Rider fares already cover only a small part of the expense of transit, but the fare is a deterrent to using transit. We need reasonably frequent service, so we can't run less buses. We could run smaller buses - an idea that's been around so long that I can't think why we aren't doing it, unless the drivers' unions have prevented it.
If you argue that transit shouldn't be free, then why is it essentially free for university and college students? They pay a nominal fee folded into their tuition and can't opt out.
Currently, if you own a car and don't live too far from work, then driving to work is cheaper than buying a transit ticket. If you have to have a car anyway, the extra $2.50 a ride or $60 a month for a pass is just an extra expense. But if transit were free, then people who own cars would be more likely to take it anyway. Sure it takes a lot longer and it can be unpleasant when the weather is bad, but they might take it sometimes. And for two car families, the next time they need to replace a car they might realize that they can use transit instead.
It could be the case that if transit were free we'd exceed our capacity. But surely that's a good thing: that's what we want. Our streets could accommodate many, many times more buses than they now do. And in fact, at this point the buses that are busy are mostly carrying high school or post-secondary students, who use different routes (by and large) than commuters.
You might say that people would take trips they otherwise wouldn't, but I doubt that's much of a consideration. When I have a monthly transit pass (which I've had many times in other cities), I haven't gone hog wild tearing around town on transit.
The only other downside I can see is that it would be very expensive - but according to the Region of Waterloo in the recent LRT debates, we would actually save money by doing it. The region claims that when we spend a billion dollars on LRT, we will save more than a billion dollars because we won't need as much road expansion. If the region is telling the truth, then we will save a lot of money by making transit free.