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Chapter 4:
Fiscal Outlook

Highlights

• For 2005–06, the federal surplus is currently estimated at $8 billion, based on monthly financial information through February 2006. The final result will reflect developments in March and year-end accrual adjustments.

• Starting this fiscal year, the Government is planning on achieving annual debt reduction of $3 billion.

• The Government is directing higher than expected surpluses over the planning period to the priorities of Canadians, largely to reducing taxes. As a result, revenues as a share of gross domestic product (GDP) are projected to decline from 16.4 per cent in 2004–05 to 15.5 per cent in 2007–08.

• The Government is committed to reducing growth in spending to a rate that is sustainable. Program expenses as a share of GDP are projected to decline from 13.7 per cent in 2004–05 to 13.0 per cent in 2007–08.

• The debt-to-GDP ratio is projected to fall to 31.7 per cent by 2007–08, on track to meet the new medium-term objective of reducing the debt-to-GDP ratio to 25 per cent by 2013–14.

Fiscal Outlook Before the Measures Proposed in the 2006 Budget

Projections in this budget are based on private sector economic forecasts as summarized in Table 4.1 (see Chapter 2 for details), and monthly financial results through February 2006. The projections are presented over two years, consistent with the Government's approach to introducing measures when they are affordable and ready to be implemented.

Private sector forecasters are projecting continued solid growth in real GDP over the planning period. Reflecting the ongoing strength of commodity prices, private sector forecasters expect GDP inflation to be 2.9 per cent in 2006. This is considerably higher than forecast at the time of the November 2005 Economic and Fiscal Update.

Table 4.1
Average of Private Sector Economic Forecasts:
March 2006 Survey

Nominal GDP growth is expected to average 6.0 per cent in 2006, up from growth of 5.2 per cent forecast in the November 2005 Update. In 2007, nominal GDP growth is projected to slow to 4.6 per cent, a rate similar to that forecast in the November 2005 Update. Combined with the stronger growth recorded in 2005 (6.1 per cent compared to 5.3 per cent estimated in the Update), the level of nominal GDP is projected to be about $22 billion higher in 2006 and 2007 than projected in the 2005 Update. This will result in increased revenues, as nominal GDP is the broadest measure of the tax base.

Consistent with stronger projected economic growth, short-term interest rates are expected to rise to an average of 4.0 per cent in 2006 (60 basis points higher than projected in the Update) and 4.1 per cent in 2007 (unchanged from the Update). Private sector forecasters also project a gradual rise in longer-term interest rates from 4.1 per cent in 2005 to 4.5 per cent by 2007 (compared to 5.1 per cent projected in the Update).

Table 4.2
Changes in the Status Quo Planning Surplus Since the November 2005 Economic and Fiscal Update

The status quo budgetary surplus, as presented in the November 2005 Economic and Fiscal Update, was estimated at $13.4 billion for 2005–06, rising to $15.0 billion in 2006–07 and $16.4 billion in 2007–08. However, the status quo surplus as presented in the Update did not reflect the cost of a number of commitments made by the previous government and which the new government has confirmed. These measures consist of the Energy Cost Benefit and funding for public transit infrastructure, the elements of the Canada-Ontario agreement that remain to be funded (see box entitled "Canada-Ontario Agreement: 2006–07 and 2007–08" later in this chapter), and other measures announced between the 2005 budget and the November Update that had spending authority or that have been confirmed by the Government. In total, these measures reduce the surplus by $1.4 billion in 2005–06, $0.9 billion in 2006–07 and $1.1 billion in 2007–08.

The November Update status quo surplus also did not reflect the impact of consolidating a number of foundations. Including the foundations in the Government's financial statements, consistent with the recommendations of the Auditor General of Canada, requires that the disbursements of these organizations be recognized as expenses. This is projected to reduce the surplus by $0.7 billion in 2005–06 and 2006–07, and by $0.8 billion in 2007–08. These adjustments reduce the underlying surplus to $11.3 billion in 2005–06, $13.3 billion in 2006–07 and $14.5 billion in 2007–08.

However, the Government's overall fiscal situation is now stronger than projected at the time of the November Update, primarily due to higher revenues, consistent with the upward revisions to private sector forecasts of nominal GDP growth in 2005 and 2006. Budgetary revenues are now projected to be higher than at the time of the November 2005 Update: $4.2 billion higher in 2005–06, $5.2 billion higher in 2006–07 and $5.5 billion higher in 2007–08.

All major federal revenue sources have contributed to these increases:

• In the period from April 2005 to February 2006, personal income tax receipts grew more strongly than expected—nearly twice as fast as the growth of personal income, the tax base. As a result, personal income tax receipts are projected to be $2.6 billion higher in 2005–06 than forecast in the 2005 Update. This higher level of personal income tax receipts is expected to carry forward over the remaining two years of the planning period, growing to $3.3 billion in 2007–08, reflecting both a higher level of personal income and a higher tax yield.

• Corporate income tax receipts have been stronger than expected in 2005–06, reflecting ongoing profitability in the corporate sector, particularly among energy-related industries. The higher projected level of corporate receipts is expected to carry forward into this fiscal year and 2007–08, as corporate profits are projected to remain high.

• Goods and services tax (GST) receipts in 2005–06 have also risen somewhat more rapidly than projected in the November 2005 Update. This adds $0.4 billion to the status quo fiscal balance for 2005–06 (i.e. before the GST rate cut proposed in this budget). This gain carries forward and increases over the rest of the planning period, reflecting a higher forecast for growth in consumer spending than in November.

• Other revenues are expected to be about $0.4 billion higher in 2005–06 than projected in the November Update, mainly due to extraordinarily high dividend payments to non-residents in late 2005 and stronger net revenues at Export Development Canada.

Program expenses in 2005–06 are $1.5 billion lower relative to the November Update, primarily because a significant portion of planned spending that would normally have taken place under appropriation bills did not proceed this year due to the dissolution of Parliament in November. Beyond 2005–06, program expenses are slightly higher, reflecting higher transfers to other levels of government due to changes in statutory tax abatements, and slightly higher direct program expenses, reflecting the impact of changes in estimates for statutory programs administered by departments.

Public debt charges in 2005–06 are forecast to be $0.3 billion lower than projected in the 2005 Update. In 2006–07 and 2007–08, public debt charges are expected to be $0.4 billion and $0.1 billion higher, respectively, compared to the November 2005 Update due to higher projected interest rates.

The net result of these changes is planning surpluses for Budget 2006 of $17.4 billion in 2005–06, $17.8 billion in 2006–07, and $19.4 billion in 2007–08.

This budget provides full funding to meet the agreement with the Government of Ontario. Funding for 2006–07 and 2007–08 for immigration, post-secondary education, housing, cities and public transit/climate change is being provided for all provinces and territories, and will cover commitments under the Canada-Ontario agreement for that period. Funding for elements of the agreement which pertain to issues of specific concern to Ontario, such as corporate tax collection, slaughterhouse inspection and infrastructure, has also been accounted for in this budget. With respect to infrastructure, an incremental top-up of $300 million will be provided to the Canada Strategic Infrastructure Fund for projects in Ontario to restore the province's per capita share of national funding under existing infrastructure agreements. The approach to meeting the commitment for labour market training and for later years of post-secondary education will be part of the discussion with provinces and territories to restore fiscal balance.

Fiscal Outlook Including Impact of Budget Measures on the Budgetary Balance

Table 4.3 summarizes the impact on the budgetary surplus of the measures proposed in this budget.

Table 4.3
Fiscal Outlook Including May 2006 Budget Measures

The measures included in this budget for 2005–06 total $5.7 billion. This budget also accounts for $3.6 billion in costs related to anticipated payments made under Bill C-48 for 2005–06. The measures proposed for 2006–07 total $14.3 billion and for 2007–08 total $15.0 billion. Overall, this budget provides more than twice as much tax relief as new spending. The cost of the measures are net of planned reallocations. These reallocations include $1 billion annually to be identified by the President of the Treasury Board, as described in Chapter 3. The Government will also reallocate resources from current climate change programming to cover the cost of the new tax credit for public transit passes proposed in this budget. In addition, pursuant to the agreements on Early Learning and Child Care signed by the previous government with the provincial and territorial governments, which allow for their termination upon one year's notice from either party, the Government is phasing out the agreements by March 2007. This will be replaced with the new Universal Child Care Benefit proposed in this budget.

After accounting for measures, debt reduction in 2005–06 is $8 billion. For 2006–07 and 2007–08 the Government is planning on achieving debt reduction of $3 billion. Reflecting the Government's more transparent approach to fiscal reporting, this budget projects unallocated surpluses of $0.6 billion in 2006–07 and $1.4 billion in 2007–08. These will be available to address future priorities of the Government including, potentially, measures to restore the fiscal balance. The final outcome for these years will, of course, depend on many factors, primarily the rate of growth in the economy and future budgetary decisions taken by the Government. Further, the Government is proposing to discuss with the provinces the possibility of allocating a portion of unanticipated surpluses at year-end for the Canada Pension Plan and Quebec Pension Plan.

Summary Statement of Transactions

Table 4.4
Summary Statement of Transactions (Including May 2006 Budget Measures)

Table 4.4 provides a summary of the Government's financial position, reflecting the cost of all measures proposed in this budget. To provide an accurate picture of the true level of revenues and expenses, the past practice of including certain expenses as a deduction from revenues (particularly the Canada Child Tax Benefit) has been discontinued. This raises both revenues and expenses by an amount equivalent to about 1 per cent of GDP, but has no impact on the budgetary balance (see discussion in Annex 2).

Budgetary revenues are estimated to increase by $9.0 billion or 4.2 per cent in 2005–06. Over the next two years, revenues are projected to increase at a rate well below that of the overall growth in the economy, reflecting the impact of tax reduction measures proposed in this budget.

Program expenses are estimated to rise 1.6 per cent in 2005–06, or $2.8 billion. This reflects, in part, the one-time increase in transfers to other levels of government in 2004–05, which significantly increased the level of expenses in that year. Program expenses are expected to rise 5.4 per cent in 2006–07 and 4.1 per cent in 2007–08, below the rate of growth of nominal GDP.

Public debt charges are estimated to decrease by $0.4 billion to $33.7 billion in 2005–06, largely reflecting a decline in the stock of interest-bearing debt. In 2006–07, public debt charges are forecast to increase by $1.1 billion to $34.8 billion, due to an expected increase in the average effective interest rate on government debt.

The federal debt-to-GDP ratio (accumulated deficit) stood at 38.3 per cent in 2004–05, down significantly from its peak of 68.4 per cent in 1995–96. Taking into account the projected debt reduction, the debt ratio is expected to fall to 31.7 per cent by 2007–08, on track to meet the new medium-term objective of reducing the ratio to 25 per cent by 2013–14.

Outlook for Budgetary Revenues

Table 4.5
The Revenue Outlook (Including May 2006 Budget Measures)

Budgetary revenues are estimated to increase by 4.2 per cent in 2005–06 and about 3.3 per cent on average in 2006–07 and 2007–08. This includes the cost of the tax relief the Government is proposing to legislate in this budget of $5.0 billion in 2005–06, $9.9 billion in 2006–07 and $11.3 billion in 2007–08. As a share of GDP, revenues are projected to fall from 16.4 per cent in 2004–05 to 15.5 per cent in 2007–08, reflecting the tax measures announced in this budget, including the proposed 1-percentage-point cut to the GST and the proposed reduction in personal income taxes.

Personal income tax receipts—the largest component of budgetary revenues—are estimated to decline slightly as a percentage of GDP in 2005–06, reflecting the impact of reducing the 16 per cent rate to 15 per cent in 2005 and the increase in the basic personal amount. In the following two years, personal income tax receipts remain stable as a share of GDP, reflecting the impact of tax reductions, offsetting the natural upward drift in personal income tax revenues in periods of real income gains.

In 2005–06, corporate income tax revenues are estimated to increase 15.3 per cent, following a gain of 9.2 per cent in the previous year. The buoyant growth in projected corporate receipts reflects gains in profitability, particularly among energy-related industries. For the remaining two years of the planning period, corporate income tax revenues are projected to grow at a slower pace than corporate profits, reflecting the acceleration of the federal capital tax elimination.

GST revenues are estimated to grow 7.3 per cent in 2005–06, slightly faster than the growth in the economy, reflecting strong growth in retail sales. In 2006–07, GST revenues are projected to decline 6.6 per cent, which is entirely due to the proposed 1-percentage-point reduction in the GST rate, effective July 1, 2006. The proposed rate cut is projected to lower GST revenues as a share of GDP from 2.3 per cent in 2005–06 to 2.0 per cent in 2007–08, the first fiscal year in which the new, lower GST rate is fully reflected.

Other income tax receipts—largely withholding taxes levied on non-residents—are estimated to increase by about 30 per cent in 2005–06 due to strong growth in extraordinary dividend payments to non-residents that were recorded over the September to December 2005 period. The monthly financial results for January and February 2006 indicate that the growth of non-resident withholding tax receipts has returned to more normal levels, broadly in line with the growth of corporate profits. The strong gain recorded in the latter part of 2005 is not expected to carry forward into the projection period.

Consistent with the employment insurance (EI) premium rate-setting mechanism, EI premiums are assumed to match projected EI program costs. The EI revenue and expense projections also reflect the implementation of the Quebec Parental Insurance Plan in 2006 and the cost of the labour market pilot projects announced in February 2005. On balance, this results in a decline in projected EI premium revenues in 2005–06 and 2006–07.

Other revenues include those of the consolidated Crown corporations, net gains/losses from enterprise Crown corporations, foreign exchange revenues, returns on investments and proceeds from the sales of goods and services. These revenues are volatile, owing partly to the impact of exchange rate movements on the Canadian-dollar value of foreign-denominated interest-bearing assets and to net gains/losses from enterprise Crown corporations. In 2005–06, other revenues are estimated to decrease 16.1 per cent, or $3.2 billion, which largely reflects the one-time gain ($2.6 billion) from the sale of the Government's remaining shares of Petro-Canada in 2004–05 and the impact of the appreciation of the Canadian dollar.

Revenue Ratio Lowered Due to Tax Cuts

• A more revealing picture of movements in tax revenue can be obtained by examining the revenue ratio—total federal revenues in relation to total income in the economy (or GDP).

• The revenue ratio is projected to decline, falling from 16.4 per cent in 2004–05 to 15.5 per cent by 2007–08, reflecting the impact of tax reduction measures.

Outlook for Program Expenses

Table 4.6
The Program Expenses Outlook (Including May 2006 Budget Measures)

Table 4.6 provides an overview of the projections for program expenses, including the cost of measures proposed in this budget. Program expenses are divided into three major components: major transfers to persons, major transfers to other levels of government and direct program expenses—the latter includes subsidies and other transfers, and defence and all other departmental operating expenses.

Major transfers to persons, consisting of elderly and EI benefits and children's benefits, including the new Universal Child Care Benefit, are expected to increase by $5.8 billion over the next two years.

• The growth in elderly benefits is due to the growth in the elderly population and changes in consumer prices, to which benefits are fully indexed.

• EI benefits are estimated to decline in 2005–06, reflecting labour market conditions as well as the transfer to the province of Quebec of the responsibility for delivering parental benefits under the new Quebec Parental Insurance Plan (QPIP), starting January 1, 2006. The projected increase in 2006–07 reflects a slight rise in projected unemployment and the first full-year impact of the labour market pilot projects announced in February 2005, slightly offset by lower parental benefits compared to the previous year due to the QPIP. In 2007–08, higher projected EI benefits are attributable to an increase in the private sector forecast of the number of unemployed. Furthermore, starting in 2007, average EI benefits are projected to increase because of the indexation of maximum insurable earnings to the growth in the average industrial wage. In 1996, the maximum level of insurable earnings under the EI program was set at $39,000 and fixed at that level until the average industrial wage caught up to this amount. This is projected to occur in 2007.

• Children's benefits, including the Canada Child Tax Benefit and the proposed Universal Child Care Benefit, are expected to be $3.1 billion higher in 2007–08 than they were in 2004–05. Including the Universal Child Care Benefit, Canadian families will be receiving $11.8 billion in support by 2007–08.

Major transfers to other levels of government are estimated to decline by $4.5 billion in 2005–06, reflecting the one-time payments in 2004–05 for the Wait Times Reduction Fund ($4.3 billion) and for the Offshore Revenues Accords ($2.8 billion) to Newfoundland and Labrador and Nova Scotia. This decline will be partly offset by the expected payment to provinces and territories of $3.3 billion under Bill C-48. In the following two years, major transfers to other levels of government are expected to rise $2.6 billion and $1.0 billion respectively, reflecting the impact of the 2004 agreement on health, and legislated increases for Equalization and Territorial Formula Financing.

Direct program expenses are estimated to increase by only $1.8 billion in 2005–06, primarily because a significant portion of planned spending did not proceed due to the dissolution of Parliament in November. This is followed by growth of $7.5 billion in 2006–07, primarily reflecting measures announced in previous budgets. New measures in the budget increase direct program expenses by $2.6 billion in 2006–07. Growth in direct program expenses is projected to slow considerably in 2007–08 to 4.4 per cent.

Wages and benefits comprise approximately one quarter of direct program expenses. The Government of Canada is committed to maintaining pension and benefit programs that are responsive to employees' needs and competitive with comparable employers while at the same time respecting the interests of taxpayers. In keeping with this commitment, the Government proposes to modify the benefit formulae of the public sector pension plans to better respect their original policy intent. Further, the Government proposes to clarify the tax-exempt status of the Public Sector Pension Investment Board to ensure that it is treated as such by other jurisdictions.

Program Expenses-to-GDP Ratio

• Program expenses as a share of GDP have been trending upwards over the past several years and increased sharply in 2004–05 as a result of the new spending initiatives announced in recent budgets. This trend will be reversed in 2005–06 and over the next two years as the growth of program expenses will be kept below the rate of growth of the economy.

• As outlined in Chapter 3, in order to begin to put spending on a more sustainable track, the President of the Treasury Board will in the coming months identify savings of $1 billion for 2006–07 and 2007–08. The Government is also committed to achieving the expected savings from the 2005 Expenditure Review, which were announced by the previous government but have just begun to be implemented. It is the responsibility of all departments to ensure these savings are realized.

Debt-to-GDP Ratio and Public Debt Charges

The federal debt-to-GDP ratio (accumulated deficit) stood at 38.3 per cent in 2004–05, down significantly from its peak of 68.4 per cent in 1995–96. Taking into account scheduled debt reduction, it would fall to 31.7 per cent by 2007–08, on track to meet the medium-term objective of reducing it to 25 per cent by 2013–14.

As a result, the ratio of public debt charges to government revenues has declined in recent years to stand at 16.1 per cent in 2004–05. This ratio is expected to decline further to 14.8 per cent in 2007–08. This means that in that year, the Government will spend just under 15 cents of each revenue dollar on interest on the federal debt.

Financial Source/Requirement

Table 4.7
The Budgetary Balance, Non-Budgetary Transactions and Financial Source/Requirement

The budgetary balance is presented on a full accrual basis of accounting, recording government liabilities and assets when they are incurred or acquired, regardless of when the cash payment or receipt occurs.

In contrast, the financial source/requirement measures the difference between cash coming in to the Government and cash going out. This measure is affected not only by the budgetary balance but also by the Government's non-budgetary transactions. These include federal employee pension accounts, changes in non-financial assets, investing activities through loans, investments and advances, changes in other financial assets, liabilities and foreign exchange activities. Non-budgetary transactions also reflect the conversion from full accrual to cash accounting.

With a budgetary balance of $3.0 billion and a requirement of $6.0 billion in non-budgetary transactions, a financial requirement of $3.0 billion is estimated in 2006–07, compared to an estimated financial source of $5.3 billion in 2005–06. The estimated requirement in 2006–07 is mainly due to the timing of payments under Bill C-48 and refunds associated with personal income tax reductions effective for the 2005 tax year. This will be financed by reducing cash balances. A financial source of $4.7 billion is expected in 2007–08.

• Pensions and other accounts include the activities of the Government of Canada's employee superannuation plans, as well as those for federally appointed judges and members of Parliament. Since April 2000, the net amount of contributions less benefit payments related to post-March 2000 service has been invested in capital markets. Contributions and payments pertaining to pre-April 2000 service are recorded in the pension accounts. The Government also sponsors a variety of benefit plans, such as health care and dental plans and disability and other benefits for war veterans and others. In addition, in 2005–06 the remaining $2.8 billion in the Canada Pension Plan operating balance was transferred to the Canada Pension Plan Investment Board.

• Non-financial assets include the cash outlay for the acquisition of new tangible capital assets, proceeds from the sale of tangible capital assets, the amortization of existing tangible capital assets, losses on the disposal of tangible capital assets, the change in inventories, and prepaid expenses. In the calculation of the budgetary balance, only the amortization of existing tangible capital assets is included. A net cash requirement of $0.7 billion is estimated for 2006–07, reflecting a net increase in the acquisition of tangible capital assets. This component is expected to rise in 2007–08, in part due to increases in defence capital spending.

• Loans, investments and advances include the Government's investments in enterprise Crown corporations, such as Canada Mortgage and Housing Corporation, Canada Post Corporation, Export Development Canada and the Business Development Bank of Canada. In addition, this component includes loans, investments and advances to national and provincial governments and international organizations, and for government programs. The financial requirement projected for this component is attributable to the share of annual profits retained by enterprise Crown corporations and the Canada Student Loans Program.

• Other transactions primarily include the conversion of other accrual adjustments included in the budgetary balance into cash, as well as foreign exchange activities. A net financial requirement of $4.3 billion is expected in 2006–07, followed by a source of $3.0 billion in 2007–08. The requirement in 2006–07 mainly reflects the expected cash payments of $3.6 billion under Bill C-48 and refunds associated with personal income tax reductions effective for the 2005 tax year.

Risks to the Fiscal Projection

Fiscal projections are inherently uncertain due to:

• Uncertainty associated with the underlying economic projections.

• Uncertainty associated with the fiscal projections themselves, including volatility in the relationship between fiscal variables and the underlying activity to which they relate.

• The long delays before final fiscal information becomes available.

Uncertainty Arising From the Economic Projections

Changes in economic assumptions affect the size of projected tax bases and expenditures that are sensitive to economic factors, such as EI benefits and public debt charges.

The following tables illustrate the sensitivity of the budget balance to a number of economic shocks:

• A one-year, 1-per-cent rise in real GDP driven equally by higher productivity and a 0.5-per-cent increase in employment.

• An increase in nominal GDP resulting solely from a one-year, 1-per-cent increase in the rate of GDP inflation.

• A sustained 100-basis-point increase in all interest rates.

These sensitivities are generalized rules of thumb that assume any increase in economic activity is proportional across GDP income and expenditure components. EI premium rates are assumed to adjust such that EI revenues exactly offset program expenses, consistent with the new EI rate-setting procedure introduced in 2005. Equal and opposite impacts would result from a decline of equal magnitude in real or nominal GDP and interest rates.

Table 4.8
Estimated Impact of a One-Year, 1-Per-Cent Increase in Real GDP on Federal Revenues, Expenses and Budgetary Balance

A 1-per-cent increase in real GDP raises the budgetary balance by $2.7 billion in the first year and $2.3 billion in the second year.

Tax revenues from all sources rise. Personal income tax receipts increase as employment and wages and salaries rise. Furthermore, due to the progressivity of the tax system, as individuals earn higher real incomes and move into higher tax brackets, they pay proportionally more of their income in taxes. Corporate income tax revenues rise as output and profits increase. GST revenues increase as a result of higher consumer spending associated with the rise in employment and personal income. Since premium rates for a given year are set based on projections carried out in October of the previous year, EI premium revenues increase in the first year of the shock (due to higher employment) but decline thereafter, reflecting the adjustment to the break-even rate.

Expenses decline, mainly reflecting lower spending on EI benefits (due to a decrease in the level of unemployment) and lower public debt charges (reflecting a lower stock of debt due to higher revenues being applied to debt reduction).

Table 4.9
Estimated Impact of a One-Year, 1-Per-Cent Increase in GDP Inflation on Federal Revenues, Expenses and Budgetary Balance

A 1-per-cent increase in nominal GDP resulting solely from a rise in prices (assuming that the Consumer Price Index moves in line with GDP inflation) raises the budgetary balance by $2.0 billion in the first year and $1.5 billion in the second year.

Higher prices result in higher nominal income and, as a result, personal income tax, corporate income tax, and GST revenues all increase, reflecting gains in the underlying nominal tax bases. Compared to the impacts of the real GDP shock, the effects on personal tax receipts are more pronounced in the initial year due to the lag with which inflation is reflected in the tax system (tax brackets are indexed to the percentage change in the Consumer Price Index for the 12-month period ending September 30 of the previous year). Over time, the impacts on personal taxes are higher in the real GDP shock, reflecting higher real income and the progressivity of the tax system. For the other tax revenue streams, the effects are similar under either the real or nominal GDP shocks. EI premium revenues increase in response to higher earnings in the first year but dissipate thereafter as premium rates adjust to the impact of higher earnings. Unlike the real GDP shock, EI benefits do not decline since unemployment is unaffected by the rise in prices.

Partly offsetting higher revenues are the increases in the cost of statutory programs that are indexed to inflation, such as elderly benefit payments and the Canada Child Tax Benefit, as well as federal wage and non-wage expenses, which are assumed to increase in line with prices. Public debt charges fall due to the lower stock of debt.

Table 4.10
Estimated Impact of a Sustained 100-Basis-Point Increase in All Interest Rates on Federal Revenues, Expenses and Budgetary Balance

An increase in interest rates lowers the budgetary balance by $1.0 billion in the first year and $1.5 billion in the second. The deterioration stems entirely from increased expenses associated with public debt charges. The impact on debt charges rises through time as longer-term debt matures and is refinanced at higher rates. Moderating the overall impact is a rise in revenues associated with the increase in the rate of return on the Government's interest-bearing assets, which are recorded as part of non-tax revenues.

Uncertainty Associated With Translating Economic Projections Into Fiscal Projections

Translating the economic forecast into a fiscal projection introduces an additional level of uncertainty, as the relationship between fiscal variables and the underlying economic variables fluctuates considerably over time. By way of illustration, the following reviews uncertainties related to personal and corporate income taxes.

For personal income taxes, there is a fairly stable relationship between personal income and personal income tax revenues over long periods of time, although in any one year this relationship may not hold. The reasons for this include:

• Differences between taxable income and the National Accounts measure of personal income (which excludes, for example, pension income and capital gains, which are part of taxable income).

• Discretion on the part of taxpayers to determine taxable income and tax liabilities (for example, in deciding how much to contribute to registered retirement savings plans or when to realize capital gains).

• Changes in the distribution of income across income brackets.

The sensitivity of personal income tax revenues to changes in their base, personal income, is summarized by a measure called the income elasticity of personal income tax revenues. This captures the change in tax revenues resulting from a 1-percentage-point change in personal income. The elasticity assumption is a key factor in the personal income tax forecast, as it serves as a benchmark for the translation of the personal income forecast into the forecast of personal income tax revenues.

An extra dollar in personal income generally translates into more than an extra dollar in personal income tax revenues. In other words, the elasticity of the personal income tax system should be greater than one, on average, due to the progressivity of the tax system—taxpayers pay progressively higher tax rates as their earned income rises. When overall income rises, some individuals move into higher income brackets and pay a proportionately greater share of their income gain in taxes. In a "normal" year, where income gains are distributed evenly across income cohorts and all sources of income increase at roughly the measured rate of personal income growth, the elasticity is about 1.2. Through the first 11 months of 2005–06, reflecting strong income gains, the elasticity has been about 1.8, while in 2001–02, following the stock market correction, the elasticity was just 0.3. Every percentage point change in the elasticity translates into an approximately $500 million change in revenues. For planning purposes, personal income tax elasticity is assumed to average 1.2 over the next two years.

For corporate income taxes, there are three key sources of uncertainty.

• Provisions in the Income Tax Act allow corporations to smooth income and losses from year to year, implying that corporate tax payments for a given year can differ substantially from corporate profits in that same year. Specifically, corporations may currently carry forward losses for up to 10 years (this budget proposes to increase this to 20 years) and carry back current-year losses for up to three years in order to offset taxes already paid in previous years. Use of these measures is at the discretion of the corporation, which introduces substantial uncertainty into the forecast.

• Projected corporate income tax revenues are based on corporate profits as a share of nominal GDP remaining at historically high levels over the next two years.

• Divergences in profitability among sectors also play a role. In the current projection, for example, while corporate profits are expected to remain at an all-time high as a share of GDP, this strength masks a divergence between soaring profits in the energy sector and falling manufacturing sector profits. As such, the outlook for corporate income taxes for 2006–07 and beyond depends heavily on assumptions about energy prices and how these will affect profitability in the various sectors of the economy. This divergence, and the potential impact on the realization and use of losses, could raise or lower the corporate income tax forecast by as much as $1 billion in 2006–07.

The table below illustrates the sensitivity of total budgetary revenues to changes to three key forecast assumptions: GDP growth, the personal income tax (PIT) elasticity and the response of corporate income taxes (CIT) to corporate profits. These sensitivities represent fluctuations similar to those seen in recent years.

• If GDP growth were higher (lower) by 0.5 percentage points in 2006–07, then the budgetary balance would be higher (lower) by $1.2 billion than the level currently forecast (consistent with the average of the sensitivity estimates for real and nominal GDP sensitivity example discussed above).

• If PIT elasticity were 0.1 higher (lower) than assumed in 2006–07, then revenues would be up (down) $0.5 billion from the level currently forecast.

• If loss utilizations or changes in profitability among sectors are considerably different than assumed, then CIT revenues could be $1 billion higher or lower than currently projected.

Table 4.11
Estimated Sensitivity of Budgetary Balance to Assumptions About GDP Growth, PIT Elasticity and CIT Response to Profits