Conservative enough? After angering core supporters by taxing income trusts, the Tories must now prove themselves investor-friendly.

IF there's something Paul Pagnuelo does not want in this spring's federal budget, it's more government programs. "The only program I want is the one that lets me spend my money the way I deem to be the best," says the 59-year-old banker from Pontypool, Ont., an hour and a half east of Toronto. The Conservatives could make his dreams come true by instituting a flat tax, but, realistically, he doesn't see that happening in his lifetime. "After almost four decades of Trudeau-style Liberal socialism, Canadians just aren't ready for it. It would be too tough to convince them that a single tax rate is the most equitable," Pagnuelo says.

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The spring budget, which federal Finance Minister Jim Flaherty promises to table before May, will probably trigger a non-confidence motion, bringing down the Conservative minority and sending Canadians to the polls for the third time in as many years. So it's a good bet Flaherty's budget will be as much a campaign platform as it is a national roadmap. If a middle-class conservative voter like Pagnuelo doesn't think the Conservatives can grant him his big wish--a flat tax--could they do anything else to please him?

Based on his experience as a married man with two children, now grown, Pagnuelo would like to see income splitting for married couples on their tax forms. "When I think back on what we went through, with the wife wanting to stay home to raise the kids, it was tough sometimes. [Income splitting] would be the best thing for the next generation," he says. And for himself? He'd like to see the capital gains tax removed. "I have a few investments I'd like to sell, and a few others I'd like to buy. But I'm not going to do that if I take a tax hit when I move my money around," he says.

Some kind of tax relief must be in the offing. Prime Minister Stephen Harper made that clear when he announced his cabinet shuffle in early January. But how much and what kind of relief is publicly still guesswork. The Conservatives clearly have to find some way to appease middle-class investors, after they reneged last fall on their election promise not to tax income trusts. How much damage that turnaround did to their credibility is uncertain, but it didn't help them. A Jan. 4 Decima poll put the Tories nationally at 34 per cent, the Liberals at 31. And they have yet to deliver on another election promise--Pagnuelo's wish--to eliminate the capital gains tax when the profits are reinvested.

In his November financial update, however, Finance Minister Flaherty put more emphasis on debt reduction than on tax cuts. The Conservatives intend to allocate $3 billion a year until at least 2021 to pay down the federal government's net debt of $481.5 billion. According to Flaherty, tax relief will be based on the savings from interest payments--currently $33.8 billion a year--servicing that debt.

John Williamson, federal director of the Canadian Taxpayers Federation, doesn't like that. "My concern is ... making future tax relief contingent on debt repayment, which means there might not be substantial broad-based tax relief in the upcoming budget. It means these federal surpluses will continue to flow to Ottawa," Williamson says. It's what happens to those surpluses that worries Williamson. Flaherty had promised that increases in program spending would stay below the economic growth rate (Flaherty used the nominal growth rate of 5 per cent; most economists use the lower real GDP growth rate, now at 2.8 per cent). But Williamson calculates that program spending was up 7.1 per cent last year. So Flaherty's already popped his own cap on spending increases. "And what's worse, 7.1 per cent midway through the year is only a short stone's throw to the 8 per cent average annual growth we saw under the Liberals, which the Conservatives in opposition said was 'out-of-control spending.' With higher spending, the Conservative government puts further tax relief at risk. I've said from day one that if this Conservative government cannot control their spending, we'll never see meaningful tax relief," says Williamson.

And meaningful tax relief is necessary for this country, says the C.D. Howe Institute's 2005 Tax Competitiveness Report. Canada and its aging population are going head-to-head in the global marketplace with emerging Asian countries such as China, with substantially lower labour costs. "Given the competitive and demographic challenges facing Canada, tax reform is increasingly urgent," the report states. There is evidence we're losing ground. Last year, China surpassed Canada as the top country for exports to the United States. The C.D. Howe report found that while Canada was in the middle of the pack of industrialized countries, when it came to tax revenues as a portion of gross domestic product, "in Canada, governments raise more [tax] revenues than in its most important trading partners--the U.S., the U.K. and Asia."

Yet cutting taxes is tricky business in an election year. That's because most economists believe the tax cuts best for the national economy are those that benefit those perceived to be wealthy--not necessarily the largest self-identified demographic in democratic Canada. The Liberals and NDP, jockeying for elbow room on the envious left, will howl loud and long, oblivious to economic sense, if the Tories gave any break to those already economically ahead.

According to Chris Edwards, tax policy studies director at the Cato Institute in Washington, D.C., there are good reasons for giving tax breaks to middle- and upper-income earners. These people are investors, so by cutting their business taxes, you reward increased investment, rather than consumption, and exponentially fuel increased productivity. Further, "those people have the biggest behavioural changes to tax rates. You lower the rates at the top end, you get a lot less tax avoidance and tax cheating. So the government will suddenly find [itself] with much larger reported incomes, and the tax base expanding, by cutting the highest rate," Edwards says. Thus, the 1980s' "Reaganomics" tax cuts paradoxically saw American tax revenues soar, due to increased productivity.

The other beneficial tax cuts are those on capital--corporate, dividend, interest and capital gains taxes. Edwards says these are more important for the economy than cutting taxes on labour. "Those [monetary] items are much more mobile in the global economy. If you tax Canadian corporations too high they simply shift their profits and investments to the United States or Britain or Mexico or elsewhere. If you impose higher taxes on Canadian labour, some ... will move to the United States, but the effect won't be nearly as big as the effect of taxes on capital," Edwards says.

University of Calgary economics professor Robert Mansell doesn't expect any radical changes in the upcoming budget, though he concedes some form of capital gains tax cut might be in the works. "Obviously, the private sector is the key driver of wealth creation. Without wealth creation, there is not a lot you can do in terms of expanding public services, so obviously that is something that, regardless of the stripe of government, they will have to look at. It has to be healthy," he says.

Given the government's leadership, Mansell believes the federal Conservatives will pay particular attention to middle-class issues. "We've seen enough signs that they're not interested in funding special groups that make a lot of noise. They're going to drive up the middle," Mansell says. So if there is any new government program, it will probably be in the environment, which one polling firm has reported is now the number one ballot box issue in Canada. Yet even there, Mansell thinks the Conservatives will look to harness the power of the marketplace, rather than rely on taxpayer-funded government programs.

Mansell predicts a "big picture" budget. "Rather than these little programs that deal with little bushfires, I would look for a fairly strong statement in terms of long-term direction. What switches do we have to make, in terms of the road we're on, to get us where we need to be in 10 or 15 years? I think that's the kind of shift in direction that we'd be looking for, more so than quick fixes, pots of money and big new programs," Mansell says.

That sounds conservative, in the sense that it's not "too much change too fast." But conservatives--the people--still want lower taxes, less government spending and less bureaucratic meddling in their day-to-day lives. And the cohort of once core Conservative supporters who took a hit on income trust will want restitution. Going into an election, political parties have to motivate their base, and big picture stuff might not do it. Decent tax cuts probably would.