Financing Federalism: The Canadian Experience Bev Dahlby Department of Economics University of Alberta and Tony Morehen Alberta Finance Government of Alberta 1

Outline Description of federal and provincial governments’ expenditure responsibilities and tax powers. Description of the evolution of the federal-provincial fiscal arrangements since WW II. Description of the main elements of federal grants to the provinces and tax collection agreements. 1

13.2% 38.4% 9.9% 0.10% 0.09% 23.7% 0.13% 0.45% 1.7% 3.7% 3.2% 3.0% 2.4% 1

Federal Constitutional Responsibilities Defence Criminal justice Old age security Unemployment insurance International trade and treaties Regulation of trade and commerce Aboriginal issues Monetary policy 1

Provincial Constitutional Responsibilities Education Health Social welfare Civil law Municipal government Gambling, liquor Natural resources (oil and natural gas, mining, and forestry) 1

Shared Constitutional Responsibilities Income support especially the Canada Pension Plan and Quebec Pension Plan Environment Law enforcement Agriculture 1

Table 1 Table 1 shows the allocation of expenditures by the federal and provincial-local government sectors in Canada in 2002. There are significant overlaps or interdependencies in the spending responsibilities of the two levels of government, e.g. Unemployment insurance (federal) and welfare (provincial). 1

Tax Powers The federal government has the power to raise revenues “by any mode or system of taxation”. The provincial governments are empowered to levy “direct taxation within the province.” Provinces are not able to levy tariffs on imported goods. This is the only effective constitutional limitation on provincial tax powers. 1

Table 2 Both the federal and provincial governments levy taxes on the most important tax bases: personal and corporate income taxes, sales and excise taxes, and payroll taxes. The provinces have exclusive control over property taxes and resource revenues, such as oil and gas royalties. 1

Major Provincial Tax Rates, 2003 1

The Federal Spending Power The courts have determined that the federal government can offer conditional grants to the provinces to promote national programs in areas of provincial jurisdiction, such as Medicare, post-secondary education, infrastructure or labour market development . This is referred to as the federal “spending power”. 1

Government Borrowing The provincial governments can borrow to finance deficits. The federal government is not responsible for provincial government debt. Although there are annual meetings of federal and provincial finance ministers to discuss their upcoming budgets, budgetary policies (including borrowing) by the federal and provincial governments are largely uncoordinated. 1

General Characteristics of the Canadian Federal System The provinces have extensive tax powers and jurisdiction in the most important expenditure areas--health, education, and social assistance. There is a high degree of overlap in federal and provincial taxes and expenditure programs. The federal government has the right to make grant to the provinces in areas of provincial responsibility. 1

Reasons for Federal-Provincial Fiscal Arrangements Mismatches between expenditure responsibilities and the revenue generating capacity of the provinces Unequal fiscal capacities among the provinces. Federal government’s desire to promote expenditures in some areas of provincial jurisdiction. Overlapping tax bases -- the need for harmonization. 1

Types of Federal Transfers to the Provinces Block Transfers Equalization Grants The Canada Health and Social Transfer Cost-Shared Grants Labour market development agreements Young offenders Disabled persons Farm disaster assistance Detailed information available at: www.fin.gc.ca/activty/fedprov-e.html 1

History of Federal-Provincial Fiscal Relations Taxation Pre-World War II a Royal Commission described the tax system as a ” tax jungle” World War II all income taxes transferred to the federal government Post-World War II Quebec opted to collect its own income taxes tax collection agreements signed with the provinces tax points transferred to the provinces 1

History of Federal-Provincial Fiscal Relations Equalization The equalization program established 1957. The Constitution was amended in 1982 to require the federal government to make equalization grants to ensure that “provinces can provide reasonably comparable levels of services at reasonably comparable levels of taxation”. Equalization grants are financed out of the federal government’s general revenues. The program is renewed every five years and is scheduled for renewal in April 2004. 1

History of Federal-Provincial Fiscal Relations Health, Education, and Social Assistance Transfers Hospital Insurance 1957 + Medicare, 1968 Canada Assistance Plan (welfare programs), 1966 Established Programs Financing (combined health care and post-secondary education grants and a tax point transfer), 1977 Canada Health and Social Transfer, 1996-97 Canada Health Transfer (CHT) and Canada Social Transfer (CST), 2004. 1

The Equation for Calculating Equalization Grants A province’s fiscal capacity is calculated using a “Representative Tax System.”(RTS) A province’s equalization entitlement for a particular tax base is calculated as follows: Eij = tsj(Bsj - Bij) where Eij the per capita equalization entitlement for province i with respect to tax base j tsj is the standard tax rate for tax base j Bsj is the standard per capita tax base j Bij is the per capita tax base j in province i i = 1…10, j = 1…34 1

The Equalization Standard A five-province standard is used to calculate the standard tax bases. This is the average per capita tax bases in British Columbia, Saskatchewan, Manitoba, Ontario, and Quebec. A province with deficient fiscal capacity receives a payment from the federal government equal to the sum of its Eijs over 34 revenue sources. Provinces with adequate fiscal capacities (Ontario and Alberta) do not receive payments and do not directly contribute to financing the grants. 1

The Impact of Equalization on the Fiscal Capacities of the Provinces 1

Problems with the Equalization Program The federal government has imposed ceilings on entitlements and changed the formula for calculating the grants. Variations in “fiscal need” are not taken into account, as in Australia. The formula may affect the fiscal decisions of the recipient provinces: rate equalization effect base equalization effect discourages development of resource projects 1

The Canada Health and Social Transfer (CHST) The Canada Health and Social Transfer (CHST) was established in 1996-97 to provide block funding for provincial health, post-secondary education and social assistance programs. It replaced the Established Programs Financing (health and post-secondary education) and Canada Assistance Plan (social assistance) programs. 1

How the CHST Works The federal government arbitrarily sets the value of the cash to be transferred to the provinces. The value of the tax points transferred to the provinces in 1977 is then calculated. The total value of cash plus tax points is allocated among provinces on an equal per capita basis. Each province’s cash transfer is equal to its allocation of tax plus cash minus the value of its tax points. 1

CHST Calculation for 2002-03 National Alberta’s CHST Grant Cash $19.1 billion plus Tax Point Transfer $16.1 billion equals Total Entitlement $35.2 billion Alberta’s CHST Grant (based on Alberta’s 9.9% share of Canada’s population) Total Entitlement $3.5 billion less Tax Point Transfer $1.9 billion Cash Transfer $1.6 billion 1

Major Federal Transfers to the Provinces and Territories, 1982-2002

Federal Transfers to the Provinces and Territories, in 2003-04 1

Major Federal Transfers 1

Federal Transfers as a Percentage of Provincial Revenues 1

Recent Developments The current CHST will be split into a Canada Health Transfer (CHT) and a Canada Social Transfer (CST), effective April 1, 2004. The Equalization program ceiling was removed, effective 2002-03. The total increase in federal transfers by $Cdn 20 billion over five years. 1

Tax Collection Agreements (TCAs) Under the TCAs, the federal government collects personal and corporate income taxes on behalf of the provinces. Quebec collects its own personal income taxes, while Quebec, Ontario and Alberta collect their own corporate taxes. Federal and provincial personal and corporate income tax bases exhibit a higher degree of harmonization than in the United States. 1

Financing Local Government Constitutionally, municipalities are “creatures of the province.” Municipalities derive their revenue from municipal property taxes, transfers from the provincial governments, user fees, and business taxes. Municipal spheres of jurisdiction Safety, health and welfare of people Protection of people and property The enforcement of bylaws Transport and transportation systems Operation and maintenance of public places 1

Sources of Funding for Local Government 1

Strengths and Weaknesses of the Canadian Fiscal System Has allowed decentralization of tax and expenditure decisions, while maintaining comparable levels of public services and tax rates in spite of large variations in the fiscal capacities of the provinces. Overlapping tax and expenditure responsibilities reduces transparency and the accountability of politicians to the voters. Interdependencies can lead to negative fiscal externalities for other governments. 1