Federal Debt Reduction: Choosing Paths

The federal government's reluctance to set out a strategy for long-term debt reduction likely arises from disagreements about how rapidly to reduce debt, how rigidly to translate the long-term debt reduction path into annual fiscal targets, and how to balance new spending and tax cuts. We try to narrow the uncertainties around these choices with Monte Carlo simulation using a model of the Canadian economy that explicitly incorporates uncertainty about future economic and financial shocks and about key relationships between the economy and the budget. We find that a "front loaded" plan, which trades bigger short-term pain for faster long-term gain, provides far greater assurance against a rapid return to deficits. A "Keynesian" approach that allows the bottom line to vary more with economic cycles stabilizes the budget and, provided that the response to cycles is symmetrical, involves no loss of credibility. Finally, devoting a sizeable proportion of each year's interest savings to lower taxes in the following year appears likelier to boost living standards during and after the program.