Prime minister-elect Stephen Harper’s campaign promises both to cut the GST and repair fiscal imbalances among the federal and provincial governments were meant to be unrelated measures, but they may end up locked together.

Analysts say the Conservative election platform — excluding additional funds for the provinces — is affordable. And although the Tory fiscal plan suggests there is $22.7 billion to play with over the next five years, Harper should keep at least some of it — and probably most of it — for new programs. Unexpected expenditures could also appear, or revenue could fall short, if the economy slows.

Thus, the best way to deliver on the promise to fix the fiscal imbalances is to view the cut in the GST as providing additional tax room for the provinces. Indeed, it’s probably the only way it can be done.

The problem is the political fallout. Provincial premiers won’t want to appear to be taking away federal tax breaks by increasing provincial taxes, and Harper will be loath to admit that he wasn’t really providing a tax break — except in his home province. Alberta, with no debt and awash in oil and gas revenue, has no need to use the tax room provided by the GST cut; indeed, it has no provincial sales taxes to cut.

But Harper can’t say the federal cupboard is bare. His position is that the federal government has too large a share of tax revenue. You can’t have a fiscal imbalance if everyone is strapped.

The alternative to tagging the GST cut as providing tax room for the provinces would be to raise other taxes or significantly curtail program spending. The Tory platform already includes some income tax increases to pay for the GST — specifically, reducing the basic personal exemption and reversing the drop in the lowest personal income tax bracket to 15% from 16%, proposed for retroactive implementation as of Jan. 1, 2005, in the Liberals’ November fiscal update. More tax increases would not be popular.

Program spending in the Conservatives’ fiscal plan rises at an average 4% a year over the next five years. That’s a little less than the projected 4.7% rise in nominal gross domestic product, the pace of spending increases on which the Liberals had based their plans. A 4% rise will involve some reallocation of expenditures but not major cuts. Significant cuts in program spending would be as equally unpopular as more tax increases.

The Tory fiscal plan, however, does not include the $3-billion annual contingency reserves and money set aside for economic prudence (which starts at $1 billion for the upcoming fiscal year and rises to $4 billion five years out) that the Liberals put into their budgets each year. The Conservatives may feel these reserves aren’t needed. Certainly, everyone agrees that the Liberal budget process was flawed, as witnessed by the large unexpected surpluses it produced.

Reform is clearly needed. Under the Liberals, the Department of Finance made very conservative estimates on tax and spending measures, says Dale Orr, managing director of economic consulting firm Global Insight (Canada) Ltd. in Toronto. The department would take the most pessimistic view of how many people would use particular tax credits or deductions and how many would participate in particular programs. The result was hidden prudence that wasn’t needed because the reserves were supposed to take care of any unexpected expenditures or unanticipated revenue shortfalls.

What isn’t known is what the hidden prudence amounts to, or if the Conservatives tried to guess its extent and remove it from their projections.

Even when these questions are answered, the Conservatives need to be cautious. The large Liberal surpluses were generated in a period of strong economic growth. The fact that they didn’t need the reserves doesn’t mean such funds won’t be needed in the future. Furthermore, the Tories are heading a minority government, an environment in which spending restraint will be hard to achieve, says Clement Gignac, chief economist and strategist at National Bank Financial Ltd. in Montreal.

As a result, the Tories may well realize that they can’t afford both to lower the GST and give the provinces more money.

Lowering the GST one percentage point in the fiscal year ending March 31, 2007, carries an estimated $4.7-billion price-tag, and that will increase each year with economic growth and inflation. With a two percentage point drop — the second is assumed to occur Jan. 1, 2010, in the Conservatives’ projections — that’s $11.2 billion in fiscal 2011 dollars, using the projections in the Liberals’ November fiscal update. The total cost for the five years is $32.3 billion.

@page_break@If the provinces — except for Alberta — raise their sales taxes to use up the vacated federal tax room, that would go a long way toward fixing any fiscal imbalances. Without Alberta, the revenue that could be raised would be about $4 billion annually now, and $9.5 billion in 2011.

There’s no agreement about what the fiscal imbalance is, but it would certainly shrink dramatically, if not disappear, if the GST cut is viewed as tax room that can be used by the provinces.

Analysts like the idea of using the GST cut to fix the fiscal imbalance. It’s simple, efficient and flexible. Provinces can decide if they really need to raise sales taxes or other taxes, or if they can manage by controlling spending. The plan also can result in more government restraint because provinces won’t want to have their tax rates too out of line with other jurisdictions, says Gignac.

Orr says the Conservatives should not even consider giving the provinces anything else. It’s up to them to use the tax room as they see fit.

Analysts would have preferred that the Conservatives went with income tax cuts instead of GST cuts, because that’s better for productivity and economic growth. It increases the incentive to work and encourages savings. The income tax system is also progressive, so lower-income groups benefit more from system-wide cuts.

Assuming the GST cuts are used to fix fiscal imbalances, it may be possible to rethink the federal equalization program. The Conservatives promised to eliminate non-renewable natural resources revenue from the calculation of equalization, but they might want to consider scrapping the current system and starting from scratch.

The program is distorted in a number of ways. In 1984, it was changed so that entitlements are based on the average of revenue for Ontario, Quebec, British Columbia, Manitoba and Saskatchewan rather than all 10 provinces. Last year, Liberal side deals with some provinces produced further distortion.

Elimination of non-renewable natural resources revenue would make redundant the special deals for Newfoundland and Labrador and Nova Scotia, which took offshore oil and gas revenue out of the calculation of their entitlements. It would also satisfy Saskatchewan, which has been lobbying for a similar deal. It wouldn’t, however, affect the Ontario deal, under which the Liberals promised $5.7 billion over the next five years in transfers to make up for all the money the province puts into equalization without receiving anything back.

The more important question is whether excluding non-renewable resources revenue is the right way to go. Resources are an important part of Canada’s wealth, and equalization is aimed at redistributing the wealth so that people in all regions have access to a minimum standard of services. If non-renewable resources are eliminated, there could be some unintended results, says David Perry, senior research associate at the Canadian Tax Foundation in Toronto. For example, provinces rich in resources but with little other revenue might at some point get transfers they don’t need.

Then there’s the question of the renewable resources. Revenue related to electricity in Quebec, Manitoba and B.C. would be counted but not oil and gas. Yet, at the end of the day, energy is energy, says Gignac.

Jack Mintz, president of the C.D. Howe Institute in Toronto, says it’s time to look at other formulas. In the U.S., for example, low-income states get higher per-capita grants for services such as transportation. In Australia, equalization is based on expenditures, not revenue.

The first step is to look at the report of the “expert” panel appointed by then-finance minister Ralph Goodale in March 2005 to look into the program. It is due this spring. IE