After Finance Minister Jim
Flaherty took his second crack at a federal budget this past spring, he is left with some unfinished business. It’s not clear, however, if he can or will be able to follow through on those unfulfilled Tory promises in his next kick at the can.

A number of the government’s major tax-cut pledges are incomplete — either partly done or not even started. But then, Flaherty’s second and most recent budget was less about delivering tax cuts and more about righting perceived federal/provincial imbalances.

To the extent that this year’s budget delivered tax relief, it did so mostly in small, targeted measures rather than with broad, sweeping initiatives. That’s not to say that a very different budget couldn’t come down the next time around, but past performance suggests that Flaherty will not be slavishly focused on major tax reform.

That said, at this point, no one is quite certain just what the government is planning to do in its next budget. The House Standing Committee on Finance began its pre-budget consultations in mid-September, and the consultations are scheduled to run through October — the theme is ensuring the tax system fosters prosperity and productivity — with a fiscal update expected in November and a budget typically coming in the new year. However, with a minority government in power, elections are an ever-present possibility.

In the meantime, the government is proving more tight-lipped than its predecessors. For instance, witness the utter surprise that greeted the income trust taxation announcement that came down on Halloween last year. The RCMP investigation and the subsequent filing of an “illegal insider trading” charge against a Department of Finance official earlier this year (concerning the previous government’s suspenseful consultation on income trust taxation in 2005) may also have put a bit of a chill on gossip around the government’s plans.

This level of secrecy doesn’t always work in the government’s favour. Although the feds have managed to shake off the previous administration’s tendency to consult things to death and have avoided allegations that they dole out privileged information to insiders — compare their handling of the income trust tax file with that of the previous government’s, for example — the reluctance to consult the Street also led to the ill-conceived proposal in last year’s budget to stop corporations from deducting interest on debt used to finance foreign earnings.

So, while no one claims to have any great insight into what the feds are planning to do, what is clear is that the government should have a fair amount of fiscal freedom. “There appears to be plenty of room for Ottawa to cut taxes in next year’s budget,” confirms Doug Porter, deputy chief economist at Bank of Montreal in Toronto.

Indeed, Finance’s reported surplus numbers are already blowing through the government’s own estimates. The most recent budget projected a surplus of $3 billion for the fiscal year ended March 31, 2008. Yet, the latest data from Finance put the surplus for the fiscal first quarter at $6.4 billion. This is up from $5.9 billion for the same period last year, when the government went on to record a surplus of $13.8 billion for the full year — trouncing its projection of a $3.6-billion surplus for fiscal 2007.

“It’s not unusual for Ottawa to underestimate its surplus, but it is unusual for Finance to be admitting so at this early stage of the fiscal year,” Porter says. “It’s safe to say that the government has lots of flexibility to trim taxes.”

Indeed, Prime Minister Stephen Harper has promised tax relief, thanks to last year’s $14.2-billion reduction in the federal debt. The Tories have pledged to devote the resulting interest savings — $725 million — to trimming personal income taxes. But that pales in comparison to the projected cost of outstanding promises and expectations for the current year’s surplus.

The question is just which taxes are likely to get the knife. The feds have already cut the GST to 6% from 7% — and have promised to trim it to 5%. However, that is likely to be a very expensive promise to keep. Cutting another percentage point off the GST would cost $6 billion, estimates Don Drummond, chief economist at TD Bank Financial Group in Toronto. As a result, he doesn’t expect to see a cut to the GST immediately. The government has given itself until 2011 to follow through on that promise.

@page_break@Neither does Porter expect to see the rest of the promised GST cut any time soon. “It seems that they really didn’t get much political bang for the buck on the first 1% cut — and economists panned the move,” he says. “So, they may save that for the next election campaign.”

Indeed, economists generally prefer to see income tax cuts because that sort of relief is believed to be a more effective form of fiscal stimulus than cutting consumption taxes.

Although a GST cut might not have done much to excite the average voting investor, two other personal tax moves that the government has bandied about would probably be more popular. Last year, the government introduced a limited income-splitting measure that applies only to pensioners. There was some hope that a broader form of income-splitting would be included in the budget this past spring, allowing all couples to minimize their collective tax burden. Drummond says that this would be a pricey move, too — probably costing around $5 billion — and doesn’t expect to see that, either.

If broader income-splitting is too expensive, the government could return to one of its past campaign promises — one that would probably be very popular with voter investors — eliminating or deferring capital gains taxes on reinvested gains. There was some hope going into the most recent budget that the government might do something with capital gains taxes to cushion the blow it delivered to income trusts in late 2006.

Certainly, the investment industry would welcome some capital gains tax relief. In a submission to the current pre-budget consultations, the Investment Funds Institute of Canada calls on the government to follow through on its promise to cut capital gains taxes. It argues that many taxpayers have accrued capital gains that are locked in solely to avoid the tax hit; this, IFIC says, prevents the efficient allocation of assets and stifles economic growth. “Canadians should be allowed to free up at least some portion of those capital gains,” IFIC says, arguing that this would provide stimulus to the economy and encourage portfolio diversification.

However, economists tend to see the idea of capital gains tax relief as unwieldy and expensive. Porter believes the kind of relief the government is contemplating is simply too cumbersome to implement. If the feds are going to do something on the personal taxes side, it will be either broader income-splitting or a simple cut in marginal rates, he predicts: “Given the feds’ tendency to go for targeted cuts, I think some kind of relief on income-splitting is possible.”

If the measure first proposed by the government is too hard to implement — and there appears to be some consensus that it is — there are other ways of providing capital gains relief. IFIC supports the idea of a “capital gains deferral account,” which has been proposed by the C.D. Howe Institute. Or, IFIC suggests, the government could simply cut the capital gains inclusion rate or adopt a simple capital gains exemption subject to lifetime and annual limits.

“This is administratively simple, would benefit a wide range of Canadians and encourage a reallocation of capital to more productive assets, which would offset, to a large part, the lost tax revenue,” IFIC says.

It estimates that an exemption with a $3,500 annual limit, for example, would cost the federal government only about $625 million in annual revenue.

If tinkering with the tax treatment of capital gains is too tricky, there are plenty of other measures that the investment industry would like to see from the government. IFIC proposes the introduction of a new retirement savings vehicle for lower-income workers — often referred to as a “tax-prepaid savings plan” — that would be funded with after-tax dollars but be allowed to grow tax-free. This type of plan is expected to be more appealing to taxpayers who don’t have a lot of use for RRSPs because they aren’t paying high income tax rates now and, as a result, don’t anticipate a significantly lower rate in retirement.

Additionally, IFIC proposes that the government offer a matching contribution grant (much like it does with RESPs) to encourage those in the lowest tax bracket to save for retirement.

For taxpayers who utilize RRSPs, IFIC would like to see a number of changes there as well, including: higher annual contribution limits; preferred tax treatment for capital gains and dividends within an RRSP (similar to the preferred treatment these forms of income get outside an RRSP); that income generated by RRSPs, RRIFs and pension plans be excluded from the guaranteed income supplement clawback; and that RRIFs become eligible for the pension income tax credit and pension income-splitting earlier than they do now (at age 65).

All of these measures, IFIC suggests, would increase the incentive to save for retirement by eliminating some of RRSPs’ negative features. Finally, IFIC calls for the elimination of the dividend gross-up in the GIS clawback calculation to help minimize the disincentives to work and to save for those receiving the GIS.

Whether the government decides to undertake mere tinkering with the tax code or tries to do something visionary with its next budget remains to be seen.

It’s expected that Ottawa will have the room to make a big splash on the tax front — if it wants to. But recent history suggests that it may prefer to do things in dribs and drabs. And its minority status may well keep it from doing anything revolutionary. IE