Back to Basics
December 20, 2012 | By Matthew Mendelsohn
The Future of the Fiscal Arrangements
In the fifth paper in the Fiscal Transfers Series, Matthew Mendelsohn argues that Canada’s system of fiscal arrangements is misaligned with current economic realities. In particular, the system transfers funds from Ontario for redistribution at a time when Ontario’s fiscal capacity is below the national average. This is not sustainable for Ontario and violates the most basic understandings of equity built into the system. The paper documents how this situation arose and makes recommendations to fix it.
Canada’s fiscal arrangements—the Canada Health Transfer, the Canada Social Transfer and Equalization—are meant to serve a simple purpose: ensure that all provincial governments in Canada have the fiscal capacity to provide their residents with comparable levels of public services at comparable levels of taxation. They clearly no longer do that.
Fiscal disparities in Canada are increasingly driven by commodities, yet our fiscal arrangements do not redistribute commodity wealth. This places Ontario in a unique situation, lacking the natural resources of the oil and gas provinces, but also significantly more prosperous than the traditional Equalization-receiving provinces.
In practice, this means that funds continue to be redistributed away from Ontario to support traditional Equalization-receiving provinces at a time when Ontario’s fiscal capacity is below the national average. This is not the fault of any one government but a result of fiscal arrangements that have not kept pace with changes in the Canadian economy.
This is not sustainable for Ontario and it is not in keeping with the most basic understanding of equity. This redistribution undermines Ontario’s ability to provide comparable levels of public services to its residents and also undermines its ability to make capital investments that will ensure its future prosperity.
Addressing this problem will require creative but principled solutions. Reform options must acknowledge that the federal government collects almost no resource royalties and that the funds available to the federal government for redistribution come disproportionately from the Ontario corporate, personal, and consumption tax bases.
Reform options should be resilient to potential macroeconomic changes, including a sustained commodity boom or a slowdown in the natural resource sector. They should strive to achieve their constitutional purpose of ensuring that provincial governments have comparable ability to provide their residents with public services.
They should also dispense with unhelpful conflations of terms like “have-not” or “poor” with “Equalization-receiving.” For many provinces, whether they have fiscal capacity above or below the national average will be determined by the internationally set prices for oil and gas. Receiving equalization (or not) is not a verdict on the entrepreneurial spirit or economic policies of a province; it is merely a relative measure of fiscal capacity over which provincial governments currently have little influence.
Moving forward, it is far more useful to think of two groups of provinces: prosperous provinces with commodities demanding high prices on international markets and less prosperous provinces with less natural resource income. Ontario, however, does not fit easily into either group and has its own unique interests in the fiscal arrangements. Currently, those interests are not well-reflected in the design of the system.
Given these realities, in the short-term the federal government should:
Immediately remove the GDP growth cap that it arbitrarily applied to Equalization
- The cap violates the agreement with the federal government that saw a movement toward per capita allocation in the CST and CHT accompanied with a move toward a formula-driven program. Although the federal government has honoured the commitment to Alberta to move towards per capita cash transfers, providing the province with approximately 900 million in 2014-15, it will violate its commitment to formula-driven equalization and clawback approximately 1.1 billion from Ontario this year.
- The cap was applied in a manner that was punitive towards Ontario in particular. Ontario loses 25 per cent of its entitlement, or $1.1 billion, while other provinces lose only 7.5 per cent of their entitlements. A full 55 per cent of the clawback comes from Ontario’s transfers.
Create an Independent Council to report on Canada’s fiscal arrangements
- Many have an interest in concealing the true nature of inter-regional redistribution in Canada. An independent, disinterested body could report on fiscal capacity and net redistribution and related issues. Much like the Canadian Institute for Health Information does for health care, a new Fiscal Transfers Council could similarly improve transparency and governance in Canada’s fiscal arrangements.
Include the cost of providing public services in the Equalization formula
- The Equalization formula measures differences among provinces in fiscal capacity only. It does not include any measure of variations in what it actually costs to provide services. In reality, it simply costs more to provide public services in Ontario and British Columbia than in other provinces. If we are serious about trying to achieve our constitutional commitment, both the revenue and the expense side of the balance sheet must be included.
- A more comprehensive “needs-based” approach should also be considered. Such a system would look at not only the cost of labour, but also the socio-demographic characteristics of the population as well as the geographic characteristics of the province.
Use the real imputed value of hydro revenues when assessing provincial fiscal capacity in order to prevent provinces from under-pricing their electricity and gaming the equalization system.
Include a measure of federal spending in measures of provincial fiscal capacity because high federal spending in some provinces offsets provincial governments’ actual requirement to spend own source revenues on public programs.
These reform options would improve the operation of the fiscal arrangements under the existing framework. Yet the structure of Canada’s fiscal arrangements is so inconsistent with the nature of our national economy that over the medium-term, more fundamental reform is necessary.
The paper avoids easy clichés like “Fixing a leaking roof when the foundation is crumbling” or “putting lipstick on a pig,” but it is clear that Canada’s fiscal arrangements are no longer consistent with Canadian realities. They fail their most basic tests. They do not consistently allocate more federal money to less prosperous provinces than to more prosperous ones, and they don’t come anywhere close to ensuring that all provinces have comparable ability to provide public services. Our fiscal arrangements should be re-designed from the ground up.
Over the medium-term, the federal government should implement one of two possible transformations:
- Create a single needs-tested federal fiscal transfer that would provide more fiscal resources to less prosperous provinces and fewer resources to more prosperous provinces; or
- Remove natural resource revenues entirely from calculations of provincial capacity, but then create a separate federally-funded transfer to partially equalize natural resource revenue fiscal capacity.
Historically, Canada’s fiscal arrangements have undergone a number of changes to respond to new circumstances. Changes are again in order to address a pressing national problem. This paper outlines the short- and medium-term options that should be pursued to bring us closer to achieving our constitutional commitment.
December 20, 2012
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- Why Canada needs a Federal Economic Agenda for Ontario
- The Federal Economic Agenda for Ontario at the Northern Policy Institute's Leadership Luncheon