Annex 5

Fiscal Outlook: Sensitivity to Economic Assumptions

Sensitivity to Changes

in Economic Assumptions

Estimates of the main fiscal aggregates are sensitive to changes in economic assumptions -- particularly to the level of nominal gross domestic product (GDP) and interest rates. The following sensitivity estimates capture the direct fiscal impacts of changes in these variables. These are partial calculations that capture the impact of the changes, one economic variable at a time. For example, in the nominal income sensitivity estimate, there is no feed-through of the change in nominal income to other variables, such as interest rates and unemployment.

Sensitivity to changes in nominal income

A 1-per-cent increase in the level of nominal GDP leads to higher tax bases and thus higher revenues. The ultimate budgetary impact would depend on the source of the increase in nominal income. The most favourable impact on the fiscal situation would occur if all of the increase in nominal GDP resulted from increased real output. Revenues would be higher, while interest rates would be relatively stable.

If, however, the improvement in nominal GDP was solely due to inflation, then higher spending on those programs indexed to inflation would offset some of the positive impact of government revenues. Higher inflation would also likely raise interest rates.

Assuming the increase in nominal income comes solely from an increase in output, with no impact on interest rates and no net effect on the Employment Insurance Program, the budgetary balance would improve by $1.3 billion in the first year, rising to $1.7 billion after four years (Table A5.1).

Table A5.1

Fiscal sensitivity analysis: 1-per-cent increase in nominal income

Estimated changes in fiscal position Year 1 Year 2 Year 3 Year 4 (billions of dollars)

Budgetary transactions Revenue increases 1.2 1.3 1.4 1.6 Expenditure reductions 0.1 0.2 0.1 0.1 Budgetary balance improvement 1.3 1.5 1.5 1.7

Sensitivity to changes in interest rates

In contrast to the uncertainties of the sensitivity of the deficit to changes in nominal GDP, the direct impact of interest rate changes on public debt charges can be calculated with considerable precision.

A sustained 100-basis-point increase in all interest rates would cause the budgetary balance to deteriorate by $1.0 billion in the first year (Table A5.2). As longer-term debt matures and is refinanced at the higher interest rates, the negative impact on the budgetary balance goes up, reaching $2.4 billion by year four.

Table A5.2

Fiscal sensitivity analysis: 100-basis-point increase in interest rates

Estimated changes in fiscal position Year 1 Year 2 Year 3 Year 4 (billions of dollars)

Budgetary transactions Revenue increases 0.4 0.5 0.5 0.6 Expenditure increases 1.4 2.2 2.6 3.0 Budgetary balance deterioration 1.0 1.7 2.1 2.4

The second, third and fourth year impacts are somewhat lower than those presented in the 1997 budget, reflecting downward revisions to the stock of the debt, due to the much better-than-expected deficit outcome for 1996-97 and the commitment to balanced budgets in 1998-99 and 1999-2000.

Over the past several years, the government has taken a number of actions to reduce the sensitivity of the budgetary balance to changes in interest rates. The most significant of these have been the overall fiscal actions to eliminate the deficit. The actions put in place in the 1994, 1995 and 1996 budgets provided annual savings of $28 billion by 1998-99. Between 1994-95 and 1998-99, the cumulative effect of these actions was to lower the debt by close to $90 billion. With an effective interest rate on the debt of about 7 per cent, these actions have lowered debt charges by about $6 billion annually.

The government has also reduced the sensitivity of the budgetary balance by pursuing a prudent debt management strategy. The objective of the government's debt management strategy is to raise funds at stable and low costs. Greater cost stability has been achieved over the past several years by increasing the share of the government's gross debt in fixed-rate form (i.e. debt maturing or being repriced in more than 12 months) to 65 per cent, up from about 50 per cent in 1992-93. A higher proportion of fixed-rate debt provides protection against unexpected changes in interest rates and brings Canada in line with other major sovereign borrowers. In the mid 1990s, the impact of a 100-basis-point increase in interest rates was estimated to raise public debt charges by $1.8 billion. Today the same increase in interest rates would increase debt charges by $1 billion.

Ensuring that the government, and other credit-worthy borrowers in the economy, can raise funds at stable and low costs requires well-functioning capital markets. The government's debt programs are being progressively restructured over time to maintain a well-functioning market, within the context of ongoing reductions in market debt. Last fall, the government switched from weekly to bi-weekly Treasury bill auctions and consultations have taken place with market participants on restructuring the bond program.

Some concerns have arisen as a result of disruptive activities by some market participants in the government securities market and these are being addressed on a priority basis, in conjunction with market participants. Initiatives include changes to the auction rules, and the development of an Investment Dealers Association Code of Conduct governing secondary markets.

Further information on the government's debt strategy can be obtained from the Debt Management Report 1997, Department of Finance.