If recent comments by Finance Minister Jim Flaherty are any indication, Canadians should expect a status-quo federal budget next week. While raising concerns about the potential impact of the US slowdown on the Canadian economy Flaherty stated, “The budget will not contain any significant new spending or tax measures.” As is often the case, it seems heightened economic uncertainty is being used as an excuse not to cut taxes. However, if the federal government is worried about the health of the economy, incentive-improving tax relief should be the key priority.

The general impression one gets from listening to Minister Flaherty is that the heavy lifting on tax relief was accomplished last October. Admittedly, the government did enact some important tax relief to improve economic incentives, i.e. the reduction in corporate income tax rates to 15 percent over the next four years. However, significantly more needs to be done to improve the incentives for Canadians to work, save, invest and be entrepreneurial.

The key to improving incentives for productive behaviour is reducing marginal tax rates. That is, the government must reduce the tax rate people and businesses face on the last dollar of income earned.

Of particular concern are Canada’s high marginal personal income tax rates on middle and upper income Canadians that apply at relatively low levels of income. For instance, Canada maintains among the highest marginal personal income tax rates on middle and upper income earners among the G7 countries. In addition, Canada’s combined federal and provincial marginal personal income tax rates are materially higher than our closest competitor and neighbour the United States. Specifically, Canada’s top marginal personal income tax rate on income over $75,000 is 43 percent compared to 31 percent in the United States, and 46 percent compared to 34 percent for income over $150,000.

Indeed the federal government already noted as much in its economic plan when it prioritized reducing the personal income tax burden on highly skilled, talented and creative people as part of its agenda to foster innovation and economic growth. To ensure future economic success, the 2008 budget must reduce personal income tax rates on middle and upper income Canadians and increase the level of income at which the rates apply.

The budget should also build on the corporate income tax cuts implemented in October. That is, the government should further reduce the corporate income tax rate from 15% to 11% by 2012. Doing so would eliminate the difference between the small business tax rate (11% in 2008) and the general corporate income tax rate. As a number of studies have shown, the enormous increase in the tax rate faced by businesses as they grow and become more successful results in a significant barrier to growth.

Additionally, the federal government should use part of the expected surplus for 2007-08 (now an estimated $11.6 billion after the tax cuts implemented in October) to finance a transitional fund to facilitate the harmonization of provincial sales taxes with the GST in British Columbia, Saskatchewan, Manitoba, Ontario and Prince Edward Island. Harmonization with the GST would exempt business inputs from provincial sales taxes and improve the incentives for business to invest in productivity enhancing machinery and equipment.

While some will be wary of another round of large-scale tax relief, the federal government can create the fiscal room needed to further reduce taxes. First, by improving incentives and making Canada more attractive to investment, the federal government will yield greater revenues since the economy will grow at a faster rate.

Second, the federal government must slow the rate of growth in spending. Since 2005/06, the federal government has increased program spending by $23 billion or over 13 percent. Going forward, it plans to increase program spending by an average of 4.1 percent through 2012/13. Slowing the rate of growth in spending to that needed to compensate for inflation and population growth – the spending goal of the Conservative Party proposed during the election – would provide an additional $50 billion for tax relief over the next five years.

Finally, the government’s own figures show a cumulative five-year surplus of $39.2 billion (2008-09 to 2012-13) after implementing the tax cuts announced in the Economic Statement.

Despite heightened economic uncertainty, the federal government can and should implement additional tax relief aimed at improving competitiveness and economic incentives. Doing so will ensure that Canadians will continue to benefit from a strong economy.