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With great fanfare, Jim Flaherty, the Minister of Finance, presented his economic update on Thursday, to give Canadians a good look at the federal books. It was a surprise to many that the federal budget is predicted to be slimly balanced in the next four years, once the government's few new fiscal measures are taken into account. Only one conclusion can be drawn from all this. The government does not want to be stampeded into providing a large fiscal stimulus. That will now wait until a winter budget is presented.

The opposition parties are howling, arguing that the economy is in much worse shape, immediately requiring a major fiscal-stimulus package. The real reason for their consternation is that the opposition could be kneecapped by the Conservative proposal to eliminate federal taxpayers' subsidies to political parties by April 1. It does not make sense that taxpayers' dollars are used to finance political parties, especially the Bloc Québécois, which pushes for Quebec's separation from Canada, but that issue should be dealt with at another time. If both sides smartly back down, they will allow Canadians to get back to focusing on the global economic crisis and its impact on Canada.

Because Canada is threatened by a major downturn — potentially more than a technical recession — we should be debating about the size and the type of fiscal stimulus that is needed to make the economy grow. Mr. Flaherty acknowledges that the financial crisis could be much deeper than he expects. The freezing up of credit markets in October has only partly unthawed recently. Some businesses have already seen falling demand for their products and, with tight credit, have had to suspend their investment plans and lay off workers. Not all is bleak; employment numbers and pre-Christmas retail sales are holding up so far, but most business leaders are expecting things to take a turn for the worse.

Though the government's forecast is for a relatively mild, 2001-type recession with two quarters of negative growth in 2009, the probability that the recession will be far deeper is high. And as the economy slows down, "automatic stabilizers" will kick in. Falling corporate profits mean less tax revenue. In the 1990-91 recession, federal corporate tax revenues declined by 25 per cent in two years, which would mean roughly a $10-billion hit to federal coffers in today's terms. Those who lose jobs or must accept pay cuts will pay less personal income and sales taxes. Any uptick in unemployment also means more spending on Employment Insurance and other social benefits.

The government understands it would be facing a deficit if it did nothing it at all. It hopes that some additional infrastructure spending, planned personal and corporate income-tax reductions, and restraint on spending (such as holding the line on civil-service salaries) will be enough to avoid a deficit. It is clearly waiting to announce both a deficit and a fiscal-stimulus package in the upcoming budget. That package could look quite large, once the effects of automatic stabilizers are taken into account.

The government is quite right to take a little time to frame a fiscal plan, given that the economy is so far chugging along better than expected, despite the storm clouds. Unlike in the United States, interest-rate cuts could have a good effect on the economy, without ramping up a deficit. We are also witnessing a massive monetary and fiscal stimulus package taking shape throughout the world, which will do a lot more to solve the global financial crisis than anything that Canada can do by itself. Waiting to see how all this pans out in the next two months makes a lot of sense. Besides, as Bob Rae found out when he was the premier of Ontario, it is not easy for governments to spend themselves out of a recession. Instead, they could create a massive deficit, which would become an albatross for the future.

In the next two months, the federal government will need to plan a smart fiscal package, in the wake of quickly changing events. The design principles for this stimulus package should become the main focus for political debate in Canada.

THREE STIMULUS PRINCIPLES

The first principle is to create confidence in financial markets. With the subprime debacle in the United States, lenders have lost trust in the assets that are being offered to them. Markets need to re-establish plausible signals about asset values, so people will once again be willing to trade them. To bring back confidence, however, governments must carefully design their policies. Certainly, supporting inefficiently operated businesses will keep many poor-quality assets in the market, making it harder for strong businesses to borrow from financial institutions.

Governments should instead put in place regulations and fiscal policies that make it harder for badly run companies to compete with better-run ones. In this light, bailouts to support weak companies should be avoided. Instead, governments should help finance the restructuring of viable businesses that are in bankruptcy protection. And fiscal programs designed to help workers retrain are more effective than keeping inefficient businesses operating.

The second principle is that any required fiscal stimulus should be immediate in its impact. Although infrastructure spending may be useful in the long run for growth, it is only helpful in the short term if the plans are ready to proceed, including the regulatory approvals. Otherwise, the projects may be executed two or three years later, when the economy is well on the way to recovery.

On the other hand, tax cuts are much more effective in putting money in the hands of Canadians to be spent. The cuts, however, should not be temporary. As the U.S. discovered last spring, the temporary tax rebates paid to Americans had little effect on consumption, because there was no increase in their continuing income levels. Instead, they reduced their debt or put money into savings accounts. This is not bad for future economic growth, but it does not provide an immediate stimulus to aggregate demand.

Similarly, a temporary GST rate cut would have little impact, except in shifting the purchase of consumer durables from the future into the current period, assuming people can afford them. A permanent tax cut and an increase in the refundable child tax benefit would be better fiscal stimulus than infrastructure spending.

The third principle is that fiscal stimulus policies that help in the short term are best when they also generate long-term growth. For this reason, it is far better to cut income taxes rather than the GST rate. Income taxes impose a greater cost on the Canadian economy, by discouraging people from working and investing. By discouraging capital investments, businesses will not adopt the latest technologies that improve the productivity of workers. For these reasons, most industrialized countries have been shifting away from taxing savings and investments.

The Conservatives have the right planned policies in this regard: the tax-free savings account and corporate tax cuts. They should contemplate Obama-style income-tax cuts for lower- and middle-income earners, rather than make another GST cut.

FISCAL DISCIPLINE

One permanent tax cut that would help seniors and those who have lost wealth in the stock market would be to make the dividend tax credit refundable. That would benefit lower-income Canadians and owners of tax-sheltered savings plans. This policy would also help improve the funding of pension plans, reducing the pressure on employers and employees to cover unfunded liabilities.

Finally, as part of the overall fiscal plan, the government should show how it will maintain fiscal discipline. After all, there is a price to be paid once a deficit is incurred. Governments face a large bill to pay it back in later years, both principal and interest, making it harder to cover program costs such as those for health care and education. If deficits are incurred over a long period, the next working generation could be faced with a large tax burden to fund various debt, pension and health liabilities built up over the years, doing little for our future competitiveness.

Thus, fiscal discipline around deficits is needed. Once the rule against running a deficit is broken, it is difficult to constrain demands for spending and tax reductions. One way to enforce that discipline is to require deficits to be repaid within, say, four years, including the resulting interest expense. In effect, the government would create a mandatory reserve, which would be added to government spending before the surplus is defined for that year. If deficits are incurred in other years, the mandatory reserve would be increased to cover the indebtedness. This approach would assure Canadians that the federal government is serious in maintaining its debt-to-GDP fiscal target.

All these issues require the government to put forth a comprehensive fiscal plan to deal with a significant economic recession. The winter budget is the right time to do it. We should get on with developing plans for it.