During the election Justin Trudeau confronted the first elephant in the Liberal budget room. They accepted that running a deficit would not lead to a Liberal election defeat, but in fact would allow them to win the election. The Liberals embraced the recommendations of many economists, including ourselves, that with a sustainable fiscal situation, they could strengthen long-term economic growth by undertaking infrastructure spending financed by borrowing at historically low interest rates. These “efficient” infrastructure investments could actually pay for themselves.  The IMF, the G20, and the OECD all recommended deficit financed infrastructure spending.

None of these individuals, or institutions, however, recommended running deficits to finance higher non-infrastructure investment spending (i.e., government consumption), but this is what the government did in the 2016 budget. All deficits became acceptable to the new Liberal government, not just those resulting from infrastructure investment.  In fact most of the new spending in the budget has very little, or nothing at all, to do with promoting economic growth.

Indeed much of the new infrastructure spending (only $11.9 billion over five years) included in the budget is questionable in terms of its long run growth impacts. This is not a growth budget and the government admits this.  It was simply a budget that made good on some of the government’s more important political promises. We are told that the real economic growth agenda will be implemented in future budgets. Let’s hope so.

But how will these future growth initiatives be financed? Or, for that matter, how will the remaining election promises be funded, if at all? The government is already forecasting a deficit of about $29 billion in 2016-17 and 2017-18 falling to just under $15 billion in 2020-21. The budget projects a relatively stable debt/GDP ratio over the period of around 31 per cent. In other words, running larger deficits in future budgets to finance new spending is not an option since this would violate the government’s only remaining fiscal anchor.

There is some cushion in the budget, which the government might be tempted to use for new spending. The deficit projections include a $6 billion annual prudence reserve, which reflects the high level of risk and uncertainty in the global economy. Finance Minister Paul Martin first introduced contingency or prudence reserves in his 1994 budget. He made very clear that if they were not needed to protect his deficit targets against errors in the economic forecast they would go to reducing the debt. They could not be used to finance new spending programs or tax reductions. Mr. Morneau, however, has not imposed any constraints on the use of the prudence adjustment, which suggests he may be “padding” the deficit forecast to allow for the possibility of either a better deficit outcome or new spending or even both.

The government remains committed to eliminating the deficit, but realistically not until “sometime in the future”.  The government faces a much bigger policy problem than deficit elimination by some arbitrary date. The Prime Minister and the Minister of Finance can no longer avoid the fundamental political and policy question that has been lurking in the background for some time, and that is how to finance a Liberal policy agenda and a larger federal government.

Currently the government is trying to squeeze a Liberal policy agenda into the financial constraints imposed by the previous Conservative government. Mr. Harper must be quietly chuckling to himself as the government struggles with this impossibility. After all he set the trap for future governments when he cut two points off the GST, which “starved” the federal government of $15 billion annually. He was betting, perhaps correctly, that any future government would be afraid to restore the cuts to the GST.

And that is the tax elephant in the budget room, which the Liberals can no longer avoid.

Would Canadians accept restoring the two points to the GST in order to finance the programs and services they believe are important to Canada? We think they would. Canadians (especially seniors), are for the most part, “small c” fiscal conservatives. They don’t want the 1970s and 1980s all over again. They don’t want another 1995 budget (we certainly don’t). They don’t want unchecked deficit financing and they will punish any government that tries it. The question for the Prime Minister is whether he is prepared to call Mr. Harper’s bluff and reverse the worst tax policy change ever made?

Restoring the two points to the GST would raise about $15 billion annually. This could be used to finance existing and new programs and services (government consumption), reduce the deficit and/or possibly even allow a cut to income taxes. Certainly the government would be larger, but only by just over one-half of one per cent per cent of GDP.

Restoring 2 points to the GST would add only $2 to every $100 spent, or two cents to every dollar spent. Not bad when you consider the penny no longer exists.  The impact on lower income Canadians could be offset through increases in the GST rebate. Finally, rising the GST to pay for existing and future government consumption would create a structural surplus rather than a structural deficit that the government created in its first budget.

The Prime Minister has consistently said he wouldn’t rise the GST. Some political promises should be broken and this is one of them. This is a promise the Prime Minister should break for the good of his government and for future generations. The sooner the Prime Minister realizes that it is not possible to implement a progressive-growth oriented policy agenda within the severe financial constraints created by the Conservative government, the better off we will all be.

The Liberals will have to let the tax elephant out of their budget room sooner or later. Lets hope they do it sooner.