The need for fiscal deficits appears to have been accepted, so public debate has now shifted to the best form of fiscal stimulus for Canada. Recently, the idea of a permanent income tax cut has emerged as a favourite in some quarters. Is it the best form of fiscal stimulus available? No.
Permanent tax cuts would mean a permanent loss in government revenues. Inevitably, spending cuts would be needed to rebalance the budget once the economy recovers. It is dangerous to assume that cuts to future expenditures can be easily accomplished. If anything, one would expect growing public pressure to spend even more on core programs that are highly valued by Canadians, such as health care. Here, the latest Conference Board forecast shows the provinces slipping into significant collective deficit in 2009, driven by falling revenues and the continuing rapid growth in health-care spending.
The most likely, and worrying, outcome of a permanent income tax cut would be a return to prolonged structural fiscal deficits. One need simply look at the U.S. experience with tax cuts under the Bush administration, and the resulting fiscal deficits when government could not rein in spending.
Next, let's recognize that almost any broad form of stimulus will create what economists call "leakages" from the Canadian economy - meaning the benefits are felt outside Canada. Canada is a highly open economy that is deeply integrated into North American production. International trade represents about 40 per cent of our GDP - unlike in the United States, where international trade accounts for just 13 per cent of GDP. This means that for every dollar of Canadian fiscal stimulus provided through a tax cut, about 40 cents will leak out of the Canadian economy through increased imports. (Leakage differs significantly by sector. Support for housing, for example, would have much lower leakage into imports than assistance to the auto sector.)
A broad-based income tax cut could also add 5 to 10 cents (conservatively estimated) of "leakage" into savings, particularly for higher income earners. In contrast, lower income Canadians are more likely to consume most, if not all, of any tax cut - which is why the government should target its fiscal stimulus toward lower income earners and their families, such as through an increase in the working income benefit and/or the child tax benefit.
The political appeal of fiscal stimulus through tax cuts is apparent. First, they are popular and an easy sell. Second, the stimulus can be delivered quickly and administered through the existing tax system - for example, income tax rebate cheques could be sent out from the Canada Revenue Agency with little addition to the government's machinery for tax administration.
However, one dollar's worth of tax cuts will provide less than 60 cents worth of stimulus - clearly not the best value for money.
And what about temporary versus permanent tax reductions? Stimulus is needed now, when the economy is in recession, not over many years, so a temporary tax cut would seem to be a better tool. True, a temporary tax cut is more likely to be saved if offered on a one-time basis, as we saw under the Bush tax cut last spring, when Americans spent only a fraction of the tax rebate and saved the rest. But leakage into savings from a temporary tax cut could be reduced by giving recipients a series of income tax rebate cheques over a few quarters, rather than a one-shot rebate. A GST cut would also stimulate spending, but good luck to any government that tries to repeal a "temporary" cut to the GST.
Clearly, permanent tax cuts to stimulate the economy are not a panacea, and may end up creating the conditions for a return to structural fiscal deficits. Instead, the federal government should consider other options for providing fiscal stimulus, specifically through initiatives targeted toward the individuals and sectors most in need, as well as shovel-ready infrastructure.
Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada.