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November 18, 2021 – The federal government should consider automatic cuts to the goods and services tax (GST) in downturns as a complementary fiscal policy measure, according to a report from The C.D. Howe Institute.

In “'The Demand Stabilization Mechanism': Using Temporary GST Cuts as Automatic Fiscal Policy,” authors Robin Boadway and Thorsten Koeppl propose an automatic mechanism that would use temporary cuts in the GST to deliver timely, targeted and fiscally anchored stimulus for aggregate demand during economic downturns and recoveries.

In a post-COVID economy, high public debt levels severely restrict governments’ capacity to provide discretionary fiscal stimulus. Likewise, low interest rates restrict the Bank of Canada’s ability to stimulate private demand through interest-rate cuts. “Overall, our proposed DSM would complement Canada’s monetary policy by acting quickly to shore up demand and protect Canadians’ future living standards by being fiscally responsible. We hope that our provocative proposal signals a starting point for making fiscal policy more effective, while ensuring governments remain fiscally responsible,” the authors conclude.

The proposed Demand Stabilization Mechanism would use a simple rule. When the economy’s negative output gap (the difference between actual and potential GDP) is forecast to reach 2 percent or more sustained for four consecutive quarters, a temporary GST cut would automatically kick in to stimulate demand for goods and services. The cut would initially remain in effect for four quarters, after which it could be extended depending on the state of the economy. Once the economy is in recovery, the GST would resume at a higher level than before the cut to recoup lost revenues for the government over a set time period, thus providing a fiscal anchor.

The DSM would have four key elements: 1) an automatic trigger; 2) a rule that determines the size and duration of the tax cuts; 3) an anchor requiring recovering the costs of the tax cuts; and 4) legislation governing the application, monitoring and auditing of the tax cuts. The DSM’s provision of a fiscal anchor is a key attribute. “Our proposed Demand Stabilization Mechanism establishes a simple anchor that allows fiscal policy to automatically react to large-scale national recessions and support periods of economic recovery,” say Boadway and Koeppl.

To fully realize the proposed DSM as a policy reality, several challenges would need to be addressed. First, the GST rate would need to be raised to provide enough headroom for any required cuts. Second, the mechanism would rely heavily on the Bank of Canada’s output gap forecast, which would need to be more transparent, published sufficiently in advance and be targeted to the strict application of the mechanism. Third, introducing the mechanism would require legislation through Parliament, which could raise constitutional questions.

Read the Full Report

For more information contact: Robin Boadway, David C. Smith Chair in Economics Emeritus, Queen’s University; Thorsten Koeppl, Professor, Robert McIntosh Fellow and RBC Fellow, Queen’s University and also is a Fellow in Residence, C.D. Howe Institute; Michael Barry, Communications Officer, 416-865-1904, ext: 9997, mbarry@cdhowe.org