Earlier this week, Finance Minister Jim Flaherty wrapped up his cross-country pre-budget consultation trip in search of recommendations for the upcoming federal budget. Most interest groups, economists, and activists are calling for massive increases in government spending to 'stimulate' the economy much of it directed at their own pet projects or industrial sectors.

The unfortunate economic reality however is that 'stimulus' spending simply does not work. If the federal government is truly interesting in doing what is best for the economy (and Canadians), the solution is reduced government spending and permanent tax cuts.

For starters, a fiscal stimulus package will require increased government borrowing, meaning that the government will take money from some Canadians (who will have less to spend) in order to give others. The end result is more redistribution rather than more economic activity.

In addition, running a deficit today (to fund the stimulus package) implies higher taxes or lower spending sometime in the future. As a result, Canadians will likely save most of a stimulus induced windfall or use it to pay down outstanding debts in order to brace themselves for higher taxes or lower government spending in the future.

This would certainly apply to temporary tax relief measures. Recent evidence from the U.S. showed that temporary increases in income (from tax rebates) did little to stimulate consumption or the economy.

Other 'stimulus' options being considered would likely be worse.

Business subsidies, bailouts, or emergency loans to troubled sectors (auto, forestry, etc.) will only delay the day of reckoning for these industries. These initiatives transfer tax dollars and employment from healthy businesses to unhealthy ones.

While Canada's infrastructure is in dire need of improvement, increased infrastructure spending will have little stimulus effect on the economy. Infrastructure initiatives are rarely 'shovel ready.' It takes time to draw up project plans, get approvals, and coordinate among stakeholders. By the time the actual spending takes place, the economy may already be rebounding.

If past evidence is any indication, increased unemployment benefits will ultimately result in higher levels and longer spells of joblessness. The unfortunate reality is that higher benefits reduce the urgency and incentive for workers to look for employment in other industries and regions.

Rather than forging ahead with stimulus initiatives, the federal government should reduce government spending and focus on tax relief aimed at improving incentives to work, invest, and engage in entrepreneurial activities.

To that end, the government should first reduce wasteful spending. A recent study led by economists at the European Central Bank found approximately 25 per cent waste in Canadas public sector. Government should follow the lead of many Canadian households: its time to trim the fat.

With reductions in spending, permanent (not temporary) personal income and business tax reductions are possible. Specifically, this would allow the federal government to:

• Reduce middle and upper personal income tax rates: reducing personal income tax rates would be a good first step to a single-rate personal income tax which would dramatically improve the incentives to engage in productive economic activity.
• Eliminate the Capital Gains Tax: the capital gains tax is one of the most damaging taxes in Canada in that it encourages the owners of capital to hold on to their investments and has a detrimental impact on entrepreneurship by reducing the return that entrepreneurs, venture capitalists, and other investors receive from risk-taking, innovation, and effort.
• Accelerate and build on the reduction in the corporate income tax: over the next four years, the general corporate income tax rate should be reduced to 11 per cent, the preferential rate levied on small businesses. This will significantly improve the incentives for business investment and will eliminate the barrier, or disincentive, for small businesses to grow beyond $400,000 (the threshold for the preferential rate).
• Work with the provinces to harmonize provincial sales taxes with the GST: 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.

The federal government could partially offset the revenue losses from tax reductions by eliminating direct corporate welfare (bailouts, subsidies, loans) and tax rebates, reductions, exemptions, and credits that favour certain types of business investments over others. Canadian governments have spent more than $182 billion on corporate welfare alone over the past 12 years.

As Minister Flaherty indicated, "We are in extraordinary times" and that "calls for some extraordinary thinking." Let's hope that his government makes the tough choices needed.