A debate has broken out over how to use the surpluses projected in the 2014 budget. Everyone expected that during the 2015 election there would be a heated debate between the Conservative government and the Opposition Parties over how to use the projected surpluses. No one expected a heated debate within the Conservative party.

But that is what has happened. Much to everyone’s surprise, the Minister of Finance, on the day after his budget, decided to go public with his concerns that the 2011 election commitment to allow the splitting of income for tax purposes for families with children under the age of eighteen, once the deficit has been eliminated. Mr. Flaherty is concerned that income splitting may not be the best way to use the surpluses.

At a minimum, Mr. Flaherty would like to see a fulsome debate at Cabinet and in Caucus on the appropriateness of the 2011 commitment. His statements, however, caused an immediate backlash from some Cabinet Ministers, as well as social Conservative members of Caucus. Their view was simple. The government has always lived up to its promises (although there are a number of cases where they haven’t, such as the taxation of income trusts) and there can be no exceptions now. This view has a lot of credibility since most of the tax cuts the government has implemented since 2006 have been directed at the Conservative base and income splitting would help solidify that base prior to the 2015 election.

Even the Prime Minister appears to have been caught off guard by Mr. Flaherty’s comments. By the end of day last Wednesday, the Prime Minister chose to hide behind the dubious position that the deficit had not yet been eliminated and there was still time to look at all options. This despite the absolute clarity of the commitment made during the 2011 election. It may be that income slitting, at least as defined in the 2011 election campaign, will be dropped. If it is then what will the Conservatives replace it with? It is likely to be some time before we know the answer to this question.

The Opposition Parties do not want the government to drop their 2011 election commitment to income splitting. They no doubt wish that Mr. Flaherty had never opened his mouth and the Conservatives would continue with their 2011 election commitment, because, in their view, it is both bad policy and bad politics.

Research done by the C.D. Howe Institute, the Canadian Centre of Alternative Policies, and others ( Doug INSERT our article on the middle class) is very clear. The proposal to allow income splitting for families with children under the age of eighteen would benefit about 15% of Canadian families, most of who would be high-income earning families. Over 40 per cent of the benefit would go to families earning over $125,000. Single parent families would get nothing and two-earner families in the same tax bracket would not benefit.

During the upcoming election campaign, the only thing that the NDP and Liberals would have to do is come up with alternative “tax strategies” that would benefit a larger number of middle-income families. That would not be very difficult and Mr. Flaherty seems to understand that.

Unfortunately for the Opposition Parties, Mr. Flaherty finally decided to read the briefing notes provided to him by the Finance Department. Too bad he didn’t read the briefing notes on cutting the GST by two points, which cost his fiscal framework $14 billion annually. Mr. Flaherty is apparently on record for saying that he dislikes debt, so you would think he would be furious now over a GST tax cut which cost him $160 billion cumulatively in lost revenues over the period 2007-2018. This is roughly equal to the increase in debt over the same period.

In retrospect, perhaps he should also have been more concerned about the tax change he introduced in 2006 to allow seniors to split pension income for tax purposes. This tax provision suffers from the same problems as the current income splitting proposal. Single seniors don’t benefit nor do seniors in the same tax bracket. The only seniors who benefit are high-income two senior families with one senior with no income or one senior with income in a lower tax bracket. And this goes for many of the other “boutique” tax credits that Mr. Flaherty has introduced since coming finance minister.

What probably got Mr. Flaherty’s attention this time, however, is the cost of introducing income splitting for families with children under eighteen. Research suggests that the annual cost could be as high as $3.0 billion per year.

Mr. Flaherty knows this is a lot of money, especially when he is forecasting very  “small” surpluses of $6.4 billion in 2015-16,  $8.1 billion in both 2016-17 and 2017-18, and  $10.3 in 2018-19.  On average this is only about 0.4 % of GDP. Moreover, the surpluses in the first two years are being propped up by the annual surplus in the EI Operating Account (something the Conservatives criticized the Liberals for).

To put the surplus outlook in perspective, the forecast surplus for 2018-19 is lower than the surplus of $14 billion the Conservative government inherited in 2006, despite all the restraint measures introduced by the government. Government debt is also now $160 billion higher, completely wiping out the decline in debt achieved under the Liberal government.

Most people have forgotten but the government’s first commitment for using any surplus was to reduce government debt by $3 billion annually. This commitment was made in the 2006 budget but was recently re-affirmed by Mr. Flaherty.  Income splitting, along with the other 2011 election commitments, would take up the rest of the projected surpluses.

If the government were to live up to these commitments there would be very little money left over for anything else in the run up to the 2015 election. Mr. Flaherty and some other Conservatives are waking up to the realization that although these commitments may appeal to their Conservative base, they don’t constitute much of an election platform. The real question is whether the Prime Minister feels the same way.

It is interesting to compare what Mr. Martin did with his first budget in February 1998, after eliminating the deficit. His entire 1998 budget was devoted to investments in education, research, infrastructure, as well as to reducing debt. In other words, the priority of the government at that time wasn’t tax cuts. The top priority was to take actions that would strengthen long-term economic growth and job creation. Tax cuts would have to wait until the 2000 budget. The total cost of the 1998 budget initiatives was $18.1 billion over the three-year period 1998-99 to 2000-01, after paying down $9 billion of debt. This was equivalent to about 2 per cent of GDP.

By comparison, Mr. Flaherty in his first budget in 2015-16 would be left with $13.6 billion (0.4 % of GDP) over three years, after reducing debt by $9 billion. Income splitting would take up $9 billion of this, leaving virtually nothing for anything else.  Unlike in 1998, the government is not planning to allocate any of the surpluses to strengthening economic growth.

The reality for all three political parties is that under the current fiscal structure, future surpluses will not be very large. There will also be no repeat of the growing surpluses of the 1990s and the first years of this Century. The strong global economy that the Liberals benefited from in the second half of the 1990s and the first part of this century will simply not be there. Over the next decade, global economic growth will be substantially less than 15 years ago. This means that any future budget surpluses will not only be small, they will also not increase significantly in size.

The most important question that must be addressed over the next 18 months is how to use the projected surplus to strengthen economic growth? Why should the first claim on surpluses be a reduction in taxes for high-income earners that will not in any way strengthen the growth potential of the economy? It would appear that strengthening economic growth and job creation are not high priorities for the Conservative government. Catering to the Conservative base appears to be the only thing that matters for the government. Its worked in the past maybe it will work again.

The Opposition parties, on the other hand, face a bigger challenge. They need to take a much broader view on managing the surpluses. The existing tax structure and tax system are simply not sustainable in a world of diminishing global growth and emerging policy challenges. They will need to think creatively and ask whether it is possible to make policy changes that would benefit middle-income families, reduce income inequality and strengthen economic growth and job creation.

We will address this fundamental question in coming articles

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