Annex 2 – Economic Impacts of Budget Measures

There are two primary channels through which government spending can affect output and employment. First, governments can invest in infrastructure or purchase goods and services, which translates into an immediate, dollar-for-dollar increase in final domestic expenditure. Second, governments can induce spending increases by households and businesses through tax measures or transfers. However, the extent to which these measures boost domestic expenditure and production will be determined by changes in saving and imports.

For example, while a reduction in personal income taxes results in a dollar-for-dollar increase in household disposable income, it does not immediately translate into higher spending. Households may choose to save some of this additional income, particularly in the short run, with higher-income households saving relatively more and lower-income households saving relatively less.¹

For any given increase in expenditure, the impact on domestic production will depend on the proportion of goods and services that will be imported, as some spending and investment by households, businesses or governments "leaks" out of the Canadian economy to foreign producers. For example, approximately one-half of all consumer durable goods are imported, compared to about one-quarter for non-durable consumer goods (such as food and energy).

For these reasons, the impact on domestic output and employment from most types of fiscal measures tends to be relatively small in the short run. Over time, however, new spending stimulates employment growth, which in turn yields a further boost to real GDP.

Estimating Economic Impacts

To estimate the economic impacts of the measures presented in this budget, they were allocated into the following categories, which correspond to those used in the Department of Finance's macroeconomic and fiscal model: housing investment (including new home construction and renovations), infrastructure investment, personal income tax and transfer measures, measures for modest- and low-income households (including changes to Employment Insurance and other transfers to low-income households), other government spending measures (such as government support for research, training and innovation) and corporate income tax measures.

Each of these categories has a different multiplier. Multipliers are summary measures that take into account the channels from measures to economic activity, including direct, indirect and induced impacts, and leakages to saving and imports. For example, the multiplier on government infrastructure investment includes the positive impacts of the direct activity (for example, construction sector output), indirect impacts (domestic firms providing inputs to the construction sector) and induced activity (increased household spending resulting from the higher employment and income). A multiplier of 1 means that one dollar in budgetary expenditure generates one dollar in real output.

Multipliers will vary by type of measure, for example reflecting the degree to which households save tax reductions rather than spend them, or the import content of goods and services purchased as a result of higher infrastructure expenditures. Further, as indirect and induced impacts take time to materialize, multipliers are initially smaller but grow over time, as new spending stimulates employment growth, which in turn yields a further boost to economic output.

As shown in Table A2.1 below, the short-term multipliers for infrastructure and housing investment are relatively high, reflecting smaller leakages to saving or imports. In contrast, a reduction in corporate income taxes has a considerably lower multiplier in the short run (meaning it has a relatively low short-term impact on real GDP), as it takes time for firms to invest and accumulate capital.¹

Table A2.2 below summarizes the value of the measures presented in this budget, as well as that of the middle class tax cut announced in December 2015, mapped to the categories presented above (see Table A2.4 at the end of this annex for additional details).

Economic Impacts

Based on the above estimated multipliers, these measures are expected to raise the level of real GDP by 0.5 per cent in the first year and by 1.0 per cent by the second year (Table A2.3). This is expected to translate into 100,000 jobs created or maintained by 2017–18.² Of note, most private sector forecasters anticipated additional government measures to promote growth to be announced in this budget, and therefore the February private sector survey to some extent incorporates the forecasters' estimates of the economic impact.

It should be noted that there is some uncertainty, and debate, surrounding the size of fiscal multipliers. However, recent economic research suggests that fiscal multipliers are larger when resources in the economy are underutilized³ and when the policy interest rate is close to its effective lower bound.⁴

In other words, in times of relatively weak economic growth, government investment is likely to have a larger impact, as it does not simply displace private investment or push up interest rates. Indeed, some research shows that multipliers can be very high when these conditions prevail, reaching between 3 and 4⁵ for overall government spending. With both of these conditions present in Canada, the above noted multipliers, and resulting GDP impacts, are appropriate and prudent.

¹ However, corporate income tax measures have among the highest multipliers over the long run, as higher investment eventually leads to higher permanent capacity to produce goods and services.

² This analysis assumes that a 1-per-cent increase in real GDP translates into an immediate 0.2-per-cent increase in employment, rising to about 0.6 per cent after eight quarters. This ratio is consistent with the historical relationship between growth in employment and real GDP in Canada.

³ Owyang, Michael T., Valerie A. Ramey, and Sarah Zubairy, 2013. "Are Government Spending Multipliers Greater During Times of Slack? Evidence from 20th Century Historical Data." American Economic Review 102(2):51-102.

⁴  Batini, Nicoletta, Luc Eyraud, and Anke Weber, 2014. "A Simple Method to Compute Fiscal Multipliers." IMF Working Paper WP/14/93.

⁵ Christiano, Lawrence, Martin Eichenbaum, and Sergio Rebelo, 2011. "When Is the Government Spending Multiplier Large?" Journal of Political Economy, Vol. 119, No. 1, pp. 78-121.

⁶   Higher savings does not lead to higher investment in the short run, but over time it leads to higher capital accumulation and therefore to a higher sustainable level of output.