The federal government will be increasingly constrained in its ability to provide effective stimulus in response to future severe cyclical economic downturns. Low interest rates restrict the Bank of Canada’s ability to stimulate private demand through interest-rate cuts. Similarly, high public debt levels post-COVID restrict government’s long-run capacity to provide discretionary fiscal stimulus. Against this background, we propose a complementary fiscal policy measure to manage aggregate demand in Canada. This measure, which we call the “Demand Stabilization Mechanism” (DSM), would use temporary cuts in the goods and services tax (GST) to deliver timely, targeted and fiscally anchored stimulus for aggregate demand during economic downturns and recoveries. Our proposed DSM 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 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 on the 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. The DSM would have four key elements: 1) a trigger that determines when temporary tax cuts should be used; 2) a rule that determines the size and duration of the tax cuts; 3) a fiscal anchor that requires recovering the costs of the tax cuts; and 4) legislation that ensures the application, monitoring and auditing of the tax cuts. To make the DSM operational, several challenges would need to be addressed. Firstly, the GST rate would need to be raised to provide enough room for a significant cut. Secondly, our proposal would rely heavily on the Bank of Canada’s output gap forecast, which would need to be transparent, published sufficiently in advance, and be targeted to the application of the mechanism. Reliance on the Bank would require its continued protection against political interference. Thirdly, introducing the mechanism would require legislation through Parliament, which could raise constitutional questions. Overall, the DSM would complement Canada’s monetary policy by acting quickly to shore up demand, and the rule would protect Canadians’ future living standards by being fiscally responsible. We hope that our provocative proposal marks a starting point for making fiscal policy more effective, while renewing the idea of a strong fiscal anchor that ensures a fiscally responsible government
