By Promit Mukherjee
OTTAWA (Reuters) -Canada's Prime Minister Mark Carney will unleash a major fiscal stimulus in his budget proposal on Tuesday as he aims to unlock billions of dollars in investment and transform the Canadian economy to rely less on the United States, its top trading partner.
Carney has promised "generational investments" in his government's maiden budget to pay for defense and housing and to grow an ailing economy battered by U.S. President Donald Trump's tariffs and trade uncertainty.
However, he has also warned of tough times ahead.
"To be clear, we won't transform our economy easily or in a few months — it will take some sacrifices and some time," Carney said last month during a speech to university students.
Economists expect Canada's highest deficit outside the COVID-19 pandemic, and they want the government to have a clear path to reduce it in coming years.
Pedro Antunes, chief economist of Conference Board of Canada, worries increased deficits mean higher interest payments or public debt charges that could be unsustainable for Canada.
Canada's public debt charges increased 125% last year from just before the pandemic and they are expected to go up even further as deficits rise.
"To be sustainable, we should have declining interest payments as a share of revenues. That's the target we should be looking at," he said.
Most economists are expecting Canada's Finance Minister François-Philippe Champagne to propose a deficit of C$70 billion ($49.91 billion) to C$90 billion for the year ending in March 2026.
The budget, which Champagne will present to Parliament at 4 p.m. EST (2100 GMT), is a major test for Carney's minority government.
Budget votes have triggered elections in Canada before and the Liberals' fate likely hinges on the small left-leaning New Democratic Party, which has just seven legislators, lacks a leader and is short of money. If the party abstains, Carney will survive.
Canada last reported a deficit, of C$62 billion for 2023-24, a 77% jump from the previous year, helping to trigger former Finance Minister Chrystia Freeland's resignation a year ago.
SPENDING PRESSURES
Facing major spending pressures and foregone revenues, the government will have to comb through each of its expenses to find savings, said Robert Asselin, an economist and senior fellow at University of Toronto's Munk School of Global Affairs & Public Policy.
Carney has promised to increase defense spending to 2% of Gross Domestic Product by the end of the fiscal year and to 3.5% of GDP on defense spending and 1.5% on defense-related expenditures by 2035.
This would mean C$150 billion of annual investments and could be as much as double the previously planned allocation for defense spending by the federal government, said Randall Bartlett, deputy chief economist at Desjardins.
However, there are few sources of new revenue. To appease Trump, Carney withdrew most retaliatory tariffs on the U.S. which were expected to bring in C$20 billion this year. He also scrapped the Digital Services Tax in June to pacify Trump.
Carney has also lost revenues due to tax breaks, housing incentives, and relief measures for tariff-hit industries.
"We need rigorous line-by-line program review as you cannot have half a trillion dollars in program expenses," Asselin said.
Champagne has asked ministries to find planned savings of 7.5% in the next fiscal year, rising to 15% by fiscal 2028. Government sources said the budget will have details on how to achieve this.
The budget will allocate billions of dollars for housing and major infrastructure projects across the country, which the government says will have a multiplier effect on the economy.
The federal budget will also present Carney's long-awaited climate strategy.
The government, for the first time, will also distinguish between operational spending and capital spending, lay out a plan to balance the operating deficit in three years and forecast a declining debt to GDP ratio over the budget horizon.
"We will be ambitious with our investments and rigorous with our expenses ... you will see historic investments in housing, in infrastructure, and certainly in the area of defense," Champagne told reporters on Monday, calling the budget a necessary pivot.
($1 = 1.4024 Canadian dollars)
(Reporting by Promit Mukherjee; Editing by Caroline Stauffer and Richard Chang)
