Focus
October 17, 2025 | 13:06
Canada’s Fiscal Policy Reboot
Economics
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Fixed Income Strategy
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Fixed Income Strategy
Economics
Canada’s Fiscal Policy RebootA much-needed shift toward tax relief and productivity-enhancing capital investment would benefit the Canadian economy, but it will come with much deeper and prolonged budget deficits—Canada is in a position to handle it. |
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Canada is on the verge of a major change in fiscal policy, and all eyes are on the November 4 budget. Major changes will be reflected both in dollars, through much larger deficits, and in shifting priorities, through a more pro-growth policy agenda. These shifts will add near-term stimulus to the economy, grab the attention of the Bank of Canada and—if executed well—could provide a longer-term boost to investment and productivity at a time when Canada seriously needs it. Awaiting Fiscal Clarity |
The fiscal picture is still cloudy given that the current government did not table a post-election budget, and the costed platform has been rendered mostly obsolete by the evolving economic outlook and shifting policy priorities. While the underlying theme of the platform still generally holds, the near-term fiscal projections will be fully redone. The Parliamentary Budget Officer’s (PBO) September outlook incorporates policy measures announced through mid-August as well as the increase in defence spending to 2% of GDP for FY25/26. That raises the baseline federal deficit to $68.5 billion (2.2% of GDP) for FY25/26 and and $64.2 billion for FY26/27, versus an average of less than $40 billion in the 2024 Fall Economic Statement (i.e., the last official budget document from Ottawa; Chart 1). |
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Moreover, additional election promises and cost-saving measures not yet announced through mid-August (and on Sep. 5) could further shift the fiscal outlook. Ottawa has flexibility here as to which priorities they want to roll out, and when, as well as how aggressive/early cost-savings will be pushed. Based on the platform estimates, however, the federal deficit could push into the mid-$70 billion range this fiscal year, and persist near $70 billion in FY26/27. Budget Process and PresentationOttawa will make two important changes to the budget process and presentation. The timing of the annual budget will shift to the fall from the spring, making the November 4 document the budget for FY26/27 (as well as making up for the missing 2025 budget). Recall that the fiscal year begins on April 1. At the same time, the fall economic and fiscal update will shift to the spring. Ottawa will also break down the budget into operating and capital components. Importantly, the current presentation will be maintained, leaving operating and capital balances as supplementary estimates. We suspect that fiscal goals will be geared toward balancing the operating budget; but are also mindful that Ottawa could shift various measures (e.g., tax expenditures, housing-related spending) into the capital budget that might be too broad in scope, making this a somewhat cosmetic exercise. Fiscal Priorities ShiftThe nature of the Canadian deficit increase is more palatable from an economic perspective than those of the prior government. That is, tax relief and infrastructure priorities bring a more pro-growth policy agenda at a time when Canada needs a boost. Some tax relief has already been rolled out on personal incomes and the carbon tax, which is already a departure from past priorities; defence spending has been ramped up to 2% of GDP immediately; and more than $20 billion in infrastructure spending in areas such as trade, transportation and health care are to roll out. Canada vs. the Past |
Canada is likely headed into a period of deeper and persistent budget deficits. Pandemic aside, we haven’t seen sustained non-recession budget deficits near 2% of GDP over a three-year period since the 1990s consolidation (which followed deep deficits through the 80s and early-90s; Chart 2). That is likely to lift the debt burden well above 40% of GDP. Debt-to-GDP had fallen to just over 30% by FY17/18, and past ‘fiscal anchors’ of a stable debt-to-GDP ratio have, predictably, broken. The good news is that Canada is still a long way from the crisis-level finances that tormented the 1990s economy. The debt burden during that period topped 60% of GDP, and debt service costs were swallowing as much 37 cents of every dollar of federal revenue—that measure stands at just over 10 cents today. However, let’s be mindful that these measures can deteriorate quickly in a recession, when denominators (i.e., GDP and revenues) fall, or if interest rates rise. Deficits should also be funding longer-term economic growth. Canada vs. the RestCanada also maintains fiscal flexibility thanks to a relatively strong standing among major advanced economies. Among the G10 and Australia, the net debt-to-GDP ratio is at the low end of the spectrum (Chart 3)—note that this IMF measure includes the value of pension assets, and Canada looks ‘less good’ using a gross debt approach. The budget deficit, while growing, is also relatively contained. The IMF measures Canada’s structural deficit at 1.6% of GDP (though we’ll note upside risk) versus more than 7% in the U.S. and 3.0% on average across the G10 and Australia. |
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It’s also notable that Canada is not alone in this stimulus push, with much of Europe embarking on large-scale spending programs including defence, and the U.S. One Big Beautiful Bill Act adding to deficits at time when shortfalls are already deep and inflation remains stubborn. |
Don’t Forget the Provinces |
The combined FY25/26 provincial deficit is pegged at $48.2 billion, the largest on record in dollar terms (Chart 4). At 1.5% of GDP, that falls shy of the FY20/21 pandemic-era shortfall, but you have to go back to the Great Recession to find the next comparable—and this at a time that is absent recession. The sharp deterioration from last fiscal year’s shortfall is also noteworthy—a 1.3 ppt deterioration relative to GDP is usually reserved for major economic episodes. There are a few factors to keep in mind: First-quarter fiscal updates tend to be thin, and we’ll get a more meaningful refresh during the October/November mid-year update period. This might be especially true since a number of provinces just posted much better-than-expected public accounts for FY24/25. With all provinces now reporting their results, the FY24/25 combined bottom line is looking $13 billion better than expected during the 2025 budget season. Some of the revenue gains that underpinned those upside surprises (spread across almost all provinces) could get carried forward in the mid-year updates. Accounting for a major tobacco settlement is also skewing the numbers somewhat. Under the agreement, $24.7 billion will be paid to the Provinces and Territories, some upfront and the rest over at least 20 years. So far, there has been varying accounting treatment, but we judge that FY24/25 revenues were temporarily boosted by more than $7 billion (B.C. booked $2.7 billion in FY25/26), somewhat exaggerating the year-over-year deficit deterioration. |
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There’s also the reality that most provinces erred on the conservative side with their 2025 budgets given the uncertainty over the trade war. This included large contingencies of roughly $11 billion for the group. While the economy is not outperforming budget expectations by any means—most of BMO’s provincial GDP forecasts for 2025 are currently running below budget assumptions—thick contingencies should provide a cushion and could help steer ultimate FY25/26 results above budget expectations. All of those factors aside, the fundamental reality is that economic growth and inflation (revenue drivers) have slowed, while spending pressures (be it public sector wages, health care or infrastructure stress from torrid population growth) continue to build. This will keep provincial borrowing programs running strong (Chart 5). Key TakeawayAssuming a federal deficit of around $75 billion, the change in the combined federal/provincial deficit could hit 2% of GDP for FY25/26, the largest non-pandemic swing since the Great Recession. That’s a heavy dose of fiscal stimulus that should support growth through 2026, and will have to be accounted for by the Bank of Canada in setting monetary policy. Longer term, a shift toward tax relief and productivity-enhancing capital investment is a much-needed change that would benefit the economy. |