How to Use the Fiscal Surplus

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When the conference How to Spend the Fiscal Dividend: What is the Optimal Size of Government? was planned in the summer of 1997, the Government of Canada was expected to present a balanced budget in the upcoming fiscal year 1998/99 and, if tax rates and spending programs remained unchanged, large annual surpluses in the following years. These expected surpluses have become known as the fiscal dividend because they are the return on the investment of fiscal restraint practised since 1993.

The government has only three ways in which it can use the fiscal dividend: increased spending, tax cuts, and debt reduction. The papers from the conference (Ottawa, December 3, 1997) published in this book consider the allocation of the expected fiscal dividend among these three competing uses. The well-being of future generations of Canadians depends greatly on the choices the government will make.

Canada's fiscal performance has been and in the future will strongly be influenced by automatic revenue growth due to the broadening of the tax base and higher taxes paid on a constant real income base. This latter phenomenon is very important. It is due to the bracket creep, which results in higher income-tax payments as inflation erodes the real value of personal exemptions and forces the payment of higher marginal income-tax rates.

Revenue growth due to bracket creep sends the wrong signals to politicians. Without having to face the wrath of the electorate over explicit tax hikes, they discover fiscal surpluses available for increased spending. If they use future surpluses for this purpose, the size of government in the economy will continue to grow. The recent period of fiscal restraint will have eliminated the deficit and lowered the ratio of debt to GDP. But the inefficiencies and reduced economic growth due to a larger government will end up being greater than they were before the fiscal crisis of the last decade.

These developments can be avoided only by lowering tax rates and paying down the debt. In addition, the indexing of personal exemptions and brackets in the personal income tax should be fully restored. If politicians in future governments want to court the favour of voters through higher spending, they should be forced to face these same voters with explicit tax increases to pay for the increases.

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