Opinion: Our big problem is provincial debt, not federal

Expected future provincial deficits will add up to debt obligations equal to roughly 170 per cent of today’s GDP

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Canadian governments are borrowing heavily to fund their COVID-19 emergency responses. This is especially true at the federal level, where public debt is rising by amounts not seen since the Second World War. Though many commentators are concerned, an even more difficult challenge faces our provincial governments. Years of steadily rising provincial debt and mounting health-care costs from aging populations will strain provincial government budgets across the country. If we stay on our current track, cumulative provincial debts will soon dwarf the federal debt — even after its latest increases.

The provincial fiscal challenge may be slower moving, but it is significantly larger and deserves more attention. Acting now to address this challenge will avoid more difficult and drastic actions later. As the prime minister and premiers begin to negotiate our path forward, they need to consider the provinces’ debts and our country’s long-term fiscal trajectory.

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Just how big is the problem? As I show in my recent analysis of debt sustainability for Finances of the Nation, there is both good news and bad. The good news is that despite its record-smashing deficit this year, the federal government’s finances are basically sound. The bad news is that provincial governments face serious long-term challenges that few are ready for.

I looked at current debt levels but also at where we are going over the next 75 years based on plausible predictions about interest rates, growth rates and cost pressures from aging populations. My projections suggest that even with all the new COVID spending, federal finances are currently sustainable. One can question whether rising debt is wise or ideal but because interest rates are low and federal revenues grow more quickly than automatic increases in spending it is mechanically sustainable. Even without new taxes or spending cuts, federal debt is therefore on track to decline over time relative to the size of the economy.

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The status quo is just one of many potential fiscal futures, however, so my analysis explores many scenarios. If interest rates rise or economic growth slows, the federal government’s fiscal future is not so rosy. If federal borrowing rates rise to roughly five per cent, then the situation becomes more difficult and the higher debt-to-GDP ratio we have in 2020 will persist. If, in addition to higher interest rates, economic growth slows by half a percentage point, federal debt does become unsustainable. Finally, even if economic fundamentals are strong, the government may make fiscal choices that alter its currently sustainable path. Still, at the moment there is no reason for panic.

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The picture is very different for the provinces. COVID-19 hit their finances hard, too. They face rising health costs associated with the pandemic and, more significantly, lower revenues from the economic contraction. The result is an increase in their debt levels of four to five per cent of GDP. But that is manageable for most of them and the effect will dissipate over time as federal health transfers rise.

Their real problem lies ahead. With status quo spending and taxation, provincial debt is set to climb significantly in the years and decades to come. I project that expected future provincial deficits, appropriately discounted, add up to debt obligations equal to roughly 170 per cent of today’s GDP. The extra four or five per cent in COVID debt is insignificant by comparison.

And closing the gap will not be easy. The scale of the challenge is equivalent to a new eight per cent HST across the country and on top of existing sales taxes. Gradual and sustained action would obviously be much better.

Ensuring provincial revenues keep pace with economic growth is one option. Many taxes, such as those on cigarettes, gasoline, property and so on, tend to grow more slowly than the economy. But if governments continuously adjust their taxes and fees to keep revenues growing in line with the economy, that meets half the long-run challenge. On the spending side, slowing the pace of health-care growth by just half a percentage point per year can make up the other half.

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With revenues growing at the rate of growth of GDP and with slightly slower spending growth, most provinces can pull through. Some, however, such as Alberta and Newfoundland and Labrador, face an even more challenging situation because of the downturn in oil and gas. They’ll have to consider larger tax or spending changes. In Alberta’s case, the necessary adjustments are equivalent to roughly $7 billion per year. And in Newfoundland and Labrador’s, a federal bailout may well be needed.

To avoid taking difficult decisions themselves, premiers are likely to ask Ottawa for help. Discussions this fall between federal and provincial leaders will surely focus on just that. The federal government does have fiscal room but faces a choice between boosting its own program spending or helping provinces by providing greater cash transfers or new tax room.

Even after the COVID-19 shock, unsustainable public debt is not a foregone conclusion. We do have options. Thoughtful, gradual, sustained action by provincial governments can overcome our challenges — but this requires us to look beyond our immediate concerns and start planning for our long-term fiscal future.

Trevor Tombe is a professor of economics at the University of Calgary and co-director of the Finances of the Nation project.

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