Intergovernmental Finance

Intergovernmental Finance

The term "intergovernmental finance" refers to the web of financial flows linking governments in a constantly evolving federal system (see FEDERALISM). In a federal state, to ensure that regional and cultural differences are respected while national interests and policies are pursued, legislative competencies and responsibilities are divided between distinct orders of government, each of which is autonomous within its own domain (see DISTRIBUTION OF POWERS). Local and First Nations governments also assume either delegated or inherent powers to raise revenues and deliver services to their residents or citizens. In a changing world, however, the fiscal capacity (revenue-raising powers) and expenditure responsibilities of the various governments will rarely be in balance; transfers will be necessary.

Since the CONSTITUTION ACT, 1867 established the initial arrangements, the system of intergovernmental finance in Canada has changed dramatically, with federal government dominance waxing and waning substantially over that period. The main elements, set out in the federal government's Federal-Provincial Fiscal Arrangements Act, are tax-collection agreements (see TAXATION), unconditional EQUALIZATION PAYMENTS and conditional block grants under the Canada Health and Social Transfer (CHST). In addition, administrative agreements provide for formula financing payments by the federal government to territorial governments.

Although the legislation behind all of these arrangements is formally a matter for the Parliament of Canada alone, tradition dictates that the terms of the arrangements should be determined by federal-provincial discussion and agreement. Unilateral introduction by the federal government of various "caps" and other provisions to limit the size of transfers, and unexpected budget measures to create the CHST, resulted in furious reactions by provincial governments.

The timing for renegotiation of these provisions varies. Much of the discussion has been driven by the 5-year cycle for renegotiation of the equalization program, which was renewed in legislation that took effect 1 April 1999. (New 5-year agreements governing territorial formula financing payments will also come into effect on that date.) Tax-collection agreements, however, have been indefinitely extended since 1977. While the Established Programs Financing (EPF) arrangements introduced in 1977 (as described below) had no expiry date, the CHST which replaced them is "sunsetted" to expire in 2002, after which renewed arrangements for these block transfers must be put in place.

Revenue Sources and Tax-Collection Agreements

The Constitution Act, 1867, assigned customs duties, excise taxes and all indirect levies to the national government. The insignificant (at that time) authority to levy direct taxes on local inhabitants was assigned to provincial governments, whose responsibilities were not expected to grow substantially. Small statutory subsidies were established to make up for anticipated shortfalls in provincial revenues arising from foregone customs duties. The century of economic expansion and national development after Confederation, however, altered this calculated balance. Provinces, faced with growing responsibilities and searching for new revenues, claimed increased subsidies and introduced a widening array of licences and taxes, succession duties and, for the first time, income taxes. Federal income tax, purportedly temporary, was introduced to finance World War I. Industrialization and urbanization led to rapid increases in provincial expenditures over the following 15 years until the GREAT DEPRESSION brought several provincial and municipal governments to the brink of bankruptcy. The unco-ordinated mesh of conflicting and overlapping direct taxation measures in force across the country was described as a "tax jungle." The ROYAL COMMISSION ON DOMINION-PROVINCIAL RELATIONS was established to address the problem.

By 1939 direct income taxes were a critical source of government revenue. To finance World War II, the federal government negotiated so-called tax-rental agreements with the provinces in 1942. Under these, provincial governments vacated personal and corporate income tax fields entirely in exchange for per capita "rental payments" by the federal government.

With the Dominion-Provincial Conference on Reconstruction of 1946, a new direction was established for Canada, with federal responsibility for maintaining aggregate levels of economic activity and for an extensive portfolio of national social programs. Continued federal dominance in access to tax room was a necessary consequence, so continuation of the wartime tax-rental agreements, with modifications, was proposed. Although both Ontario and Québec initially objected to the proposals, Ontario later agreed. In 1947 Québec opted out and established its own corporate and personal income-tax collection system. The province has consistently maintained its objections to the federal role in these arrangements ever since.

Similar arrangements remained in force until 1962, when the tax-rental agreements were replaced by a tax-sharing arrangement under which the federal government undertook "tax abatements" or payments to provinces of specified shares of personal and corporate income taxes and inheritance taxes, and stood ready, under tax-collection agreements, to collect additional income taxes levied by provincial governments under their own provincial legislation.

In 1972, after 10 years of bitter debate over the appropriate sharing of the available tax room and then over federal proposals for tax reform (see TAXATION, ROYAL COMMISSION ON), the tax-collection agreements were changed again and have remained in essentially their 1972 form up to the present. The federal government lowered federal rates of personal and corporate income taxation, leaving room for provincial governments to levy their own income taxes directly. The federal government, however, would continue to collect income taxes on behalf of most provinces.

In 1991, in a highly controversial measure, the federal government replaced the federal manufacturers' sales tax with the more broadly based Goods and Services Tax (GST). The government expected that provinces would harmonize and integrate this tax with their own sales tax provisions, and agree to federal administration of the harmonized tax. In fact, agreement was initially reached only with Québec, and that only on Québec's condition that Québec administer both its own tax and the federal GST within the province. Subsequently, 3 of the Atlantic provinces - New Brunswick, Nova Scotia and Newfoundland - agreed to roll their tax into the harmonized system, but only with compensation through a federal subsidy to make up the revenues lost by the need to bring their provincial rates down to 8%. Combined with the 7% federal rate, this led to a total 15% rate for the new harmonized sales tax (HST), administered by Revenue Canada.

Federal-Provincial Grants and Programs

Instead of transferring taxing powers or tax room, governments may make direct annual payments (or cash transfers) to each other. Several different types of transfers exist, the most important distinctions resting on whether they are conditional or unconditional, and whether they are general purpose (block) grants or specific-purpose grants. Unconditional grants require no particular commitment by the recipient government, while conditional grants require that certain criteria or conditions decided by the donor government (such as those laid down in the Canada Health Act, for example, or the Canada Assistance Plan regulations) be met by the recipient government. Examples of specific-purpose transfers include incentive grants (to stimulate expenditure by the recipient government on particular activities), and matching or shared-cost programs. Block grants may be conditional, but, as the name implies, the amount of the transfer is fixed independently of the purpose to which the funds are put.

Equalization Payments

The most important set of unconditional payments reflects what has become accepted as the federal government's responsibility "to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation" (see EQUALIZATION PAYMENTS).

Since its introduction in 1957, the federal government's Equalization Program has been re-negotiated at 5-year intervals and, with modifications, has remained in force up to the present. Negotiations are underway for a renewal to take effect on 1 April 1999. Estimated at $8.5 billion for the 1998-99 fiscal year, these equalization payments now represent over one-third of total federal-provincial cash transfers.

Territorial formula financing payments made under federal-territorial agreements serve for territorial governments the same purpose as equalization payments for provincial governments. However, given that the fiscal capacities of territorial governments are modest relative to expenditure responsibilities, territorial payments are made in a more direct manner, taking into account expenditure needs in the special circumstances of the North. Such payments to the Yukon and Northwest Territories were estimated at $1.1 billion in 1998-99; for the following fiscal year, with the birth of the new territory of Nunavut on 1 April 1999, increased payments are to be made to the 3 territories under a new 5-year agreement.

Canada Health and Social Transfer

A variety of other federal-provincial transfers designed to encourage provincial expenditures in particular areas such as health, education and social services, which are generally thought to fall within exclusive provincial jurisdiction, are more controversial.

In particular, cost-sharing arrangements provided the vehicle for federal encouragement of national programs of hospital insurance in 1957. This is also true for medical insurance, the Canada Assistance Plan (CAP) and post-secondary education financing, all dating from around 1967. In 1977, the health and post-secondary education financing programs were rolled into a single block grant, the Established Programs Financing (EPF) program. It is structured as a per capita entitlement and escalated to reflect growth in the economy. Payment was to be made by the federal government primarily through a transfer of tax points, or "tax transfer" (provincial revenues resulting from a federal reduction in income tax rates accompanied by a corresponding increase in provincial income tax rates, with the taxpayer being left unaffected), with the balance made up by cash payments. Because the value of the tax points was greater in high-income provinces, the residual per capita cash payment was lower. This disparity gave rise to continuing complaint on the part of the richer provinces.

Through the 1970s and 1980s a variety of unilateral federal measures resulted in reduced cash transfers under EPF and cost-sharing programs. The most controversial and objectionable of these, from the provincial perspective, was the so-called "cap on CAP." Nevertheless, a Supreme Court of Canada ruling maintained the legal right of the federal government to alter the amounts of such transfers stemming from federal-provincial agreements but authorized under federal legislation.

In 1996, the last of the major cost-shared programs, CAP itself, was rolled into the EPF arrangements, and the overall program relabelled the Canada Health and Social Transfer (CHST). This coincided with a significant reduction in the aggregate cash transfer and further "equalization" to which richer provinces continue to object. Payment to Québec continues to be made through an "abatement" of federal taxes rather than a direct transfer.

As of 1998-99, the profile of federal cash payments was roughly $10 billion for unconditional general-purpose transfers (equalization, territorial financing, statutory subsidies and grants), $12.5 billion for Canada Health and Social Transfer (CHST), and $1.5 billion for a variety of specific-purpose transfers to both provinces and municipalities (the latter principally for infrastructure investment and transportation services). This total of close to $24 billion represents just over 20% of federal government program spending. In addition, the federal government attributes as part of the CHST another $12.5 billion associated with the 1977 transfer of tax points. This leads to an estimated total of around $36.5 billion in federal transfers to provincial, territorial and local governments and represents over 40% of revenues for the poorest provincial governments, and close to 20% even for the richest.

Provincial governments have argued that the "tax transfer" is history and relates to each province's own revenues. Because of this, they have focused on the cash transfer and have expressed concern about the prospect of continuing declines, particularly in respect to the CHST, during a period of continuing fiscal restraint. In 1998 the federal government responded with legislated amendments assuring a minimum "floor" of $12.5 billion in aggregate cash transfers under the CHST. For 1998-99, the cash transfer was about $24 billion and was almost entirely in the form of general-purpose or block grants.

Provincial-municipal Transfers

Provincial-municipal transfers have followed a somewhat different path, but have prompted similar complaints. Rather than being negotiated between autonomous orders of government, provincial-municipal transfers are largely dictated by provincial governments to shape the activities of municipal governments, which serve, in effect, as agents of the provincial governments which finance them.

Higher expenditures at the local level have been financed not so much through increasing revenues through the property tax, which is the main revenue source for municipalities, as through conditional, closed-ended matching grants from provincial governments. Such transfers increased as a percentage of both provincial expenditures and municipal revenues over the postwar period up to the mid-1970s, but have declined (as percentages) over the past 2 decades. Just as provincial governments have criticized federal "off-loading" of responsibilities while restraining cash transfers, so there has been considerable complaint by municipalities about provincial governments transferring responsibilities for service delivery with no corresponding increase in transfers of resources.

In the postwar period, federal-provincial transfers have shifted from a predominance of special-purpose grants or shared-cost programs towards (conditional) block grants that may be used for any purpose provided conditions are met. Although provincial governments must still satisfy the conditions set out in the Canada Health Act, and the requirement that no residency period be imposed in social assistance programs, their entitlements to transfer payments under the CHST do not depend at all on the level or composition of provincial expenditures. Federal-provincial negotiations on the social union may be moving closer to agreed restrictions on exercise of the federal spending power, and on provincial roles in establishing agreed national standards or guidelines for social programs, but the issue remains unresolved.

Fundamental questions remain also with respect to the equalization program. The treatment of revenues from both onshore and offshore resources (particularly in light of possibly increasing use of "green" taxes) remains a concern, as does the related question of whether the baseline measure of fiscal capacity should be a 5-province average, as at present, or 10, or some other number. The impact of land-claims settlements, self-government arrangements and modern treaties with First Nations is unclear. There are also problems connected with the increasing use of user fees and charges, and other forms of earmarked taxes or benefit taxation, as well as to gaming and lottery revenues and local government finance. More fundamental still, perhaps, is the ongoing debate as to whether there are market mechanisms ("capitalization" processes) that render explicit equalization programs unnecessary and whether existing equalization provisions built into the cash transfers, coupled with the equalization program itself, do not result in substantial "over-equalization." It has also been argued that the net effect of federal-provincial arrangements combined with tax and transfer mechanisms is a far from uniform method of taxing Canadians. The net redistribution of income resulting from the interaction of taxes, transfers and expenditure programs may vary substantially depending on where a resident lives.

Finally, tax transfers and cash transfers form only one part of an apparatus of government that also includes regulatory powers, direct services and a maze of production activities. Fiscal arrangements also affect interprovincial flows of goods, services and productive resources. When competition among provinces for productive activities intensifies, tax concessions - incentives to locate economic activity in one province rather than another - are commonly introduced. Such provisions can reduce the effectiveness or even threaten the existence of a Canadian common market. Because of this, federal-provincial tax-collection agreements to promote tax harmonization are essential to the preservation of a strong economic union (as is compliance with the provisions of the Agreement on Internal Trade).

The pressures of fiscal restraint (from 1978 onwards) and ideological stance (from the increasingly pronounced free market and free trade orientation of much Canadian opinion, particularly following the report of the Macdonald Commission in 1986) have led the federal government to a much reduced role in the economy; by 1998 the federal minister of finance was able to report that federal program expenditures had fallen below 12% of gross domestic product, their lowest level since the 1940s. Concern for harmonization within Canada has to some extent been overtaken by anxiety about harmonization with trading partners (above all the US). Still unresolved is the question of whether the scale of Canada's equalization payments and other transfers is compatible with achieving or maintaining a strong competitive position in a continental and global economy.