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...government's spending power gives Ottawa when it comes to steering policy--and resources--in areas of provincial responsibility.
The recent proliferation of provincial commissions, special parliamentary committees, and calls for a Royal Commission on the finances of the federation suggests that the case for reform is settled--the question is what sort. This Commentary recommends closing the much-debated fiscal gaps, or imbalances, through changes to federal and provincial tax and transfer arrangements that would see provinces adopt more responsibility for raising the revenue that underpins spending programs within their jurisdictions. This involves Ottawa taxing less, alongside reduced provincial cash transfers, and the provinces perhaps taxing more, continuing the process of tax and spending realignment that governments have, since WWII, occasionally found necessary to keep the federation working. The purpose of this paper is to recap the reasons why, (1) and explain the arithmetic of how the process works.
The political tension over these issues is at times extreme. Provincial leaders have used the opportunity to extract federal commitments to substantial new spending plans, with support in particular for healthcare financing. Federal politicians have seized the opportunity to extend influence over provincial policy, while satisfying voters' demands to see more of their federal tax payments sent back to their neighbourhoods. They have done so in the form of rapidly expanding cash grants to provinces, nominally labeled as healthcare financing.
One recent watershed event was triggered by the anger of Nova Scotia and Newfoundland and Labrador over the prospect of federal equalization transfers being reduced on a formulaic basis as provincial resource revenue increased. Such an outcome, of course, would have been exactly as prescribed by the equalization program's longstanding legislation. The federal government's response was to suspend the direct link between provincial fiscal capacity and provincial entitlements to equalization grants, leaving the provincial fiscal equalization program in existential limbo. (2) What is the equalization program intended to do and how? Ottawa has appointed an "Expert Panel on Equalization and Territorial Formula Financing," to propose answers, and that panel is scheduled to report its findings in the spring of 2006.
Meanwhile, high energy prices have been generating unexpectedly large revenue flows for Alberta's government--and unexpectedly high costs for many households and businesses--prompting envious eyes to turn toward Alberta. Fresh discussions about how best to share Alberta's energy (3) wealth prompted an unenthusiastic Ralph Klein, the province's premier, to tell the rest of the country to "keep its hands off Alberta's oil" (The Globe and Mail 2005).
As debate over Quebec secession reheats, attention to fiscal federalism, and fiscal balance-sheet politics, naturally grows. Yet the heat is perhaps strongest in Ontario, where residents are increasingly aware of the province's strained fiscal relationship with Ottawa. Since the province has above-average income per capita, its taxpayers finance more than their national per-capita share of federal spending. Moreover, Ottawa has shifted from spending far more than it collected over the 25 years leading up to 1995, to collecting far more than is needed to fulfill federal constitutional responsibilities. In the process, the apparent net loss to Ontario taxpayers has grown to substantial figures. The Ontario government now speaks of a "$23 billion funding gap" between the province and the federal government, and has called for a commission to examine Canada's fiscal architecture, determine the source of the leak, and plug it.
The recently large federal surplus has made the dollar outflow more visible in the richer provinces, because of the gross mismatch between federal taxes paid and services and transfers received, as shown in Panel A of Table 1. On a federal balanced-budget basis, where a federal deficit represents future taxes on provincial residents and a federal surplus represents prepaid taxes (Panel B), the figure in Ontario is not as large as headlines have indicated. However, the flow has been persistently large over time, and in Alberta and Ontario has often been in the neighbourhood of $2,000 per head (Panel C).
From the point of view of "have" provinces, federal transfers do not much help matters. British Columbia, for example, receives significant federal cash transfers (see Panel D of Table 1), but when those receipts are netted against the share of federal taxes provincial residents pay in support of those transfers, the balance turns negative (Panel E). On an inflation-adjusted, per capita basis, the pattern is remarkable stable over time (Panel F).
With the improvement in federal fiscal fortunes in the past decade, the pressure has grown on Ottawa to respond with numerous, one-off solutions. These have included blanket increases in federal transfers to all provincial governments and ad hoc side-deals with individual provinces. Along the way, this approach has highlighted some of the political difficulties created by a system with overlapping and unclear responsibilities for social program spending and for imposing taxes to fund those programs. The resulting policy adventurism is not merely inequitable; the mismatch in governments' revenue raising and spending also imposes efficiency costs on the Canadian economy, depressing the standard of living that Canadians might otherwise enjoy.
A view to a resolution
Three generic resolutions to these problems would seek to put Canada's federal-provincial fiscal arrangements on a more politically sustainable foundation. The options are: first, increasing federal transfers to the provinces, perhaps with the transfers governed by a revised architecture; second, increasing provincial taxes; or third, decreasing federal taxes alongside increases in provincial taxes, whether or not coordinated or negotiated.
The first approach, advocated by Boadway (2004), for example, recommends a relatively centralized solution that would guard federal tax room and expand federal transfers, though in a more principled fashion than recent policies. This approach is grounded in the beliefs that national considerations are more important than provincial ones, and that governments are less self-serving than analysts sometime assume. Boadway suggests tackling the accountability and sustainability problems, such as may arise under centralized arrangements, through the creation of an arm's-length body that would advise on federal-provincial issues. (4)
The federal Department of Finance contemplates the second approach. It argues that the appropriate policy action--if action is needed at all--is for provinces to unilaterally increase their own-source revenues through higher provincial tax rates. (5) After all, goes this quite reasonable line of thought, both federal and provincial governments have unfettered access to the major sources of tax revenue--personal, corporate and sales taxes. In addition, the provinces have access to potentially lucrative natural resource royalties. Nothing in policy, nor politics, need block provinces, whose voters seek more publicly financed services, from taxing their residents to finance the services they desire.
The Seguin Commission (Government of Quebec 2002), and a recent C.D. Howe Institute Working Paper series (Dahlby, McKenzie, Poschmann, Smart 2005), among others, describe a third approach: tax realignment and reform. Tax realignment involves lowering federal taxes, while permitting or encouraging provinces to raise the taxes of their choosing to better match own-source revenues with spending responsibilities. (6) Under such an arrangement, the overall tax revenue collected in the federation would be more or less unchanged. However, all governments would have an opportunity to use the realignment process to implement reforms that made the total tax mix less damaging to the economy. What is most important, however, is that with provinces more responsible for collecting their own revenue to finance their spending, they would be in a better position to match the wants and needs of their voters with their abilities to fund them. Proponents of this view argue that spending is, thus, more accountable to voters (Oates 2005) and fiscal policy ultimately more sustainable. In fact, McKenzie (2005) believes such changes, in the face of continuing political strain, are a matter of inevitability.
The three competing approaches may seek to address the problem over the medium term, but "there can be no final solution ... only adjustments and reallocations in light of changing conditions" (Wheare 1963). Furthermore, as Boadway (2004) notes, any analyst's preferred approach is influenced by the weight given to subjective factors--such as provincial autonomy versus a "nationhood" view of public services, and prior views about the ability of governments to act in benevolent ways. Hence, reasonable people can disagree on the correct policy option. This is not to say that all options are created equal; rather, that any proposed solution will be controversial to some and that with policy improvements there come drawbacks. In other words, the usual policy tradeoffs arise.
In the face of uncertainty about the weight to attach to divergent viewpoints, the way to proceed is to identify the pressing problems that hinder Ottawa and the provinces in achieving their policy goals. The major failings of current arrangements do not lie in an insufficiently national flavour for policies, or in insufficient total tax revenues being collected across the Canadian federation. Rather, the issues identified in a wealth of prior research include: poor government accountability for raising and disbursing tax revenue; federal and provincial tax designs; and tax levels that hold back Canada's growth potential (Mintz et al. 2005).
Given improved accountability and better tax design as central targets, the proposed solution must first address these problems. This Commentary, therefore, focuses on the implications of the tax realignment approach for reasons to be discussed in the next section. Our rationale for this approach is followed by a discussion of our proposal and its fiscal impacts.
This paper's primary conclusion is that Ottawa should initiate tax realignment and reform that would see increased revenue raising and spending responsibility seated with the provinces. In the process, the line of accountability would tighten between the governments that provide services and the regional voters who pay for them. We would see provinces collecting more revenue, yet doing a smarter job of it.
Ottawa should lower personal income tax rates...
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