which successfully brought federal finances back under control. By 2006, the federal government’s debt fell to 32.2 percent of GDP—a remarkable fiscal turnaround.

The clear message of this essay series is that deficits do matter and repeated debt accumulation can impose significant costs on Canadians. It is crucial that Canadian governments exercise considerably more caution than they are now showing and that they re-establish prudent fiscal principles. Ignoring the long-term effects of current budget deficits will only lead to us repeating past mistakes.