Taxing Questions

Over the coming days, we will learn whether U.S. lawmakers have been able to reach a compromise on how best to tackle the federal deficit. Already this week we have seen both President Obama and the Republican Speaker of the House of Representatives, John Boehner, make their respective pitches to Americans.

While all sides agree that spending needs to be curtailed, there are differing views as to by how much and in what areas. That there are differing views on government spending is normal and in fact healthy. We are about to embark on a similar such debate here in Canada.

However, where the divide between the two sides is more pronounced and the debate potentially less healthy is on the question of taxes. More specifically, should taxes be increased to bolster government revenues?

The Democrats would favour some increases as part of what the President has called a balanced approach. The Republicans favour no increases. At all.

This intransigence on the question of taxes, while rooted in the Republican mindset, is becoming further entrenched due to the presence of the Tea Party - a group which is fast becoming the conscience of Republican party. Republican lawmakers have both an eye forward to the 2012 elections and the memories of the 2010 elections, and know that they need the support of the Tea Party.

On or before August 2, we will have a better sense as to how this conflict of views plays out. In the weeks that follow, we will also see how the markets, rating agencies and the public respond.

As we watch this all unfold, it is useful to consider whether there are any lessons for Canada. To date, the discussion as far as Canada is concerned has been about the parallels between what is happening in the U.S. today and what happened in Canada in the 1990s, when we embarked on a deficit reduction program.

To be sure there are useful comparisons that can be made, particularly as it relates to how to implement program cuts. However, the area which interests me and which I think we need to consider more fully in Canada is the question of taxes.

The Conservative Party of Canada does not favour tax increases - quite the opposite. Their long-term focus is on further reducing taxes. This is the mindset that drove the GST cuts, and is the mindset which will further govern how they manage Canada's economy.

There are real similarities here with the Republican position. Unfortunately, in the U.S. this position has over the past three decades effectively taken off of the table one of the major tools available to a government to manage the affairs of state. Pity the politician in the U.S. who openly contemplates a tax increase, regardless of the need it could serve.

Unfortunately, this "stigmatization" of taxes is becoming more and more a part of our political discourse in Canada. We are not far from the point where the merits of a policy initiative or course of action take a back seat to rhetoric on taxes.

When considering any new initiative, costs have to be considered and choices need to be made. One of the choices should be around whether taxes are an appropriate and effective means of funding an initiative. The U.S. has taken this off of the table, which in part has fueled the crisis in which they find themselves.

A lesson for us? We would do ourselves a favour in Canada if we pulled back from the current path we are on, and resist the temptation to take taxes off of the table. Good policy requires a thoughtful consideration of all of the options.

So Mr. Flaherty, where do we go from here?

On Tuesday the Minister of Finance, Jim Flaherty, will release the government's fall economic and fiscal update. We're being told to expect something straightforward and containing no mini-policy announcements, say like the one that nearly lost the government the confidence of the House in 2008. So far, so good.

What we can expect to hear is that the government's finances are poor and that the deficit has grown. However, the Minister will reaffirm the government's commitment to balancing the books by around 2015. The question to ask Mr. Flaherty is "how?"

The government's strategy has rested on three things: the rollback of stimulus; stronger tax revenue through growth in the economy; and cuts in government spending. Let's consider this a moment.

Stimulus spending will end, likely before the next budget - though the Minister has a left a small window open that this timetable may change depending on how soft the global recovery turns out to be. However, the end of stimulus will not restore the nation's financial health, it will mainly stem the bleeding from the state coffers.

Ok, so how about the projected growth in government revenue as the economy begins to expand? The challenge here is that the government's projections assume a recovery and pace of economic growth similar to that which occurred after previous recessions. Unfortunately, this does not seem likely.

Our major trading partner is continuing to falter and in fact could fall back into recession. Other OECD countries (Germany is an exception) are faring poorly, and the spectre of sovereign defaults in the European Union continues to loom. While their growth and resilience is impressive, emerging markets like China and India cannot compensate for this loss of economic output in the West (never mind the fact that the West has been the biggest consumer of emerging market exports).

So, if the end of stimulus is akin to us no longer digging a hole, and the prospects for "normal" growth must be tempered, where does that leave us? Spending, that's where.

The government will need to look at spending if it is serious about balancing the books. Let's not forget that the Conservatives spent heavily before the recession (defence, Quebec) and they have cut taxes - corporate, personal and consumption in the form of the GST. These steps have seriously limited their maneuverability - and that of any other party aspiring to power.

We will not hear much tomorrow about "the plan." However, we can now count on entering a period of trial balloons and ground softening to prepare us for an austerity budget.

Thoughts?

The $15 billion swing...

On Friday (of course on a Friday), the Department of Finance released Canada's Annual Financial Report for the 2008-2009 fiscal year. Basically, how we did from April 1, 2008 through to March 31, 2009.

In case you were wondering, we did poorly.

At the beginning of the fiscal year, Canada had a budgetary surplus of $9.6 billion. 12 months later, we had a deficit of $5.8 billion. Yes, that's right. National finances suffered a $15.4 billion swing. In the wrong direction.

Now, I don't know about you but if I my household finances suffered a swing of similar proportions, there would be a heck of a conversation looming...

Being a Department of Finance document, there were lots of other statistics - the vast majority of which I won't bore you with (geeks go here: http://www.fin.gc.ca/afr-rfa/2009/afr-rfa09-eng.pdf).

Now, for those concerned about the national debt (i.e. 1 of the 2 people who have commented here), we are still sitting at a comfortable 29% debt-to-GDP ratio. This is one of the numbers I suspect will get bandied about as the government is challenged on the deficit.

It gets at the ability of a country to serve its debt, and by all measures Canada is in good shape (and for that matter in much better shape than other G7 countries). Expect the government to play this up.

But let's go back to our question of the deficit and more importantly how it can be eliminated. As noted in previous blogs, it is unlikely that economic growth will take care of things for the government. Most economists expect this deficit to grow over the next few years until it approaches the $50 billion level. If we believe this needs to be addressed, what's the solution?

I'll put some thoughts down:

• As mentioned in earlier posts, increase the GST. It is consumption oriented and the previous cuts only favoured those who spend more on luxury items. Increase the tax and make sure to carve out those items which are not luxury (key foodstuffs, baby items, books - most of this is already done, but address any remaining items).

• Continue to increase consumption taxes for cigarettes and alcohol.

• Review federal assets, including foreign real estate holdings, to identify savings through divestiture.

Will any of this do the trick? Not any one item. The biggest bang will come from the GST, but I would worry about two things. First, the courage of any government to move on a tax increase. Second, the fact that for all of the spending cuts or revenue increases a government can get in place, there will be a long line of other financial asks waiting in the wings.

What I am trying to say is that the politician who tells you no tax increases is likely wrong. The politician who says no cuts to programs is also wrong. For Canada to get out of this hole the government (whoever is in charge) will need to raise taxes. They will need to cut spending (if only to make room for spending in new areas). It won't be fun, but it will be interesting...

Thoughts?

Uh, we seem to have lost several billion dollars. Has anyone seen them?

Yes, we have a deficit. And yes, it's big and growing. So what should we do?

In answering, I think it is important to consider how we arrived at the current state of affairs. Without question the economic stimulus introduced though Budget 2009 (or Canada's Economic Action Plan if you prefer the marketing approach to government policy) accounts for a lot of the deficit.

But what else? Well, increased government spending pre-economic crisis ranks right up there. Over the past several years, under both Conservative and Liberal governments, federal expenditures have steadily risen.

For a time, this was ok as the economy and government revenues (through taxes) were growing more quickly. The GST alone was bringing in billions each year. Eliminate the deficit - sure! Need a Canada Foundation for Innovation? No problem! Pay down debt? Bingo!

Things were so good, in fact, that in 2006 the decision was made to reduce that cash cow of cash cows. The cuts the Conservatives made to the GST (in two phases) took billions out of the government's coffers.

Ok, fine. So what about spending? Did government adjust for this loss in revenue? In a word, no. Corporate and personal taxes were lowered, thereby reducing revenues further. And overall program spending rose (defence was a big leader), further chipping away at the remaining surplus.

The result was that Canada was close to or more likely in deficit this time last year. Pre-crisis. The ensuing stimulus measures, combined with a sharp reduction in government tax revenue as the economy faltered, then took things to the levels we see today.

I raise this because knowing how we got there should help us figure out how we get out. It's like when you lose your keys. The first thing someone says is, "Well, where did you last see them? Retrace your steps."

In our case, we have "lost" billions. Retracing our steps leads us, from my perspective, to this conclusion. Spending must be lowered and selected taxes must go up.

Ok, that was the easy part. Now for the challenge. What spending gets cut? What tax gets raised?

For me, returning the GST to pre-2006 levels - while not a political winner - may be the route to go. I would not be surprised if at some point the Liberals float this one to see how it plays.

On spending, the winding down of the stimulus measures will help. However, there are big ticket items out there including a new spending accord with the provinces on health care. You think saving GM and Chrysler were expensive, try health care on for size.

Then you have the Liberals, who having moved away from the green shift are now looking to invest heavily in a green economy. That can't be done on the cheap.

I raise this because for every expense that is cut, there are 5 new unfunded ideas lining up and needing money to get them going. That isn't to say they aren't good ideas or the right things to do. It's just that they are expensive and money will be tight.

This is the challenge facing anyone who wants to be PM and form a government. Still want the job, Mr. Ignatieff?