Don't blame the feds

The fiscal imbalance is largely a problem imposed by the provinces on themselves through destructive tax competition
July 21, 2006

Next week, the 13 premiers and territorial leaders will meet in
St. John's, N.L., with fiscal issues dominating the agenda. It is not going to be pretty.

Studies and background work over the past few months have drawn the fault lines between the provinces with stark clarity. Every provincial and territorial leader knows down to the last dollar which combination of options is of greatest benefit to his province or territory.

Surprisingly, in all of this discord, the provinces are unanimous in agreement on one thing: their determination to ignore inconvenient facts and the policy consequences of those facts.

They are agreed in assigning full responsibility for their fiscal problems to the federal government, ignoring the fact that tax-cut competition among provincial governments has reduced provincial fiscal capacity by more than cuts in federal transfer payments.

They are agreed that local governments' financial problems are not part of the national fiscal agenda, ignoring the fact that when the federal government cut transfer payments to the provinces in the late 1990s, the provinces as a group insulated themselves from the fiscal consequences by cutting their transfers to local governments.

The inconvenient facts are clear. Since the mid-1990s, provincial taxation revenue has dropped by 1.7 per cent of GDP, driven by cuts in personal and corporate income taxes that began in Ontario and
Alberta and swept across the country. Between 1996 and 2001, provincial revenue from personal income tax dropped from 66 per cent of federal revenue to 61 per cent. Provincial corporate income tax dropped from 60 per cent of federal revenue to 50 per cent.

In 1995, federal government transfer payments to provincial governments stood at 4.1 per cent of GDP. By 2000, these transfers had dropped to 3 per cent of GDP. Over the same period, provincial transfers to local governments dropped from 3.9 per cent of GDP to 2.9 per cent of GDP.

What this means is that the fiscal imbalance -- understood as an imbalance between provincial fiscal capacity and provincial program responsibilities -- is largely a problem imposed by the provinces on themselves through destructive tax-cut competition. And the impact of the federal transfer payment cuts was actually shifted by the provinces onto local governments.

Tax-cut competition and its impact on provincial fiscal capacity and the real fiscal crisis facing
Canada's largest cities are the 400-pound gorillas sitting in the corner of the room that no one wants to talk about.

All of this would merely be interesting if it weren't for one thing. Misunderstanding the roots of the problem of fiscal imbalance is taking us down a path that does not lead to a solution, and may make the problem worse.

In the absence of changes that will strengthen the ability of provincial governments to protect their fiscal capacity, tax-cut competition will continue to erode that fiscal capacity and exacerbate what we call the fiscal imbalance, regardless of what the federal government decides to do with its transfer payments.

Indeed, some of the proposals for reform under discussion, such as transferring income tax points from the federal government to the provinces, would actually make matters worse by making provincial governments even more dependent on the tax bases that are most vulnerable to attack from tax-rate competition.

This is by no means a new problem for
Canada. As early as 1940, the last royal commission to focus specifically on federal-provincial fiscal issues recommended a reallocation of tax responsibilities to make the federal government responsible for collecting taxes on bases that are difficult for sub-national governments to defend.

In the late 1960s, one of the lower-profile recommendations of the Carter Commission on Taxation was to transfer responsibility for corporate income taxation to the federal government, for the same reason. Exactly the same kinds of issues confront every provincial government considering alternatives to property taxes as revenue sources for local governments.

These are not easy issues. The European Union has been struggling for years to develop tax treaties to limit tax competition among member states. The obvious solution for
Canada of reassigning constitutional responsibility for the most competition-vulnerable tax bases to the federal government got nowhere in the 1940s and is even more of a non-starter today. But there are options available short of the dreaded spectre of constitutional change.

To get started, we have to acknowledge and talk about the problem. It isn't good enough to pretend it doesn't exist, as is the case in the current federal-provincial bun fight over fiscal imbalance.

The same thing holds true for the financial issues facing cities. Our urban governments were already financially weak before provincial governments passed on the transfer-payment pain of the late 1990s. The new federal transfer tied to gas-tax revenue in the celebrated "new deal for cities" is dwarfed by the size of the cuts in transfer payments. If it were fully implemented and made permanent, the "new deal" transfer will amount to about $2 billion a year; the cut in provincial transfers to local governments in the late 1990s, which has not been recovered, amounts to $12 billion.

Local public infrastructure continues to deteriorate as the growing importance of cities in our economy continues to raise the economic stakes. To pretend that two cents of gas-tax revenue spread out across
Canada solves the problem would be laughable if it weren't so dangerous to our economic future. Yet our big cities cannot even get a seat at the table.

Enjoy the theatre next week. But avoid disappointment. Don't expect to hear about the real issues of fiscal imbalance in
Canada. They're not in the script.

Hugh Mackenzie is an independent economist and a research associate of the Canadian Centre for Policy Alternatives. He recently authored 'The Art of the Impossible,' an extensive analysis of federal-provincial financial relationships, which is available for free on the CCPA website at