Higher rates will cost Canadians billions in government debt interest

Last week, the Bank of Canada raised its policy interest rate by half a percentage point, the largest rate hike since 2000. The move was meant to combat inflation, but it also has important implications for government finances across Canada.

In the decade leading up to the pandemic, Canadian governments collectively accumulated approximately $525 billion in net debt — this despite a growing national economy in nine of the 10 years. COVID-19 then exacerbated the problem, as governments increased spending and amassed hundreds of billions in additional debt during 2020 and 2021. In its recent budget, the federal government alone projects its net debt will surpass $1.3 trillion this fiscal year (2022-23) and continue climbing until at least 2026-27.

The burden of government debt falls on Canadian families today and in the future. Like households, governments must pay interest on their debt, and that interest ultimately is raised from Canadians by means of taxes. Servicing the debt also diverts resources away from services such as health care and education.

Federal debt interest costs alone will hit a projected $26.9 billion (or $696 per person) in 2022-23 and rise to $42.9 billion (or $1,065 per person) by 2026-27. In aggregate, interest payments on the federal debt will cost Canadian taxpayers roughly $180 billion over that period.

As the Bank of Canada raises interest rates, government debt interest costs also rise, all else equal. The federal budget does bake some interest rate hikes into the fiscal plan, as the private-sector forecasters the government consults have been anticipating rates will be rising gradually over time. But if, for example, the effective interest rate on government debt rose one percentage point higher than forecast, annual interest costs on federal debt would jump from $42.9 billion to $52.2 billion by 202627, an increase of $9.3 billion for that single fiscal year.

The debt interest burden for Canadians doesn’t end there. Many provincial governments borrowed heavily both before and during the pandemic, contributing to significant increases in debt interest costs at the provincial level, too.

Take Alberta, for instance. Not long ago, the province’s debt interest costs were negligible — in 2008-09, they were just $58 per Albertan. But times have changed. This year the province will incur a projected $2.7 billion in debt interest costs, equal to $591 per Albertan. Needless to say, that interest bite is growing larger by the year.

Higher debt interest costs can also contribute to larger budget deficits as, in effect, governments borrow money to pay interest. And any further deterioration in federal and/or provincial finances could lead to further downgrades in the debt rating for Canadian governments, which would bring a higher risk premium on our debt and thus even greater interest costs. Canada experienced this vicious cycle of larger and larger budget deficits and greater and greater debt accumulation during the 1990s debt crisis when interest costs on federal debt consumed one out of every three dollars of government revenue instead of going towards services for Canadians.

As the Bank of Canada hikes interest rates in an effort to reduce inflationary pressures, governments across the country should exercise caution with their borrowing and spending. Otherwise, Canadian taxpayers will pay a significant price.