## 1. A sHIfTING GLObAL LANdsCApE ANd THE OUTLOOK fOR THE UNITEd sTATEs ANd CANAdA

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### Global outlook and recent adjustments
- World real GDP growth:
  - 3.1 percent in 2016; projected 3.4 percent in 2017 and 3.6 percent in 2018.
- Forecast drivers:
  - Stronger rebound in advanced economies since last October.
  - Weaker-than-expected activity in some emerging market economies led to small downward revisions to their overall growth prospects for 2017–18.
  - China’s growth in 2017 marked up owing to stronger-than-expected policy support.
  - Firming commodity prices since last October should gradually improve conditions in commodity exporters with macroeconomic strains.
- Financial market developments since the U.S. election:
  - Stronger dollar and higher interest rates in the United States.
  - Appreciable gains in equity markets in advanced economies.
  - Elevated financial risks and higher volatility in emerging markets.
  - Recovery in capital flows to emerging markets after an initial drop in November 2016.

### Shifts in the global landscape and commodities
- U.S. policy mix assumption:
  - Near-term fiscal stimulus and faster monetary policy normalization relative to previous forecasts.
- Commodity markets:
  - Agriculture, metals, and energy commodity prices have firmed.
  - Latest forecasts incorporate higher oil prices following the OPEC-plus supply-limiting agreement.
  - Medium-term outlook for oil markets remains broadly unchanged around “lower for longer” oil prices.
- Inflation:
  - In many emerging markets, downward pressures on headline inflation have receded in part owing to firming commodity prices and a pickup in growth.
  - Latin America is an exception where inflation has been easing.

### Range of global risks (slanted to the downside)
- Risks and amplifiers:
  - Policy uncertainty about the direction of U.S. tax, trade, and immigration policy, and about financial and business regulation.
  - Possibility that U.S. fiscal stimulus will trigger a quicker tightening in global financial conditions, including abrupt tightening via sharp movements in U.S. term premiums.
  - Risk of inward shift in policies, including trade or immigration restrictions, and associated retaliatory responses.
  - Building vulnerabilities in China’s financial system as policy stimulus is extended and continued.
  - Balance sheet weaknesses and currency mismatches in other emerging market economies that could amplify tightening financial conditions.
  - Geopolitical tensions, domestic political discord, terrorism, and security concerns.
  - Interconnectedness: for example, insular policies could be associated with heightened geopolitical tensions, higher risk aversion, and tighter financial conditions.
- Potential consequences:
  - A stronger dollar could contribute to widening U.S. external deficits and larger global imbalances.
  - Protectionist measures and retaliation would lower global growth through reduced trade, migration, and cross-border investment flows and heighten policy uncertainty.

### Policy recommendations (global)
- IMF staff recommend a three-pronged policy approach tailored to country circumstances that relies on:
  - Fiscal policies,
  - Structural policies,
  - Monetary policy.
- Safeguarding an open, rules-based, multilateral trading system is critical to preserve the global economic expansion.
- Governments should pursue redistributive policies and investments in skills and high-quality education, and facilitate labor market adjustment to ensure gains from technological progress and economic integration are shared more widely.

### U.S. outlook: recent performance and projections
- Recent performance:
  - U.S. real GDP growth settled at 1.9 percent (seasonally adjusted annual rate) in the last quarter of 2016.
  - Consumption remained the engine of growth; a stronger dollar and restructuring in the oil sector weighed on business investment.
  - Core personal consumption expenditure inflation: 1.8 percent.
  - Average hourly earnings rose by 2.7 percent over the past 12 months.
  - Labor force participation continues to drop; economy approaching full employment.
- IMF staff projections:
  - U.S. economic activity projected to expand by 2.3 percent in 2017 and 2.5 percent in 2018.
  - Core inflation projected to gradually pick up and reach the Federal Reserve’s target by mid-2018.
  - U.S. current account deficit projected to widen to about 3 ½ percent of GDP by 2020.
  - Public finances expected to worsen, with debt held by the public approaching 110 percent of GDP by 2022.

### Changes in U.S. policy direction: assumed baseline and implications
- Baseline assumptions:
  - Shift in policy mix toward more fiscal stimulus and faster monetary policy normalization relative to October forecasts.
  - IMF staff assume a 1.2 percent of GDP increase in the federal primary deficit in cyclically adjusted terms from 2017–19, driven by personal and corporate income tax cuts.
  - Fiscal stimulus estimated at 2 percent of GDP, cumulated over 2017–19, consisting of personal income tax rate cuts equivalent to 1.1 percent of GDP over three years and corporate tax cuts equivalent to 0.9 percent of GDP.
  - Monetary policy: IMF staff forecasts assume three policy rate hikes in 2017 and five hikes in 2018, in line with most recent Federal Open Market Committee guidance.
- Expected market pricing and effects:
  - Markets have largely priced in these anticipated policy changes: steepening yield curve, higher equity prices, and U.S. dollar appreciation.
  - Fiscal expansion would likely cause a durable increase in the budget deficit and rising public debt.
  - Combination of fiscal expansion and monetary tightening could induce further upward pressure on the U.S. dollar, especially if fiscal stimulus is larger than anticipated or if inflation pressures emerge more quickly.

### Strategic shifts, policy instruments, and two-way risks
- Corporate tax reform:
  - Expected simplification of the tax system with lower average tax rates and a broader base.
  - Potentially positive for long-term growth and a near-term demand stimulus if revenue losing.
  - Destination-based cash-flow tax (DBCFT) under consideration could boost business investment and domestic growth but may create tensions with World Trade Organization rules and precipitate trade disputes and possible retaliation.
- Two-way risks:
  - Changes in the underlying direction of U.S. policies represent both upside and downside risks to the medium-term outlook depending on execution.
  - The border adjustment element of some tax proposals could trigger international trade tensions with spillovers to global growth.

### United States: Policy risks and priorities
- Business regulation:
  - Administration ordered reexamination of existing federal regulations affecting businesses across a range of areas, with a view to scaling them back.
  - Targeted deregulation that leads to simplification and streamlining of existing rules, harmonization of regulations across states, or better coordination of tax reform with regulatory reform could present an upside by stimulating efficiency, growth, and job creation.
  - Unintended negative side effects from deregulation efforts could occur for the environment, workplace safety, or protections for those with lower incomes.
- Financial regulation:
  - Plans to reconsider aspects of the Dodd-Frank Act; scope exists to make legislation less burdensome, particularly for smaller financial institutions (for example, higher asset size thresholds in the application of enhanced prudential standards) or granting regulatory relief for small and community banks.
  - Many existing provisions have helped make the U.S. and global financial system considerably safer and more resilient; diluting these provisions may raise the likelihood of future economic dislocation despite potential near-term growth gains.
- Trade policy:
  - Intentions to reopen existing trade agreements, including renegotiation of NAFTA.
  - Cooperative updates to NAFTA (for example, in e-commerce and services) could generate growth dividends for all signatories.
  - Unilateral imposition of tariffs or other trade barriers would be damaging, given the predominance of intermediate goods trade and established cross-border value chains; effects would include weaker trade, higher production costs, more expensive imported consumer goods, and lower potential growth. Tariff retaliation would deepen these adverse effects.
- Immigration reform:
  - About 1.3 million immigrants enter the United States legally each year, supporting the workforce and positively affecting productivity.
  - Skills-based immigration reform could increase human capital, labor force participation, and productivity.
  - A broadly applied, more restrictive immigration approach would slow the influx of both skilled and unskilled workers, potentially depress innovation and productivity growth, reinforce demographic aging, and have untoward effects on potential growth.
  - Depending on the scale of restrictions, they could create upward pressure on U.S. production costs including wages (beneficial for low-income households) and generate negative spillovers for remittance-reliant countries.
- Longer-term fiscal and structural priorities:
  - U.S. public finances are on an unsustainable path given future increases in health and pension outlays as the population ages and potential output slows; a credible deficit- and debt-reduction strategy continues to be absent.
  - Tackling medium-term fiscal imbalances could create more room for policies that improve infrastructure, boost the labor force, and improve human capital.
  - Structural policy priorities recommended: infrastructure investment, education spending, stronger social safety nets (such as expanded earned income tax credits), tax and pension reform, and a higher minimum wage.
  - Measures to expand skilled labor include skills-based immigration reform, job training, and child care assistance.
  - Reforms to the U.S. immigration system should balance skills-based objectives with breadth sufficient to reverse demographic trends toward a rising elderly dependency ratio.
  - The path of future health care costs needs to be lowered, particularly for vulnerable groups, to secure sustainability of public finances.

### Canada: Recent performance and near-term outlook
- Growth and sectoral shifts:
  - Quarterly GDP was volatile in 2016 due to severe Alberta wildfires and swings in oil production.
  - Overall GDP growth: 1.4 percent for 2016, up from 0.9 percent in 2015.
  - GDP growth is projected to strengthen to 1.9 percent in 2017 and 2 percent in 2018.
  - The services sector accounts for about 70 percent of GDP and has been expanding steadily; finance and real estate activities have been boosted by the housing boom.
  - Investment and employment have been reallocated from the resource sector to other areas, most notably services.
  - Higher oil prices since mid-2016 are now well above operating costs for many oil sands producers, though still below full-cycle breakeven costs.
- Prices, productivity, and labor costs:
  - Headline consumer price index inflation was in the range of 1 to 1.5 percent for most of last year, below the midpoint of the Bank of Canada’s target band of 1 to 3 percent, though it has risen to about 2 percent more recently due to gasoline price increases.
  - Core inflation measures have remained below 2 percent since late 2016.
  - Business productivity running about 1 to 1.5 percent over the past year.
  - Growth of unit labor costs has hovered around 1 percent, posing little upward price pressure.

### Canada: Elevated macro-financial vulnerabilities
- Housing and household balance-sheet indicators:
  - Housing sector poses risks to macro-financial stability.
  - High or rising house prices in key markets have led borrowers to acquire larger mortgages with higher loan-to-income ratios.
  - The share of mortgage borrowers with loan-to-income ratios greater than 450 percent increased:
    - Toronto: from 32 percent in 2014 to 49 percent in 2016.
    - Vancouver: from 31 percent in 2014 to 39 percent in 2016.
  - Household indebtedness continued to rise, approaching a historic high of nearly 170 percent of disposable income.
  - Households’ total debt-service ratio has been broadly unchanged, with lower interest payments offsetting higher principal repayments.
- Banking sector exposures and tail risks:
  - Mortgage and consumer loans account for about one-third of bank assets.
  - Although the banking system is sound and profitability is high, banks’ exposures to highly indebted households have risen.
  - Plausible (but tail) risk scenario: a severe recession with a large and persistent rise in unemployment could trigger increased mortgage defaults, a deep correction in house prices, hurt banks’ profitability and capital positions, lead to a credit crunch, and magnify negative spillovers.
- Macroprudential and other policy responses already taken:
  - New measures: requiring lenders to subject all insured borrowers to mortgage rate stress tests; tightening eligibility criteria of low loan-to-value ratio mortgages for portfolio insurance; implementing tighter supervisory expectations for mortgage underwriting standards; and strengthened bank capital requirements.
  - Other announced measures: closing tax loopholes pertaining to capital gains tax exemptions for principal residences and launching consultations on lender risk sharing.
  - Some housing markets have shown signs of cooling: Vancouver house prices and home sales have both fallen, likely reflecting macroprudential tightening and new provincial and municipal tax measures (for example, British Columbia’s 15 percent property transfer tax for foreign buyers in Greater Vancouver and Vancouver’s empty-home tax).

### Canada: Risks and policy priorities
- Key downside and upside risks:
  - Higher uncertainty about the U.S. policy stance and its spillover impact: the United States receives about 75 percent of Canada’s goods exports.
  - U.S. fiscal stimulus could benefit Canada depending on implementation, but U.S. protectionist measures would reduce foreign demand and drag on Canadian exports and business investment.
  - A sharp correction in domestic housing markets could be triggered by a sharper-than-expected increase in mortgage interest rates, tighter global financial conditions, or a sudden shift in price expectations; if accompanied by a severe recession and rising unemployment, financial stability risks could emerge.
- Macro policy stance and fiscal space:
  - Current policy mix is appropriate: Bank of Canada policy rate at 0.5 percent since July 2015, given persistent economic slack; markets assume the rate will be kept unchanged until mid-2018.
  - Federal government has fiscal space and is committed to expansionary policy; the 2017 federal budget expects the deficit to widen slightly from 1.1 percent of GDP in FY2016/17 to 1.4 percent of GDP in FY2017/18, largely due to higher infrastructure spending.
  - If downside risks materialize, there is scope for additional stimulus, with a preference for more fiscal and less monetary support to discourage households from taking on more debt.
- Macroprudential stance and structural reform priorities:
  - Impact of recent macroprudential policy measures should be carefully watched before deciding further action; additional macroprudential measures may be needed if housing imbalances continue to grow, possibly targeting regional imbalances.
  - If housing markets correct much faster than expected and raise financial stability concerns, there may be a case for easing macroprudential measures.
  - Structural priorities to improve productivity and external competitiveness include enhancing innovation, upgrading labor skills, empowering women in the workplace, establishing an infrastructure bank to leverage private capital, diversifying trade partners (including implementing the EU free trade agreement), and reducing non-tariff barriers across provinces.

### Box: The Destination-Based Cash Flow Tax (DBCFT)
- Proposal overview:
  - U.S. House of Representatives’ proposal seeks to replace the corporate income tax with a cash flow tax with border adjustment and a lower tax rate for U.S. firms.
  - Proposal would transform the current 35 percent corporate income tax rate to a 20 percent destination-based cash flow tax (DBCFT).
- Two basic components:
  1. Cash flow tax mechanics:
     - Corporate taxes would be paid on revenues less expenses—including wages, investment, and intermediate inputs used for production.
     - Existing system of depreciation allowances and net interest payment deductions would be eliminated and replaced by immediate expensing of capital investment.
     - This would help eliminate tax bias toward debt finance (since interest costs would no longer be tax deductible) and would tax economic rents rather than the normal return to capital.
  2. Destination-based component (border adjustment):
     - Proposal would exempt exports and tax imports (or equivalently, not allow imports to be a deductible expense when calculating the firm’s tax liability), shifting corporate taxation from a source basis to a destination basis analogous to a VAT.
     - Text presents the VAT base relationship exactly as:
       Revenue 2 intermediate purchases 1 imports 2 exports 2 wages
                                                      VAT base
- Potential macroeconomic and spillover implications:
  - Under revenue neutrality, the proposed tax system should boost U.S. investment and induce reallocation of productive capacity to the United States by removing tax distortions on investment.
  - Adoption would face legal, practical, and political hurdles: transition rules for existing capital and debt, taxation complications for the financial sector, providing refunds to sectors facing persistent tax losses, and uncertain distributional effects.
  - Moving to a DBCFT could generate significant appreciation of the U.S. real exchange rate through a stronger dollar; large shifts would affect balance sheets, particularly for economies with unhedged and leveraged dollar positions.
  - Potential inconsistency of the border adjustment with World Trade Organization principles and existing tax treaties could open the door to retaliatory measures by trading partners.
  - Many countries would face challenges attracting foreign direct investment and controlling tax-base erosion and profit-shifting to the United States from home jurisdictions.

_Italic source: Prepared by Hamid Faruqee with Kotaro Ishi and Emanuel Kopp; Regional Economic Outlook: Western Hemisphere, International Monetary Fund | April 2017._

### 3.1 percent in 2016 to 3.4 percent in 2017 and 3.6

### 3.1 percent in 2016 to 3.4 percent in 2017 and 3.6

### Global outlook and recent adjustments
- World real GDP growth: 3.1 percent in 2016; projected 3.4 percent in 2017 and 3.6 percent in 2018 (Figure 1.1; see also Chapter 1 of the April 2017 World Economic Outlook).
- Forecast drivers:
  - Stronger rebound in advanced economies since last October.
  - Weaker-than-expected activity in some emerging market economies led to small downward revisions to their overall growth prospects for 2017–18.
  - China’s growth in 2017 marked up owing to stronger-than-expected policy support.
  - Firming commodity prices since last October should gradually improve conditions in commodity exporters with macroeconomic strains.
- Financial market developments since the U.S. election:
  - Stronger dollar and higher interest rates in the United States.
  - Appreciable gains in equity markets in advanced economies.
  - Elevated financial risks and higher volatility in emerging markets.
  - Recovery in capital flows to emerging markets after an initial drop in November 2016.

### Shifts in the global landscape and commodities
- Assumed changing policy mix in the United States with near-term fiscal stimulus and faster monetary policy normalization relative to previous forecasts.
- Commodity markets:
  - Agriculture, metals, and energy commodity prices have firmed.
  - Latest forecasts incorporate higher oil prices following the OPEC-plus supply-limiting agreement.
  - Medium-term outlook for oil markets remains broadly unchanged around “lower for longer” oil prices (Figure 1.1).
- Inflation:
  - In many emerging markets, downward pressures on headline inflation have receded in part owing to firming commodity prices and a pickup in growth.
  - Latin America is an exception where inflation has been easing.

### Range of global risks (slanted to the downside)
- Risks and amplifiers:
  - Policy uncertainty about the direction of U.S. tax, trade, and immigration policy, and about financial and business regulation.
  - Possibility that U.S. fiscal stimulus will trigger a quicker tightening in global financial conditions, including abrupt tightening via sharp movements in U.S. term premiums.
  - Risk of inward shift in policies, including trade or immigration restrictions, and associated retaliatory responses.
  - Building vulnerabilities in China’s financial system as policy stimulus is extended and continued.
  - Balance sheet weaknesses and currency mismatches in other emerging market economies that could amplify tightening financial conditions.
  - Geopolitical tensions, domestic political discord, terrorism, and security concerns.
  - Interconnectedness: for example, insular policies could be associated with heightened geopolitical tensions, higher risk aversion, and tighter financial conditions.
- Potential consequences:
  - A stronger dollar could contribute to widening U.S. external deficits and larger global imbalances.
  - Protectionist measures and retaliation would lower global growth through reduced trade, migration, and cross-border investment flows and heighten policy uncertainty.

### Policy recommendations (global)
- IMF staff recommend a three-pronged policy approach tailored to country circumstances that relies on:
  - Fiscal policies,
  - Structural policies,
  - Monetary policy.
- Safeguarding an open, rules-based, multilateral trading system is critical to preserve the global economic expansion.
- Governments should pursue redistributive policies and investments in skills and high-quality education, and facilitate labor market adjustment to ensure gains from technological progress and economic integration are shared more widely.

### U.S. outlook: recent performance and projections
- Recent performance:
  - U.S. real GDP growth settled at 1.9 percent (seasonally adjusted annual rate) in the last quarter of 2016.
  - Consumption remained the engine of growth; a stronger dollar and restructuring in the oil sector weighed on business investment.
  - Core personal consumption expenditure inflation: 1.8 percent.
  - Average hourly earnings rose by 2.7 percent over the past 12 months.
  - Labor force participation continues to drop; economy approaching full employment.
- IMF staff projections:
  - U.S. economic activity projected to expand by 2.3 percent in 2017 and 2.5 percent in 2018.
  - Core inflation projected to gradually pick up and reach the Federal Reserve’s target by mid-2018.
  - U.S. current account deficit projected to widen to about 3 ½ percent of GDP by 2020.
  - Public finances expected to worsen, with debt held by the public approaching 110 percent of GDP by 2022.

### Changes in U.S. policy direction: assumed baseline and implications
- Baseline assumptions:
  - Shift in policy mix toward more fiscal stimulus and faster monetary policy normalization relative to October forecasts.
  - IMF staff assume a 1.2 percent of GDP increase in the federal primary deficit in cyclically adjusted terms from 2017–19, driven by personal and corporate income tax cuts.
  - The baseline projection notes fiscal stimulus is estimated at 2 percent of GDP, cumulated over 2017–19, consisting of personal income tax rate cuts equivalent to 1.1 percent of GDP over three years and corporate tax cuts equivalent to 0.9 percent of GDP.
  - Monetary policy: IMF staff forecasts assume three policy rate hikes in 2017 and five hikes in 2018, in line with most recent Federal Open Market Committee guidance.
- Expected market pricing and effects:
  - Markets have largely priced in these anticipated policy changes: steepening yield curve, higher equity prices, and U.S. dollar appreciation.
  - Fiscal expansion would likely cause a durable increase in the budget deficit and rising public debt.
  - Combination of fiscal expansion and monetary tightening could induce further upward pressure on the U.S. dollar, especially if fiscal stimulus is larger than anticipated or if inflation pressures emerge more quickly.

### Strategic shifts, policy instruments, and two-way risks
- Corporate tax reform:
  - Expected simplification of the tax system with lower average tax rates and a broader base.
  - Potentially positive for long-term growth and a near-term demand stimulus if revenue losing.
  - Destination-based cash-flow tax (DBCFT) under consideration could boost business investment and domestic growth but may create tensions with World Trade Organization rules and precipitate trade disputes and possible retaliation.
- Two-way risks:
  - Changes in the underlying direction of U.S. policies represent both upside and downside risks to the medium-term outlook depending on execution.
  - The border adjustment element of some tax proposals could trigger international trade tensions with spillovers to global growth.

_Italic source: Prepared by Hamid Faruqee with Kotaro Ishi and Emanuel Kopp; Regional Economic Outlook: Western Hemisphere, International Monetary Fund | April 2017._

### 1. A sHIfTING GLObAL LANdsCApE ANd THE OUTLOOK fOR THE UNITEd sTATEs ANd CANAdA

### 1. A sHIfTING GLObAL LANdsCApE ANd THE OUTLOOK fOR THE UNITEd sTATEs ANd CANAdA

### United States: Policy risks and priorities
- Business regulation
  - The administration has ordered a reexamination of existing federal regulations affecting businesses across a range of areas, with a view to scaling them back.
  - Targeted deregulation that leads to simplification and streamlining of existing rules, harmonization of regulations across states, or better coordination of tax reform with regulatory reform could present an upside by stimulating efficiency, growth, and job creation.
  - Unintended negative side effects from deregulation efforts could occur for the environment, workplace safety, or protections for those with lower incomes.
- Financial regulation
  - Plans to pursue changes in regulation of the financial industry include reconsidering some aspects of the Dodd-Frank Act.
  - Scope exists to make legislation less burdensome, particularly for smaller financial institutions (for example, higher asset size thresholds in the application of enhanced prudential standards) or granting regulatory relief for small and community banks.
  - Many existing provisions have helped make the U.S. and global financial system considerably safer and more resilient; diluting these provisions may raise the likelihood of future economic dislocation despite potential near-term growth gains.
- Trade policy
  - The United States has declared intentions to reopen existing trade agreements, including renegotiation of NAFTA.
  - Cooperative updates to NAFTA (for example, in e-commerce and services) could generate growth dividends for all signatories.
  - Unilateral imposition of tariffs or other trade barriers would be damaging for the United States and its trading partners, especially given the predominance of intermediate goods trade and established cross-border value chains; effects would include weaker trade, higher production costs, more expensive imported consumer goods, and lower potential growth. Tariff retaliation would deepen these adverse effects.
- Immigration reform
  - Currently, about 1.3 million immigrants enter the United States legally each year, supporting the workforce and positively affecting productivity.
  - Skills-based immigration reform could create an upside for U.S. potential growth by increasing human capital, labor force participation, and productivity.
  - A broadly applied, more restrictive immigration approach would slow the influx of both skilled and unskilled workers, potentially depress innovation and productivity growth, reinforce demographic aging, and have untoward effects on potential growth.
  - Depending on the scale of restrictions, they could create upward pressure on U.S. production costs including wages (beneficial for low-income households) and generate negative spillovers for remittance-reliant countries.
- Longer-term fiscal and structural priorities
  - U.S. public finances are on an unsustainable path given future increases in health and pension outlays as the population ages and potential output slows; a credible deficit- and debt-reduction strategy continues to be absent.
  - Tackling medium-term fiscal imbalances could create more room for policies that improve infrastructure, boost the labor force, and improve human capital.
  - Structural policy priorities recommended: infrastructure investment, education spending, stronger social safety nets (such as expanded earned income tax credits), tax and pension reform, and a higher minimum wage.
  - Measures to expand skilled labor include skills-based immigration reform, job training, and child care assistance.
  - Reforms to the U.S. immigration system should balance skills-based objectives with breadth sufficient to reverse demographic trends toward a rising elderly dependency ratio.
  - The path of future health care costs needs to be lowered, particularly for vulnerable groups, to secure sustainability of public finances.

### Canada: Recent performance and near-term outlook
- Growth and sectoral shifts
  - Quarterly GDP was volatile in 2016 due to severe Alberta wildfires and swings in oil production.
  - Overall GDP growth: 1.4 percent for 2016, up from 0.9 percent in 2015.
  - GDP growth is projected to strengthen to 1.9 percent in 2017 and 2 percent in 2018.
  - The services sector accounts for about 70 percent of GDP and has been expanding steadily; finance and real estate activities have been boosted by the housing boom.
  - Investment and employment have been reallocated from the resource sector to other areas, most notably services.
  - Higher oil prices since mid-2016 are now well above operating costs for many oil sands producers, though still below full-cycle breakeven costs.
- Prices, productivity, and labor costs
  - Headline consumer price index inflation was in the range of 1 to 1.5 percent for most of last year, below the midpoint of the Bank of Canada’s target band of 1 to 3 percent, though it has risen to about 2 percent more recently due to gasoline price increases.
  - Core inflation measures have remained below 2 percent since late 2016.
  - Business productivity running about 1 to 1.5 percent over the past year.
  - Growth of unit labor costs has hovered around 1 percent, posing little upward price pressure.

### Canada: Elevated macro-financial vulnerabilities
- Housing and household balance-sheet indicators
  - The housing sector continues to pose risks to macro-financial stability.
  - High or rising house prices in key markets have led borrowers to acquire larger mortgages with higher loan-to-income ratios.
  - The share of mortgage borrowers with loan-to-income ratios greater than 450 percent increased:
    - Toronto: from 32 percent in 2014 to 49 percent in 2016.
    - Vancouver: from 31 percent in 2014 to 39 percent in 2016.
  - Household indebtedness continued to rise, approaching a historic high of nearly 170 percent of disposable income.
  - Households’ total debt-service ratio has been broadly unchanged, with lower interest payments offsetting higher principal repayments.
- Banking sector exposures and tail risks
  - Mortgage and consumer loans account for about one-third of bank assets.
  - Although the banking system is sound and profitability is high, banks’ exposures to highly indebted households have risen.
  - A plausible (but tail) risk scenario: a severe recession with a large and persistent rise in unemployment could trigger increased mortgage defaults, a deep correction in house prices, hurt banks’ profitability and capital positions, lead to a credit crunch, and magnify negative spillovers.
- Macroprudential and other policy responses already taken
  - New measures include requiring lenders to subject all insured borrowers to mortgage rate stress tests, tightening eligibility criteria of low loan-to-value ratio mortgages for portfolio insurance, implementing tighter supervisory expectations for mortgage underwriting standards, and strengthened bank capital requirements.
  - Other announced measures included closing tax loopholes pertaining to capital gains tax exemptions for principal residences and launching consultations on lender risk sharing.
  - Some housing markets have shown signs of cooling: Vancouver house prices and home sales have both fallen, likely reflecting macroprudential tightening and new provincial and municipal tax measures (for example, British Columbia’s 15 percent property transfer tax for foreign buyers in Greater Vancouver and Vancouver’s empty-home tax).

### Canada: Risks and policy priorities
- Key downside and upside risks
  - Higher uncertainty about the U.S. policy stance and its spillover impact: the United States receives about 75 percent of Canada’s goods exports; U.S. fiscal stimulus could benefit Canada depending on implementation, but U.S. protectionist measures would reduce foreign demand and drag on Canadian exports and business investment.
  - A sharp correction in domestic housing markets could be triggered by a sharper-than-expected increase in mortgage interest rates, tighter global financial conditions, or a sudden shift in price expectations; if accompanied by a severe recession and rising unemployment, financial stability risks could emerge.
- Macro policy stance and fiscal space
  - The current policy mix is appropriate: the Bank of Canada has maintained an accommodative stance, with the policy rate at 0.5 percent since July 2015, given persistent economic slack; markets assume the rate will be kept unchanged until mid-2018.
  - The federal government has fiscal space and is committed to expansionary policy; the 2017 federal budget expects the deficit to widen slightly from 1.1 percent of GDP in FY2016/17 to 1.4 percent of GDP in FY2017/18, largely due to higher infrastructure spending.
  - If downside risks materialize, there is scope for additional stimulus, with a preference for more fiscal and less monetary support to discourage households from taking on more debt.
- Macroprudential stance and structural reform priorities
  - The impact of recent macroprudential policy measures should be carefully watched before deciding further action; additional macroprudential measures may be needed if housing imbalances continue to grow, possibly targeting regional imbalances.
  - If housing markets correct much faster than expected and raise financial stability concerns, there may be a case for easing macroprudential measures.
  - Structural priorities to improve productivity and external competitiveness include enhancing innovation, upgrading labor skills, empowering women in the workplace, establishing an infrastructure bank to leverage private capital, diversifying trade partners (including implementing the EU free trade agreement), and reducing non-tariff barriers across provinces.

### Box: The Destination-Based Cash Flow Tax (DBCFT)
- Proposal overview
  - The U.S. House of Representatives’ proposal seeks to replace the corporate income tax with a cash flow tax with border adjustment and a lower tax rate for U.S. firms.
  - The proposal would transform the current 35 percent corporate income tax rate to a 20 percent destination-based cash flow tax (DBCFT).
- Two basic components
  1. As a cash flow tax, corporate taxes would be paid on revenues less expenses—including wages, investment, and intermediate inputs used for production.
     - The existing system of depreciation allowances and net interest payment deductions would be eliminated and replaced by immediate expensing of capital investment.
     - This would help eliminate tax bias toward debt finance (since interest costs would no longer be tax deductible) and would tax economic rents rather than the normal return to capital.
  2. Destination-based component (border adjustment)
     - The proposal would exempt exports and tax imports (or equivalently, not allow imports to be a deductible expense when calculating the firm’s tax liability), shifting corporate taxation from a source basis to a destination basis analogous to a VAT.
     - The text presents the VAT base relationship exactly as:  
       Revenue 2 intermediate purchases 1 imports 2 exports 2 wages  
                                                     VAT base
- Potential macroeconomic and spillover implications
  - Under revenue neutrality, the proposed tax system should boost U.S. investment and induce reallocation of productive capacity to the United States by removing tax distortions on investment.
  - Adoption would face legal, practical, and political hurdles: transition rules for existing capital and debt, taxation complications for the financial sector, providing refunds to sectors facing persistent tax losses, and uncertain distributional effects.
  - Moving to a DBCFT could generate significant appreciation of the U.S. real exchange rate through a stronger dollar; large shifts would affect balance sheets, particularly for economies with unhedged and leveraged dollar positions.
  - A potential inconsistency of the border adjustment with World Trade Organization principles and existing tax treaties could open the door to retaliatory measures by trading partners.
  - Many countries would face challenges attracting foreign direct investment and controlling tax-base erosion and profit-shifting to the United States from home jurisdictions.

*International Monetary Fund | April 2017 — wreo0517-chp1*

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_Source: https://www.imf.org/-/media/files/publications/reo/whd/2017/may/wreo0517-chp1.pdf_