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Ottawa Should Focus on Tax Relief Instead of More Spending

11/17/2014 09:26 EST | Updated 01/17/2015 05:59 EST

After seven years of budget deficits and over $160 billion in new debt, the federal government confirmed in its financial update Wednesday that it expects to record a surplus next year. With the deficit set for elimination, now is the time to shift focus on ways to lay the foundation for stronger economic growth and increased prosperity. Using the new fiscal room for pro-growth tax relief warrants serious consideration.

Starting in 2015/16 and up to 2019/20, the government expects to run cumulative surpluses of $31.2 billion. Its projections include an annual $3 billion contingency buffer, so the surpluses could actually total as much as $46.2 billion. That leaves substantial fiscal room for enacting tax changes that improve Canada's competitiveness and put the country on a stronger economic footing.

The expected surpluses would have been higher had the government not already used part of them on a series of initiatives announced last month including family income splitting for tax purposes (limited by a cap), an expansion of the Universal Child Care Benefit, an increase in the Child Care Expense Deduction limit, a doubling of the Children's Fitness Tax Credit, and a new tax credit for small businesses. The cumulative price tag of these initiatives is $27.5 billion (from 2014/15 to 2019/20) or roughly $5 billion annually once fully implemented.

If the government's goal is to enact "prudent" new measures that encourage economic growth and "boost job creation," other options would generate greater economic bang for the buck.

Flash back to the late 1990s when the federal government last eliminated a deficit. The public debate about how best to use the so-called "fiscal dividend" led to the then Liberal government enacting an important series of tax reforms that helped usher in a period of strong economic performance.

The Liberals used the surpluses to reduce personal income taxes, lower capital gains taxes, and set in motion a multi-year reduction in the corporate tax rate that has made Canada's business tax regime more competitive with the United States.

But the federal pro-growth tax reform agenda has since largely stalled. The major tax reductions enacted by the Conservatives have been limited to decreasing the GST rate, following through on scheduled reductions to the corporate tax rate, and creating several tax credits for particular individuals or activities that have complicated the tax code. The personal income tax rate structure has essentially been unchanged.

Therein lies a major opportunity for maximizing the economic impact of the fiscal dividend today.

A recent study surveying the existing research on marginal tax rates clearly shows that high and increasing personal income tax rates discourage investment and entrepreneurship, which form the basis for a thriving economy. The same study shows that Canada is uncompetitive on personal income tax rates and the income levels at which they apply.

Consecutive federal governments, both Liberal (in 2005) and Conservative (in 2006), have identified the destructive effect of Canada's personal income tax rates. Indeed, the Conservatives highlighted the need to reduce personal income tax rates well before any mention of income splitting.

Broad-based tax relief in the form of lower personal income tax rates would improve Canada's competitiveness and strengthen our economy by encouraging productive activity like increased work effort, saving, investment, and entrepreneurship.

Another option is for the Conservatives to take a page from the 1990s Liberal playbook and reduce capital gains taxes, which apply to the sale of assets when the selling price exceeds the original purchase price. This may not be the sexiest policy topic heading into an election year but the reality is that capital gains taxes impose enormous economic costs and bring in relatively little revenue in return (just 1.1 per cent of total federal revenues).

A wealth of research shows that eliminating or at least reducing capital gains taxes would increase the supply and lower the cost of capital for new and expanding firms, leading to higher levels of entrepreneurship, economic growth, and job creation.

The Conservatives should be commended for sticking to their commitment to the balance budget. But balancing the budget cannot become an end in itself or it can come to serve as a justification for spending increases with limited economic benefit. Reducing personal income tax rates and capital gains taxes would be a productive use of future surpluses.

This piece was co-written by Milagros Palacios, Senior Research Economist, Fraser Institute.

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