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The Fiscal Balance in Canada:
The Facts

January 2004

The argument by provincial governments that the money is in Ottawa while the needs are in the provinces does not withstand the test of facts, or take into account the reality that sound fiscal management by the federal government through balanced budgets or better benefits all Canadians.

The fiscal balance debate is not new. In the early 1980s there was considerable debate as to whether an imbalance in favour of the provinces existed. Eventually, the claims were dismissed, largely due to provincial arguments against the existence of a fiscal imbalance. To make this point, Ontario’s 1982 budget quoted a study by the Economic Council of Canada, which stated:

"In order to say that there is a "structural" economic problem relating to fiscal imbalance, it must be argued that one of the levels of government does not have access to the revenues required to fulfill its obligations…The mere existence of deficits at one level of government does not indicate the existence of such a structural imbalance nor does it mean that such deficits have to be rectified at the expense of another level of government."

Therefore, the key issue in this debate is whether both orders of government have access to revenue sources so that they can fulfill their responsibilities. A study by Norrie and Wilson¹ makes the point that the distribution of taxation powers in Canada is unique – both orders of government do in fact have full access to all current major revenue sources, and therefore the traditional concept of a vertical fiscal imbalance does not apply to Canada.

Is the money in Ottawa?

• Both the federal and provincial governments have access to all the major tax bases – personal and corporate income taxes, sales taxes and payroll taxes – and both can set their own tax rates (see Table 1).

• Provinces also have access to certain tax bases, some of which are growing rapidly.

• Compared to other federations, Canadian provinces have freedom to set their tax policies (see Chart 1). Even provinces that have shared administrative arrangements for tax collection with the federal government have had considerable flexibility to customize their personal income tax systems to their own policy objectives. The tax-on-income arrangement, introduced in 2001, added even more flexibility in terms of tax rates, credits and incentives.

Sources: Department of Finance calculations; Organisation for Economic
Co-operation and Development (OECD), Taxing Powers of State and Local Government (Paris: OECD, 1999).

• Total provincial revenues – that is, their own-source revenues plus federal transfers – have substantially exceeded federal revenues for more than two decades (see Chart 2).

• In 2002-03 total provincial revenues amounted to $199 billion, including $34 billion in federal cash transfers, compared to about $178 billion in total federal revenues, or $143 billion net of cash transfers to the provinces (see Chart 3).

• Total provincial revenues are expected to continue to exceed federal revenues for the foreseeable future.

• As a result of the $100-billion Five-Year Tax Reduction Plan announced in 2000, federal revenues are expected to grow at an average annual rate of only 0.5 per cent between 2000-01 and 2004-05. Federal tax cuts amount to about $25 billion in 2003-04 alone.

• In addition, federal cash transfers to the provinces (which they can spend on their own priorities such as health and education) are expected to grow at an average annual rate of 6.2 per cent between 2000-01 and 2004-05, which is more than ten times faster than the expected growth in federal revenues (see Chart 4.1). This reflects recent federal investments mainly under the new Accord on Health Care Renewal. The expected growth in major federal cash transfers until 2008-09 is a testimony to the co-operation between the federal government and the provinces (see Chart 4.2).

• Although the federal share of personal income tax collections is larger than that of all the provinces, it did not lead in the past to faster overall revenue growth. In fact, over the last 20 years, provincial own-source and federal revenues have, on average, grown at a broadly similar rate (see Chart 5).

• More than three-quarters of the $100-billion in federal tax reductions is concentrated in personal income taxes.

• This includes the restoration of full indexation of the personal income tax system, reductions in tax rates, increases in income tax thresholds and increases in the Canada Child Tax Benefit.

• Full indexation will permanently reduce the growth of federal personal income tax in the future.

• The federal government will face continuing pressure to reduce taxes, particularly in light of the tax cuts recently introduced in the United States. This is particularly a federal pressure because, for fairness and equity considerations, only the federal government can provide countrywide income tax relief that improves the standard of living for all Canadians, and not just those in more affluent provinces. For example, it is estimated that provincial governments in Ontario, Alberta and British Columbia reduced their taxes by about 30 per cent over the last seven years, more than one-and-a-half times the tax reductions seen in other provinces.

Are the needs mainly in the provinces?

• Debt charges consumed about 21 cents of every federal revenue dollar in 2002-03 compared to an average of about 11 cents for the provinces (see Chart 6). Thus, the federal government paid $37 billion in interest costs compared to about $22 billion for all the provinces combined.

• The federal government’s higher debt burden reduces its fiscal room to manoeuvre when managing its own responsibilities and pressures, and makes it more vulnerable to volatility in global financial markets.

• While the provinces face spending pressures in the areas of health care and education, which represent a large share of provincial spending, the federal government has made significant reinvestments in both health and education through the CHST.

• In fact, since the federal government balanced its budget, about 80 per cent of all new federal spending initiatives have been related to health care and education, including research and development and skills upgrading. This includes the new funding under the 2003 Accord on Health Care Renewal. Under the Accord, federal support for health care will increase by $34.8 billion between 2002-03 and 2007-08.

• The provinces have flexibility to use federal transfers where they deem their priority pressures to be. Provincial governments are accountable to their citizens, not to the federal government, for how they use these funds.

• The federal government also faces growing spending pressures in other areas such as: elderly benefits, strengthening Aboriginal communities, research and development, skills and learning, and security.

• The federal government also responds to national emergencies and natural disasters. For example, the 2001 budget provided $7.7 billion over five years to enhance security for Canadians following the events of September 11, 2001.

Conclusion

• Provinces in Canada have the constitutional powers and independence to make their own choices about taxes, spending and debt, just like the federal government. Provincial governments have access to all the major tax bases and they are free to set their own priorities.

• The fact that virtually all provinces have chosen to reduce taxes in recent years implies that they believe that they have sufficient revenues to manage their spending pressures. Forgone revenues due to provincial tax initiatives that began with their 1995 budgets amounted to $21 billion in 2003-04 alone.

• Sound fiscal management by the federal government through balanced budgets or better benefits all Canadians.

• Improving federal finances has helped maintain lower interest rates across the country. This benefits provincial governments, businesses and families.

• Only the federal government can stand behind nationwide programs and standards.

Annex

In 2002, the provincial and territorial Ministers of Finance commissioned the Conference Board of Canada to produce 20-year fiscal projections for the federal government and the aggregate of the provinces and territories³. The resulting report shows large and growing federal surpluses over the next two decades while the provincial-territorial sector records small deficits. The report thus concludes that a vertical fiscal imbalance exists in Canada.

However, the Conference Board report does not prove the existence of a fiscal imbalance. A closer examination of the facts suggests that the results must be interpreted with caution.

• Although long-term fiscal projections can be useful in some contexts, they are not relevant in assessing the existence of a vertical fiscal imbalance because this is determined by assessing access to the revenue sources required to meet expenditure needs.

• The fact that both orders of government have access to all the main revenue sources required to fulfill their obligations implies that a vertical fiscal imbalance cannot exist in Canada, regardless of what surpluses or deficits are projected over the long term.

• The Conference Board report defines vertical fiscal imbalance as a situation where "the distribution of revenue resources between the federal and provincial/territorial orders of government is inconsistent with the cost of meeting their respective constitutional spending responsibilities" (p. 1).

• This definition, when applied to Canada, is flawed since the "distribution of revenue resources" is not a constraint imposed on governments; this distribution can be modified by federal and provincial tax policy choices.

• A study by Norrie and Wilson⁴ argues that both orders of government have full access to all major revenue sources and therefore the traditional concept of vertical fiscal imbalance does not apply to Canada.

• Long-term fiscal projections are notoriously sensitive to the choice of assumptions. For example, another Conference Board report⁵ – published in October 2001 – projected that the provinces would record surpluses over the next 20 years under reasonable assumptions.

• A small change in an assumption can alter revenue or spending projections by billions of dollars over a 20-year horizon.

• For example, if federal program spending were to grow 1 per cent faster each year than assumed by the Conference Board, the federal government would record a surplus of less than $2 billion in 2019-20, rather than the $85-billion surplus projected in the latest Conference Board report.

• On the other hand, if total federal revenues were to grow 1 per cent slower each year, the federal government would record a deficit of $15 billion in 2019-20.

• Because of the high degree of uncertainly surrounding long-term projections, governments must remain vigilant and not lock themselves into actions today based on projections that may not materialize in the future.

• The Conference Board's 2002 report made the key assumption that the federal government will not introduce any new tax cuts or spending measures for the next 20 years, with all surpluses being earmarked exclusively for debt reduction. This assumption tends to inflate federal surpluses.

• It is simply unrealistic to assume the absence of any new federal initiatives for two decades. For instance, federal tax cuts and spending initiatives implemented since the 1997 budget amounted to about $55 billion in 2002-03.

• If none of these measures had been introduced and if all resulting budgetary surpluses had been applied to debt reduction, the federal government would have recorded a surplus of about $70 billion in
  2002-03.

• This unrealistic result illustrates the purely hypothetical nature of the Conference Board projections.

• In the short to medium term, where projections tend to be more helpful, the 2002 report shows only small federal surpluses, even before fiscal prudence is subtracted. This confirms the view that the federal government will have limited fiscal room to manoeuvre over the next five years.

• In addition, over this period, federal cash transfers to the provinces are projected to grow at a faster rate than total provincial spending.

• The Conference Board's 2002 report also counters the provinces’ argument that federal revenues grow faster than provincial revenues. The report shows virtually the same growth rate for both orders of government.

¹ Kenneth Norrie and L.S. Wilson, "On Re-Balancing Canadian Fiscal Federalism," Toward a New Mission Statement for Canadian Fiscal Federalism, ed. H. Lazar, Institute of Intergovernmental Relations (Montréal and Kingston: McGill-Queen’s University Press, 2000), pp. 79-98.  [Return]

² Throughout this document, chart data come from the federal and provincial Public Accounts and federal and provincial estimates.  [Return]

³ Fiscal Prospects for the Federal and Provincial/Territorial Governments. Conference Board of Canada, July 2002. The report can be accessed at http://www.conferenceboard.ca/pdfs/fiscalimbalance.pdf.  [Return]

⁴ Kenneth Norrie and L.S. Wilson, "On Re-Balancing Canadian Fiscal Federalism," Toward a New Mission Statement for Canadian Fiscal Federalism, ed. H. Lazar, Institute of Intergovernmental Relations (Montréal and Kingston: McGill-Queen’s University Press, 2000), pp. 79-98.  [Return]

⁵ The Future Cost of Health Care in Canada, 2000 to 2020. Conference Board of Canada, October 2001. The report can be accessed at http://www.conferenceboard.ca/press/documents/futurehealth.pdf.  [Return]