The federal government is looking at a menu of cuts including a public service hiring freeze and delaying current and election platform spending plans to avoid falling into a deficit, sources familiar with finance options say.

Prime Minister Stephen Harper and Finance Minister Jim Flaherty have been dismissing any possibility of running a deficit for months, including during the federal election campaign.

But as the reality of the financial crisis and economic slowdown sinks in, Harper has become less categorical and on Friday for the first time explicitly did not rule out a deficit.

At a news conference with European leaders in Quebec City, the prime minister said he saw no reason to think Ottawa's books won't be in balance in the 2008-2009 fiscal year, which ends March 31.

But of future years, he added: "I don't think we're in a position to know all of the information in that regard and I think it would be premature to speculate in that regard.

"I'll say very clearly that the government of Canada will maintain responsible fiscal policies and the government of Canada will ensure that whatever we do is in the long-run interest of the Canadian economy."

Spending pressures increase as economy declines

With the Canadian economy expected to grow little this year and next, revenues from corporate and personal income taxes as well as the GST will grow very slowly or decline, while spending pressures on everything from defence and business subsidies to social transfers will expand.

Deficits and accumulated debt ballooned at the federal level during the 1981-82 recession, when the jobless rate hit 13 per cent, and the early 1990s recession, when unemployment rose above 10 per cent.

In Ontario, the impact of the 1991-92 recession devastated the finances of Ontario's NDP government, pushing the provincial deficit towards $17 billion and forcing the government to cut spending and reduce wages in the public sector.

One source with knowledge of both the Finance Department and Flaherty told the Canadian Press that a deficit would be the least palatable of the options the finance minister would consider.

"Deficit financing would be probably the dead last option. They would go to great lengths to prevent a federal deficit," the insider said.

Possible spending cuts would include delaying until the end of the mandate campaign promises such as the two-cent a litre diesel fuel tax reduction, which would save the government $600 million a year.

Others include accelerating the current spending review program by increasing the number of departments affected and looking for outright savings rather than re-allocation of funds. Ottawa could also look at all current programs that have escalating costs and delaying or slowing future increases.

Transfers to provinces could be at risk

Even transfers to provinces and individuals would not be ruled out, one source said, if the fiscal hole is deemed sufficiently deep.

Flaherty will lay out his projections for the economy and government revenues and spending when he tables his fall fiscal update at the end of November.

In his last budget in February, the minister projected a $2.3-billion surplus this fiscal year and a $1.3-billion surplus in 2009-2010.

Merrill Lynch economist David Wolf and TD Bank chief economist Don Drummond both analyzed the changed economic outlook and predict the federal government is headed for a $10-billion deficit in 2009-10. As well, both project deficits several years down the road, which would cause considerable political problems for the Harper government.

Under Drummond's analysis, Ontario becomes a have-not province and will collect equalization payments receiving $400 million next year and $1.3 billion in 2010.

While the $10-billion shortfall for Ottawa does not represent a sizeable portion of a $250-billion budget, Drummond points out about half the spending is on hard-to-touch programs such as Old Age Security, defence, or transfers to provinces for education, health care and social programs.

The best option, said Drummond, a former senior finance department official, is for Ottawa to accept some kind of deficit next year but slash spending in future years so that the problem is short-lived.

"You can't wipe out $10 billion coming up that quickly," he said. "But a one-year deficit is not such a bad thing. The thing that troubles me is that it goes on for four years and that's a bad thing because you don't want to go back to the situation we had in the '80s."

To bring the budget back in balance after 2009, Drummond said the government would need to limit program increases from the current projected four per cent to about two per cent.