The federal budget, scheduled for March 19, is expected to focus on the environment and possibly federal/provincial fiscal imbalances, with some additional money for defence and tax breaks for individuals.

It will likely be an election budget because the minority Conservative government may have to go to the voters this spring.

Fortunately, it looks like the government will have more money to spend or use for tax cuts than it had thought in November, when it released its economic and fiscal update. Don Drummond, chief economist at TD Bank Financial Group in Toronto, thinks the surplus for fiscal 2007, ending Mar. 31, is likely to be $1.8 billion-$2.8 billion higher than the $7.2 billion forecast in November. That’s before any yearend bookings, such as the recently announced $1.5-billion Eco-Trust and Clean Air Fund for provincial environmental initiatives.

The bigger surplus is the result of $1 billion — possibly $2 billion — more in revenue, $500 million-$1 billion less in program spending and $500 million-$1 billion less in interest on the public debt. Drummond thinks it’s reasonable to assume that the future surplus in each of the next two years will be $1.7 billion higher than previously forecast.

As a result, the Conservatives could have a little more than $5 billion to play around with in fiscal 2008 after the $3 billion in planned debt reduction. The $3 billion is to be used for debt reduction only if there is enough money left at the end of the year; it also can be used to cover unexpected revenue shortfalls or unforeseen expenditures. As such, it plays the same role as the $3 billion in contingency reserves used in Liberal budgets.

The environment has become a high-priority issue and the Tories are responding. They shifted John Baird to the Environment ministry from the Treasury Board and have committed to introducing measures to reduce greenhouse gas emissions. There probably will be more initiatives than the Eco-Trust, possibly including support for investing in new technologies, and tax credits, rebates and/or write-offs for both business and individuals.

Derek Burleton, senior economist at TD, thinks “a fair chunk of money” will go to environmental measures, some of which, such as the Eco-Trust, will go to the provinces, thereby providing part of the solution for the fiscal imbalances.

In his opinion, the environment and fiscal imbalances will be the main themes in the budget.

Another measure that would deal with imbalances is increased funding to the provinces for education.

However, these two measures represent only a partial solution to the imbalances; more transfers of cash or tax room will be needed. The ideal way to resolve this would be to position the promised additional one percentge point cut to the GST as a transfer of tax room to the provinces. Provinces could then increase their sales taxes if they needed extra revenue. If they did so, voters could decide if the resulting increase in program spending was worth forgoing the federal tax cut.

In addition to tying the next GST cut to fiscal imbalances, analysts hope the Conservatives will also make harmonizing the GST with provincial sales taxes part of the package for Ontario, British Columbia, Manitoba, Saskatchewan and Prince Edward Island. Quebec and the other Atlantic provinces are already harmonized; Alberta has no sales tax.

GST harmonization is considered desirable by economists because it means all sales taxes paid on business inputs would be rebated. In unharmonized provinces, only the GST portion is rebated. Full sales tax rebates would reduce business costs in general and encourage investment in new plants, machinery and equipment.

The problem is that harmonization means broadening the provincial sales tax base to that of the GST, which means items currently exempt from PST, such as haircuts, taxi fares and other services, would be taxed at a higher rate. While unharmonized provinces don’t want to be seen as raising taxes, they would be more apt to do so if they could point to increased federal transfers for program spending or tax cuts.

It’s possible the next GST cut could be included in this budget for 2008, 2009 or 2010; the Tories have promised the cut will be implemented within five years of the last election or by 2011.

Dale Orr, managing director of economic consultancy Global Insight (Canada) Ltd. in Toronto, suggests that the second GST cut could be as early as 2008 or 2009. The Conservatives could argue that they don’t really need to put aside $3 billion as a contingency reserve in a particular year and use that money to offset part of the $5 billion-$6 billion GST revenue loss.

@page_break@That would make sense, in light of the criticisms of previous Liberal governments’ tendency to end up with much higher surpluses than expected — a criticism that the Tories also may face, given the higher than expected surpluses now expected this year.

Diverting the funds from the contingency reserve could be done, however, only if economic growth prospects were good.

Another election promise that will have to be dealt with — although, again, not necessarily with measures that are implemented immediately — is the elimination of capital gains taxes if the proceeds are reinvested within six months. The Tories haven’t provided details and there’s speculation about what would be included in such a measure. It was clear that the sale of such items as cottages, family heirlooms and fishing quota licences would qualify. Gains on the sale of equities were not mentioned, and many analysts think this won’t be included because of the danger of speculators moving in and out of assets every six months.

Orr thinks one solution is to have a lifetime exemption for capital gains, with no reinvestment requirements. This would encourage people to sell assets when it’s economically appropriate rather than hanging on to them because of the taxes they would have to pay.

Because this is so complicated an issue, the Conservatives may issue a discussion paper or set up a committee to examine it. Something must be done, however, because some people have been holding off on selling items such as cottages because they are counting on an exemption. They need a time frame for when it will be available, at least.

Another issue is income-splitting. The pension income-splitting measures that accompanied the income trust taxation change can be seen as a first step toward a tax system that gives the choice of doing a tax return as a family. With family returns, total income could be split between the two adults, resulting in a lower average taxation rate than would apply if all or most of the income was taxed in the hands of one of them. This is in line with the Conservatives’ desire to encourage stay-at-home mothers.

Making a change like this would have major implications for individual tax filers, as the tax rate they pay would have to be adjusted upward to make up for the revenue loss that would occur from those taxpayers filing family returns.

David Perry, senior policy analyst at the Canadian Tax Foundation in Toronto, notes that previous federal governments — both Conservative and Liberal — believed the tax distribution in Canada was about right.

Given that, changing the distribution is something that deserves a lot of thought. Perry thinks a discussion paper “would get the Tories a lot of bonus points without getting them into too much trouble.”

More spending on defence for personnel costs and bringing in the next generation of men and women in uniform is urgently needed, according to Bill Robson, president of the C.D. Howe Institute in Toronto. The pressure for this is quite intense, he says.

On the tax side, Orr doesn’t believe the Conservatives will go into the next budget with the basic personal exemption or lowest personal tax rate lower than it was under the previous government. The Liberals had increased the basic exemption to $9,039 for 2006 from $8,648 and lowered the base rate to 15% from 15.5%. To help pay for the first GST cut, the Tories reduced the exemption to $8,639 and raised the lowest rate back to 15.5%, both as of July 1, 2006.

Robson thinks most of the budget’s tax measures will be on the personal side. The corporate and small-business income tax rates are already coming down; capital taxes are set to be eliminated as of 2008.

However, Orr would like to see the Tories move further on corporate income taxes — in particular, by increasing depreciation rates on machinery and equipment on an industry basis. Various industries claim that their depreciation rates don’t match the life of their M&E; the federal Department of Finance has said it is open to this. Depreciation rates for computers were increased a few years ago, and it’s not expensive to do.

Furthermore, an increase in depreciation rates would encourage more M&E investment and, thus, increase productivity, which the Conservatives have said is a priority. As there aren’t likely to be a lot of other measures that would raise productivity, this would be an ideal way for the government to address that issue. IE