Earlier this week, federal Finance Minister Jim Flaherty floated the possibility of business and personal income tax relief giving Canadians a first glimpse into the government’s intentions for its 2007 budget. The move to reduce income and profit taxes should be welcome news to Canadians as our governments rely far too heavily on these economically damaging taxes. There is however a genuine opportunity for the federal government to move even more aggressively in changing Canada’s tax mix while addressing another critical issue: the fiscal imbalance. Achieving both next spring would result in perhaps the most important federal budget in recent times.

Start with the federal government’s commitment to address the fiscal imbalance. Last spring the government released a 125-page document, Restoring Fiscal Balance in Canada, to lay out their approach for improved fiscal relations. In that document they clearly acknowledged that K-12 education, health, municipalities, social assistance, and social services are exclusive areas of provincial jurisdiction.

If the federal government is serious about respecting provincial jurisdiction it should start by removing itself from these provincial areas of responsibility. More specifically, this would require the elimination of $31 billion in provincial cash transfers designated for health and social programs, namely the Canada Health Transfer (CHT) and Canada Social Transfer (CST).

The reduction in federal spending would need to be offset with an equivalent reduction in taxes. The litmus test for which taxes to cut should be based on the degree to which it improves Canada’s economy. Minister Flaherty’s own department has estimated the economic impact of different types of tax cuts and found that reducing personal income and capital based taxes yields the largest benefit to society. On the other hand, reductions in sales taxes like the GST were found to provide the smallest benefit.

These findings are compounded by the fact that Canada, when compared to other nations, is among the most reliant on the most economically-damaging taxes. Specifically, Canadian governments collect 46 per cent of their tax revenue in income and profit taxes compared to an average of 34 per cent among industrialized countries.

To make Canada’s tax system more competitive and prosperity friendly, the federal government should use the $31 billion saved on decreased spending to further reduce business income taxes, middle and upper personal income tax rates, and eliminate capital gains taxes.

Finally, to compensate for the loss of revenues from the elimination of the CHT and CST, the provinces would have to increase their own taxes. Using the same litmus test, the provinces should increase, or adopt, the least costly tax available, a GST-based provincial sales tax. The GST rates required to replace the revenues received from federal CHT and CST payments range from a low of 4.2 per cent in Alberta to high of 7.1 per cent in Newfoundland and Labrador. Canada’s most populous provinces, Ontario and Quebec, would require rates of 5.6 per cent and 6.4 per cent, respectively.

Eliminating the federal CHT and CST, coupled with reductions in federal taxes and increases in provincial GSTs would dramatically improve the functioning of the economy and Canada’s most cherished social programs.

For starters, clearer lines of accountability and responsibility for critical areas such as health, education, and social assistance would be re-established. In other words, when one level of government is responsible for raising revenues and providing programs, the confusion among Canadians about which government is responsible for the performance of these programs is eliminated. Without federal interference, the provinces would also be free to experiment in how best to provide services such as health care.

Perhaps even more important would be the dramatic improvement in Canada’s tax system and resulting economic performance. Reduced reliance on income and capital-based taxes would markedly improve the economic incentives for Canadians to work, save, invest, and act entrepreneurially.

While reductions in federal business and personal income taxes should be implemented regardless of any decentralization proposal, Canada has a unique opportunity to push the tax envelope further. Reducing federal transfers and taxes while increasing provincial taxes would solve two very significant issues in one federal budget.