Is Public Debt Reduction Worthwhile?

This paper examines whether reducing Canada’s federal debt is a worthwhile policy objective, in light of economists’ advice and public opinion favouring debt reduction. As well, the federal government has projected a gradual decrease in its debt-to-GDP ratio over the next 30 years. Reducing the public debt means that governments have to adopt a policy of fiscal austerity. This paper focuses on the trade-offs of fiscal austerity — short-term sacrifices for long-term benefits.

The benefits of debt reduction depend on factors such as the discount rate society applies to future gains and the extent to which lower debt levels will reduce interest rates, boost growth and diminish risks of debt crises. Using a Monte Carlo model of debt dynamics, the study evaluates a 12-percentage-point reduction in Canada’s federal debt-to-GDP ratio over 10 years. The analysis finds that such a policy would pass a cost-benefit test if a discount rate of four per cent or less is applied. The biggest benefits come from fiscal insurance and growth rate effects, leading to substantial long-term welfare gains.

This analysis supports the argument for targeted debt reduction in Canada, provided the discount rate remains low and the anticipated benefits, such as fiscal insurance and economic growth, materialize. While fiscal austerity imposes short-term hardships, the long-term gains make a compelling case for reducing the federal public debt.