It's not a matter of if, but a matter of when Canadians will pay more tax

There is an economic storm coming. Simply put, it’s a bug waiting for a windshield. The amount of government revenue going to pay the interest on the debt is about to jump by 20%.

It’s been brewing out in the open ocean for years, but now we can see the clouds from the shoreline, and we should be battening down the hatches for when it makes landfall. Massive government debts are all being re-priced - starting today - at absurdly higher costs, and in order to maintain the interest cost on these debts, its likely to see a jump in tax rates, or other major shifts in policy. We will show some observations of what is likely to happen, based on the Canadian government bonds coming up for maturity in 2023.

For years we have heard that our politicians have “acted responsibly” and added billions of dollars to the federal debt without burdening the financial picture of the country, because of historically low interest rates. In this way, they have provided billions of dollars of support to the economy and still lowered interest costs nationally. Of course, this message is purely ideological and not rooted in logic or reason. But worse, they have applauded themselves, believing that they could get away unlimited spending forever. After all, the budget would “balance itself.”

Fate, it seems, is not without a sense of irony.

This year, the Canadian government has $163 Billion dollars worth of debt that will roll over on or before September 1, 2023. This debt has been accumulating for decades, but since the beginning of 2020, the federal government poured billions of debt-fuelled money into the economy in hopes of sustaining the shutdown they also simultaneously deemed necessary.

As people familiar with the Austrian definition of both money and inflation know, this expanded increase of capital into the market far surpassed the growth of production of goods. As people were lowering their spending, the increased money started to seek a return. Real Estate and the public markets shot up, as people started bidding up prices with their new “wealth.” Eventually, as the economy started opening up again, a frenzy of pent-up demand started driving up commodity prices throughout the world. People started demanding goods instead of cash, and people were experiencing the loss of buying power of their cash.

The Bank of Canada (BoC), in the meantime, had supported the parabolic federal government spending programs by purchasing bonds in open market operations. Additionally, they were active in supporting CMHC by purchasing mortgage-backed securities from the Canadian commercial banks, and even going as far as purchasing other market securities. All these strategies increased the commercial banks lending activities, which pumped additional billions into the real estate and equity markets.

Now with the BoC increasing interest rates in hope of curbing inflation, we have seen a slide in investment values, but inflation is still troubling the economy greatly, mainly because the interest rate is influencing demand, but primarily by not curing the problem of having too much money in the system. The BoC’s actions have manifested in the following ways:

1-?????Bank of Canada losses,

2-?????Years of cheap money has created distortion and mispriced all assets,

3-?????The value of money has been depreciated rapidly,

4-?????The Government of Canada costs are about to skyrocket.

Let's make some in-depth observations:

1-?????Bank of Canada losses. Several years ago, the BoC started paying the commercial banks for the money they held on “reserve” with the central bank. These rates are commonly known as the “overnight rates.” Banks can, at their option, exercise a risk-free rate of return on their capital for every dollar held by the BoC, or they could pay an employee a salary to adjudicate lending risk at or above the prime lending rate.?With the rise of interest rates in the last year, the banks have steadily increased their returns with their assets with the BoC with increasing the overnight rate. To offset the expense of paying commercial banks on their money held on reserve, the BoC has income producing assets (see above government bonds). The income of these bonds are set at the date the bond was purchased. For example, the BoC owns a particular Canadian government bond, paying a dividend of 0.25%. If the expenses are set at 4.75%, then the BoC is losing money at a rate of 4.50%. They have asked for a bailout from taxpayers which could total somewhere between $5-$10 Billion. They have painted themselves into a corner and are now trapped in a money-losing cycle until either interest rates are pushed back down, or the coupon rates of the bonds they own start increasing over time.

Special note: Remember that your bank’s expenses is your money you have loaned to them.

2-?????Years of cheap money has created distortion and mispriced all assets. The responsibility of the boom-and-bust cycle is laid at the feet of central banks around the world. As central banks feel that there is a danger of the economy falling into recession and too much unemployment, and as they have been empowered to attempt to centrally plan the economy, they create stimulus in the form of expanding the money supply, which provides banks the opportunity to expand their loans. When the central bank thinks the economy is running too hot, they attempt to cool off the economy by lowering demand for credit by raising interest rates. The attempt to maintain a balance between recession and full employment leaves the economy expanding and contracting sporadically, all on the whims and ideas of a handful of people who are neither rewarded for success nor penalized for failure. As people react to the nattering of the BoC’s comments, they gamble on the direction of policy; some successful, others not. In this seesaw of speculation, prices are sacrificed, as catallactics becomes more difficult. It’s proven that people (including politicians and bureaucrats) make worse financial choices when presented an opportunity with unnaturally low interest costs. When interest rates normalize, the investments don’t look as compelling. All these investments have to be unwound during times of higher interest rates.

3-???The value of money has been depreciated rapidly.?As mentioned earlier, by increasing the growth rate of currency beyond the growth of demand for currency, you automatically reduce the demand for money. We see this as rising prices, but when you consider the reality of the purchasing power of every unit of currency, it becomes a degradation of the value of each unit of currency. Not only do people tend to lower their demand (and therefore the value of each dollar), but they feel as though the assets they buy are buying more purchasing power. This couldn’t be further from the truth! By buying inflation hedging assets such as real property, precious metals, or equities, they are merely preserving their comparative purchasing power. When measured in dollars, the exchange value of those assets appear to be increasing, but relative to other commodities or assets, all assets now appear to be “more expensive.” The purchasing power of all currencies are racing to zero value. No matter who jumps out of the plane last, if everyone jumps without a parachute, it is no victory to say that you’ll hit the ground last.

4-?????The Government of Canada costs are about to skyrocket. This is the focal point of this article, given its urgency.

As mentioned above, politicians have boasted about managing the interest costs of the federal debt down while still providing “needed” and “necessary” stimulus and transfer payments to the provinces. These interest costs – not the spending itself – is the narrative that we have been spoon-fed.

With the increases to the interest rates, bond rates across all industries and sectors are also skyrocketing. When the overnight rates were essentially zero at the beginning of 2020, the government debts spiralled while interest rates were at their lowest point in recorded history. Now that the BoC has increased the overnight rates, government bond yields have increased in kind. Instead of a bond coupon priced at .25%, today they are closer to 3%.

In the Government of Canada’s case, there is a significant amount of debt that is scheduled for re-issue this year, and all of that debt will be re-priced at current yields. There are $163 Billion of government bonds rolling over on or before September 1, 2023. In addition, there is $158 Billion rolling over in T-bills. All of these will be repriced at new rates.

According to the government’s own financial statements, the interest costs of the sum of all government debts are $24 Billion. Included in that amount is the currently maturing bonds, carrying an interest cost of $263 Million without considering the T-Bills. If these bonds roll at the current 5-year rate of 3.02%, the interest cost on the $163 Billion jumps to $5.4 Billion, an increase of almost 20 times the interest cost. The total government interest expense will rise to $29.657 Billion, up by more than 20%.

Of course, these debts set to roll over are only a fraction of the total indebtedness of the country, and if rates are higher for longer than planned by the BoC, those interest expenses will only increase further, putting extreme pressure on the Ministry of Finance to raise taxes to cover these expenses now and in the future.

There are a range of possible outcomes. Of course, there’s no way anyone can accurately predict the future. However, there are a few likely or plausible scenarios that may unfold in the next few months or year.

One of the more likely scenarios is increased taxes. The government cannot afford the spike in bond yields. Therefore, government income has to increase in order to afford the additional $5 Billion of expenses. You can only choose one of two ways to fill a bathtub – either increase the flow of water beyond the outflow capacity of the drain, or plug the drain. The same is true of government finance, where the tap has to run a greater flow of tax revenue or the drain has to be plugged. Considering that increasing taxes, or instituting a wealth tax, or increasing the inclusion rate of capital gains affects less voters than decreasing entitlement spending, it’s more politically expedient to raise taxes.

Another scenario may be the return to lower rates and further stimulus by the BoC to reduce rates to lower the sticker shock. Of course, this action would avoid any attempt to curb inflation, and in fact, would promote inflation with further expansion of the supply of money and credit. In an effort to combat the expansion of credit, the BoC may have to reinstitute some form of reserve requirements with banks. Canada dispensed with “reserve requirements” with the commercial banks since the early 1990’s, and ever since, they only have to meet a 30-day liquidity measurement instead of withholding a percentage of their deposits for “safekeeping.” This would be a problematic shift in policy, especially given the desire to avoid further causes of price inflation.

Another possible scenario may be an outlier, but could an election be in the wings? The current government knows that they are quickly slipping in the polls, so handing off a disaster to the next party and placing the hard job of righting the ship in their hands. Given the options between austerity or tax hikes really leaves the next party with a Hobson’s Choice, and the possibility of getting voted out next election cycle if unsuccessful or Canadians feel too much pain in the moment.

What can the average Canadian do?

I’ve always suggested that one should prepare for the worst and plan for the best. In preparing for the worst, and given the likelihood of a tax increase, getting as much money sheltered from tax as allowable under the law is the first step. Consulting with a financial, tax, and legal professional as a team to offer guidance and direction is crucial. There are many options to reduce tax that many Canadians do not know even exist; whether that is starting a small side business that allows different deductions to normal expenses, or using a TFSA or properly designed life insurance contract that can legally shelter specific amounts of capital from tax.

Another recommendation might be to seek investment guidance to hedge into longer term inflation proof assets such as farmland or other income producing real estate on the residential and commercial property. There is also commodities and equities to consider, as well as precious metals including gold and silver, or alternative currencies from other countries, or even a position in other alternatives. Deploying or leveraging capital into any investment should be, of course, an undertaking of serious contemplation and consideration of all the risks and benefits therein.

I feel the primary concern for every Canadian should be to the preservation of the wealth from tax, as there are many paths forward for the government to take to increase their share of the economic pie of this country.

Data Sources:

https://www.bankofcanada.ca/stats/goc/results/en-goc_tbill_bond_os_2022_11_30.html

https://www.canada.ca/content/dam/fin/publications/afr-rfa/2022/afr-rfa-2021-22-eng.pdf

https://www.canada.ca/content/dam/fin/publications/fs-ef/fs-ef-21-eng.pdf