Fiscal Imbalance

Equalization Program in Canada: Overview and Contemporary Issues

Jay Makarenko — Thu, 24 Apr 2008 11:28:13 -0600

The Equalization Program is an important component of Canadian federalism and the notion of equality between provinces regarding the social services they provide. Moreover, the principle of equalization has been a major source of debate in Canadian politics, between the federal and provincial levels of government, as well as between provinces. This article provides an overview of the purpose, operation and history of the Equalization Program, including a summary of key contemporary issues and debates.

Introduction to the Equalization Program

Definition, purpose and history of equalization in Canada

Operation of the Equalization Program

The equalization formula and how the numbers are crunched

Issues and Debates on the Equalization Program

Contemporary issues on the operation and nature of equalization

Sources and Links to More Information

List of article sources and links to more on this topic

Introduction to the Equalization Program

Definition, purpose and history of equalization in Canada

Definition of the Equalization Program

Equalization is the Government of Canada’s program for addressing fiscal disparities between provinces. The territories do not participate in the Equalization Program (finances for the territories are governed under a separate program – the Territorial Formula Financing program). Under the Equalization program, the federal government makes financial transfers to the provinces in support of their spending initiatives. These federal transfers are unconditional block grants, meaning there are no federal conditions on the transfers, allowing the recipient province to spend the money however it chooses.

In this context, Equalization is one of three major federal transfer programs. The others are the Canada Health Transfer and the Canada Social Transfer.

Purpose of the Equalization Program

The purpose of the Equalization Program is to allow provinces to provide comparable levels of social services at comparable levels of taxation. The program’s goal is to ensure citizens in all provinces have access to roughly the same level of social services – such as education and social assistance – without having to pay exorbitant levels of taxation. In understanding this purpose more fully, it is important to note two sorts of fiscal imbalances that can arise in federations such as Canada – vertical and horizontal.

Vertical imbalance is an imbalance between the different levels of government; in the case of Canada, between the federal and provincial levels of government. This sort of imbalance occurs when the responsibilities of one level of government are disproportionately large compared with its share of revenues. Such imbalances can be addressed by a transfer of responsibilities and/or revenues from one level of government to another. In the context of Canada, the Canada Health Transfer and the Canada Social Transfer are meant to address vertical imbalances by transferring funds from the federal government to the provinces.

Horizontal imbalance, by contrast, is a fiscal imbalance within one level of government; in the case of Canada, between the various provincial governments. This sort of imbalance occurs when some provincial governments have much weaker fiscal capacities than others. Traditionally, this has included provinces such as Quebec, Manitoba and those in Atlantic Canada. Because of their smaller populations and/or economies, these provinces tend to have less capacity to support social services than their larger provincial cousins, such as Alberta, British Columbia and Ontario. Equalization is meant to address this horizontal imbalance by providing federal monies to those provinces with lesser financial capacities. The result is greater equality between provinces in terms of their levels of taxation and ability to provide comparable social programs.

Equalization and Tax Rental Agreements

The history of equalization dates back to the 1940s, with the introduction of tax rental agreements between the federal government and the provinces. These agreements meant that each province ‘rented out’ its right to collect taxes to the federal government. Under this arrangement, the federal government took over the collection of personal income taxes, corporate income taxes and succession duties from participating provinces. In exchange, the federal government paid annual compensation to the provinces to make up for the income each province lost by not collecting these taxes. The terms of the tax rental agreements were renegotiated every five years, and federal compensation was unconditional, meaning that provinces could spend the money as they saw fit.

First implemented during World War II, the tax rental agreement arrangement between the two levels of government ran until 1962. Thereafter, the federal government entered into a new system of tax collection with the provinces. Throughout this period, several provinces remained uncomfortable with the idea of ceding taxation powers to the federal government, even as part of a temporary rental agreement. Ontario did not participate until 1952, when the federal government changed the way payments were calculated, and Quebec never participated in the tax rental agreements.

Initially, the principle of equalization was not found in the tax rental agreements. Indeed, the arrangements were designed solely to compensate a province for lost tax revenues, not to increase the revenue of the provinces to a higher level based on a national norm. In 1957, however, poorer provinces whose per capita tax revenues fell below a national standard found themselves eligible for additional federal compensation. This marked the beginnings of the Equalization Program in Canada.

Evolution of the Equalization Program

Since 1957, the Equalization Program has undergone a number of significant changes, mainly having to do with the manner in which equalization has been calculated. Originally, Ontario and British Columbia were used as the comparative benchmarks. If a province’s per capita revenue from three sources of revenue (personal income tax, corporate tax and inheritance taxes) were less than these two provinces, then it was entitled to receive equalization from the federal government.

Over time, however, the equalization formula was adjusted. Today, the comparative benchmark is based upon a multi-provincial average, as opposed to simply British Columbia and Ontario. Moreover, the number of different revenue sources included in the calculation has been significantly broadened beyond simply personal income tax, corporate tax and inheritance taxes. For example, provincial revenues from natural resource extraction is now included. However, offshore oil revenue for Nova Scotia and Newfoundland has been excluded at times through individual deals between the federal government and those provinces.

See the Operation of the Equalization Program section of this article for more information on precisely how the equalization payments are calculated.

One of the most important changes to the Equalization Program came in 1982, with its inclusion in the Canadian Constitution. Section 36(2) of the Constitution Act, 1982 states that the federal government and the provinces are “committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation” (Department of Justice Canada, Constitution Acts 1867 to 1982). It is important to note, however, that Section 36(2) only provides a commitment to the principle of equalization payments, but does precisely outline how such payments are to be calculated or made.

Operation of the Equalization Program

The equalization formula and how the numbers are crunched

Legislative Framework of the Equalization Program

As the Equalization Program involves federal transfers to the provinces, its framework is set in federally enacted legislation. This legislation is renewed every five years, at which time the federal government and the provinces work together to negotiate any changes to the program. The legislation is then debated upon and passed by the federal Parliament. Within the five-year period, the federal government can modify the program.

Calculation of Equalization Payments

The federal legislation sets out precisely how equalization payments are calculated. The following provides an overview of the equalization formula as of December 2007. It is important to note that this current Equalization Program is the result of significant reforms introduced by the federal Conservative government in its 2007 budget.

The equalization formula involves two key calculations. First, the fiscal capacity of each province must be determined. Provincial fiscal capacity is measured using five tax bases: personal income tax, business income tax, consumption tax, property tax and natural resources. However, 50 per cent of natural resource revenues are excluded in determining each province’s fiscal capacity, as well as the national standard (see below for more on the national standard). The result is a determination of how much revenue per capita (or per person) each province is able to raise. These figures will not be uniform across all provinces, as some have higher fiscal capacities than others.

Second, these per capita revenue figures are then compared with a national standard. Prior to 2007 this national standard was based on the average incomes of the five middle-income provinces: Quebec, Ontario, Manitoba, Saskatchewan and British Columbia. Following the 2007 changes, however, the national standard is now based on the average incomes of all 10 provinces. Whether a province is eligible for equalization, and how much it may receive, is based on its comparison to this national standard. Those provinces that are below the national standard will receive funds to top them up to the average of all 10 provinces. Those provinces that are above the national standard are not eligible for equalization payments.

Certain qualifications have been built into this basic system of calculation. For example, Nova Scotia and Newfoundland and Labrador have been allowed to maintain the benefits the Atlantic Accords, which had been agreed to in 2005. Under these Accords, the federal government had committed to completely protecting the two provinces from any reduction in equalization payments due to increased revenues stemming from the offshore oil industry. Originally, the Conservatives’ new system of equalization had backtracked from this commitment, which had been negotiated by the previous Liberal government. However, after these two Atlantic provinces strongly denounced the plan, the Conservative government agreed to a compromise. Under the agreement, Nova Scotia and Newfoundland and Labrador have the option of continuing under the old equalization system with the full protection of the Atlantic Accords, or adopting the new system, which includes higher levels of federal transfers for those provinces that fall below the national standard.

Comparison of Provincial Equalization Entitlements

In 2007-2008, the federal government transferred $12.9 billion to the provinces through the Equalization Program (Department of Finance, Federal Transfers to Provinces and Territories). The following provides a breakdown of equalization payments by province.

2007-2008 Equalization Payments by Province ($ millions)
British Columbia	0	Quebec	7,160
Alberta	0	Newfoundland/Labrador	477
Saskatchewan	226	Nova Scotia	1,465
Manitoba	1,826	New Brunswick	1,477
Ontario	0	Prince Edward Island	294

(Source: Department of Finance, Federal Transfers to Provinces and Territories)

Traditionally, the key recipients of equalization payments are the Atlantic provinces and Quebec, especially when examining the amounts they receive on a per capita basis. By contrast, Alberta, British Columbia and Ontario generally do not receive equalization payments (although, British Columbia did receive small levels of payment between 1999 and 2006).

Issues and Debates on the Equalization Program

Contemporary issues on the operation and nature of equalization

Determining the Equalization Formula

Since its inception in 1957, there has been a debate on precisely how equalization payments should be calculated. Two issues are central to this debate: calculation of the national standard and calculation of individual provincial fiscal capacities.

A province’s fiscal capacity is measured against a national standard comprising the average taxing capacity of a number of given provinces. Since the first equalization agreement in 1957, the number of provinces making up the national standard has changed several times. In 1957, a province’s fiscal capacity was measured against the average taxing capacity of Ontario and British Columbia, which, at the time, were Canada’s two richest provinces. In the 1960s, the federal government changed the calculation to include all 10 provinces. Including oil-rich Alberta in the calculation created problems in the 1970s when international oil prices skyrocketed. Alberta’s tax revenues raised the average to the point where even Ontario would have received equalization.

In 1982, the federal government removed both Alberta and the poorer provinces from the calculation. The national standard was based on the average taxing capacity of five middle-income provinces – British Columbia, Ontario, Saskatchewan, Manitoba and Quebec. Several provinces argued that the five-province standard unfairly lowers their entitlements, and sought a return to the ten-province standard.

In 2007, the Conservative federal government introduced significant reforms to the Equalization Program to address some of these issues. The new system reverts back to a national standard based on the average fiscal capacities of all 10 provinces (instead of just the five middle-income provinces). In order to deal with problems stemming from including oil-rich Alberta, the new system includes only 50 percent of provincial resource revenues in calculations of the national standard. This qualification is meant to mitigate a rise of the national standard to an inflated level. Nevertheless, the result has been a substantial increase in equalization payments to eligible provinces.

In regard to the calculation of individual provincial fiscal capacities, some experts had argued that the equalization formula was too complicated. Since its inception, the number of items used to determine each province’s fiscal capacity had risen from the three items contained in the original tax rental agreements (corporate income tax, personal income tax and succession duties) to 33. Critics argued this made the program more difficult to understand, and increased the possibility of error.

The new equalization system introduced in 2007 significantly reduced the number of items used to determine a province’s fiscal capacity. Instead of taking into account 33 different types of provincial revenues, the new system is now based on only five types: personal income tax, business income tax, consumption tax, property tax and natural resources.

Equalization Encourages Dependency

Some economists have argued that the Equalization Program contributes to financial and economic dependency, particularly in the case of Atlantic Canada. The basic argument is that no incentive exists for a province to strengthen its economy, since generating more revenue would equal losing out on financial transfers from the federal government. Similarly, if a province has discovered potential sources of revenue, such as natural resources, there is no incentive to develop them, as the new revenue would lower the provinces equalization payments.

In the past, the federal government has attempted to address this issue with special agreements, such as the Atlantic Accords. These agreements provided Nova Scotia and Newfoundland and Labrador with temporary protection from reductions in equalization payments due to increased government revenues from their offshore oil industries (until these industries are fully developed). As such, the motivation to develop new revenue streams is maintained.

It is important to note that such dependency arguments assume that provincial governments are only motivated to develop their economies if it will result in greater government revenues. One may argue, however, that other factors motivate provincial governments in this respect, such as improving the economic conditions and quality of life of their residents. In this context, a government may be motivated to improve its economy even though it may result in decreased equalization payments.

Equalization Unfair to the Richer Provinces

Another important debate regarding the Equalization Program concerns its fairness to richer provinces — in particular, those provinces ineligible to receive payments from the federal government. The basic concern here is that the federal government takes tax dollars it has collected from the richer provinces, and redistributes those monies elsewhere in the country. As such, the equalization system is unfair in the sense that it represents a financial drain on the economies of non-eligible provinces.

Supporters of the Equalization Program, in contrast, draw attention to the fact that all provinces, even the rich ones, receive substantial transfers from the federal government every year (for example, through the Canada Social Transfer and the Canada Health Transfer). Moreover, supporters argue that the Equalization Program is fair in the sense that it is meant to ensure a comparable level of social services at a comparable level of taxation across the country.

At the core of this debate are very different senses of ‘fairness.’ The anti-equalization argument conceives of fairness in terms of proportionality. Those provinces with stronger economies are entitled to the full rewards of their economic success, while those with weaker economies should be satisfied with what they have. The pro-equalization argument, by contrast, views fairness in terms of sameness; all citizens are entitled to the same social services at the same tax rate, regardless of where they live. How one personally views fairness in this context will bear heavily on whether or not they support the very notion of the Equalization Program.

Equalization and the Atlantic Accords

Another important issue regarding equalization has been the 1985 and 2005 Atlantic Accords, which were agreed to by the federal government and the provinces of Newfoundland and Labrador and Nova Scotia. Under these Accords, the federal government agreed to protect these provinces from any loss in equalization payments due to increased provincial revenues stemming from the development of offshore oil industries.

For more information on the Atlantic Accords:

Mapleleafweb: Federalism and the Atlantic Provinces: Contemporary Issues and Debates

Some critics of the Atlantic Accords have questioned whether such protection should be afforded Newfoundland and Labrador and Nova Scotia. If these provinces are gaining new revenues from the extraction of offshore oil, why should they be entitled to the same levels of equalization payments as before? This criticism can seem particularly strong considering that no other provinces received similar protection regarding their natural resources revenues.

In response, supporters of the Accords have argued that Newfoundland and Labrador and Nova Scotia still require equalization protection in order to continue their financial turnarounds. These provinces have endured an extended period of economic decline, which have contributed to a cycle of government deficits and ballooning debt. Moreover, unlike other oil-rich provinces, such as Alberta, the Atlantic offshore oil industry is still in its infancy, and will not fully reward the provinces for several years to come. As such, supporters of the Accords argue that some temporary equalization protection must be offered to Newfoundland and Labrador and Nova Scotia to ensure their long-term financial stability.

This debate came to a head in 2007, when the new Conservative federal government, helmed by Prime Minister Stephen Harper, unilaterally altered the Equalization Program and the Atlantic Accords. Under the reforms, federal transfers under the Equalization Program were enriched; Newfoundland and Labrador and Nova Scotia, however, would no longer be completely protected from declines in these payments due to increasing provincial oil and gas tax revenues. This change led to a very public conflict between the two provinces and the federal government, and created strong dissent within the federal Conservative Party and its Atlantic caucus.

In an effort to overcome the issue, the Harper government offered two options to Newfoundland and Labrador and Nova Scotia. The provinces could either continue with the old equalization formula and the Atlantic Accords, or they could enter into a new enriched equalization formula that included a cap on the amount of equalization payments if offshore oil and gas revenues reached a certain level. In 2007, both provinces agreed to the new formula – although Newfoundland and Labrador did so only for one year, leaving the door open to change its position in the future.

Sources and Links to More Information

List of article sources and links to more on this topic

Sources Used for this Article

Bélanger, C. “Canadian Federalism, the Tax Rental Agreements of the Period of 1941-1962 and Fiscal Federalism from 1962 to 1977.” MarianopolisCollege. 19 February 2001. 11 February 2007. <http://faculty.marianopolis.edu/c.belanger/QuebecHistory/federal/taxrent.htm>
Courchene, T.J. “Equalization Payments.” The Canadian Encyclopedia. 11 February 2008. <http://www.thecanadianencyclopedia.com/index.cfm?PgNm=TCE&Params=A1ARTA0002632>
Makarenko, J. “Federalism and the Atlantic Provinces: Contemporary Issues and Debates.” Mapleleafweb.com. 06 February 2009. 11 February 2008. <http://www.mapleleafweb.com/features/federalism-and-atlantic-provinces-contemporary-issues-and-debates>
“The Constitution Acts 1867 to 1982.” Department of Justice Canada. 11 February 2008. <http://laws.justice.gc.ca/en/const/index.html>
“Achieving a National Purpose: Putting Equalization Back on Track.” Expert Panel on Equalization and Territorial Formula Financing. May 2006. 11 February 2008. <http://www.eqtff-pfft.ca/english/EQTreasury/index.asp>
“Renewing Equalization.” Department of Finance Canada. 11 December 2007. 11 February 2008. <http://www.fin.gc.ca/transfers/transfers_renew_e.html>
“Equalization Program.” Department of Finance Canada. 11 December 2007. 11 February 2008. <http://www.fin.gc.ca/FEDPROV/eqpe.html>
“Federal Transfers to Provinces and Territories.” Department of Finance Canada. 11 December 2007. 11 February 2008. <http://www.fin.gc.ca/FEDPROV/mtpe.html>

Links to More Information

Fiscal Imbalance Debate: Origins and Perspectives

Brian Doody — Tue, 18 Dec 2007 13:27:56 -0700

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.

Introduction to the Fiscal Imbalance Debate

Fiscal federalism and the origins of the fiscal imbalance debate

Perspectives in the Fiscal Imbalance Debate

Proponents and critics of the idea of fiscal imbalance

Assessing Perspectives in the Fiscal Imbalance Debate

Understanding how fiscal transfers are made

Future of the Fiscal Imbalance Debate

Where the debate goes from here

Sources and Links for Further Information

Lists of article sources and links for more on this topic

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.

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.

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.

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.

Sources and Links for Further Information

Lists of article sources and links for more on this topic

Sources Used for this Article

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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>
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Government of Ontario: <http://www.fairness.ca>