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Finance Minister Bill Morneau has declined to say whether Ottawa will run deeper deficits than originally planned in light of the weakening revenue picture.

CHRIS WATTIE

The federal Liberal government is facing a multibillion-dollar cash shortfall as it prepares to deliver a Throne Speech Friday that will outline how it will turn campaign promises into government policy.

A new report to be released Thursday by the C.D. Howe Institute warns that the Liberals are significantly overestimating the amount of money the government will raise by hiking taxes on Canada's highest income earners.

That finding comes on the heels of a warning earlier this week from the Parliamentary Budget Officer that Liberal assumptions for economic growth are "optimistic," meaning the government is counting on billions in future revenue that may not materialize.

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The changing economic landscape raises questions as to whether the Liberals can afford to deliver on all of their election promises or whether the governmreent will need to run larger deficits than outlined in the election platform. Finance Minister Bill Morneau has not yet said how the government will respond to lower-than-expected federal revenues.

"It places the new Minister of Finance in a very difficult situation," said Alexandre Laurin, the C.D. Howe Institute's director of research and the author of Thursday's report. "It's tough to come into office and face potential deficits like this … The problem is when your actual tax reform creates even more deficits, that's when I think you're in a bad situation."

The Liberals have indicated that one of their first orders of business during a brief sitting of Parliament this month will be to pass a motion enacting promised income-tax changes so that they are in place as of Jan. 1. Billed as the middle-class tax cut, the government will reduce the tax rate on income between $44,701 and $89,401 to 20.5 per cent from 22 per cent. They will also introduce a new tax rate of 33 per cent on income earned above $200,000, representing the top 1 per cent of income.

The party estimated that these two measures would offset, meaning the tax hike would generate $3-billion in revenue and cover the $3-billion revenue cost of the tax cut.

Thursday's report estimates the tax cut will actually raise less than $1-billion and will also cost provincial governments an estimated $1.4-billion.

The arguments in the report are the latest contribution to an ongoing debate among economists over the "elasticity" of taxable income, a term aimed at measuring the degree to which high-income taxpayers will shift their behaviour to avoid paying higher taxes. This could include choosing to work less, using small-business arrangements to shift income or spreading out income over time in a way that reduces taxes.

The C.D. Howe report argues that these types of behavioural responses to the federal change will also impact the provinces because high-income individuals will find ways to reduce their annual taxable income.

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Another recent paper on the topic by economists Kevin Milligan and Michael Smart for the Institute for Research on Public Policy pointed out that the reverse is true, as well. That paper noted that since 2010, seven provinces have introduced new tax brackets and increased tax rates on upper incomes. The paper noted that behaviour responses to these tax hikes could have a negative impact on federal revenue.

That paper argued that individuals are more likely to shift income from province to province in a bid to avoid higher taxes than they are to shift income to another country.

Mr. Laurin counters that any shifting of taxes outside of Canada should be taken seriously given that it would hurt both levels of government.

An October paper by Dalhousie University economics professor Lars Osberg for the left-leaning Canadian Centre for Policy Alternatives concluded that there is "scant evidence" to support claims that high-income earners would emigrate to avoid higher taxes.

The Liberals have argued that concerns over revenue losses will be addressed by tighter tax enforcement and changes to small-business tax rules. The party also says its middle-class tax cut and deficit-financed infrastructure spending will boost economic growth and federal revenues.

After a Liberal caucus meeting, Mr. Morneau repeatedly declined to say whether Ottawa will run deeper deficits than originally planned in light of the weakening revenue picture.

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"As you can imagine, one of my next steps over the next few months is to work together with my colleagues and to listen to Canadians on building a budget, and that's what we will be doing," he said. "As we go through that process, you'll have a better understanding of the numbers, as we will."

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