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1999 Article IV Consultation with Canada Statement of the IMF Mission
November 30, 1998
1. The implementation of sound policies in recent years has established a firm foundation for the sustained favorable performance of the Canadian economy. The inflation targeting policy pursued by the Bank of Canada continues to maintain inflation at a very low level. At the same time, budget positions at all levels of government have been substantially improved, with the federal government achieving a budget surplus in 1997/98 for the first time since 1969/70 and the consolidated general government also moving into surplus. Prospects are good that the ratio of government debt to GDP will fall significantly over the next several years. Important steps have also been taken to improve the financing of the public old-age support system, particularly the Canada Pension Plan, and all levels of government are also working to deal with the immediate and longer-term financial challenges faced by the health care system.
2. These policy efforts, as well as other structural reforms, have been reflected in a significant reduction in inflationary expectations, a marked decline in both nominal and real interest rates, improved functioning of the labor market, and the removal of barriers to internal and external trade, all of which have underpinned the current economic expansion. The staff of the IMF commends the authorities for their efforts and the success of their macroeconomic and structural policies.
3. At this juncture, a great deal of uncertainty clouds the prospects for the Canadian economy, with external factors posing the greatest risk to Canada’s ability to sustain strong economic growth. In particular, instability in global financial markets could continue to unsettle the external environment for Canada. Given the relative importance of commodity-producing industries and the openness of the economy, Canada could not have been expected to escape unscathed from the global events of the past year. However, the extent of the downward pressure on the Canadian dollar in 1998 and the volatility in financial and exchange markets on a number of occasions appears to have been excessive, in light of the strong fundamentals of Canada’s economy. This situation suggests that the country continues to be vulnerable to adverse shifts in market confidence.
4. The inflation targeting approach used by the Bank of Canada to implement monetary policy has been very successful in lowering inflation and maintaining it at a low level. In the period immediately ahead, the cost environment in Canada is likely to continue to be benign, as significant slack remains in the economy, and inflation is expected to remain within the bottom half of the official target range. In such circumstances, the prospects for economic activity should be the key determinant of the stance of monetary policy. The Bank acted appropriately in raising interest rates in late August to stem the decline in market confidence and in unwinding most of that increase subsequently. The IMF staff believes that, if the outlook for economic growth worsens, the Bank of Canada will have scope for reducing interest rates further. However, the Bank will need to proceed with caution to ensure that its monetary policy actions do not unduly undermine market confidence in the Canadian dollar which, in turn, could put upward pressure on long-term interest rates and potentially undo the intended effects of the policy easing.
5. Fiscal policy will need to retain its medium-term focus to bring down the ratio of government debt to GDP and to strengthen market confidence in the country’s fiscal management. Canada’s fiscal position is fundamentally very sound, and on a status quo basis, the budget surplus could be expected to rise to 2½ percent of GDP over the next five years, provided that there are no further significant adverse economic shocks which would prevent the economy from moving to full employment in this period. In such circumstances, the IMF staff believes that it would be appropriate to run annual budget surpluses on the order of 1 percent of GDP over the next few years. By doing so, the debt-to-GDP ratio would be brought down rapidly, falling from 67 percent of GDP in 1997/98 to around 50 percent in 2003/04, and the reduction in the debt servicing burden would free resources to fund the Government’s fiscal priorities of reforming the tax system and improving health care and education. In the meantime, each year new measures of $2–4 billion (about ¼ percent of GDP) could be introduced to begin the task of addressing these priorities, with these measures providing over five years roughly $35 billion of tax relief and new spending initiatives. The Employment Insurance (EI) premium also could be brought down gradually over this period to its estimated break-even rate of roughly $2.20. At the end of the period, sizable resources would be available that could be used to complete a comprehensive reform of the income tax system and/or to meet health care and education needs.
6. Against this background, the IMF staff commends the authorities for their determination to ensure that a sound fiscal position is maintained and that the budget does not slip back into deficit. At the same time, the Government’s success in consolidating the fiscal position and the policy credibility that has been established provides an opportunity to allow the automatic fiscal stabilizers to function in the event that economic growth in Canada weakens by more than is expected. The contingency reserves built into the budget are intended to provide a cushion to permit the stabilizers to function without significantly undermining the fiscal position, and these reserves should be utilized if circumstances warrant. Only in the face of a significant downturn in Canada’s economy, especially in the context of a broader fall in world economic activity, would the IMF staff see the need for an easing of fiscal policy that goes beyond the operation of the automatic stabilizers.
7. In view of Canada’s relatively high ratio of personal income taxes to GDP and the significant distortions caused by high marginal tax rates, the IMF staff believes that priority should be given to reforming income taxes in order to improve incentives to work and save. Restructuring these taxes would leave a permanent legacy of higher growth and prosperity in Canada. To do so, however, will be costly in terms of revenues forgone, and a phased approach to tax reform will need to be adopted. The lack of effective indexation of the tax system has been a problem, and consideration needs to be given to compensating partially for this by further discrete adjustments in nominal income thresholds and standard credits. In time, when sufficient resources are available, efforts could be directed to more sweeping changes in the personal income tax to lower average and marginal tax rates. Actions in these areas taken at the federal level will need to be coordinated with the provincial governments to help ensure that federal government tax reform measures are not offset by tax increases by the provinces.
8. A key to the strength of the fiscal position and the magnitude of prospective surpluses is the substantial net receipts generated by the EI program. The Government has suggested that the EI premium be lowered only gradually, rather than reducing it immediately to eliminate the excess in the program’s receipts over expenditures, and that net receipts under the program be used to help finance the Government’s priorities with respect to taxes and spending. The EI premium in Canada (and payroll taxes more generally) is not high by international standards, and empirical work does not show a significant adverse effect of payroll taxes on Canadian employment. Hence, the IMF staff supports the Government’s suggested approach.
9. The 1996 reforms to the EI system sought to improve the flexibility and efficiency of the labor market and, thereby, help to reduce structural unemployment in Canada over time. For these reforms to have their intended effects, it is essential that they be fully implemented. Any tendency to ease some of the impact of the reforms as they begin to have binding effects needs to be strongly resisted if progress in fostering greater employment opportunities is to be sustained. Further efforts are also needed to deal with the employment disincentives that remain in the EI system. In particular, the scope for reducing the EI premium offers an excellent opportunity to tie the premium more closely to the experience with unemployment in individual firms. In addition, elimination of regional extended unemployment benefits would significantly reduce disincentives to work.
10. The provinces are implementing their own individual plans to maintain, or achieve, budget balance or surpluses by 2000. In light of recent economic developments and uncertainties with regard to Canada’s economic prospects, the budgets of some provinces may be adversely affected, and policy actions may be needed to preserve the soundness of their fiscal positions. To a large extent this could be achieved by adjusting spending initiatives or plans to reduce taxes that were developed when the economic outlook was more favorable.
11. Fiscal consolidation at both the provincial and federal levels has been reflected in substantial efforts to contain the growth in outlays for medical services and to improve the efficiency of the health care system. Further efforts will be required to meet the growth in health care expenditures over the long term that will arise from the aging of the population. Hence, it may be appropriate for the provinces to target budget surpluses over the medium term to ensure that sufficient resources will be available to meet these longer-term health care financing requirements. The federal government also should make provisions as part of its fiscal policy planning to meet the likely calls that will be made on it to provide additional resources for health care over the longer term. New spending initiatives should be used to support reforms in the health care system to improve its efficiency and the quality of care.
12. In recent years, most provinces have also introduced important changes in their social assistance programs by reducing benefits and establishing work and/or training requirements for employable social assistance recipients. Further measures need to be considered, as part of efforts to raise employment through improvements in the flexibility and efficiency of the labor market. In particular, barriers to labor force entry could be reduced by additional coordinated efforts on the part of the federal and provincial authorities to mitigate the disincentive effects of the interaction of the income tax system and social assistance programs. The availability of benefits without time limits, combined with high benefit withdrawal rates and taxes applied at relatively low income thresholds, may have created "poverty traps," whereby it is advantageous to remain on social assistance rather than to work. The introduction of the National Child Benefit is an important step in addressing this problem, and the IMF staff encourages additional efforts to reduce the high effective marginal income tax rates that social assistance recipients face if they enter the workforce. The announced increase in the National Child Benefit will help to address the problem of child poverty and deal with poverty traps, but it may also be necessary to further reduce other forms of social assistance over time, especially for employable recipients who do not accept offers of employment.
13. The recent proposed mergers of several of Canada’s largest commercial banks and the push toward establishing large financial conglomerates to compete in globalized financial markets raise the question of how further concentration might affect competition in the market for financial services. Independent of the decision that is made on the proposed mergers, there is considerable scope for reducing barriers to entry into the financial system by both domestic and foreign investors that would serve to increase competition in the financial sector. The IMF staff encourages the federal authorities to work with the provinces to evaluate the regulatory framework in financial services to ensure that there is an appropriate balance between prudential concerns and ease of entry to promote competition.
14. The Agreement on Internal Trade (AIT) provides a framework for ongoing reductions in interprovincial barriers to the free flow of goods, services, workers, and capital. The completion in 1998 of an agreement to extend liberalization of provincial government procurement activities to municipalities, municipal organizations, school boards, and publicly funded academic, social service, and health entities was a significant advancement of the AIT, but further work remains to be done. The IMF staff urges the provinces, with the encouragement of the federal government, to continue pushing forward with these reforms to improve the allocation of resources across the country. In particular, labor mobility would be appreciably enhanced by harmonization of provincial licensing requirements for professions or by the recognition of professional credentials across provinces.
15. Canada is a leading advocate of liberal trade and continues to work for trade liberalization in particular sectors and through regional and multilateral fora. The recently completed initiative to simplify the tariff system is a commendable unilateral step toward a more transparent and open trade regime. Competition from imports has intensified in the wake of the fallout from financial crisis in Asia, and protectionist pressures can be expected to rise. It is important that such pressures are strongly resisted. The IMF staff encourages the authorities to continue to pursue trade liberalization, and in particular to take every available opportunity in the context of multilateral and regional negotiations to achieve greater trade liberalization in such sensitive sectors as agriculture and textiles and clothing.
16. Canada’s official development assistance (ODA) declined as a share of GNP from 0.46 percent in 1992 to 0.32 percent in 1996, before increasing to 0.36 percent in 1997. The Government remains committed to improving the effectiveness of ODA and to moving toward an ODA target of 0.7 percent of GNP, as Canada's fiscal situation allows. The IMF staff encourages the authorities to make further progress toward reaching this goal.