Preface

by Michael A. Walker, Executive Director, The Fraser Institute

This is an important study. Its results are crucial to the understanding of the current and prospective state of Canada's finances. Its message is one that must be understood by every adult Canadian if they are to make informed and correct decisions about the sort of policies they will endorse as Canada comes to grips with its public sector economic maladies. Because of its importance, we have devoted the entire August edition of Fraser Forum to its presentation. Regular features will return in the next edition.

The research which has gone into the study consists largely of applying techniques which were first devised to make calculations for the United States. The innovation which it contains is to construct measurements for Canada and to make comparisons with the corresponding U.S. data. The essential point of the analysis is to see how different generations of Canadians fare in terms of getting benefits from government and paying for those benefits. A particular interest is to determine whether the current settings of tax and spending policy can be sustained into the future. That is, will the future generations of taxpayers be willing and able to carry the burdens which are implied by the current policies of government.

It is fitting that such a study be undertaken by a member of one of the generations who will have to grapple with the problems that previous generations may have created. Chris Good, who is completing his Ph.D. at Harvard University, undertook the research for this study during two terms as a summer intern at The Fraser Institute. The Fraser Institute has been pleased to suggest this line of enquiry and to support Chris Good's research to complete the analysis. However, the conclusions to which Mr. Good comes have been independently arrived at, and may or may not reflect the views of the members and trustees of The Fraser Institute.

Those conclusions are both alarming and reassuring. Alarming in that if nothing is done, the current course of policy is unsustainable. Reassuring in that there is a way out of the box into which we have fallen. That solution makes clear why some analysts are proposing to solve Canada's fiscal problem by lengthening the period of normal retirement and in other ways freezing the levels of benefits available. According to the findings of this study, some sort of freeze on benefits will be required to ensure that the future "adds up."

Because of the very nature of the analysis, this is not an easy study to read. However, the busy reader or those who are less interested in the mathematics of the paper will be relieved to learn that there is a handy summary of the method and the conclusions in Section 1. I highly recommend it to anyone who is concerned about the current course of tax and spending policy in Canada.

About the Author

Christopher Good has a B.Comm from Queen's University, an M.A. in economics from the University of British Columbia, and an A.M. in economics from Harvard University. Currently, he is a Ph.D candidate in economics at Harvard University. His fields of interest are financial economics and econometrics.

Summary

(1) Using a technique called generational accounting which looks at the future stream of government taxes, transfers, and expenditure, this study concludes that Canadian fiscal policy is unsustainable.

(2) This study performs the generational accounting technique with Canadian all-government data under various assumptions of discount rates, productivity improvements, and changes in tax, transfer and government expenditure policies.

(3) The paper's major working assumption is that those alive as of this study's base year, 1991, live their entire lives under current (1991) tax and transfer policies, while future generations' net payments must provide for sustainable government operations, including the net indebtedness which is left to them by those currently alive.

(4) With the assumption of a 2 percent discount rate for transactions, the present value net payment obligations of future generations increase by 196 percent over current newborns to $598,000 dollars each. Under the assumption of a 4 percent discount rate, the present value net payment obligation increases by 151 percent over current newborns to $317,000 each. Lastly, a 6 percent discount rate implies that future newborns must pay 160 percent more in present value net payments each over current newborns.

(5) An alternative assumption is that government expenditure be permanently decreased given current tax and transfer policies. In this case, government expenditure must be cut permanently by 61 percent, 36 percent, or 32 percent, given discount rates of 2 percent, 4 percent or 6 percent, respectively.

(6) If current tax and transfer policies continue for all current and future generations then the present value of the government sector's unfunded liabilities is $21.2 trillion, $2.3 trillion, or $1.2 trillion with a 2 percent, 4 percent, or 6 percent discount rate, respectively.

(7) In comparison with a similar study for the United States under the assumption of a 6 percent discount rate and a 0.75 percent annual productivity growth assumption, this study finds that the Canadian government sector is overspending at a vastly greater rate than its U.S. counterpart. Whereas the Canadian government must increase the net payment obligations of future generations by 225 percent in order to provide sustainable government policy, the U.S. government need only increase the burden placed on future generations by 33 percent.

(8) Another way to make government policies sustainable is a "freeze and growth through productivity" policy. In this study, this means that at each age, an individual's taxes are increased at the rate of productivity, while his or her transfers and government expenditure remain constant in real terms at the 1991 levels. The study uses Canada's historic productivity growth rate: 0.6 percent. Under the 2 percent discount rate assumption, the present value net payment obligation of future generations can decline by 25 percent over current generations. With a 4 percent discount rate, future generations face similar net payment burdens as current generations. With a 6 percent discount rate, future generations must pay 60 percent more in net payments than current generations.

Introduction

[The author thanks Michael Walker for his comments, corrections, and support. In addition, much thanks is owed to Victor Waese and Isabella Horry for innumerable (and invaluable) discussions, advice, and help. Lastly, thanks to Robin Richardson for the opportunity to present this research to the Joint Meeting of the Canadian Institute of Actuaries and the U.S. Society of Actuaries in June 1995.]

The burden of the debt

Already Canadians are bearing substantial total all-government Canadian debt burdens. Robin Richardson, in his recent Fraser Institute study on the Canadian government's debt situation, reports that the Canadian government sector gross debt as of March 31, 1992 is $921 billion. See Richardson [1994a], table 3.2.Note In contemplation of this debt overhang and the country's medium term economic outlook, Moody's Investor Service reduced Canada's credit rating, and others have questioned whether this current situation is sustainable. Yet the Canadian government is going to continue to build on its current debt load for the foreseeable future. Moreover, as the population ages and the number of young people shrinks and the number of elderly increases, the tax base falls and the transfer requirements in terms of guaranteed pensions and other social spending increase. This combination of developments is likely to lead the country into further indebtedness.

Is Canadian government policy sustainable?

Under these circumstances, it is quite natural to wonder whether current government policies are sustainable in the long run. That is, if the current policies are maintained, is there a reasonable prospect of the government being able to meet the financial obligations which are implied by these policies? The answer does not turn upon whether the government runs a deficit or surplus in any given year. Rather, the issue is whether the government will be able to pay all of its current and future obligations. In the terms of the current debate about fiscal policy, a deficit today followed by a greater surplus tomorrow will satisfy creditors as well as balanced budgets today and tomorrow.

The purpose of this study

The purpose of this study is to determine whether the Canadian government's policies regarding taxation, transfer payments, and government expenditure are sustainable over the long run. By sustainable, this study means the ability of the government to collect enough taxes to be able to pay the transfers to the public, government expenditure on goods and services such as health care and education, and the government debt.

In addition, the study determines the extent of Canadian government overspending given the current path of government policy. The greater the current government expenditure and debt load, the more resources future generations will have to sacrifice in order to pay off these liabilities. The extent of government overspending is made clearer when one compares the future expected tax burden with the current tax burden.

This study contains three main sections in order of increasing complexity. The first section is for "beginners" and presents preliminary results. It discusses the importance of generational accounting and presents a basic discussion of Canada's fiscal situation as revealed by generational accounts. The second section is the main body of the report and should be of primary concern to those interested in becoming familiar with Canada's generational accounts. This section delves into the principles underlying generational accounting, presents a discussion of how the accounts are constructed, and provides an in-depth analysis of Canada's generational accounts. The third section is a technical appendix and is intended mainly for researchers planning either to construct generational accounts or to use them in a decision-making capacity. It offers a mathematical presentation of generational accounting theory and discusses in further detail the approach used to construct this study's generational accounts.

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Last Modified: Wednesday, October 20, 1999.