IN CANADA: TWO PROPOSALS FOR REFORM
Prepared by Marion G.
RE-ALIGNMENT OF TAXING POWERS
The Potential Advantages
B. Some Potential
FEDERAL BAILOUT OF THE PROVINCES
The Potential (Dis)Advantages
The Impact on Aggregate Deficits
IN CANADA: TWO PROPOSALS FOR REFORM
The last round of constitutional
discussions led Canadians once again to reconsider the appropriate roles
for each of their various levels of government. While the discussion was
dominated at that time by the re-allocation of spending and regulatory
powers, the appropriate distribution of taxing powers would follow logically
from any rearrangement of responsibilities.
The division of such powers
in Canada has not been static over time, despite the fact that constitutional
change has been hard to come by. As economic and political circumstances
have changed, and as citizens have increased their demands for publicly
provided goods and services, the relative size of the provincial and federal
governments has altered. Since World War II, when the federal government
received about 80% of all government own-source revenues for example,
the relative position of that government has declined, so that it now
receives less than one-half of all own-source revenues.
Changing economic and fiscal
circumstances are today causing some to call for revised federal-provincial
economic roles. Current and past fiscal decisions by governments have
created problems that require some fiscal realignment. Similarly, present
trends indicate that existing arrangements might not be optimal, or even
This paper is concerned
with two recent proposals for restructuring federal-provincial economic
roles, each of which is driven by purely economic considerations. Neither
proposal would make major changes to the current distribution of spending
powers. One would involve simply a re-alignment of taxing powers, while
the other would be based upon a large-scale federal loan to the provinces
coupled with constraints on transfer reductions and provincial deficit
financing. Both of these proposals can be seen as responses to an impending
vertical imbalance in the resources available to these two levels of government.
One way of defining structural
imbalance for any level of government is to determine whether the future
growth of revenues and expenditures in the existing system (i.e., one
with no change in policy) tends towards fiscal balance, growing deficits
or growing surpluses. Determining vertical imbalance requires us to look
at the structural balance of two different levels of government. If there
exists a structural imbalance at the federal level moving in one direction
and a structural imbalance at the provincial level moving in the opposite
direction, a vertical imbalance exists. Put simply, the term implies an
inappropriate allocation of taxing powers in the face of existing spending
Such an imbalance is thought
to exist in Canada because the provinces are responsible for people-oriented
programs (health, education, social services, etc.) with high inherent
growth rates, yet they rely for funding upon a set of taxes that cannot
grow adequately to fund expenses. The federal government, on the other
hand, has at its disposal a set of taxes expected to generate revenues
that will grow faster than program spending requirements. These are the
conclusions of a series of studies by Ruggeri et al.(1)
which offer a solution to what the authors view as vertical imbalance
in the fiscal structure of Canada.
Such a misallocation of
taxing powers can produce a host of negative consequences. Provincial
governments faced with growing deficits will have to cut back on necessary
programs or raise taxes. The federal government, on the other hand, might
be prompted to search for new spending programs in view of its strong
and un-needed revenue growth. This could increase the aggregate size of
the overall government sector at the same time as it reduced to sub-optimal
levels the size of the provincial government sector. The authors see a
problem in the fact that this fiscal imbalance, rather than political
and economic considerations, might be the driving force behind future
Michael Mendelson, a senior
bureaucrat in the Ontario government, has also concluded that a structural
imbalance exists at the provincial and federal levels, with the imbalance
more pronounced at the provincial level. In an October 1993 paper,(2)
Mendelson predicted that both the federal and provincial governments will
experience stronger pressures to cut program spending on account of debt
servicing costs, which will continue to grow, despite strict controls
on real program spending. Mendelson is predicting very slow revenue growth
(three-quarters the growth of income) in the future. This is in sharp
contrast to the estimates of Ruggeri et al., who see total revenues
growing faster than output in the future, largely on account of the fecundity
of the personal income tax.
The debt servicing situation
varies enormously by province. It is predicted that interest costs will
consume a growing proportion of the revenue of the Ontario and Nova Scotia
governments but will fall in other provinces. This problem is, however,
greatest for the federal government.
RE-ALIGNMENT OF TAXING POWERS
The tax re-alignment proposals
of Ruggeri et al. call for the federal government to take exclusive
control of sales taxes as well as corporate income and capital taxes.
(Currently the provinces are involved in both and are in fact dominant
in the sales tax domain.) The provinces, on the other hand, would take
exclusive control over the personal income tax field, which both jurisdictions
currently inhabit, although the federal government has clear dominance.
The personal income tax
is so lucrative that such reform would shift more financial resources
to the provincial sector in aggregate than are needed to meet program
spending demands. Consequently it is proposed that the provinces would
return to the federal government about 5% of their personal income tax
Such a re-alignment would
still leave the federal government with sufficient resources to finance
its own spending programs. The authors believe it would stabilize the
ratios of deficit and debt to GDP for both levels of government and would
lead to the end of Canada Assistance Plan and Established Programs Financing
transfers to provinces from the federal government. The equalization program
could also be set up so that the "have" provinces would transfer
moneys directly to the "have not" provinces.
The Potential Advantages
This proposal would generate
more tax and fiscal stability and eliminate vertical fiscal imbalance.
The provinces, the jurisdictional level with the greatest demands for
growth in program spending, would be given the revenue tools to finance
By giving the federal government
exclusive jurisdiction for corporate income and capital taxes, provincial
tax competition in this area would be eliminated. The corporate tax would
be harmonized and simplified, enhancing economic efficiency. Capital is
the most mobile factor of production and a single tax would lead to a
geographic distribution of capital and production based solely on economic
factors, not tax rules.
Similarly, a single sales
tax would reduce compliance and administration costs and enable federal
collection of the tax at the border. All of these items have become controversial
since the introduction of the GST on top of the nine existing provincial
retail sales taxes.
Finally, these proposals
would improve the accountability aspect of taxation. By thus eliminating
overlap and duplication, Canadians would become more aware of where tax
increases originated. If sales tax rates were increased, we would know
that this was a federal decision. If personal income taxes were increased,
we could blame the relevant provincial government. With the end of federal-provincial
transfers, we would be less likely to hear one level of government blaming
another level for the fact that it needs to raise taxes.
Each level of government
would impose taxes to finance its own program spending. Citizens and voters
would have a clearer view of the fiscal consequences of any demand for
new program spending.
Some Potential Problems
These proposals are not
without problems. The federal government's complete departure from the
personal income tax field, by far the most important tax area in Canada,
might lead to a disintegration of the highly harmonized personal income
tax system that now exists. This would increase compliance and administration
costs and lead to some additional resource misallocation. Although individuals
are not as mobile as capital, there are real economic benefits to harmonization
which might be lost. Some tax-driven mobility does exist already and could
be enhanced under this proposal.
With the exception of the
proposal for the corporate income tax, the other proposals go against
the current public finance wisdom.(3)
For example, it is commonly argued that sales taxes are suited to provincial
governments because they attempt to tax consumption and result in few
cross border movements. (This is notwithstanding what many people believe
to be the effects of the GST.) The fewer the mobility effects of a tax,
it is said, the lower the level of government that should use it. Yet
this proposal would give the federal government exclusive jurisdiction
over this domain.
The personal income tax
is the workhorse of the tax system and is the tax most suited to achieving
distributive goals. Since we generally view such goals on a national rather
than strictly provincial basis, a strong federal presence is normally
held to be desirable. Moreover, federal transfers to persons are increasingly
being structured like negative taxes. Conflict and inconsistency in program
design might arise if the federal government were to abandon the personal
income tax field yet maintain responsibility for most transfers to persons.
There is also a more fundamental
issue. The existing vertical imbalance is in many respects deliberate
and in some ways desirable. It allows the federal government to make transfers
to the provinces. These fiscal transfers are used to promote equity and
efficiency; they deter some fiscally driven mobility of resources and
allow provinces to fund programs that benefit Canadians in other provinces,
and could be used to promote the integrity of the internal common market.
If no fiscal gap existed, "there would exist NFB [net fiscal benefit]
differentials from provincial budgetary activities, and these could be
quite large. The differentials would lead to a violation of horizontal
equity across the federation so-called fiscal inequity and,
to the extent that labour was mobile, to an inefficient allocation of
labour as well."(4)
It is unlikely, in the absence of federal participation, that the provincial
governments could produce an equalization system that would sufficiently
close this gap in NFBs.
FEDERAL BAILOUT OF THE PROVINCES
Mendelson proposes a three-part
package of fiscal reforms. In the first place, the federal government
would assume a very large part of the existing provincial government debt,
anywhere from $100,000 million to $200,000 million. This would be achieved
by lending to each province an equal per capita amount over a very long
period of time at zero interest. This would be equivalent to annual transfers
to the provinces for the purposes of paying much, if not all, of their
debt servicing costs. In effect, however, it would be a full or partial
bailout of provincial government debt. Such a loan would carry the proviso
that it must be repaid in full should a province leave Confederation.
The second part of the plan
is for a constitutional requirement for provinces to balance their budgets
within a short period of time and for future budgets to be balanced on
an annual basis. Mendelson does not specify whether this balance would
apply to the total or current budget, or some other subset, or how quickly
budget balance should be achieved. The third component would be a constitutional
amendment to limit severely, if not completely, the ability of the federal
government to change transfer payment formulas unilaterally.
The Potential (Dis)Advantages
As a result of their current
fiscal problems, the provincial governments currently face enormous difficulties
in meeting their spending obligations. Debt servicing costs are consuming
ever-increasing amounts of their revenues. Revenue growth has been curtailed
by the past recession while demographic and economic demands are putting
upward pressure on expenditures. Provincial governments would find it
much easier to meet their program demands if they were not burdened by
high debt servicing costs. This is, of course, true also of the federal
The Mendelson plan would
not remove the burden of debt; it would merely transfer that burden from
one level of government to another. There is a financial advantage to
such a transfer, since the federal government enjoys lower borrowing costs
than the provincial governments. Thus, through the transfer, the total
national resources devoted to interest payments could be reduced and a
greater portion of tax revenues could be spent on programs.
Mendelson is also concerned
with the instability of provincial fiscal capacity. Migration between
provinces is common and easy. Large-scale out-migration can erode a province's
tax base and greatly exacerbate its debt problems. Two potential candidates
for such concerns are Newfoundland and Saskatchewan. Emigration is far
less of a problem at the national level, which explains why provincial
governments have higher debt servicing costs.
By removing high debt servicing
costs from the provincial budgets Mendelson thinks such inefficient migration
would diminish. This is not completely true. The various provinces would
still have differential fiscal capacities. Some would have lower tax rates.
Some would have higher benefits. These factors could still encourage fiscally
based migration. Furthermore, concern about migrating to avoid one's share
of the debt is based on an assumption that the province offers no long-lasting
benefits resulting from the policies that created the debt in the first
place. Thus deficit spending must have been used for current consumption
or to finance private capital accumulation. In these circumstances tendencies
towards migration might in fact be a reflection of bad fiscal policies
on the part of the respective governments.
Provincial governments rely
upon external financing much more than the federal government. Provincial
governments pay interest to foreigners, whereas the federal government
pays interest to Canadians, who subsequently pay taxes in this country
at the federal and provincial levels. This is true but irrelevant. Shifting
the debt burden to the federal government would do nothing to reduce our
external indebtedness. Canadians must borrow abroad because our economy
does not generate sufficient savings to meet the needs of the private
and government sectors. If the government sector attempted to tap more
of the domestic savings market, the private sector would be driven to
the foreign market. The liabilities of individual borrowers might change
but the situation would remain the same in aggregate. Thus there really
would be no reduction in the current account leakage, as Mendelson suggests.(5)
The Mendelson proposal is
also believed to have an advantage in that it would put all fiscal policy
in the hands of the government with ultimate control over monetary policy.
In fact Mendelson is able to claim that his proposal would produce declining
interest costs over time only because of his inherent assumption of a
"more flexible monetary policy" which could "reduce debt
servicing costs dramatically."(6)
This is potentially a very dangerous proposal as he is coming close to
suggesting that part of this debt be monetized.
The Mendelson proposal sees
as an advantage the fact that only the federal government would be able
to engage in economic stabilization, which would make it easier to co-ordinate
monetary and fiscal policies. The federal government has indeed been promoting
greater fiscal co-ordination between the provinces and itself. But such
a centralized policy approach does not come without costs.
It has long been recognized
that local stabilization policy is less effective than national policy
because of the large leakages from any particular region. For example,
if one province wants to stimulate local economic activity, much of the
increased spending will go to goods and services imported from outside
the region. But this is true whether or not the stabilization activity
is undertaken by the provincial government or the federal government.
The extent to which local
stabilization policy results in leaks out of a region depends upon the
size of the region, its economic makeup and the nature of the stabilization
policy undertaken. While 75% of fiscal multiplier effects in the Atlantic
provinces remain in that region, 92% of such effects remain in Ontario.(7)
It also appears that leakages are greater when fiscal policy is dominated
by tax changes than when such policy is undertaken on the spending side.
While federal transfers
into and out of a region do provide some degree of regionally sensitive
stabilization, there may still be room for additional provincial initiative.
Professor Edward Gramlich argues that the traditional lack of faith in
sub-national fiscal policy is now misguided.(8)
He believes that business cycles now seem to be originating from the real
side of the economy and that regional economies differ sufficiently to
make regionally differentiated stabilization policy a good idea. Moreover,
leakages have diminished as a result of the growing importance of local,
Consider the case of Ontario.
The recent recession was largely an Ontario recession, in sharp contrast
to the recession of the early 1980s. Moreover, the province had experienced
a boom of unprecedented proportions in the late 1980s, causing the Bank
of Canada to tighten its monetary policy in order to control the inflationary
effects. That monetary policy, being national in scope, imposed costs
on other sectors of the economy, even though they were not the source
of the problem and even though parts of Canada outside Ontario were experiencing
poor economic conditions. Federal fiscal instruments were also largely
impotent: the tax and transfer system was channelling economic resources
out of the province, but insufficiently to curb demand. Clearly, there
was room here for tighter fiscal policy on the part of the Government
The problem was not that
the provincial government could not contribute to local stabilization,
the problem was that it did not. In fact, the Ontario fiscal stance in
1988 and 1989 contributed to the boom rather than dampening it.(9)
Had the government of Ontario conducted tighter fiscal policy in the late
1980s, its record of high deficits in the 1990s might not be so worrying,
because its accumulated debt would be smaller. Just as important, had
a countercyclical fiscal policy on the part of the province enabled the
Bank of Canada to avoid its particularly tight stance in the late 1980s,
the recessionary impact on the nation and on Ontario might have been reduced.(10)
The Impact on Aggregate Deficits
Any assumption of debt on
an equal per capita basis would have a differential impact across the
nation since the existing debt load varies enormously from province to
province, whether measured on a per capita basis or as a percentage of
provincial Gross Domestic Product. In addition, some provinces run operating
surpluses while others run operating deficits. Whatever the amount chosen,
some provinces would be pushed into a surplus position while others would
still be in deficit. For example, even if the federal government assumed
$200,000 million in provincial debt, Ontario and Nova Scotia would still
have an annual deficit in excess of $200 per capita. The other provinces
would be pushed to surplus, with the exception of Quebec, which would
experience a small per capita deficit. The surplus could be substantial
in some cases. According to Mendelson, it would amount to $200 per capita
in Newfoundland, $300 per capita in Manitoba, $400 per capita in Saskatchewan,
and about $650 per capita in Prince Edward Island.
Even if the federal government
assumed all provincial debt, some governments, Ontario and Nova Scotia
for example, would continue to run deficits because their revenues today
do not even cover the program costs of government.
For a provincial agreement
to balance future budgets, how much provincial debt would the federal
government have to assume? For example, a total loan to the provinces
amounting to $100,000 million would leave seven of ten provinces with
deficits of $100 per capita or more. The Nova Scotia deficit would exceed
$600 per capita while the Ontario deficit would exceed $500 per capita.
Would these provinces agree to a constitutional requirement that they
balance their budgets?
If the required amount of
a loan was $200,000 million or more, some provincial governments would
find themselves in a substantial surplus position. If they were required
to maintain the surplus over time, by establishing, for example, a sinking
fund with the federal government with which to repay the loan ultimately,
aggregate government deficits would be stable. If they lowered taxes by
the appropriate amount or spent the windfall, aggregate government sector
deficits would grow, even though the provincial government was in strict
compliance with any balanced budget requirement. The Mendelson proposal
could, then, be a recipe for growing government and growing deficits.
Deficit reduction comes
about because governments take appropriate action to control spending
and raise revenues. Provincial governments have in the past run fiscal
policies that are cyclically sensitive. Large provincial deficits have
proved to be more temporary than their federal counterpart. The 1993 provincial
budgets promise deficit cuts over one year which amount to 1% of GDP at
the same time as the federal deficit is growing by about 0.4% of GDP (see
Figure 1). Moreover, two provinces, Alberta and New Brunswick, have put
in place legislation mandating balanced budgets, while three additional
provinces are predicting budgetary balances over the next few years. All
this is taking place without a bailout of their existing debt.
The provinces are already
putting in place the fiscal policies needed to reduce their deficits;
if past performance is any indication, they will likely do a better job
of it than the federal government. A bailout of the provinces' debt could
lessen the need to take measures to balance their books.
All governments are today
facing a grave fiscal challenge they are accumulating debt at rates
that most Canadians consider unacceptable. In addition, however, there
is clearly a mismatch between the tax-raising capacities of the provinces
as a group and the expense of the programs for which they are responsible.
Part of this gap is filled by transfers from the federal government. For
several years, however, neither level of government has been completely
satisfied with the structure of these transfers. In a nutshell
the provinces are responsible for programs with high growth rates yet
the federal government dominates the personal income tax, the only tax
with inherently high revenue growth.
It is likely that federal-provincial
fiscal relations will change in response to economic pressures of the
kind described above. The two proposals examined here are aimed at solving
existing problems with respect to the misallocation of revenues between
the two senior levels of government. One proposal is very centralizing;
it relies on what amounts to a bailout of provincial debt and would grant
virtually all stabilization powers to the federal government in exchange.
The other proposal is at the opposite extreme; re-allocating taxes and
eliminating the vertical fiscal gap would enable provincial governments
to become much more independent in conducting their fiscal affairs. The
federal government would lose much of its clout. What appear, on the surface
at least, to be mundane and technical considerations about the allocation
of tax room can thus have very profound effects on the governance of this
country, and these profound effects could come about with little or no
G.C. Ruggeri, R. Howard, G.K. Robertson and D. Van Wart, "Rebalancing
Canada's Fiscal Structure," Policy Options, December 1993,
p. 27-30; and C.G. Ruggeri, R. Howard and D. Van Wart, "Structural
Imbalances in the Canadian Fiscal System," Canadian Tax Journal/Revue
Fiscale Canadienne, Vol. 41, No. 3, 1993, p. 454-472.
Michael Mendelson, Fundamental Reform of Fiscal Federalism, mimeo,
14 October 1993.
An expression of this conventional economic wisdom is found in: R.W. Boadway
and P.A.R. Hobson, Intergovernmental Fiscal Relations in Canada,
Canadian Tax Paper No. 96, Canadian Tax Foundation, Toronto, 1993. The
discussion therein is broadly consistent with that found in I.K. Ip and
J.M. Mintz, Dividing the Spoils: The Federal-Provincial Allocation
of Taxing Powers, C.D. Howe Institute, Toronto, 1992.
Boadway and Hobson (1993) p. 150.
Mendelson (1993), p. 12.
Y. Rabeau, "Regional Stabilization in Canada," in J. Sargent,
Research Coordinator, Fiscal and Monetary Policy, Vol. 21 in a
series of studies commissioned for the Royal Commission on the Economic
Union and Development Prospects for Canada, Ottawa, 1986.
E.M. Gramlich, "A View from the Outside: The Relevance of Foreign
Experience," paper presented to the Canadian Tax Foundation, Conference
on Provincial Finances, Toronto, 30-31 May 1989.
T.J. Courchene, Rethinking the Macro Mix: The Case for Provincial Stabilization
Policy, SPS Working Paper, No. 90-01, School of Policy Studies, Queen's
University, Kingston, Ontario, 13 February 1990.
Ibid., p. 36-37.