CIBC Economists Ali Jaffery and Katherine Judge break down how federal and provincial budgets are shaping growth, based on a new measure of the fiscal impulse in Canada, and how manufacturing in Canada compares with the U.S.
Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.
Katherine Judge: Welcome to the Eyes on the Economy podcast. I'm Katherine Judge, an economist at CIBC, and today I'm speaking with Ali Jaffery, also an economist at CIBC, about recent papers that we've published. Ali, so you and Avery just wrote a piece looking at the contribution of fiscal policy to growth in Canada. Can you give us an overview of that piece?
Ali Jaffery: Yeah, absolutely. So since the federal government budget in the fall, we've been getting a lot of questions about the role of fiscal policy, what's the fiscal impulse in Canada. So what we've tried to do in this piece is really examine, you know, what's fiscal policy doing to growth, and to do that, we developed a fiscal impulse measure that kind of gets into the details of what the government is spending the tax measures transfers to households kind of a fairly comprehensive view of fiscal policy. Now typically, economists like to cite a range of different measures of fiscal policy or the fiscal stance. One of the most common and popular measures is to cyclically adjust the deficit or deficit numbers to kind of give you a gauge of how loose or tight fiscal policy is. Now that's a useful metric, generally speaking, and in particular when you want to do international comparisons or thinking about fiscal sustainability, but we found that it's not very good at really giving us a sense of what the fiscal impulse is, because it treats every spending and tax dollars essentially same. And it's, know, a low frequency metric. So it doesn't tell us about the rollout of initiatives. And it's difficult to extract information about the multiplier benefits on the economy as a whole. So what we did is we borrowed the approach of the Brookings Institute in the US, which actually borrowed from some research on the Fed and the CBO has a similar approach. And in those methods, they look at the fiscal policy contribution of the US federal government to growth, and we've adapted that methodology to Canada. And so that takes every piece of fiscal policy, discretionary spending, transfers, tax measures, and kind of looks at how they grow relative to a steady state growth rate, rate of potential output. We describe in detail in the note about the methodology, but listeners can also look at the Brookings Institute website and the papers we cite to get more details. But what we do is we add two twists to that methodology. First, we don't just look at the federal government in Canada. We combine federal government and the provincial government and we aggregate their budgets to get a forward-looking view of what fiscal policy is going to do. And also what we do is we estimate the total impact of fiscal policy, which is what the direct impact of government spending and tax measures plus the indirect, which is the multiplier benefits on the rest of the economy. We kind of use a dynamic multiplier to do that. So all that being said, what we find is fiscal policy will essentially be neutral through most of this year. So won't have a big growth impulse in 2026, but starting in the back half of this year and through 2027, it should have a sustained positive impulse on growth. So we expect growth will be about 0.5 percentage points higher in the second half of next year and second half of 2027 and overall the level of GDP could be higher by a bit under 1% by the end of 2027.
Katherine Judge: Wow! That's surprising and might disappoint some people who are looking for a larger fiscal lift given these recent announcements from the government.
Ali Jaffery: Yeah, that's right. So obviously a lot of hype and interest around the federal government budget, but people forget several important details that are constraining the impulse in the near term. So first is the federal government itself is trying to walk a tightrope. They're shifting the composition of spending away from operational spending to capital spending. But that shift involves significant cuts to operational spending. They want to achieve around $14 billion over the next three fiscal years in operational spending. That means a reduced discretionary spending. The second is the capital spending program that they want to roll out, which is an extra 1% of GDP over their projection horizon. That takes time to implement and we assume that doesn't happen as quickly as maybe they're projecting. So it has a weaker fiscal impulse in the near term. And also the multiplier benefits take time to accrue to the economy. And the third point is the provinces matter more for fiscal policy in Canada than the federal government, which people don't really appreciate. And right now the provinces are trying to lean against budget deficits of the past several years and also constrain some of their operating spending. So federal government spending as a whole is only about two thirds the size of the collective spending of provinces and revenues are only about 70% of the provinces. So you have the provinces swimming in another way and that's why when we look at our overall fiscal impulse which we decompose by federal and provincial most of the bang we're getting is from the federal government. Now if the provinces do start to spend more which is possible you know our projections are based on informed, I should say, by the budget. So if provinces spend a bit more, the fiscal impulse could be larger. But overall, certainly the fiscal policy landscape and its impact on GDP isn't going to be transformational in the economy, but it's not small either. Remember that growth is going to be around mid 1% range, so every little bit helps. And I think this particular type of fiscal policy support is more of a slow and steady wins the race type of approach that could potentially upgrade Canada's potential rate of growth. If the government can execute properly and crowd in private sector investment, we estimate that potential output could be higher by about a quarter of a percentage point. And so that might leave more benefits down the road than upfront. So Katherine, I've said a lot about fiscal policy. I want to turn the tables here and ask you about the piece you wrote with Benny Tal on manufacturing in Canada and the US. Can you give us kind of an overview? What's the state of manufacturing activity in Canada?
Katherine Judge: Yeah, so as you said, Benjamin Tal and I just published a piece on the state of manufacturing activity in Canada. So as of lately, as of November, manufacturing GDP was actually at its lowest level since the height of the pandemic. So clearly right now there's a lot of uncertainty around tariffs, global demand is muted, and that's weighing on the manufacturing sector. But in our piece, we took a look over a longer time horizon. And if you look back decades, Canadian manufacturing has been underperforming the US. And that's something that continued post COVID and the gap has widened a lot recently. So what we're seeing is the US is outperforming largely because of greater investment and a better performance in the capital intensive sectors. So part of this reflects investment in technology like AI adoption that's helping productivity. So if you look at the two countries, essentially these capital intensive sub-sectors of manufacturing are around 50% of US manufacturing GDP, but just over 40% in Canada. And since COVID, those sectors in Canada have gotten smaller, and they've grown in the US. So we're not in a good place in terms of productivity impacts and driving growth through capital intensive sectors. And the industry composition differences between the countries only accounts for part of the gap. So if you impose the manufacturing sub industry distribution from Canada on the US, the gap narrows a bit, but not fully. So there are a lot of implications and impacts, of course, of this. So if you look at productivity and manufacturing, there's been a 5% drop in Canada since 2019, whereas the US has seen a 2% increase in productivity. Capital intensive industries also have higher profit margins. So if you look at US manufacturing capital intensive has about a 17% profit margin versus 8% for labor intensive industries. Canada's overall manufacturing sector has a 6% overall profit margin. So obviously very low. And this isn't due to one sector. As I said, we looked across all subsectors, but obviously the computer and electronics area has really taken off in the US. So that specific sub industry accounts for about 50% of profits and capital intensive in the US and margins in that sector are thick, sorry, profit margins in that sector are 36% versus in Canada, they're only 5%. We're in a situation where we have very muted activity in these productivity enhancing capital intensive sectors and we've seen very weak technological adoption and investment in Canada relative to the US so that doesn't leave us in the best position to generate output essentially.
Ali Jaffery: That sounds gloomy.
Katherine Judge: Hahaha
Ali Jaffery: So what are the implications of this kind of continuing, this underperformance in capital intensive manufacturing relative to the US?
Katherine Judge: Yeah, so as I said, the productivity issue is probably the biggest one. I mean, going forward, if you look at a lot of factors that are structural changes that are underway and things like that in manufacturing, so you have de-globalization, you've just encased inventories, you have tighter labor markets due to retirees and slower population growth and you have this technological revolution in AI. So those are all things that favor capital intensive manufacturing. But at the moment, it's just been very difficult to attract business investment in Canada given that the state of global trade right now has been challenged. But the good news is that there is a lot of low hanging fruit in Canada because we haven't made as much progress in terms of AI adoption. But what this also means is that the gap between GDP and employment in manufacturing will widen. This is really more relevant for the US at this point, but basically the Federal Reserve will pay more attention to output in the manufacturing sector. But yeah, I think I'll leave things there. Ali, thank you for joining me for this discussion and to our listeners, if you're interested in learning more about these topics, please check out the papers on the CIBC Economics website. Until the next time, we'll be keeping our eyes on the economy and calling it as we see it. Thank you.
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