This information was provided to the Halifax Initiative Coalition (the Social Justice Committee is a member) Sept. 30 1999, in response to a request under the Access to Information Act. 

SECRET

INTERNATIONAL MONETARY FUND

CANADA

Article IV Consultation Discussions

Statement by the Fund Mission to the Minister of Finance

Ottawa, December 7, 1995

1. Two years ago, the Government defined its central policy objective as the sustained expansion of output and employment, stressing the importance of low inflation, fiscal adjustment, and labor market reforms in achieving that goal. The Government and the Bank of Canada have made considerable progress in pursuing that strategy: inflation has been kept low and is projected to fall; the federal fiscal deficit has been put on a downward path; program spending has been cut to its lowest levels in many years; and a reform of social programs, including the unemployment insurance system, has begun in earnest. In the period ahead, it will be crucial to maintain the momentum of adjustment in order to lock in the gains made so far and solidify market confidence, particularly given the risks stemming from political developments.
2. Even with the ongoing recovery in economic activity, there is considerable slack in the economy, and CPI inflation is projected to decline into the lower half of the 1-3 percent target band in 1996 (Table 1). Thus it would be appropriate for the Bank of Canada to seek an easing of monetary conditions, particularly if a strong pace of fiscal adjustment by the federal and provincial governments were to result in a substantial withdrawal of domestic demand. However, recent experience shows that aggressive efforts to reduce interest rates could be resisted by financial markets, and it is advisable to undertake monetary easing with caution, as the Bank of Canada has been doing.
3. With the strong measures taken in the past two budgets, the Government is on track to meet its deficit reduction target for 1996/97 (Table 2). After 1996/97, however, the pace of adjustment in the structural deficit would slow sharply, despite strict expenditure control, because of the prospective reduction in the unemployment insurance premium to about $2. The slackening in the pace of adjustment would leave the federal finances in a vulnerable position. The federal debt/GDP ratio, although declining, would continue to be extremely high at around 66 percent at the end of the century, while interest payments would absorb one third of government revenue. An additional source of concern is the large, and growing, unfunded liability of the Canada Pension Plan.
4. The large size and relatively short maturity of the federal debt-- despite efforts to lengthen the maturity--make the budget highly vulnerable to interest rate shocks. The recent period has shown that market confidence in Canada's longer-term prospects is tenuous and can be easily shaken by domestic political events, concerns about the fiscal situation, or financial crises outside Canada. In this context, a faster pace of fiscal adjustment, with a more rapid reduction in the debt/GDP ratio, would enhance the credibility of the fiscal program and lessen the risk that the adjustment process could be derailed by an economic downturn or other shocks. It would also facilitate the Bank of Canada's efforts to support the economic expansion through an easing of monetary conditions and encourage a decline in real interest rates.
5. In the mission's view, it would be appropriate for the Government to aim to reduce the budget deficit to about 1 2 percent of GDP in 1997/98 and to about 1 percent of GDP in 1998/99. On the basis of present projections and making some allowance for the risk of higher interest rates, these targets would require additional measures yielding between 6 and 9 billion dollars in 1998/99. The type of actions that could be contemplated in the spending and revenue areas are shown in Table 3. In the near term, in particular, it will be critical to maintain the overall tax effort by phasing in slowly the cut in the unemployment insurance premium and offsetting the revenue loss through other means. In certain areas, such as unemployment insurance, the tax system, and pension benefits, further action is required not only to strengthen the fiscal position but also to bring about structural reform.
6. The proposed reform of the unemployment insurance (UI) system, together with the earlier reforms, go a long way towards curtailing the UI system's adverse effects on the labor market. Future reform efforts could aim at eliminating regionally extended benefits and introducing experience rating. The reform proposal also calls for an expansion of programs to assist the unemployed in preparing for and finding a new' job. However, the experience of many industrial countries suggests that the effectiveness of such programs is questionable, particularly if account is taken of the employment cost of the payroll taxes used to finance them. Serious consideration should be given to reducing the scope of these programs and using the savings to cut the budget deficit or the UI premium.
7. In order to offset the loss of revenue entailed by the prospective reduction in the UI premium, consideration should be given to broadening the bases of the income tax and the Goods and Services Tax (GST) and to raising the GST rate, actions that could improve efficiency and strengthen incentives for saving. The federal government has been negotiating with the provinces to harmonize the GST with provincial sales taxes. Harmonization would improve the efficiency of the indirect tax system by shifting the incidence of provincial taxes away from intermediate inputs to consumption, and it could also permit a reduction in the costs of compliance and tax administration. However, it will be important to ensure that harmonization is reached without a significant erosion of the GST base.
8. Demographic trends will put considerable financial pressures on the federal government and the Canadian Pension Plan (CPP) unless benefits are reduced and the contribution rate and retirement age are raised. With regard to the OAS-GIS system, it would be appropriate to replace the transfers and tax credits with a combined benefit, as explained in Table 3, while raising the age of entitlement and recovering a greater portion of the benefit from higher-income families.
9. The present CPP contribution rate is about half of the actuarially fair rate of 10-11 percent of earnings. consequently, the CPP has accumulated an unfunded liability estimated at 70 percent of GDP, a level similar to the recorded net federal debt, This liability will continue to mount unless the CPP contribution rate is raised fairly quickly to the actuarially fair rate. In the longer term, the unfunded liability will have to be dealt with through further increases in the CPP contribution rate, reductions in benefits, an increase in the retirement age, and measures to generate savings in the federal budget. It will also be desirable to maximize the yield of the CPP's assets. In this connection, consideration should be given to assigning the investment of these assets to private portfolio managers under strict supervision.
10. The February 1995 budget took a major step toward rationalizing federal transfers to the provinces in a manner that will assist provincial efforts to reform major social programs in the face of tight fiscal constraints. With the exception of Ontario and Quebec, the provinces have adopted in recent years sound fiscal adjustment programs and most are expected to achieve budget balance by 1996/97. Recently Ontario announced measures to reduce its deficit through sharp cuts in spending. Quebec, however, has yet to formulate a much-needed deficit reduction program.
11. Canada has continued to show its strong support for free trade by passing the legislation needed to implement the Uruguay Round Agreement and signing the interim financial services accord reached last July. Tariffs have also been reduced on a wide range of manufacturing inputs, and further consolidation and simplification of the tariff structure are intended. In the agricultural area, the elimination of the Western Grain Transportation Act subsidy is welcome. At the same time, the supply-management system and the associated prohibitive tariffs for certain agricultural commodities continue to be major impediments to efficient resource allocation, resulting in unduly high prices for Canadian consumers.

Table 3: Canada Illustrative

Revenue end Expenditure Adjustment 0ptions

1/ Yield estimates are for 1997/98.
2/ Roughly 15% of the projected 1997/99 level of the cash portion or the CHST.
3/ Roughly 10% of projected 1997/98 amount 

Continued
 

1/ Assumes elimination of transfers to the CBC, VIA Rail, the Canadian Film Development Corporation, the National Film Board and a 50 % cut in other transfers all relative to projected 1997/1998 levels.
2/ Assumes a 5 percent reduction from projected 199.7/98 levels,
3/ Equal to 1/2 percent of projected 1997 GDP.

INTERNATIONAL MONETARY FUND
WASHINGTON, D.C. 20431

May 18, 1995

The Honorable Paul Martin
Minister of Finance
Ottawa, Canada

Dear Minister:

I understand that you and your colleagues will soon begin the process of shaping the 1996-97 budget, and are considering a number of important structural reforms. I would like to take this opportunity to summarize some of the key points that were raised during the Executive Board discussion of Canada's 1995 Article IV consultation on May 3.

The Board generally commended the Canadian authorities for their conduct of monetary and fiscal policy in the recent period, which was viewed as having contributed to Canada's strong growth and low inflation. In particular, the February 1995 budget, which showed considerable political courage, was considered a significant step toward reducing the federal budget imbalance.

However, there was a consensus among Executive Directors that important challenges remained. In particular, while the 1995 budget would permit a reduction of the federal deficit to 3 percent of GDP by fiscal year 1996-97, it would still leave federal debt and interest payments at extremely high levels by international standards. Hence, the fiscal position would continue to be vulnerable to adverse interest rate shocks from abroad or to an economic downturn. Moreover, concern was expressed that the persistence of a sizable fiscal imbalance would increase the risk of a loss of confidence in the Government's economic policies, and could lead to higher interest rates and a weaker currency.

There was broad agreement among the Directors with the staff's view that a more fundamental correction of the fiscal situation was warranted. Specifically, there was a call for a front-loaded package of additional measures that would lead to a mare rapid balancing of the budget and put the debt/GDP ratio and the interest burden on a clearly declining path. Such action would strengthen market confidence and help alleviate pressures on interest rates. It also would strengthen national saving, contribute to an improved external current account performance. and improve Canada's growth prospects.

During the course of the Article IV Consultation discussions in Ottawa, the Fund mission prepared a detailed list of measures that could be considered to reduce the deficit to below 2 percent of GDP by 1996-97 and to well below 1 percent of GDP by 1998-99. The February 1995 budget took measures in many of the areas identified in that list but there seems to be scope for additional action in a number of important areas. In particular:

• Elderly benefits: The current system of federal benefits to the aged is very generous, providing substantial benefits to middle- and upper- income pensioners. Early action to increase the means testing of the system would yield considerable fiscal savings. At the same time, the unfunded liability of the Canada Pension Plan is one of the largest among the industrial countries in terms of GDP. In order to resolve this situation, an increase in premiums or a reduction in benefits will be required. In this connection., consideration also could be given. to raising the age of entitlement for public pension benefits.
• Unemployment insurance: Reforms are needed in the unemployment insurance system so that it provides short-terra basic income support without discouraging job search. This would help reduce the structural rate of unemployment in Canada, which is high by international standards. While such changes would not provide a permanent improvement in the fiscal situation, they could be used to build up a higher surplus in the short term, while other fiscal adjustment measures are phased in
• Subsidies and other transfers: Considerable progress was made in reducing industrial and agricultural subsidies. However, transfer payments are expected to remain large for the Crown corporations, cultural subsidies, and employment programs. Since these programs often lead to an inefficient allocation of resources, there would seem to be scope for further saving in this area.
• Transfers to other levels of Government: The current system of federal-provincial transfers may have led to inefficient provincial spending programs, an overdependence on federal transfers, and reduced incentives to develop provincial revenue bases. The first step toward reforming the system was taken with the establishment of the Canada Social Transfer. However, the modalities for determining the site and allocation of these transfers still need to be addressed. This could provide the opportunity to achieve further saving.
• Tax Policy: The scope for increasing tax revenues may be limited given that effective tax rates are already high compared to the United States and many other industrial countries. However, the potential exists for adopting measures that would broaden the base for the Income tax and Goods and Services Tax, thereby improving their horizontal and vertical equity.

In closing, I would like to thank you and your staff for the cooperation that was shown to the Fund mission during the Article IV consultation discussions, and I wish you every success in your endeavors.

Yours Sincerely,

Michel Camdessus
Managing Director

SECRET

INTERNATIONAL MONETARY FUND

CANADA

Article IV Consultation Discussions

Statement by the Fund Mission to the Minister of Finance

Ottawa, December 9, 1994

1. The current economic situation presents both favorable elements and serious risks. Economic growth in Canada has been very strong, inflation is low, and the unemployment rate has fallen considerably. Monetary conditions, even with some recent tightening, remain accommodative, and the momentum of aggregate demand appears likely to persist in the quarters ahead. If so, the economy could be operating in the high employment range in the first half of 1996. However, there is no room for complacency. These economic gains will be short-lived unless the following challenges are addressed:
2. To consolidate the federal fiscal position by reforming and cutting government spending, eliminating the deficit, and setting the debt/GDP ratio on a clear downward trend.

• To bring down gradually the rate of expansion of aggregate demand to the rate of potential output growth, that is to say, from about 5 percent in recent quarters to below 3 percent, This will help prevent the emergence of excess demand pressures that would reignite inflation.
• To support productivity growth by encouraging national saving and eliminating distortions that impair resource allocation.

3. It is critical that fiscal policy takes the lead in meeting these challenges. The Government has set an interim target for the federal deficit of 3 percent of CDP by 1996/97. However, meeting that target would still leave the federal finances under severe stress. The debt/GDP ratio would continue to be extremely high at about 70 percent, and interest payments would still consume about one third of government revenue, making the budget highly vulnerable to interest rate shocks or an economic downturn.
4. A more fundamental correction of the fiscal situation is needed, a fact that seems to be well understood by both investors and the general public. This means that confidence in the Government's economic policies will be undermined if the forthcoming budget merely aims at meeting the interim target, leading to sharply higher interest rates and downward pressure on the Canadian dollar. Without question, delaying action would only magnify the fiscal problem. Government debt would continue to rise, and ultimately more strenuous efforts would be required to deal with an even more serious fiscal situation in an environment of public skepticism.
5. Thus it is crucial to seize the moment and put in place a front-loaded package of fiscal adjustment measures leading rapidly toward federal budget balance. The Fund mission proposes that new measures be adopted to reduce the deficit by 2 percentage points of GDP in 1996/97 relative to the baseline. An additional adjustment of 1 percent of GDP spread over the following two years would reduce the federal deficit to well below 1 percent of GDP by 1998/99. Such an adjustment program would go a long way toward meeting the economic challenges outlined above. It would put the debt/GDP ratio and the interest burden on a declining path. By strengthening financial market confidence and reducing the risk premium on long-term bonds, it would alleviate pressures on interest rates.

• It would help to moderate the expansion of aggregate demand, reduce pressures on credit markets, increase the credibility of the authorities' commitment to price stability, and ease the task of monetary policy.
• It would add substantially to the national saving rate, releasing resources for domestic investment or for foreign debt reduction and raising living standards in the long term.

6. The mission has prepared a detailed list of the measures that could be considered to achieve fiscal adjustment (see attached table). For reasons of economic efficiency and international competitiveness, the scope for increases in tax rates does not appear significant. Thus an adjustment package would need to emphasize expenditure cuts rather than tax increases. At the same time, it is important to protect the yield and efficiency of the present tax system. In this respect, the mission would support efforts to harmonize the Goods and Services Tax with provincial sales taxes but, if such efforts failed, would advise against eliminating the GST.
7. The measures in the list add up to an amount somewhat larger than the desired size of the adjustment package, thus permitting some choice between them. Different measures will have different implications for the welfare of different regions and sectors of society, as well as for the division of responsibilities between the federal and provincial governments. Such considerations will be important in determining the final shape of an adjustment package. 
8. Virtually no area of federal spending has been left untouched in this list; on the principle that the needed adjustment is so large that the burden must be widely spread. In many cases, the proposed cuts will improve economic efficiency. As noted above, one of the principal challenges to be met by policy makers is the elimination of distortions that impair resource allocation. The major distortions introduced by current fiscal policies are in the areas of unemployment insurance, business subsidies, and agriculture.
9. It is by now well accepted that structural unemployment probably can be reduced through a reform of the unemployment insurance system so that it does not serve as a long-term welfare system and a disincentive to employment, we would support a scheme that provides short-term, basic income maintenance, excludes frequent users, and permits the eventual reduction of the premium to levels that do not significantly add to labor costs.
10. Except in cases of public goods or market failure, government subsidies or government production (such as by Crown corporations) generally favor specific groups with adverse effects on the economy's potential output and overall welfare. Although each case must be assessed on its own merit, there seems to be little reason for maintaining many of the subsidy programs and certain Crown corporations. We recommend' terminating such programs unless an overwhelming public interest can be demonstrated.
11. In the agricultural area, federal transfers in the form of direct subsidies, income support, and subsidies for transportation of agricultural commodities are significant in relation to agricultural output. Clearly there is scope for reforms in this area that increase efficiency and provide budget savings.
12. The implementation of the Uruguay Round agreement will provide the opportunity to phase out longstanding distortions. In particular, the supply-management system for certain agricultural commodities constitutes a major impediment to efficient resource allocation and results in unreasonably high prices for Canadian consumers. Quotas restricting market access to imports of those commodities are being replaced by tariffs at prohibitive levels in line with the letter but not the spirit of the Uruguay Round - cutting tariffs to levels that permit genuine access would improve resource allocation and reduce prices for consumers, while raising government revenue.
13. Fiscal adjustment also is needed beyond the federal government. While most provinces have begun to adjust, considerable additional action is still required, particularly in Ontario and Quebec. In the public pension system, a substantial increase in payroll taxes would be needed in the future to fund the benefits for the aging population at existing statutory levels. Early action to phase in increases in the age of entitlement would reduce the pressure for tax increases.

 Canada Illustrative

Revenue and Expenditure Adjustment Options

1/  Estimates are relative to projected 1998/99 expenditure and revenues.
2/  This figure is based on the savings projected by Government of Canada.  From Unemployment insurance to Employment insurance (1994), and would result from reductions in regional benefits and the Developmental Uses Program, as well as restrictions on the frequency of claims.
3/  Assumes a 10 percent cut in projected 1990/99 baseline level
4/  Assumes elimination of the DIPP and a number of other smaller transfers, as well as a 50 percent reduction in the Aboriginal Economic Program.  Note that the fiscal savings would be reduced to the extent that repayments of contributions are lowered.
5/  Assumes a 50 percent reduction in projected 1998/99 transfers (the baseline assumes some continued Green Plan funding)
6/  Assumes elimination of transfers for trade development, communications and culture, the EDC and the IDRC from projected 1998/99 levels.
7/  Assumes elimination of all agricultural subsidies.
8/  Assumes a 50 percent cut in the Canadian Identity program (including official languages) from its projected 1998/99 level
9/  Assumes a 50 percent cut in projected 1998/99 spending on employment programs’ funding for Canada Student Loans is assumed to remain at baseline levels.
10/ Assumes a cut of less than 10 percent of projected 1998/99 spending on aboriginal health.
11/ Assumes that projected 1998/99 transfers are eliminated.  Baseline transfer does not include the Strategic Capital initiative, which is assumed to expire, or transfers to Crown corporations.
12/ Assumes no new loan commitments by CMHC; elimination of transfers to CIA Rail, the Canada Film Development Corporation and the National Film Board; and a 50 percent cut in other transfers, all relative to projected 1998/99 levels.
13/ Assumes a 15 percent reduction from projected 1999/99 level
14/ Assumes a 20 percent cut in spending relative to projected 1998/99 levels.
15/ Assumes a 10 percent reduction in the projected 1998/99 tax expenditures noted.
16/ Assumes roughly a 10 percent reduction in the tax expenditures noted

 STATEMENT OF THE MISSION

December l, 1993

Recent Developments and Outlook

1. Real GDP grew at an annual rate or 3 percent during the first three quarters of 1993, compared with an average of one percent a year during 1991-92. However, a large share of recent output growth was attributable to stock-building. Machinery and equipment investment has been strong, but other components of final domestic demand have been sluggish. The contribution of net exports to output growth has been modest so far in 1993.
2. Employment is still nearly 2 percent below its previous cyclical high and the unemployment rate has eased only modestly from the peak of 11 ½ percent reached in late 1992. With substantial economic slack inflation has come down. During the year ended in October 1993 the CPI rose by 2 percent, despite a considerable depreciation of the Canadian dollar since late 1991. Wage inflation also has eased and unit labor costs declined during the first half of 1993.
3. The external current account balance strung from a small surplus in 1984 to a deficit of about 4 percent of GDP in recent years. This deterioration was associated with a sharp fall in the domestic saving rate especially in the public and corporate sectors. With the heavy use of foreign savings, the net external debt/GDP ratio increased rapidly in the past few years and reached 44 percent in 1992.
4. In the IMF staff forecast, real GDP growth is projected to rise to about 4 percent in 1994-97. Demand growth in Canada's trading partners and the improved level of competitiveness are expected to raise net exports in the latter part of 1993 and in 1994. Spending on consumption and housing should grow faster in response to the substantial decline in interest rates over the past three years. The unemployment rate would drop to about 9 percent in 1997, while CPI inflation would be less than 2 percent a year.
5. Fund Staff Economic Projections (In percent)

QIV/QIV 

Annual Averages

Policy Issues

5. The federal fiscal deficit rose from about 5 percent of GDP in the early 1990s to over 6 percent (about $44 billion)in 1993/94.  During that period measures were adopeted to cut the deficit, including the establishment of a strict expenditure control system.  However, the effect ov the measures was overshadowed by cyclical factors, increased tax evasion, and start-up difficulties in the implementation of the GST.
6. The fiscal projection we have prepared (with the assistance of Finance officials and on the basis of the economic outlook set out above) suggest that the budget deficit could fall to $32 billion (3.7 percent of GDP) in 1996/97 as the economic expansion continues, provided that the spending path underlying the April 1993 Budget is observed (see table).  The structural component of the Deficit – the part that would remain at high-employment – would be over 3 percent of GDP in 1996/97.
7. The Liberal Party platform set forth the elimination of the federal fiscal deficit as a goal for fiscal policy. It also proposed an interim target of reducing the deficit to 3 percent of GDP by 1996/97 this interim target, which should be seen as a minimal objective, would require at least the following:

• Passing legislation and taking other steps necessary to meet the April 1993 Budget spending path
• Ensuring that any new spending initiatives are matched by cuts in other areas; and
• Adopting deficit-reducing measures yielding $6 billion a year by 1996/97

8. There is a question whether the objective of reducing the budget deficit to 3 percent of GDP by 1996/97 is ambitious enough. Achievement of this target still would leave the federal finances under stress, with a large structural deficit, a high level of federal debt (about 70 percent of GDP), and the prospect of only a modest pace of reduction of the debt/GDP ratio. The sizable fiscal deficits of the provinces and rising pension obligations in the longer term reinforce the importance of fiscal consolidation at the federal level. Thus, there is a case for a more. ambitious deficit-reduction target in the near term and correspondingly stronger measures. The preceding considerations also argue for a front-loading of adjustment measures. We are mindful Of the concerns posed by the large output gap and high unemployment. However, a comprehensive program of fiscal consolidation, which starts with forceful measures that unmistakably put the deficit on a downward path, should serve to boost confidence and cushion economic activity.
9. In formulating the adjustment package the measures chosen should both help strengthen the fiscal situation and improve the effects of specific government programs on potential growth and employment. While the unemployment rate is expected to decline as the economic expansion proceeds a high level of structural unemployment is likely to persist unless action is taken to improve the functioning of labor markets.  In particular, it has been well established that unemployment insurance (UI) benefits reduce incentives to work, and the system’s reliance on payroll taxes also affects employment adversely.  Reform of the UI system – including cuts in the UI benefit rate and regional extended benefits – help reduce structural unemployment.  A review of income support and social assistance programs also will be needed to support deficit reduction.
10. On the revenue side, there is room to step up collection efforts and review the features of the tax system that encourage evasion, particularly of alcohol and tobacco taxes. We understand that the Government intends to examine the operation of the GST with a view to its overhaul or replacement with one that, inter alia, permits a better harmonization with provincial taxes.  While improved harmonization would be desirable, it is essential that such a review take into account the costs of switching to a new tax system, the advantages of a value added tax that prompted the adoption of the GST and the need for increased revenue to pursue fiscal consolidation
11. The provinces are in a difficult fisca1 situation.  The aggregate provincial deficit has risen sharply, and the debt of several provinces has been downgraded by rating agencies during the past two years, with adverse repercussions beyond the purely fiscal. In response, all provinces have adopted restrictive budgets for the current fiscal year.  However, further adjustment measures will be required.  There is also a need to reform provincial social welfare and health care programs with a view toward increasing their efficiency, reducing their distorionary affects on the economy, and generating fiscal savings.
12. Monetary policy has succeeded in reducing inflation, and the credibility that has been earned in this area has made possible a substantial easing of interest rates to levels, not seen in many years.  Such easing should make it possible for economic slack to be taken up even as further progress is made toward price stability.  To derive the full benefits of the improved price performance, it is necessary that monetary policy continues to foster expectations of such progress.
13. Canada's efforts toward s successful conclusion of the Uruguay Round by the December 15 deadline are a positive force for multilateral trade liberalization. The willingness of Canada to accept tariffication of the quantitative restrictions on dairy and poultry products would contribute to the leadership needed to reach the compromises required for successful completion of the Uruguay Round.
14. The Government's resolve to seek to strengthen discipline in the areas of antidumping, subsidies, and counterveil holds out the promise of improving market access, reducing uncertainty, and minimizing future trade disputes among the NAFTA partners.  Hopefully these objectives can be pursued within the existing framework established in the NAFTA text, making it possible to bring NAFTA into effect as scheduled or January 1, 1994.