2007 Article IV Consultation with Canada -- Preliminary Conclusions of the IMF Mission

IMF News, December 7, 2006

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The economy has remained close to potential over the last year, with robust domestic demand offsetting weakness in net exports from past currency appreciation.
Unemployment rate dipped to a 31-year low.
Projection: recovery in growth to around 2¾ percent by mid-2007, broadly in line with potential.
Projection: inflation staying at about 2 percent.

Downside risks to activity are tilted by external factors and questions surrounding productivity growth.
Upside domestic risk: strong household and corporate balance sheets could lead to domestic demand surprising on the upside.
Key downside risk: larger-than-anticipated slowing of activity in the United States, especially in the auto sector, which has significant spillovers for Canada.
Inflation risks are described as smaller and more balanced.

The Bank of Canada has left rates on hold since May.
Assessment of stance: apposite given projections that headline and core inflation will remain around the middle of the target range, broadly symmetric inflation risks, approximately neutral real short-term interest rates, well-anchored inflation expectations, and moderate wage pressures.
The mission welcomes the decision to leave the inflation targeting framework unchanged, with somewhat greater flexibility regarding the inflation horizon while continuing to explore the possibility of future improvements.

Bank profitability and capital are high by historical (and, for capital, international) standards.
Risks from the housing market are more limited than in other cyclically-advanced countries.
Recommendation: improve financial sector efficiency and innovation by reducing regulatory thresholds to bank restructuring and by moving toward establishing a national securities regulator.
The financial sector is considered well positioned to cope with a turning of the global credit cycle.

Welcome for the Fiscal Update's focus on fiscal prudence, including planned debt reduction of C$3 billion a year.
Intention to allocate unanticipated surpluses to further lower the debt burden is welcomed.
Advancement of the commitment for reducing the federal debt ratio to 25 percent of GDP by a year to FY 2012—13 is welcomed.
Long-term fiscal sustainability requires a steady and significant decline in debt in coming decades and further steps to contain the growth of public health spending due to population aging.
The new objective to eliminate general government net debt by 2021 highlights the joint role of public pension plans and provincial—territorial governments in achieving a sustainable fiscal position.
Recommendation: complement the new objective by publishing a regular assessment of the long-term fiscal outlook.

The government's intention to lower the tax burden is appropriate.
Recommendation: use modest fiscal space after planned debt reduction for growth-enhancing cuts in personal and (in particular) corporate marginal effective tax rates.
Welcome for the commitment to use interest savings from debt reduction to lower personal income taxes and the objective of achieving the lowest marginal effective tax rate on new investment in the G-7.
Observation: marginal income tax rates are high by international standards, implying larger efficiency gains from reductions in this area than further cuts to the Goods and Services Tax (GST).
With population aging and a steady lowering in the ratio of workers to the overall population, there is a case for increasing the role of consumption taxes in the overall revenue effort.

The reforms suggested by the O'Brien panel would make the equalization system more predictable.
With differences in provincial fiscal capacity widened by the boom in world commodity prices, there is urgency to return the program to a rules-based system and to avoid ad hoc bilateral arrangements.
Specific welcome for the suggestion to include resource revenues from all provinces in the standard for the calculation of equalization transfers.

With sound frameworks delivering macroeconomic stability, focus should shift to enhancing prosperity.
Theme of Advantage Canada is timely given modest business investment in machinery and equipment and R&D, and a continuing productivity gap with the United States.
Priorities to enhance the business environment:
- Cut high marginal effective tax rates on capital (including by promoting the harmonization of provincial sales taxes with the GST).
- Improve financial market intermediation.
- Phase out restrictions to foreign direct investment.
- Reduce the regulatory burden on firms.
- Eliminate interprovincial barriers to trade in goods and labor mobility.
- Adapt the immigration system more fully to the needs of the economy.

2007 Article IV Consultation with Canada -- Preliminary Conclusions of the IMF Mission, December 7, 2006