Smart money: Focused fiscal policy needed more than ever

Much has changed since the spring of Budget 2024. The feds’ lower immigration targets will hamper the growth engine the Canadian economy has relied on in recent years. U.S. President-elect Donald Trump’s policies could dictate domestic economic outcomes and spending priorities. A federal election also looms.

And, a lot of the same challenges remain. Canada’s unemployment rate has risen faster than any other advanced economy, productivity growth is among the weakest, and many continue to grapple with a lack of general affordability.

Though tracking of the 2024-25 fiscal plan so far this year indicates some upward pressure on the federal deficit, the issues above bring greater risks to the government’s bottom line in the years ahead.

As we get closer to 2025 and when a Fall Economic Statement has historically been released, we’ll be looking for how government budgets tackle the new, but also persistent challenges while maintaining fiscal responsibility.

1. Managing the fiscal fallout from lower immigration targets

Robust population growth—which has supported growth but also comes with its own set of challenges—is set to moderate sharply given lower targets for immigration and temporary residents.

Lower population growth means lower total consumption and employment growth for the economy as a whole in the years ahead, restraining the expansion of the tax base and government revenues. These changes will shave nearly 1 percentage point off economic growth over the next three years compared to our previous projections, negatively affecting the budgetary balance by a cumulative $50 billion over five years starting in 2025.

But, other factors will help partially offset this negative fiscal shock over the planning period. Primarily, lower interest rates than planned in Budget 2024—given the Bank of Canada will have to cut rates more aggressively to get ahead of economic weakness—will support federal finances. In total, we estimate that all economic developments since Budget 2024 will subtract almost $20 billion from the budgetary balance over the forecast horizon.

However, lower-trend population growth will be an ongoing fiscal drag, because it pulls growth from the entire economy. Canadian demographics are bound to return to an aging trend after the post-pandemic immigration boom pushed the median age down for the first time. Fiscal pressures will increase as a larger share of the population draws on costly government services and programs with lower fiscal support from a smaller workforce.

2. Preparing for trade-induced volatility

The incoming U.S. administration is adding more turbulence to the Canadian economic and fiscal outlook.

Our early read is that most Trump campaign promises would be negative for growth in Canada. Increased tariffs on Canadian imports to the U.S. would be a significant drag on demand for Canadian-made goods, while lower U.S. personal and corporate tax rates would undermine Canada’s tax competitiveness and investment prospects. But, the magnitude of these challenges is uncertain right now. Still, rising U.S. deficits and debt needed to finance these promises could add pressure to long-term interest rates, affecting the borrowing costs of Canadian governments.

U.S. policy is also likely to dictate Canadian government spending priorities. Greater defence spending and more border patrol appear necessary for the Trump administration to reconsider tariffs, adding weight to Canada’s bottom line if we want to remain within the U.S. trade tent. Matching tax rate reductions is another spending pressure point the Canadian government may need to address.

Given the significant uncertainty around the extent and timing of when Trump’s promises are converted into actual policy, how the government builds contingencies into its fiscal planning, and how it at least signals its overlapping priorities to the U.S. will also matter.

3. Tackling ongoing affordability challenges amid election-year pressures

Canadian cost of living and affordability concerns are a very real economic problem and need both near-term and structural solutions.

Federal policy has also already provided major and ongoing cost relief to many Canadians with tens of billions in annual funding for hallmark programs like national childcare, dental care, seniors’ benefits enhancements, and housing. Further relief is in the works. Childcare fees are still set to fall in at least two provinces and housing demand will moderate further following revised immigration targets, which should soften competition in the rental market. Housing supply initiatives, including efforts from other levels of government, will reduce price pressures in years to come. These types of supply-side-driven and targeted benefits help alleviate the cost of living in the long run.

Broad-based and demand-side initiatives like cash transfers don’t tend to solve the underlying problem and they risk exacerbating inflationary pressures while complicating the role of monetary policy. Cash transfers that also flow to higher income households, for example, dilute relief to those most in need, while almost guaranteeing a large share of the benefit will be saved by these households.

We’ll be assessing future government spending through the lens of targeted and supply-side approaches that help reduce inflationary pressure versus broad-based and demand-side measures that have the opposite effect.

4. Cracking Canada’s productivity puzzle

Canada will need to rely on other levers for economic growth with a less potent immigration policy. Skills upgrading and matching would recruit more of the domestic labour pool into the workforce. But, most of the work will depend on enhancing labour productivity growth, where Canada has been lagging and progress has been elusive.

Fiscal prudence is necessary, but markets are unlikely to punish new spending with a clear link to growth—like improved labour supply matching, infrastructure investments, scaling of advanced technologies, and incentives to promote greater capital investment. The greater the emphasis on enhancing productivity versus other spending, the more likely it is that growth forecasts are raised and inflation forecasts are decreased. This distinction separates the total amount of money spent by a government and its overall impact. The destination of each dollar spent can be more relevant to the outlook than the total spend.

5. Preserving fiscal health is paramount

Fiscal prudence must be at the top of the priority list when it comes to navigating the challenges ahead.

As a starting place, there are plenty of positives to Canada’s fiscal position. The country is one of a few rich economies with a triple-A credit rating, enabling it to borrow at lower costs. Its budget planning looks responsible relative to the U.S.’s fiscal largesse. Investors continue to purchase Canadian government debt and the budget watchdog previously found federal finances to be sustainable in the long term— i.e., debt-to-GDP levels are stable even with billions in new structural spending.

However, Canada is not a golden child and invincible to the shifting economic and market winds. Its gross debt level is high and more than half of it is held by provinces (which largely continue to deficit spend aggressively). Fiscal credibility has suffered with successive, major new structural program spending, deficit-financed even during the expansionary phase of the economic cycle, and weak fiscal anchors.

Deficit financed current consumption erodes fiscal space that may be needed in a downturn, given the substantial uncertainties in the near and medium term. Fiscal space should be carefully guarded. Moreover, Canada does not benefit from a reserve-currency status or global demand for its sovereign bonds the way the U.S. does. So, while it is generally in better fiscal health, it needs to keep it that way.

Assessing fiscal health is not straightforward, because the economic outlook can shift and markets can suddenly decide that government plans are untenable. Still, even as Canada approaches this era in decent shape, it will need to signal dedication to its fiscal anchors with a focused fiscal policy that tackles external challenges, targets assistance to those most in need, and encourages domestic investment and growth.

Cynthia Leach is the Assistant Chief Economist, Thought Leadership at RBC. She helps shape the narratives and research agenda for the team’s structural economic and policy analysis, covering topics such as human capital, innovation, and trade. She joined the team in 2020.

Previously, Cynthia was an executive at Finance Canada, most recently heading a team responsible for housing finance policy. Cynthia holds an M.A. Economics degree from the University of Toronto.

Rachel Battaglia is an economist at RBC. She is a member of the Macro and Regional Analysis Group, providing analysis for the provincial macroeconomic outlook and budget commentaries.

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