Fiscal policy is the use of government taxing and spending powers to manage the behaviour of the economy. Most fiscal policy is a balancing act between taxes, which tend to reduce economic activity, and spending, which tends to increase it — although there is debate among economists about the effectiveness of fiscal measures.

Managing Economic Demand

The economy's total output, income and employment levels are directly related to private and public spending — or aggregate demand. Private spending consists of purchases of goods and services by consumers, by businesses for investment, and net exports (exports minus imports). Public or government spending comes from the revenues raised from taxes and other sources, which are spent on such things as health care, education, pensions, social assistance and defence.

Fiscal policy refers to government action to change the total amount or the composition of these revenues and expenditures, in order to manage the growth of demand in the economy. The objective is to keep a growing labour force and the country's stock of industrial plants and machinery employed at relatively high levels, but without generating inflation or having to rely on excessive foreign borrowing to pay for imported goods.

Increases in government revenue (taxes) reduce aggregate demand, and higher expenditures increase it. Thus, if private spending such as purchases of cars by consumers falls, governments might seek to prevent demand and, as a result, total output, income and employment from falling, by increasing their expenditures or reducing taxes.

Impact of Surpluses and Deficits

The traditional view of fiscal policy emphasized the direct impact of government revenue and spending on aggregate demand. Although it was recognized that some tax and expenditure changes affect the economy more than others, the government budget balance was used as a rough indicator of the impact of the government on aggregate demand. Initially, it was thought that government surpluses were associated with depressed economic activity and deficits with a high level of output and employment. Eventually, as economic reality disproved these simplistic notions, a more sophisticated view evolved that related changes in the balance of government revenues and expenditures to changes in aggregate demand.

All other things being equal, if government revenues increase more than expenditures, the resulting improvement in the budget balance (increase in the surplus or decrease in the deficit) tends to reduce aggregate demand, putting downward pressure on output, incomes, employment, and eventually prices. On the other hand, if government spending increases more than revenues, the resulting deterioration in the budget balance (increase in the deficit or decrease in the surplus) raises aggregate demand, bolstering output, incomes, employment, and consequently prices.

Economists Disagree

Some economists do not believe fiscal policy has any impact on aggregate demand. One group makes the claim that any deterioration in the budget balance has to be financed by government borrowing, and that this borrowing in turn represents future taxes that rational consumers will take into account in the same way as current taxes, by curtailing their spending. This offsets fully any impact of an expansionary fiscal policy on aggregate demand.

Another group points out that the increase in government borrowing resulting from an expansionary fiscal policy will compete with private borrowers for funds, driving interest rates and the exchange rate up and making private investment and exports more costly. Again this offsets some of the original expansionary impact of the policy. Monetarist economists (led by Milton Friedman at the University of Chicago) have gone so far as to argue that all of the expansionary impact of fiscal policy would be so dissipated.

Moreover, if deficits continue for prolonged periods, the accumulation of public debt and rising interest payments on that debt will raise interest rates further over time, depressing aggregate demand and jeopardizing the government's ability to undertake further revenue and expenditure changes for stabilization purposes.

Macroeconomic models of the Canadian economy somewhat confirm the views of those who argue for some crowding out of private expenditures by government spending. Fiscal multipliers (the induced increase in Gross Domestic Product, divided by the assumed increase in government spending) produced by simulations of these models are initially greater than one but then decline to zero over several years. This indicates that increased government spending has only a temporary expansionary impact on output, but does not permanently raise its level. It also provides further evidence that the effects of fiscal policy cannot be viewed in isolation from those of monetary policy (money supply and demand), and of changes in government debt.

How Fiscal Measures Are Reported

Fiscal policy is primarily the responsibility of the federal government, although the provinces have a role. In the annual budget, the federal minister of finance presents the planned expenditures of the government, the revenues anticipated and, if a deficit is expected, the amount that must be borrowed (total financial requirements, including "nonbudgetary" transactions such as pension accounts and loans, investments and advances).

While the expenditures and revenues reported in the budget are presented on the public accounts basis required for reporting to Parliament, they can also be presented on a national accounts basis, in which various revenues and expenditures are grouped under headings related to their impact on the economy (eg, purchases of goods and services, federal transfers to persons, and federal transfers to other levels of government) rather than — as in the administrative budget — by department or broad purpose (eg, social programs).

The government's actual surplus or deficit on the national accounts basis can be misleading as an indicator of the impact of fiscal policy on the economy. For example, particularly from 1979 on, Ottawa took action to make fiscal policy more restrictive by reducing some expenditures and increasing taxes. Yet its actual deficit still ballooned during the 1981-82 recession, and continued to rise relative to the economy's total output until the mid-1980s. In part, this was because some tax collections and some expenditure items responded automatically to changes in the level of economic activity and prices. For instance, such "built-in stabilizers" include personal and corporate income taxes which fall, and employment insurance payments which rise, as economic activity declines, thus increasing aggregate demand and income even without specific government policy action.

Also, interest payments on the public debt tend to rise with inflation. To separate these effects from deliberate policy actions, the minister has presented "cyclically adjusted" and "inflation-adjusted surplus/deficit" figures to show respectively what the fiscal position would be with higher average levels of output and employment, and without the effects of inflation on debt charges.

Evolution of Canadian Fiscal Policy

Prior to the 1930s, many economists felt that swings in the level of economic activity were largely self-correcting, though perhaps with some assistance from monetary policy to prevent excessive movement in prices. Governments, like prudent households, were simply expected to balance their budgets annually. This sometimes led to tax increases or expenditure cuts when economic activity was already low, making the business cycle even worse. But fortunately the government sector was relatively small so that fiscal policy changes usually had small impacts on the economy.

Keynes, the Great Depression and War

The severe and prolonged unemployment of the Great Depression ended the optimism about self-correction and brought increasing demands for positive action by governments. Economists had no coherent theories to explain the Depression and differed widely on what should be done. At least, that was until John Maynard Keynes provided the blueprint for action in his book the General Theory of Employment, Interest and Money (1936), which supplied a theoretical explanation of how such high unemployment could persist for so long (see Keynesian Economics). This remains one of the most controversial books ever written, and economists still argue over the causes of the Great Depression. Monetarist economists led by Milton Friedman put the blame on mistakes in monetary rather than fiscal policy.

Nevertheless, the Depression and Keynes's book, along with the illustration of what governments could do following their greatly expanded wartime role, brought a revolution in thinking, including a strong emphasis on fiscal policy and, for a while, a downgrading of monetary policy in the pursuit of economic stability. In 1945, Canada's federal government committed itself to use fiscal policy "to maintain a high and stable level of employment and income" by setting its budgetary position as the business cycle required.

Monetary Policy Returns

During the 1950s, especially after the Korean War, the government was reasonably successful in keeping unemployment low and prices stable, partly through fiscal policy, but also through monetary policy which became more active after mid-decade. The rebirth of interest in monetary policy was prompted by monetarist economists, who increasingly challenged the mainstream of economic thought.

By the early 1960s, mainstream Keynesian economists became convinced that simply trying to smooth the ups and downs of the business cycle sometimes choked off recovery before the economy reached full growth. Attention shifted to the possibility of using a combination of fiscal and monetary policies to stimulate the economy. This led to the tax cut proposed by President Kennedy in the United States in the early 1960s and to similar tax reductions in Canada. It was felt that it was possible to "fine-tune" the economy, steering it along a path of continually growing output and employment, even if that meant balancing the budget only over periods much longer than the usual business cycle. The strong growth that developed in the mid-1960s served to create a climate of optimism about the use of "aggregate demand" policies. It was believed that any desired level of unemployment could be achieved, if people were only prepared to accept the rate of inflation that went with it.

Oil Shocks and Stagflation

This optimism disappeared in the 1970s as events proved that the choice between inflation and unemployment was not so simple. As a result, an increasing number of economists rejected the notion that there was a fixed trade-off between inflation and unemployment as portrayed in the so-called Phillips curve — which showed inflation as being inversely related to the unemployment rate. Instead, more and more economists came to believe there was a natural rate of unemployment to which the economy would automatically gravitate (estimated to be around 7.5 per cent in Canada). If the government pursued expansionary monetary or fiscal policies to push unemployment below the natural rate, inflation would accelerate. If the government pursued contractionary policies causing the unemployment rate to rise above the natural rate, inflation would drop.

However, stagflation — the combination of weak output growth, high unemployment and accelerating inflation — was particularly acute after 1975, partly as a result of external shocks, especially major increases in the price of oil. Policy makers tried at first to keep output and employment up by a series of tax reductions, while checking inflation through wage and price controls (1975-78), and slowing down new expenditures programs. But even the imposition of wage and price controls from 1976 to 1978 only succeeded in temporarily halting the upsurge of inflation which climbed to double-digit levels in 1981. It was only a severe tightening of monetary policy that brought inflation down to more moderate levels. This produced in 1981-82 the deepest recession Canada had undergone since the 1930s, and drove unemployment up to a peak of more than 12 .5 per cent in 1982 at the trough of the recession.

While there were some tax hikes and selective expenditure cuts during this recession, fiscal policy remained basically expansionary. The stimulative thrust of policy continued into the recovery as rising debt charges and the costs of statutory programs proved difficult to pare back.

Despite a reasonably strong economic recovery, the recession was so deep that output did not surpass its pre-recession level until 1984, and it remained below capacity into the second half of the decade. Unemployment fell back to the 9-10 per cent range, and stabilized at that level only in 1986.

Ballooning Debt and Deficits

During the recovery from the recession, the direction of fiscal policy shifted from promoting growth to deficit reduction. This was prompted by the mounting burden of federal government debt. The federal government had run a deficit every year since 1976, with particularly large increases from 1982 to 1985, so that by the mid-1980s its debt had risen substantially relative to the economy's total output. Increasing concern with the accumulation of debt led the government in its 1985 and 1986 federal budgets to introduce both tax and expenditure measures to reduce the deficit to a more manageable level.

By 1989, the deficit had been brought down significantly. But at that point, the focus of stabilization policy shifted to the goal of price stability. Consequently, monetary policy was tightened in an effort to bring inflation down from the 4 per cent rate, where it had been stuck since the 1981-82 recession. This tightening was also intended to short circuit the pickup in wage inflation that was getting underway in anticipation of the 1991 imposition of the Goods and Services Tax. The result was another recession in 1990-91, which took the unemployment rate back over 11 per cent. On the positive side, the policy was successful in bringing inflation sharply down to 1.5 per cent in 1992 — near the bottom of the 1-3 per cent target band set for inflation in 1991.

The government deficit mushroomed during the 1990-91 recession because of the impact of falling incomes on tax revenues, and the effect of rising interest rates on public debt charges. It continued rising during the lacklustre recovery that ensued. The deficit only began to come down significantly in 1994, when a new Liberal government introduced the first of three annual budgets containing tough expenditure cuts designed to get the federal budgetary deficit down to 3 per cent of GDP by the 1996-97 fiscal year. While this was not a very ambitious target, the government was able to bring the deficit down more quickly than planned to almost 1 per cent of GDP in the 1996-97 fiscal year.

First Balanced Budget in 30 Years

Buoyed by the government's success in attaining a balanced budget in 1997-98 for the first time in almost 30 years, the minister of finance proclaimed new balanced-budget targets for the 1998-99 and 1999-2000 fiscal years in his 1998 budget. Those targets soon morphed into a string of budget surpluses until 2008.

The reduction and subsequent elimination of the deficit put the debt-to-GDP ratio on a steady downward track, from the peak level of almost 72 per cent of GDP in fiscal 1995-96. This, combined with a favourable external environment and low inflation, allowed interest rates to come down in 1997 to the lowest levels in almost 30 years. In response, economic growth picked up and the unemployment rate began to decline. Everything seemed to be unfolding as planned until mid-1998, when the Asian economic crisis and worsening political and economic instability in Russia cast a shadow over growth prospects.

The government's concentration on deficit reduction in the 1990s, in spite of the continuation of relatively high unemployment, marked the abandonment of an activist Keynesian approach to fiscal policy. The new approach puts more emphasis on the international and domestic constraints on fiscal policy. It is based on the premise that the only way to achieve sustained growth and low unemployment is to get interest rates down and that this requires a credible strategy of deficit elimination and reductions in the debt-to-GDP ratio. In the absence of such a strategy, it is believed that domestic and foreign holders of government debt will sell their securities, triggering increases in interest rates sufficient to undermine economic growth.

The government's strategy was implemented through a "prudent approach" to budgeting. This involved making sure deficit targets can be reached using prudent economic planning assumptions for real growth and inflation that are more conservative than the average forecasts, and by including a large contingency reserve in public expenditures that gives the government a cushion to make sure deficit targets are met. This approach was successful in enabling the government to do better than its deficit targets, although it was dependent on international developments and the global economic situation.

Financial Crisis and the Return of Deficits

The Canadian government reported its largest fiscal surplus on record, $14-billion, in 2008. But deficits would return to the federal balance sheet the following year. The 2009 budget projected a fiscal deficit of $55-billion because of increased government spending and the 2008-09 global recession (triggered by the 2008 financial markets credit crisis). That record Canadian deficit was followed by several years of progressively lower deficits with a government target of a balanced budget again in 2015-16.

By contrast, the federal debt-to-GDP ratio steadily declined from its peak of 1995-96. The ratio was down to 38.7 per cent in 2004-05 and hit 28.6 per cent in 2008-09. In 2008, the Canadian government said its objective was to whittle the ratio down to 20 per cent by 2020. However, the global recession of 2008-09 reversed the progress. In addition to a return to deficits, the ratio had climbed back to 33.9 per cent by 2010-11.

In 2012, the Department of Finance forecast a ratio of 23.8 per cent by 2020-21.

In its 2014-15 budget the federal government forecast a deficit of $2.9-billion, followed by a small, forecasted surplus to come in 2015-16.