August 1, 2013
Addressing Horizontal and Vertical Fiscal Imbalances
The sixth paper in our Fiscal Transfers series explains surplus recycling, and analyzes its role and importance for understanding and strengthening Canadian intergovernmental fiscal issues.
Effective surplus-recycling mechanisms are essential in ensuring the internal stability and resilience of macro-economic systems because they keep the overall system in equilibrium. Put simply, an internal recycling method establishes an equilibrium between a region running a surplus and a region running a deficit by ensuring that some of the surplus is flowing back to the region in deficit.
For example, historically, the operation of the global macro-economic system under the gold standard was an effective surplus-recycling mechanism. Countries running balance-of-payments surpluses would experience inflows of gold that in turn will increase domestic wages and prices thereby eroding their balance of payments surplus by decreasing exports and increasing imports. Balance of payments deficit countries would experience the opposite impacts, with the result that the system would re-equilibrate.
If internal recycling mechanisms are not functioning properly, as for example, in the Eurozone at the moment, economic crises can become exacerbated and cycles can emerge that are difficult to stop.
This study takes a close look at the effectiveness of Canada’s surplus recycling mechanisms and finds them to be seriously wanting. Canada currently faces three challenges with regard to its fiscal and economic resilience and stability that are not being adequately addressed.
First, the equalization program, designed to ensure that fiscally weak provinces have access to revenues sufficient to provide reasonably comparable levels of public goods and services, is too generous to those provinces that have traditionally received equalization, but provides inadequate transfers to Ontario. Our analysis shows that once federal transfers have been distributed, Ontario has the lowest real purchasing power of provincial public goods and services of all provinces. Potential policy responses include changes to formula for calculating and allocating federal fiscal transfers, as well as changes to foundational programs such as Employment Insurance so that they work better in Ontario.
Third, an emerging fiscal challenge lies in the disparity between the provinces’ responsibility for most of the open-ended and/or demand-driven programs whereas the federal government has been able to cap or reduce many of its spending commitments. This could result in significant under-investment by provinces in programs essential to their prosperity, such as infrastructure and education. Credible policy responses to this challenge would include an increase in federal funds transferred to the provinces or the transfer of some powers from provinces to the federal government.
Empirical evidence is presented to demonstrate the existence of each of these three problems and the failure of existing surplus recycling mechanisms to deal with them. Potential policy responses are surveyed. What emerges from this analysis is the relevance of the surplus recycling mechanism framework for understanding Canadian intergovernmental fiscal issues, the inadequacy of current arrangements to address these fiscal issues, and the existence of real – if politically challenging – policy tools to strengthen the Canadian economic and fiscal union.
Thomas J. Courchene
August 1, 2013