Fiscal Imbalance Debate in Canada

Federal-provincial relations in Canada have been dominated in recent years by debate over the “fiscal imbalance,” defined as the apparent shortfall of provincial government revenues compared to the federal government’s surpluses, relative to the spending requirements of each level of government under the Constitution.  This article gives an overview of debate on the fiscal imbalance in Canada, including a summary of its origins, as well as discussions of alternative perspectives on the issue.

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Introduction to the Fiscal Imbalance

Fiscal federalism and the origins of the fiscal imbalance debate

Canadian Fiscal Federalism

Fiscal federalism refers to the division of taxing and expenditure functions between the two primary levels of government in Canada – the federal government and the provincial governments.

There are two primary issues in Canadian fiscal federalism. The first is the issue of vertical fiscal balance, which involves ensuring that each level of government has enough revenue to meet its constitutional responsibilities. The second challenge, horizontal fiscal balance, recognizes that some provinces have a lower capacity to generate revenue than others and, consequently, might require greater assistance, usually in the form of cash payments under the federal Equalization program.

Origins of the Fiscal Imbalance Debate

Under the Constitution, the provinces have legislative authority over most areas of social policy, such as healthcare, education, and welfare. The federal government indirectly participates in these policies fields by providing financial assistance to the provinces. It does so either in the form of cash payments or through the transfer of tax points (transfer of tax points allows the provincial governments to collect a portion of federal tax revenues for themselves).

In 1995, the federal government cut the cash portion of its annual transfers to the provinces for health, post-secondary education, and welfare by nearly one-third, from $18.5 to $12.5 billion, over a two-year period. Those cuts were made as part of a wider program of spending restraint implemented by the Liberal government, headed by Jean Chrétien.

Beyond 1998, however, the federal government began recording a series of consecutive surpluses in which federal revenues exceeded annual expenditures (these surpluses have been in the billions annually). This, in turn, led to the provinces arguing that a vertical fiscal imbalance existed in the Canadian federation, in which the federal government had revenues that far exceeded its expenditure functions, while the provinces’ expenditures often outstripped their spending obligations. Provinces with lesser financial capabilities, such as the Atlantic Provinces, also argued that a horizontal fiscal imbalance existed. These provinces were hardest hit by federal cutbacks and had a much more difficult time meeting their expenditure obligations than the wealthier provinces.

Recent Politics of Fiscal Imbalance

The case for the fiscal imbalance was given impetus in 2002 with the publication of the Quebec government’s Séguin Report, A New Division of Canada’s Financial Resources. That commission, chaired by Yves Séguin, was appointed by Quebec premier Bernard Landry in 2001 to examine the consequences of the federal government’s 1995 cutbacks. The Report argued for a major re-division of resources between the federal government and the provinces.

The issue of fiscal imbalance has also been promoted by a new forum of provincial premiers, known as the Council of the Federation. It began demanding federal action to redress the fiscal imbalance. Not all provinces agreed on how such an imbalance might be addressed, however. Ontario, for example, separately organized its own public “Campaign for fairness,” arguing that federal cash transfers and direct spending in the province systematically short-changed Ontario taxpayers. Not surprisingly, those provinces receiving Equalization payments argued in favour of greater federal spending to restore the horizontal fiscal balance.

Several bodies were appointed at both levels of government to study the issue and, in 2006, three major reports were released. In March 2006, the Advisory Panel on Fiscal Imbalance (appointed by the Council of the Federation) released its final report, Reconciling the Irreconcilable: Addressing Canada’s Fiscal Imbalance. This was followed, in May, by the release of a federal government budget-related document, Focusing on Priorities: Restoring Fiscal Balance in Canada. Later that month, the federal government’s Expert Panel on Equalization and Territorial Formula Funding, chaired by Alberta’s former Deputy Treasurer Al O’Brien, released its final report, Achieving a National Purpose: Putting Equalization Back on Track.

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Perspectives in the Fiscal Imbalance Debate

Proponents of and opposition to the idea of fiscal imbalance

Proponents of the Fiscal Imbalance Argument

Using 2001-02 data on federal transfers to the provinces as a base, the Séguin Commission calculated Quebec’s share of the vertical fiscal imbalance, arising from Ottawa’s 1995 cuts in cash transfers, at $2.2 billion annually. The Séguin Commission also recommended the horizontal fiscal imbalance be redressed by calculating Equalization payments using a 10-province average fiscal capacity, a change from the five-province standard which excludes Alberta and the Atlantic provinces. In sum, the Commission concluded that Quebec would be better off if Ottawa abolished cash transfers to the provinces altogether and instead transferred more tax points – including dollars collected through the Goods and Services Tax (GST) – to the provinces. The Commission calculated that the loss of cash transfers would cost Quebec $5.4 billion annually but that the transfer of the GST collected in the province would provide Quebec with $7.2 billion annually.

Later, although the Council of the Federation’s Advisory Panel stopped short of recommending the transfer of the GST, it largely endorsed the Commission’s analysis of the causes and consequences of the fiscal imbalance. According to this view, a vertical fiscal imbalance exists when the federal government’s cash transfers to the provinces are less than the ‘fiscal gap’ between the two orders of government, as determined by comparing the respective revenues and spending responsibilities of each government. This argument also presumes that a vertical fiscal balance can be measured entirely in terms of the amount of cash transfers to the provinces, in a manner that excludes the dollar value of existing tax-point transfers to the provinces. This view of the ‘fiscal gap’ also frequently excludes direct federal transfers to individuals and institutions in areas regulated by the provinces.

Those who claim there is a fiscal imbalance argue that the federal government’s reduction of cash transfers to the provinces in the 1990s is the main cause of the vertical fiscal imbalance. They argue that new transfers made after the federal government’s return to budget surpluses in 1998 have not yet resulted in a full restoration of the cuts absorbed by the provinces since 1995. Moreover, some have argued that these new transfers to the provinces appear to have been designed primarily with the federal government’s political visibility and social policy agenda in mind, while direct federal spending on education-related post-secondary scholarships and research chairs – considered areas of provincial jurisdiction under the Constitution – seem to provide further proof that the federal government has sufficient funds to meet its own obligations.

Proponents argue that if current trends persist the fiscal imbalance will continue to favour the federal government, while the outlook for the provinces will only worsen. They argue that raising taxes and cutting services are not viable options in a global economy where the provinces face increasing pressures to keep taxes low while staying competitive in areas such as education, health, infrastructure, research, and training. Even when the federal government does help with defraying these costs, those who contend there is a fiscal balance suggest that its actions are often arbitrary and make long-term planning difficult.  Recent reductions in transfers to the provinces for their child-care programs, implemented in 2006 when the Conservatives took office, offer one example.

Critics of the Fiscal Imbalance Argument

In reply to those who contend there is a fiscal imbalance, the federal government has advanced four main arguments, either to deny the existence of a fiscal imbalance or to claim the problem of fiscal balance arising from the 1995 cuts is being addressed. First, the federal government argues that since the provinces have access to all the same sources of tax revenue as the federal government, they are free to raise taxes in order to pay for the social and infrastructure costs within their respective jurisdictions.

Second, they suggest that, since 2000, federal transfers to the provinces across a wide range of program areas, including health care, Equalization, cities, and early childhood learning, have arguably helped considerably in restoring the cuts made in 1995, and that indexed transfers to the provinces for health care– transfers that increase each year by a fixed percent – exceed the inflation rate. 

Third, they posit that federal tax cuts that have reduced the Government of Canada’s share of taxes – from 17 percent of GDP in 2000-01 to less than 15 percent in 2005-06 – have presumably made it easier for the provinces to raise their own taxes, even in a competitive tax environment. 

Fourth, the federal government argues that its own spending responsibilities – notably for Aboriginal People, defence, security and sovereignty – are substantial and growing. Further, it is argued the federal government’s debt reduction initiatives, made possible since the budget deficit was first eliminated in 1998, have had a positive impact on its own – and provincial – budgets and competitiveness by keeping interest rates low and reducing debt-servicing costs.

Over the years, the federal government has also suggested that proponents of the fiscal imbalance sometimes exaggerate their claims by focusing primarily on cash transfers for health, post-secondary education and welfare, rather than the dollar value of the tax points transferred to the provinces in 1977 , or of direct federal transfers to individuals and institutions. Changes to the Equalization program were not arbitrary, it is argued, but purportedly made necessary by provincial tax cuts – which in turn reduced the provinces’ average tax revenues used to calculate the payments – and success in reducing regional disparities.

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Assessing Perspectives in the Fiscal Imbalance Debate

Understanding how fiscal transfers are made

When the federal government claims that, since 2000, increased transfers to the provinces have largely restored cuts made in 1995, it does not always distinguish between payments made to all provinces (to promote vertical fiscal balance) and Equalization payments (made only to some provinces to address the horizontal fiscal balance). This failure to distinguish between these two types of payments can sometimes lead to confusion, and helps explain why provinces that do not receive Equalization, such as Ontario, sometimes dispute those claims. At the same time, however, Ontario does not always seem to distinguish between these two types of fiscal transfers when it claims that residents of some provinces that benefit from Equalization payments receive more federal dollars per capita than Ontarians.

Perhaps more significantly, however, Ontario does not seem to take account of tax points in its calculation of the ‘fiscal gap’ in areas such as health care and post-secondary education spending. Overall, the provinces argue that the federal government’s inclusion of tax points in the calculation of fiscal transfers is confusing, difficult to explain to taxpayers and – in an era of tax cuts – no longer a true reflection of provincial revenues. In 1977, the federal government transferred 13.5 percent worth of its own income tax potential, in the form of “points”, and one percent of its corporate tax points, to the provinces. Since then, the federal government has made annual cash payments to the provinces to ‘top up’ the value of these tax points and ensure their value is equal across Canada (the federal government bases its payments on the province with the highest tax yields  in each year to determine the amounts of the cash payments to the nine other provinces). The Advisory Panel on Fiscal Imbalance calls these payments ‘supplementary equalization’ even though they are also made to provinces that receive no payments under the federal Equalization program. Nevertheless, these extra cash payments allow the federal government to claim it provided $47.9 billion, or $1,474 per capita, in fiscal transfers to the provinces in 2005-06 for health, post-secondary education, and welfare. This $1,474 figure is broken down into $667 in equalized tax points and $807 in cash. This formula for ‘equalizing’ tax points – given Ontario’s higher average tax revenues – also helps explain why Ontario receives a smaller per capita share of cash transfers for health, post-secondary education, and welfare.

Some commentators have argued that the partial restoration of federal transfers since 2001-02 means that the calculations of the ‘fiscal imbalance’ first set out the Report of the Séguin Commission are no longer valid. The newspaper La Presse has put the annual $2.2 billion shortfall in cash transfers calculated by the Séguin Commission in 2002 at only $500 million in 2006, making a transfer of the GST – a key recommendation of the Séguin Report – less viable as a solution than maintaining the existing system of federal cash transfers to Quebec.

The federal government’s adoption of fixed Equalization payments in 2004 –instead of making them based on the representative fiscal capacity of five provinces – has further confused the debate by severing the link between average fiscal capacity and fiscal transfers under Equalization. Arrangements in 2005 to allow Newfoundland and Labrador, and Nova Scotia, to keep their Equalization payments – despite increases in their resource revenues – have arguably helped to undermine confidence in the principles of fairness and equity upon which the Equalization program is purportedly based.  The Expert Panel on Equalization chaired by Al O’Brien, a former Deputy Treasurer of Alberta, has recommended a return to the formula-based approach.

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Future of the Fiscal Imbalance Debate

Where the debate goes from here

Motivations to Resolve Fiscal Imbalance Debate

A resolution to the fiscal imbalance question, in 2007, would serve the interests of several key political actors. Conservative Prime Minister Stephen Harper and Quebec Premier Jean Charest have staked a great deal of political capital on the need to find a solution to this issue. In addition, Ontario Premier Dalton McGuinty faces an election in the fall of 2007. McGuinty has made a concerted effort (since becoming Premier in fall 2003) to argue that a fiscal gap exists between what the federal government collects in taxes in Ontario and what it transfers to the province to help defray the costs of Ontario’s health, education, social service, and infrastructure programs.

Possible Solution: Tax Point Transfer

One possible solution might involve a tax point transfer – targeted at perhaps one percent of the GST – coupled with a corresponding increase in the provincial sales tax rates. Since there are arguably fewer disparities in consumption tax revenues between the regions, a GST tax point transfer might also reduce the federal government’s Equalization and ‘supplementary equalization’ payments.

Major political and technical obstacles make this option unlikely in 2007, however.  First, it is not clear how voters would react to a GST tax point transfer after they had been promised a GST reduction in the 2006 election campaign, or whether federal Conservative politicians would be willing to take such an electoral risk to find out. Second, at present only the three Atlantic provinces that have harmonized their sales taxes with the GST (see Harmonized Sales Tax), and Quebec, which collects the GST and remits it to Ottawa, could implement the transfer without making changes to their sales-tax systems. Ontario, for one, would be highly unlikely to undertake major sales-tax reform in an election year.  The federal government might still consider transferring an equivalent amount to the provinces in cash, but that would mean either reneging on its election promise to further reduce the GST (by continuing to collect six percent GST but transferring the equivalent of one percent in cash to the provinces), or else keeping its promise but foregoing additional GST revenues in favour of the provinces (by reducing the GST to five percent while still transferring the equivalent of one percent of the GST in cash to the provinces). The political, administrative, and fiscal consequences of a transfer of GST tax points to the provinces are likely to eliminate such transfers as a realistic option for the federal government in 2007.

Possible Solution: Reform of Funding Formula

Another, less politically divisive option might involve: a) a return to formula-based funding for Equalization payments, combined with b) a Canada-wide per capita fiscal transfer to the provinces for health, post-secondary education, welfare, cities and infrastructure, and c) a new element to ensure both horizontal fiscal balance for poorer provinces and fairness to taxpayers in wealthier ones. This third step could involve seeking a federal-provincial agreement on how the federal government might withhold part of the Canada-wide transfer from each province progressively, based on each province’s fiscal capacity, analogous to the way low-income senior citizens receive a Guaranteed Income Supplement and all seniors receive Old Age Security, but the latter is taxed back in the case of wealthier taxpayers (This process has also been described as a ‘claw back’). The design of such a progressive claw back formula might be open to negotiation, but could involve a 10-province average fiscal capacity that includes both Equalization payments and resource revenues, as a means of improving the equity and transparency of fiscal transfers for rich and poor provinces alike.

By the end of 2006, the provincial premiers and their ministers of Finance were unable to agree on a funding formula to recommend to the federal government for its Equalization program. In a letter released to the provincial premiers on January 17, 2007, federal Finance minister Jim Flaherty suggested he would adopt at least some of the recommendations of the report of the Expert Panel on Equalization (the O’Brien Report) in his forthcoming budget. (The ‘O’Brien formula’ would calculate federal Equalization payments to the provinces using a 10-province average fiscal capacity but include only 50 percent of resource revenues in the calculation.) Further details would be set out in the budget..

The federal budget of March 19, 2007 announced major changes to the Equalization program and to the system of fiscal transfers to the provinces for health and social programs. With respect to the calculation of Equalization payments, the budget declared that the O’Brien formula would be adopted but that a province could choose to continue to receive its payments under the previous formula. It also introduced changes that would simplify the calculation of a province’s ‘fiscal capacity.’ In addition to increased funding for health and social transfers, the budget announced that each province would eventually receive an equal per capita cash transfer for these programs – thus eliminating supplementary equalization – and that a ‘fiscal cap’ would be introduced to ensure that Equalization-receiving  provinces do not have a higher fiscal capacity than provinces that do not receive Equalization. The details of these changes would be set out in legislation to be introduced at a later date. Soon after the budget was announced, provinces such as Newfoundland and Labrador, and Saskatchewan, expressed concern that some of their payments from the federal government might be ‘clawed back’ under these changes even if they chose to continue to receive Equalization under the pre-2007 formula. Jean Charest announced prior to the provincial election on March 26 that Quebec’s increased share of Equalization under the O’Brien formula would be used to cut taxes, a move that appeared to contradict arguments made by the Séguin Commission that the money was urgently needed to pay for health and social programs.

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Sources and Links for Further Information

Lists of article sources and links for more on this topic

Sources Used for this Article

• Canada.  Council of the Federation. 2006. Reconciling the Irreconcilable: Addressing Canada’s Fiscal Imbalance. Advisory Panel on Fiscal Imbalance. Final Report. Ottawa. Council Secretariat.  <http://www.councilofthefederation.ca>
• Canada. Department of Finance. 2007. Restoring Fiscal Balance for a Stronger Federation. Budget 2007 document. Ottawa. Department of Finance Canada. <http://www.budget.gc.ca/2007/themes/bkrfbse.html>
• Canada. Department of Finance. 2006. Focusing on Priorities: Restoring Fiscal Balance in Canada. Budget 2006 document.  Ottawa. Department of Finance Canada. <http://www.fin.gc.ca/budget06/fp/fptoce.htm>
• Canada. Department of Finance. 2006. Achieving a National Purpose: Putting Equalization Back on Track. Expert Panel on Equalization and Territorial Formula Financing. Final Report.  Ottawa. Department of Finance Canada. <http://www.eqtff-pfft.ca/english/index.asp>
• Quebec. Commission on Fiscal Imbalance. 2002.  A New Division of Canada’s Financial Resources. Report and Supporting Documents. Quebec. Commission Secretariat.  <http://www.desequilibrefiscal.gouv.qc.ca/en/document/publication.htm>
• Policy Options. 2006. Special issue on the fiscal imbalance. Six articles. Various authors. Montreal. Institute for Research on Public Policy. September.  <http://www.irpp.org/po/index.htm>
• “Oubliez le rapport Séguin!” La Presse. 10 November 2006. A24.
• “PM warned against largesse for Quebec.” Globe and Mail. 19 January 2007. A7.
• Government of Ontario: <http://www.fairness.ca>

Links to More Information

• Department of Finance Canada: The Fiscal Imbalance in Canada: the Facts
• Council of the Federation