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Is debt-to-GDP ratio a valuable fiscal anchor for the Liberals?

There is a view out there that the Liberal government’s focus is on achieving some stable debt-GDP ratio, but the government’s expressed views are somewhat vague.

Graham Hughes/THE CANADIAN PRESS

During and since the last election, many have written, approvingly, that the debt-to-GDP ratio is a better indicator of fiscal policy than balanced budgets. While there is a view out there that the Liberal government's focus is on achieving some stable debt-GDP ratio – which would allow them to permanently run relatively large budget deficits – their expressed views are different but somewhat vague.

For example, Budget 2016 states: "The Government is committed to reducing the federal debt-to-GDP ratio to a lower level over a five-year period, ending in 2020-21" and: "The Government remains committed to returning to balanced budgets, and will do so in a responsible, realistic and transparent way." This naturally raises many questions such as: What is their desirable "lower level of debt-to GDP ratio?" And, when do they expect to return to balanced budgets? And, are these two objectives even compatible, as targeting one would force an outcome on the other fiscal indicator? And is it even desirable to have either of these objectives?

Many who champion the cause of balanced budgets also champion the cause of lower taxes. While this policy may sound attractive to many Canadians, it has social policy implications that may or may not be obvious. Lower taxes mean less revenue and, with a target of balanced budgets, must also mean reduced expenditures. Given the large size of expenditures on social programs relative to other expenditures in Canadian government budgets, the axe must fall on social spending. That may not be a bad outcome for those who may also believe that that much social spending has a negative impact on economic outcomes. However, the economics profession is generally of the view that targeting balanced budgets is bad for the economy in general.

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The focus on the debt-to-GDP ratio avoids the social policy consequences of the balanced-budget/low tax philosophy. However, what is its value as a fiscal anchor in the context of achieving good economic outcomes?

It is hard to find answers to this question. Presumably, a reasonable (what is reasonable?) and stable debt-to-GDP ratio means that future generations would find there would be a relatively stable fraction of debt charges going to service the government debt, meaning there will be a relatively stable large (how large?) portion of revenues that would be available to meet spending priorities. It is not clear why this would be a good economic outcome: a lower and declining debt-to-GDP ratio would make more resources available for the spending priorities of the future.

The problem with any debt-to-GDP ratio target is that it may produce results contrary to a simple economic principle to maximize a country's economic and social well-being: the government should spend an extra dollar on a program when the economic and/or social benefit of the dollar spent exceeds the economic cost of financing through taxes or borrowing. There would be situations where that may not be the case and actually require a scaling down of spending and deficits. There would be situations where this principle would lead to increased spending financed through taxes and thus require balanced budgets. Or, there could be situations where increased spending should be financed through larger deficits and potentially a rising debt-to-GDP ratio.

Suppose a budget told you that increased spending on a particular objective would raise GDP a lot more than any economic cost of deficit financing. Should you undertake that spending regardless of the debt-to-GDP ratio? I would assume the answer is yes (ignoring the rearranging of the budget items). Alternatively, assume that this spending was bad for the economy, but we have a low debt-to-GDP ratio. Should we proceed with it? I assume the answer is no. Then what is the value of a debt-to-GDP ratio?

The debt-to-GDP ratio is accounting and is informative, but not public policy. So is information contained in data on budget balances. Such information cannot be a substitute for a cost-benefit economic anchor underlying fiscal policy. Cost-benefits analysis may require tedious empirical work. In some cases, it may not even be practical. But, despite the challenge, we need to make progress in that direction to get a handle on the setting of fiscal policy, given problems with both balanced budgets and debt-to-GDP ratios. Even qualitative analyses of the perceived magnitudes of the economic impacts of proposed fiscal actions compared with their economic (as against fiscal) cost could be quite helpful.

While economic cost-benefit analysis is the appropriate anchor for fiscal policy, its need is even greater when a government may be focused on a debt-to-GDP ratio than in balancing the budget. That is because, while both these indicators are flawed, balancing the budget at least forces discipline that is missing from the debt-to-GDP ratio. The million-dollar question that we need to reflect upon is: What public policy framework would get a government, which has considerable freedom to do what it wants in a debt-to-GDP world, to begin to use constraints such as economic cost-benefit analysis to anchor fiscal policy? We need to think about that.

Munir Sheikh is a former Chief Statistician of Canada.

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