Proceedings of the Standing Senate Committee on
National Finance
Issue 4 - Evidence - Meeting of October 17, 2006
OTTAWA, Tuesday, October 17, 2006
The Standing Senate Committee on National Finance met this day at 9:35 a.m. to examine and report on issues relating to the vertical and horizontal fiscal balances among the various orders of government in Canada.
Senator Joseph A. Day (Chairman) in the chair.
[English]
The Chairman: Honourable senators, the Standing Senate Committee on National Finance is meeting today to continue its study into the vertical and horizontal fiscal balances among the various orders of government in Canada. This is a timely study of an issue that is attracting more attention. We will be building on our previous work on the equalization formula and a previous report by this committee, but we will also move beyond that to consider the issue more broadly.
Today I am pleased to welcome Michael Smart. Mr. Smart is a professor of economics at the University of Toronto, a research fellow of the C.D. Howe Institute and a specialist in the economic analysis of government policy. He has published widely in academic and policy journals on such subjects as tax policy design, tax compensation among governments, fiscal federalism in Canada and abroad and the politics of taxation in government.
Michael Smart, Professor, Department of Economics, University of Toronto, as an individual: Thank you, Mr. Chairman, and I thank the committee for this opportunity to speak about these interesting and important issues. On a personal note, I would like to say it is very interesting to do this presentation in this room where I held my first student summer job some years ago as a runner in the old Canadian Press parliamentary bureau. I like what you have done with the place. It is nice to be back.
I will talk about equalization reform as it currently stands in Canada. I think you will agree these last few years have been a fairly tumultuous period in fiscal arrangements in the country. It is interesting that what is normally quite a sleepy area now gets a lot more attention at higher levels. That is a positive force in many ways. I am thinking in particular of the changes since 2004, when Prime Minister Martin and the premiers negotiated a fundamental change in our equalization arrangements — the so-called new framework agreement. The various side deals to equalization came along during that period as well.
More broadly, I am thinking about the greater high-level political attention to these fiscal gaps among the provinces. There is now a tendency to view transfer reform as a kind of zero-sum game in which all that matters in considering reforms is the impact on the bottom line for one particular province — that overarching principles no longer matter, as they did for many participants in the past. That is a fundamental aspect of the current situation that we need to address.
Into that environment came the release of the report of the expert panel on equalization, chaired by Mr. Al O'Brien. In that context, the report should be viewed as an attempt to return our equalization formula to a principle basis, which means to have a formula and to stick with a particular formula. At the same time, I think the report is a pragmatic attempt to ensure that the reforms that should be undertaken will have no large impact on the bottom line for any individual province, and no substantial implications for the bottom line for the federal government for total spending under the program. There is a lot to admire in that combination of principle and pragmatism. The O'Brien report is a very good working basis for thinking about reform.
I come to these issues as a supporter of the principle of equalization in Canada and, in large measure, a supporter of the pre-2004 status quo formula that operated in various forms for two generations in this country. Inevitably, that view makes me a critic of some aspects of the reforms of the last two years and of some aspects of the O'Brien report as well.
Today, I will try to go beyond this kind of zero-sum thinking focusing on fiscal gaps among provinces, and talk about some issues of principles — in particular, the likely effects of equalization reform on the economy of the country. I will discuss three points and then move on to a general discussion. The first and most important point will be the equalization of natural resource revenues.
This is some of the most interesting and complex of the issues currently facing the government and of the issues addressed in the report. The recent comments of Premier Williams in Gander attest to the fact that the equalization of resources is also the most controversial area in the formula today. We cannot get away from these political aspects even as we talk about principle.
In the panel's very interesting reform proposals, I think there is a serious possibility that the impact of implementing that package of reforms would be to lower the level of natural resource taxation, the royalty rates being imposed by provinces. I will explain that argument in detail as we go forward. We should think not about the bottom line for an individual province, but the level of resource taxation we will see in the country as a whole if the reforms are adopted.
I take the view that resources are taxed preferentially within our system. There is a lot of evidence to support this idea that the resource sector gets a special deal from all levels of government. The view that equalization reforms will result in lower taxes is problematic and we should give it some thought.
I will go on to talk about two other aspects. First, I wish to offer comments on how we got here; that is, what was going on prior to 2004 that led to these reforms. I would argue that there was a big reduction in equalization entitlements under the old formula in 2000-04. That reduction was entirely appropriate. The formula was working as it was supposed to work. What failed was the political compromise in support of the formula. We need to think about that because this new political environment will certainly change the likelihood that any particular reforms will be adopted and will lead to the possibility that only certain reforms are politically feasible.
Second, I will talk about the panel report broadly and its implications on affordability for the federal government. The proposals in the panel report are carefully calibrated so that the bottom line impact is relatively small. There is the potential that if the government adopts some parts of the proposals, the program could become more expensive. Relatively small changes in the economic environment, such as the price of oil going forward, also have the potential to change the bottom line impact for the federal government. In that context of risks to affordability, it may be reasonable to return to the 2004 new framework agreement idea of a global cap on the cost of the program. There may be no choice but to do that. I want to look at a particular reform package that takes elements of the panel proposal and elements of the new framework and talk about how that would work.
Let me offer you a quick review about what the panel said about the resources. The chief recommendations that bear on resources are, first, a proposal that we should return to a 10-province standard for equalization. The standard is the level that we attempt raise all provinces to through the equalization transfer system. The proposal is that, instead of the five-province standard that excluded Alberta and the Atlantic provinces up until 2004, we should go to the 10- province standard. That is not about resources, but if Alberta's resource revenues go into the formula, it will increase the costs to the federal government of achieving the equalization objective.
The second key component is that in doing so we should now include only 50 per cent of the natural resource revenues instead of the 100 per cent in the old formula. That clearly tempers the 10-province standard recommendation. It means that we will count Alberta's revenues, but only 50 per cent of them. That is also the case with the other provinces in doing the calculations.
The third component, which is equally important, is a proposal that when we calculate each province's entitlements in respect of these resource taxes, we should measure their fiscal capacity — that is, their ability to raise resource revenues — by the actual revenues they raise. That aggregate measure of actual revenues would replace the 14 different and complicated current measures of the potential for each province to raise resources revenues.
The fourth element is a cap on entitlements. After calculating the transfers, we should ensure that the fiscal capacity of no province, including transfers, exceeds those of a province that does not receive equalization. That would be Ontario. Consequently, no province could have more after equalization than Ontario has in the same year. That is not about resources but it is most likely to bind on two provinces, namely, Saskatchewan and Newfoundland. It is most likely to affect those provinces because of the treatment of resource revenues in the proposed formula.
The 10-province standard is not really about resources or about what is the correct principled basis for equalization in the country. It is simply a statement about to what level to raise the receiving provinces in the country. A decision to adopt a 10-province standard instead of a five-province standard realizes that Alberta has a higher fiscal capacity than the other provinces. By going to a 10-province standard, we will raise all provinces to a level higher than before. It is an equal per capita increase in the transfers to all provinces. That would be a win for all the receiving provinces.
The 50 per cent inclusion will have two effects. It will benefit the receiving provinces that have above average resource revenues. Presently, their equalization transfers go down through resources. If we only include half of that in the formula, the losses will be relatively small. That means Newfoundland and Saskatchewan would gain from 50 per cent inclusion. However, with the proposed cap, which may not be implemented, in particular for Newfoundland and Labrador given the current offshore accords, the effect would be to tax back all of that benefit to Newfoundland and Labrador and Saskatchewan. The main impact of the 50 per cent inclusion is to control the costs for the federal government. There are principles induced by the panel for this in the report, but it really comes down to a measure for affordability.
I will focus on the effects that I believe these reforms would have on the level of resource taxation by the provinces. This is a bit technical. I will review the public finance notions of how the provinces set taxes. It is useful in this context to think of the hypothetical example about the current negotiations between the Government of Newfoundland and Labrador and the consortium that has the rights to develop the Hebron offshore oil field. I stress that I am not party to any particular elements of that negotiation, but they illustrate the principles that govern these situations. We should think of a government that is choosing a level of resource taxation and the royalty rates that are being applied to resource projects in a way that is attempting to trade off the best interests of its citizens, and the benefits of the additional revenues resulting from higher royalty rates. We must think of this against the potential for economic losses resulting from projects being abandoned because of high royalty rates. The more the Government of Newfoundland and Labrador hypothetically demands more in royalties on a particular project, the greater the likelihood that project will not happen. There is a trade-off between the benefits of higher revenues and the potential economic losses from the failure of development. That is at the heart of what governments must decide when they decide upon resource taxation rates.
Into that context, let us think about the implications of the equalization formula and the so-called tax back problem that equalization creates. Recall that equalization works as follows: Each province is paid an amount equal to the difference between the so-called yields of its tax bases; that is, the amount of revenue that can be raised from its tax bases at the national average tax rates and the standard level, either the five-province or the 10-province standard. The lower the province's tax bases under the formula, the higher will be its equalization transfers. In this Hebron example, insisting on higher royalty rates may make economic development of these fields less likely, which makes the measured tax bases of the provinces small which, under the equalization formula, increases the transfers that the provinces receive. Equalization changes this trade-off between revenues and economic development in a fundamental way. From the perspective of the province, if development does not go forward that is unfortunate because of the economic costs to the province; however, it will be compensated through higher transfers under the equalization program.
An unintended consequence of our equalization formula is to subsidize tax increases by the provinces. Sometimes that is regarded as a bad thing and as undesirable. My view is that resources are already taxed preferentially in this country. Therefore, this unintended effect to raise resource taxes is a desirable part of the formula. That is my perspective on tax back and resources. It does have some beneficial effects on the way resources are taxed in this country.
What about the panel's reforms in this context? I want to focus on two things — partial inclusion and revenues as the base.
Notice that if only 50 per cent of resources are included in the calculation of equalization, then this tax-back effect will get smaller. Any losses in economic development, because projects are not carried forward at higher royalty rates, will still be compensated but only at half the rate they were before because we only count half of the revenues in the formula under the proposal. That means that the subsidy to maintaining relatively high royalty rates would become lower if the panel's 50 per cent proposal were adopted, and I think we would see relatively low resource taxes being imposed by equalization-receiving provinces in the country. That is the theory.
We can look for some evidence of that prediction in what has happened in the history of these arrangements in Canada. Between 1973 and 1981, we had only partial inclusion of resource revenues in the formula — 33 per cent and then 50 per cent over that previous period of relatively high oil prices. As I have shown in some recent research, what happened to the effective tax rates imposed by receiving provinces in that period conforms exactly to the prediction I have just described to you. In particular, the receiving provinces had relatively low tax rates on resources compared to after 1981, when we went back to 100 per cent inclusion. That was not just a difference between the 1970s and the 1980s. The non-receiving provinces did exactly the opposite; they had relatively high taxes during the earlier 1970s period. In comparing the receiving to the non-receiving provinces, my estimate is that partial inclusion lowers taxes on resources by about 20 per cent, a very significant amount and, therefore, an important consideration in thinking about that reform.
The second point is this proposal to have just one resource revenue base and to measure fiscal capacity by the actual provincial revenues. This is part of a more general and desirable idea to simplify the equalization formula. We currently use 33 different bases to measure the province's capacity to raise revenues. That is too many for the formula to function well and to be transparent to its users. The panel has proposed that we use five bases and I think that would work very well. We could do a good job in getting the right kind of transfers with a much simpler calculation. One of those five bases is resources and my concern is the idea that we should measure revenue potential by actual revenues in that category.
The problem is clearest for a province like Newfoundland. Recall that under the panel's proposals, Newfoundland would be in all likelihood subject to a cap, which would limit the transfers it receives so it could never exceed Ontario's fiscal capacity. If we use actual revenues to measure capacity, it means each dollar in additional revenues from resources generated by Newfoundland will lead to a one-dollar fall in its equalization transfers. They will get nothing; there will be a full tax back of all revenues.
This kind of revenue sharing arrangement makes it very unlikely that a government facing those incentives would choose to tax these categories at all. For a province that is subject to the cap — like Newfoundland and Labrador and Saskatchewan — this simply would not work. We would not see these provinces engaging in appropriate taxation of the sector at all, given that they would receive no financial benefits from doing so. They would just concentrate on the economic development incentives. For the other provinces not subject to the cap, the problem is less because of 50 per cent inclusion, but I think it is still there. Also, this notion that we should use revenues as the base in the calculation would lead to lower resource revenues overall in the country.
I will turn to these broader issues for just a few moments. First, in the brief I have submitted to you, I present some calculations on what I believe precipitated the sharp decline in equalization transfers under the old formula prior to 2004, which led to the new framework and the current reform process. That decline was substantial, a reduction of about 20 per cent in the total payments received by those provinces in four years. I think it was entirely appropriate as well because it reflected an increase in the fiscal capacity to raise revenue for the equalization-receiving provinces. That is how the formula is supposed to work; payments go to provinces when their capacity is low and not otherwise. That leads me to think that the collapse of the old formula reflects the political situation rather than anything fundamentally wrong with the formula. I want to offer some brief comments on the political process.
Over the last 10 years, we have gone from a situation where fiscal arrangements were determined through consultations at the officials level, through committees of federal and provincial officials, to a process that is more and more dominated by first ministers, where more decisions are taken unilaterally by the federal government and where the process of negotiation among first ministers seems to drive more of the detailed elements of the calculations. Increasingly, because the first ministers play such a role in these details of the calculations, what we are seeing is that changes even in federal legislation and programs seem now to require unanimity or a super-majority of the premiers' consents before going forward. That approach makes no sense and is likely to bias the transfer reforms we will see in this country in predictable ways in the future.
The first example of that is your committee will think about the choice between horizontal equalization transfers and vertical balance issues of how much should be transferred to the provinces through the other major transfers for health and social services. It seems to me now that many of us think there could be benefits from devoting more federal resources to the social transfers. At this time, six out of 10 provinces would prefer additional federal support to come in the form of equalization, from which they receive more than their equal-per-capita share. In that environment, because the first ministers are so important, it seems almost inevitable that the reforms will be biased toward equalization and away from other transfer reforms. You may think that is good or bad, but I do not believe it is a rational process for making those decisions. We see these kinds of problems in the equalization program, too.
One important point is it may be appropriate to increase the amount paid through the equalization program. The panel has argued, and most academic experts agree, that if you are going to pay more, you should increase equalization transfers by equal-per-capita amounts. That is what it would mean to increase the standard.
That is not what happened in the new framework agreement. Instead, when additional funds were made available, there was a proportionate scaling of the equalization transfers that were received by all provinces. Therefore, that gives more to the provinces of relatively low fiscal capacity — it actually over-equalizes provinces like Newfoundland and Prince Edward Island and costs Quebec relative to equal-per-capita increases.
Among the equalization receiving provinces, all of them except for Quebec prefer that kind of scaling of transfers, even though it leads to this bizarre situation that Newfoundland's equalized fiscal capacity exceeds that of Ontario. This kind of skewed increase in the formula makes sense to a majority of the equalization receiving provinces but it does not make sense to the academic experts who have looked at this program. The question is how can we change the reform process, the process of negotiation of these things so that these obvious biases do not effect what comes out of the process?
It is too late to put the genie back in the bottle. We can no longer expect officials alone to determine the important elements of this program. We might want to put important decisions in this area into the hands of a separate body of elected or appointed officials. The panel rejected that, but I think it is worth our consideration. We can think about the way it is done in some other countries, where the body has an appropriate regional balance and has clear rules for decision making.
In Germany, for example, both the upper chamber of the legislature and the courts play a role in determining these things. That has never been the case in Canada. We may need those kinds of formal consultation and decision-making processes because the existing processes do not seem to be working.
I will make a brief concluding remark about affordability. There is a lot to like in the expert panel's reports and recommendations, particularly the focus on principle and sticking to a formula. I have not discussed simplification of the bases, the treatment of property taxes and the role that fiscal needs should or should not play in the formula. Perhaps we can discuss that more if you are interested.
I have two concerns. First, there is insufficient consideration of these incentive problems I have talked about; and, second, affordability. There is a high probability this program will be much more expensive than the way it has been costed by the panel. If that happens, the federal government will have to consider a hard global cap on the total size of the program. If we adopted some of the panel's proposals but put a limit on how much the government would pay in total for this program, we would be moving towards a new framework environment. That is not a bad thing. It is possible to have the federal government use other principles to determine the overall size of the pool to be allocated. However, we should use a formulary basis to allocate it among the provinces. Although it is a major departure from how we have done things in the past in this country it could work very well. This kind of compromise or hybrid proposal is worth considering.
The Chairman: Thank you very much. I am keeping a list of senators who would like to ask questions. Before I go to the list, however, could I clarify a point that you made?
You were talking about the new framework and the proportionate increase when there is more money available. You said that Newfoundland and Labrador equalized fiscal capacity greater than Ontario. Could you explain that, please?
Am I correct in interpreting that if you look at per capita in each of the provinces, Newfoundland and Labrador and Ontario, after equalization there is more revenue available per capita in Newfoundland and Labrador than there is in Ontario? Am I interpreting that correctly?
Mr. Smart: Yes, I believe that is correct. I do not have the numbers at the moment, but this applies to a single fiscal year. There are frequent recalculations of these numbers so that these statements can come and go. My understanding is that for the current fiscal year, 2006-07, the effect of the new framework has been to increase Newfoundland, and only Newfoundland, to a fiscal capacity after transfers that is higher than Ontario's. This is relatively small. Under these calculations, Ontario's fiscal capacity is something like $7,000 per capita; Newfoundland and Labrador's is something like $7,010. That is a relatively small difference at this point. I want to stress that this happened not simply because a new framework set aside more funds for equalization than what the old formula would have permitted, but it said that the more you receive from equalization in the past, the greater share of these additional funds we will give to you. You can think about calculating fiscal capacity and then pouring in the money under an equalization formula to raise everyone to a common standard. That is how academics think it should work. Instead, under this proposal Newfoundland and Prince Edward Island were increased — two provinces that received more in per capita in terms of the program in the past. The result was a skewing in that direction.
The Chairman: When we look at fiscal capacity, you are saying how much the fiscal capacity is in terms of population does not factor in the extra costs of delivering government services by virtue of a smaller population. It is a bit of a misleading figure to look at without calculating some of the other issues.
Mr. Smart: That is absolutely true. It is the case that under our current formula there is no attempt to measure the differences in costs in delivering public services across the province. There is no adjustment for fiscal need in the formula. Fiscal needs may differ in very marked ways among the provinces. Simply comparing dollars across provinces may be like comparing apples and oranges. The panel considered including fiscal need measures in the formula, adjusting for differences in need, and rejected that option for a variety of reasons. I will not summarize the panel's arguments, but introducing fiscal need would be a potential Pandora's Box for the formula. It would add to complexity and at this point we have very little idea what impact it would have on entitlements under the allocation of funds under the program. In particular, it looks attractive to a lot of people now because they think their province will do better than others. An academic study about 10 years ago suggested that if you put need measures into the formula, the main beneficiaries would be Ontario, Quebec and British Columbia. The costs are relatively high in those provinces. That may have changed since that study was done, and it is not clear in particular how demographic changes within the country have affected the fundamental costs of delivering services. We can certainly discuss that more, but my sense is that it looks good because everybody thinks it is good for them.
Senator Ringuette: Thank you very much for your presentation. I understand that this is a very complex topic. In your research, have you done comparison charts of the different options that could you share with us?
Mr. Smart: I have prepared a number of documents on this subject, but none that do that useful thing of providing a kind of matrix to compare the various options. I would certainly be glad to share with you what I have written in more detail on this program. I am not aware of that useful attempt to organize all of the various proposals in terms of the various options. That is certainly something that you might want to get your research staff working on.
Senator Ringuette: Is it better to look at increasing equalization, or is it better to look at equalization and social program financing and post-secondary education financing? These are three different funding mechanisms. Is it better to have them under one funding program, or is it better to have it under three different funding programs?
Mr. Smart: The premise of your question is absolutely right. We cannot consider the equalization questions in isolation from the other major transfers. We cannot think about horizontal balance in isolation from vertical balance — that is, the question of how much the federal government should contribute from federal tax revenues to the provinces to fund social programs.
I do not think, however, there is an easy answer to this question. It depends very much on your beliefs about the desires of citizens of this country to truly establish an equitable basis for taxation and government services in all of the provinces. There will always be a judgment call associated with the choice between more federal money for equalization, which is targeted to at least six of the 10 provinces, and more federal resources of various kinds for the major social transfers.
In terms of making that choice, let me repeat that I think the old formula worked relatively well, even as the amount the government had to devote to it was getting smaller and smaller. The formula still made sense to me, even at $8.8 billion instead of the current $11.5 billion.
That is not the only view of this subject. As you know, the old formula did not raise all the provinces even to the average level, the so-called 10-province standard. It raised the provinces to about 93 per cent of the average. Even going to 100 per cent is not really going all the way because it still leaves Alberta very significantly above and makes no attempt to reduce its fiscal capacity. All of that says to me that it would be entirely reasonable to think that more resources should be devoted to equalization. After equalization on any of these bases, the difference between equalized fiscal capacity and the receiving provinces and Ontario is much smaller than the difference in the fiscal capacity of Ontario and Alberta. In that sense, it may be that additional resources should be devoted to a different margin, perhaps spent elsewhere within the system.
If you accept that, then we should focus on the vertical gaps and transfers for social programs. My own view in this area is different from that of many people. I would like to see more federal resources devoted to those programs; however, I do not think additional cash transfers are the way to go. In particular, the experience of the country over this tumultuous 10-year period with health transfers tells us it is difficult for the federal government and the provinces to agree on what is an appropriate level of cash support for health and social services. In essence, any arrangement will no longer be the right arrangement when the news about the current federal surplus comes in at budget time. This commitment problem for the federal government in arriving at a transfer arrangement for health over the past 10 years that made sense to everybody will be a perennial issue in the current fiscal environment, and it has real costs. It means that the attention of our political leadership is very much diverted from fundamental reforms to the economy and to public services and more toward this kind of zero-sum calculus, which is unfortunate.
Although this strays from our subject, I want to say that if more federal resources are devoted to a post-secondary education transfer, which was alluded to earlier, that should be done in the form of revisiting the old idea of tax point transfers that we saw in 1977. Admittedly, it had its problems and we may want to discuss those problems. I think that could very much change the political environment in which these decisions are made. It is possible to make federal support for new programs in this area a transfer of tax room from the federal government to the provinces. We would no longer have this kind of fiscal churning where the federal government raises taxes and simply hands over the cash to the provinces. There would be a direct link between the tax decisions of individual provinces and the set of services that it is choosing to provide to the residents of that province. That direct link and the accountability benefits associated with it are very much worth exploring.
That is where I would like to see governments devoting their attention to reforms in the future. If we were to revisit the idea of tax point transfers, it should be done on the 1977 basis, in which those tax points were fully equalized. They should have the same value to every province, irrespective of the fiscal capacities and the value of tax points in the different provinces. It is possible to construct that full equalization of the tax points and still have a much better accountability-type link between tax decisions of individual governments and the services their citizens receive.
Senator Eggleton: I wish to ask questions about the Government of Ontario's position on all of this. Ontario's position is "There is no evidence to support the call for further increases in equalization at this time. " "The current size of the program is sufficient to meet our constitutional and moral obligations to ensure that Canadians have comparable levels of public service and comparable levels of taxation. " "No equalization receiving province should have greater overall fiscal capacity than a non-receiving province. " The last statement goes to the point you make about Newfoundland and Ontario.
In making the case for no increase in equalization, Ontario is concerned about the 10-province standard in particular and the inclusion of resource revenue. However, the combination of resolutions from the expert panel appears to be far more palatable to than the other proposition. Could you comment on Ontario's position in general?
You mentioned the per capita transfers. Again, Ontario has said that it is at the low end in terms of post-secondary education, and in terms of getting these per capita grants.
Could you comment generally on the Government of Ontario's position?
Mr. Smart: Thank you for the opportunity to respond; however, I am a little afraid that if I go on criticizing Ontario's position as often as I have in the last few months I may not be welcome back at my office outside of Queen's Park. Let me choose my words carefully.
As you have said, the Ontario position is that there is no need for increases in equalization. Ontario has said that in a number of ways. As my answer to Senator Ringuette suggests, there are two ways of seeing that. It is entirely reasonable to make an argument for the need for greater equalization transfers and that greater attention is paid to the situation of the receiving provinces rather than the other provinces. That is the case because, in effect, any standard would reasonable all the way up, frankly, to the old top-province standard in which Ontario received transfers to bring all provinces up to the level of Alberta. That is a principled and reasonable position. It is simply completely unaffordable for the federal government. That means we will have to take a pragmatic view. We will have to decide at the margin for the additional dollars that are available where we think they would be best spent.
I want to suggest that the issue of more equalization or not is entirely a pragmatic decision. It is entirely based on your assessment of where the needs are the greatest. In particular, I would say there is nothing special about the 10- province standard. Many people disagree with this statement; however, I would say there is no sense in which the 10- province standard is a more natural or principle-based. Any standard would make sense. It would simply be a statement about how much we are willing to assist provinces that have lower than average fiscal capacity. We would simply be saying, "We are willing to go this far and no farther for the moment. "
If you look at similar arrangements in other countries around the world, you will see they often adopt something other than the average of all provinces. In the German federal equalization system, an important component of it is based on 92 per cent of the average, which is what we received through our five-province standard in the past. In Germany, they are comfortable with saying, "We will not go all the way to the average. " It is not a principled choice. It is natural in that context that the province that does not receive these transfers would say, "We can go a little farther, but no farther, " which is perhaps what they are saying.
The more difficult thing is Ontario's attitude to reforms in the other major transfers. I have two comments on that. You alluded to the argument about so-called associated equalization, the complaints that Ontario receives less under the cash transfer programs per capita than other provinces. That is absolutely true. As a result of the tax point transfers that took place in 1977, as you know, the deal at the time was that these tax powers would be given to the provinces to replace the existing cash grants of that time, and that it would be done in a way so that the value of that transfer was the same for all provinces. I was not party to those discussions, but it seems to me that was a completely reasonable approach. We need to make a decision in choosing tax point transfer levels about the appropriate amount of decentralization in the country, whether the tax powers should lie with the same governments which are doing the spending or whether the federal government should do the taxation and the provinces should do the spending. If we are going to make that decision about how much to decentralize in a principled and non-political way, the best thing we can do is all agree that if we transfer those tax powers, they will have the same value to all provinces. We should insulate this question of the vertical transfer of powers entirely from the horizontal questions of which province gets more or less than average.
Senator Murray: In other words, equalize tax points.
Mr. Smart: Tax points should be equalized not only up to the average, but down to the average. That is to say, for Ontario, Alberta and any other provinces that has above average fiscal capacity for the points, the only way to bring them down to the average so they do not benefit more than proportionately from the transfer of tax powers is to reduce other cash transfers by that amount.
That made sense in 1977, and I think it can only make sense for the future if we accept that those deals last forever. Therefore, Ontario should recognize that its lower cash transfers reflect that decision that was made in 1977 and it is important to stay with that principle now and forever.
Senator Fox: On the transfer of tax points, we have one province that has its own tax collection system. In the other provinces, I assume that if you do a transfer of tax points — equalized or not — it is seamless on the tax form because the federal government picks it up. In Quebec, it would be mean a tax increase by the provincial government on that form. In the case of an equalized one, Quebec always has been against it because it argues that the tax points brought in less money than equalization formulas. It would be seen in Quebec as an additional tax, would it not?
Mr. Smart: It has been a while since I have looked at a Quebec tax form, so I am not entirely sure how it is implemented.
Senator Fox: We only look at it once a year.
Mr. Smart: We all prefer not to be reminded of those forms for the rest of the year. My recollection is that the federal income tax form refers particularly to the abatement for those 1977 and earlier tax point transfers. The form is explicit that federal taxes are lower because of this and that provincial taxes are higher.
Whether the average Quebec taxpayer is sufficiently informed on the more theological aspects of fiscal arrangements to appreciate that difference and to not feel especially troubled by the higher Quebec tax rates, I really cannot say. I think that you have touched on a very important point in general, that if we were to consider these kinds of tax point transfers — or, more broadly, the decentralization of tax powers in one way or another to the province — we have to be very sensitive to the political concerns that would arise for the provincial governments. It has to be done in a coordinated and seamless way so that initially it appears to be no change at all for Canadian taxpayers.
The important issues of accountability arise down the road when an individual province might decide to raise or cut taxes and change its own services to citizens correspondingly. Immediately, in order to make this politically feasible, we should be very careful about the way in which it is presented to the taxpayer. The taxpayer should be made to understand that it is essentially a wash and not a tax increase.
You also alluded to the opposition of Quebec to this change. It is important to think about these things. It has not always been the case that Quebec was opposed to tax point transfers. Indeed, it has been one of the most aggressive provinces in the willingness to take up tax room and to allow its policies to differ from those of the other provinces. There is a great deal to be admired in that opposition.
As recently as 2002, the Seguin commission by the previous Quebec government came out with what I thought was a very intelligent critique of the current system and an argument for tax point transfers. Since then, some elements in the Quebec government are doing this zero-sum calculation and saying we can get one dollar per capita from that kind of arrangement and we can get something more like $1.60 per capita if the same federal resources are put into equalization reforms. We need to look beyond those considerations to what is best for the country as a whole.
Senator Eggleton: The two most current studies that we are looking at are from the advisory panel and the expert panel, or the O'Brien panel. Do you have a preference between the two, and why?
Mr. Smart: You are really placing me in a difficult position, senator.
Senator Eggleton: Wait until we get to the next question.
Mr. Smart: I should start by stating my biases. As you know, I was not a panellist for the federal report, but I did spend more time talking to them and came to understand their concerns. Conversely, I believe they understood some of the issues that I raised.
In terms of the substantive differences between the two reports, there were two important differences to stress. The first is that the amounts of money involved are quite different. Again, this comes down to one's assessment of the need for horizontally oriented transfers — that is to say equalization transfers — that go to some provinces and not others versus other reforms in federal-provincial transfer arrangements. That is in the eye of the beholder.
The federal panel managed to strike a reasonable balance between what is affordable for the federal government and what is approximately revenue neutral for each one of the provinces. The panel spent a lot of time thinking about how to make sure that entitlements for no individual province were much reduced, and that kind of pragmatic element appeals to me.
The second part of the panel report that I stress is the focus on some of these details of how the calculations are done. I am sufficiently a policy wonk to think those things are important. This proposed reform to use five measures of fiscal capacity in place of the current 33 is another thing I would stress. I do hope that reform goes forward in one form or another out of the panel recommendations.
Senator Eggleton: Let us go to the vertical issues. Municipalities like the one we live in, and all the others across the country, are concerned about fiscal imbalance. They do not have the resources that they need to carry out their responsibilities. We all know this is tied in to the constitutional framework; the responsibility of the municipalities really resides with the provinces.
If the money is in the federal hands, how can it be calculated as part of dealing with it? The things that happen in our municipalities are very vital to the quality of life in this country and to the growth of the economy, so we cannot simply ignore it. How would you suggest we deal with it in the framework of a vertical look at fiscal imbalance?
Mr. Smart: It is a very difficult issue and I do not have clear answers. We have not seen a similar panel report on municipal transfers and municipal tax levels across the country.
There is a horizontal element of the municipal question as well, in the sense that property taxes go into the current equalization formula and are part of any future formula. In that sense, there is an attempt to deal with differences in capacities among the different municipalities in different provinces of the country. That seems like a desirable part of the formula, because it is very difficult to distinguish between property taxes that belong to the provincial governments versus the municipal governments. We have to treat the thing as a whole within the formula. However, we really do not go all the way. As you know, there have been a number of changes to the treatment of property taxes. The central tension is that if we really equalized the apparent differences in the property values across the country — which seem to some people to indicate differences in the potential to impose property taxes — that would be a big increase in the inequality across the country and in the total amount of transfers that some people think are inappropriate. In summary, it is in the formula and we are trying to deal with those things but there is a tentative aspect and we are certainly not going all the way.
As concerns the vertical aspects, it is reasonable to think that we should look for different fiscal arrangements for the municipalities, in as much as municipalities in Canada, for a variety of reasons, rely almost exclusively on property tax to finance their own operations. That is different from most other countries in the world, including most other Western developed countries, where they have almost exclusive reliance and single tax basis. There are problems with that. There are reasons to believe that municipalities should use that first, but it may not be enough.
On the vertical questions we must ask whether the solutions to the potential gap where the municipalities do not have access to the taxes they need to finance municipal infrastructure. Is the solution more transfers from the provinces or the federal government? Is the solution a fundamental change in the tax powers? It is natural that, the average big city mayor would prefer transfers. He would not want to choose between federal and provincial transfers; the mayor would want them both. That is not a principle basis for reforms in this area. Let me say as frankly but as politely as I can that if the feeling is that the big cities in the country need the resources, I do not see any evidence that the federal government will provide the resources through cash transfers. We saw that with the last government and it is natural that the political and fiscal pressures on the federal government mean that resources of that type will not be transferred mainly to big cities and to big infrastructure projects in the industrial core but will be distributed much more equally.
What are the alternatives? Other countries have looked for things like differentiated sales taxes and income taxes at the municipal level. Perhaps we should consider steps in that direction. It is difficult to imagine giving those powers to municipal governments, which do not have the apparatus or the expertise. However, revenue sharing arrangements could lead to real differences of that kind. That may have more attractive features.
Senator Rompkey: I want to highlight a couple of remarks that you made, namely, that asking or demanding a higher royalty will increase equalization. You seem to say that if the project did not go ahead, obviously there would be increased equalization. On the other hand, what is fundamental to Premier Williams' thinking is that we would like to get rid of equalization altogether. Since we have joined Canada, we have been a dependency. We would like to not have that situation continue and be able to stand on our two feet. That is the difficulty. You either make your own money through higher royalties or you make more money through equalization. We prefer the former, I think.
I want you to go over the effect of the cap if we go to the expert panel's recommendation. This is a 10-province standard and the inclusion of 50 per cent of non-renewal resource revenue. You said that the most adverse effects would be on Newfoundland and Labrador. I would like you to review that again. As Senator Ringuette said, this whole subject is complex.
Mr. Smart: I will start with the last question. I am glad to have a chance to come back to these things. I stress that I am not an insider, and I do not know everything about how this would work and how the key players would react. I do think it is important and worth more discussion.
To summarize, in the panel report, the proposal is that the cap would guarantee that in calculating the fiscal capacity of each province, plus the transfers it receives under equalization, we would never arrive at an amount higher than Ontario's fiscal capacity, the lowest non-receiving province. One distinction in that is that the panel proposes we account 50 per cent of resources to calculate equalization but the cap would apply to a measure of capacity, including 100 per cent of the resources as part of fiscal capacity for purposes of a cap. We will measure fiscal capacity in two ways to calculate transfers on a 50 per cent basis and on a 100 per cent basis to see whether the total resources are too high and transfers might need to be reduced by the cap. That distinction is not an inconsistency, but it is an important part of this calculation because the 50 per cent inclusion will be good for Newfoundland, which is above the national average resource fiscal capacity. As we shrink the amount of resources that we count, we increase the transfers that Newfoundland receives under the formula. The cap says that we will increase it, but not too far, it will not allow them to leap frog Ontario. The cap makes sense, both from the perspective of affordability of the federal government. The panel's estimate is that they will save $500 million a year by imposing that cap on Newfoundland and Labrador and also Saskatchewan. In terms of fairness, should the recipient of these grants do better than a province that does not qualify? I think all that does make sense.
With the inconsistency between the 50 per cent and the 100 per cent, you could make a case for it on the grounds that the 50 per cent offers an attractive deal to Newfoundland and Labrador in terms of the equalization in the future. The cap says we do not want that 50 per cent to be too skewed to the province. There are legal, political and constitutional issues about whether it is possible to impose that kind of cap in a way that will be consistent with the offshore accords with Newfoundland and whether it be necessary or desirable to respect those accords. Everyone in this room but me would have better sense of where that debate comes down, but it is a great difficulty with the panel's proposal.
In terms of the tax back story, you have it right, Senator Rompkey. I am talking about this idea that when the government says, as it did to the consortium developing Hebron, "Oil prices are up. We want a better royalty deal and an equity stake in the project, " they are essentially saying, "We think there are more resource rents in the project than before and as the effective owners of the resource, we believe we should have more. " That is a reasonable statement, but not one that necessarily will lead to the desired results. There will be some cases where that kind of approach in the best interests of the citizens of Newfoundland and Labrador will result in delay or no development at all. That might be what happened under the Hebron project, although others would disagree. The consortium would say that economic factors elsewhere in the world drove us out, but we must think about that trade-off in precisely that way.
When I say that equalization changes that, I am saying that the Government of Newfoundland and Labrador is thinking about the equalization transfers it receives, as well as the economic, development and direct own source revenue tax benefits it gets from the projects that proceed. I hope everyone recognizes that, as an economist, I think that is precisely how I would want my government to behave — to trade off the fiscal and economic consequences of all of these decisions. It is an entirely reasonable way for the government to proceed.
Over the long term, the perspective of the government and the residents of Newfoundland and Labrador, to the extent of my understanding, there is an attempt to seek development strategies that will make all of these issues irrelevant in the future. In the short term, that is not the way in which these agreements are proceeding. The offshore accord specifies the nature of equalization entitlements, to the extent that Newfoundland qualifies, to the year 2019. Over the long medium term, these equalization incentives are important to the way in which these projects will be developed in Newfoundland and Labrador.
Senator Rompkey: I had in mind to ask you about the accords but perhaps we should leave that for another day.
The Chairman: As you wish, Senator Rompkey.
Senator Fox: Under the previous formula, which you seem to endorse, there was a major problem with clawbacks. Would you explain how those clawbacks occurred and what can be done? It puts a province in a terrible fiscal position if two years down the road it has to pay back millions of dollars.
Mr. Smart: I will make a distinction between the two clawbacks to which I referred. The first occurs when the economy of a province develops such that it qualifies for a lower transfer entitlement in equalization payments. The second occurs with the process of continual re-estimation of entitlements under the program when a province is asked by the Department of Finance for occasional repayments. The calculations are complicated and based on detailed Statistics Canada data on the economy and the public finances of all the provinces. It takes a long time for the data to become available. Under the old system, we re-calculated seven times each province's transfer entitlement for each fiscal year. It took up to three years for those numbers to converge or to reach a final calculation. Therefore, up to three years later, the federal government could say that it paid a province too much because its economy was stronger than the government thought it was. I suspect there has never been a repayment from a province to the federal government but rather a reduction in amounts received in subsequent fiscal years. The provinces hate that. Clearly, this has been a real sticking point in the formula. I would tend to downplay its fundamental importance because this is an accounting issue, which is important to a government trying to balance a budget. There are probably ways of dealing with those accounting issues that would be much less disruptive to the budget planning and accounting process than what was done. In particular, provincial governments could set aside a reserve fund, in an accounting sense, to allow for the possibility that they might face this kind of clawback in the future. They could use the reserve fund to smooth the impact of a clawback on a year-to-year basis. If it were so important to provinces, I do not know why they did not take that approach. Perhaps because it would have been costly to build up a reserve fund. Beyond that there is no issue about the cash arriving but rather about the accounting. I am surprised that seemed to drive so much of the process.
There is a related issue that is a much more fundamental substantive and economic risk in the program and has troubled many of the provinces — the way in which we used to calculate the transfers as the difference between the yield of a province like Nova Scotia and the five-province standard, which was, almost effectively, Ontario. The transfers that each province received amounted to the difference between their respective economies and the economy of Ontario. When the Ontario economy did poorly or less well than the rest of the country, it was much more troubling and it created an economic risk for the provinces that might have been inappropriate. The Ontario economy suffered much more in the 1991-92 downturn than the other provinces did. Even if Ontario cuts taxes, it is not clear whether that should have direct impact on the amount of transfers and the overall fiscal health of the other receiving provinces under the formula.
Although it is not related to your question about the continual re-estimation of the old transfers, it is a more fundamental risk that we needed to deal with under the old formula. The new framework agreement was an attempt to deal with both the accounting risk and the economic risk in a way that makes sense. It specified not only the total amount that the federal government would spend on the program but also the shares of that amount to be received by the provinces, more or less. There have been different aspects to it in different years since 2004. The provinces should not be looking for that kind of surety for transfers received but rather for a highly responsive assurance formula whereby a weaker provincial economy will receive more in transfer payments from the federal government. The old formula did have elements such that if Nova Scotia's capacity fell, the transfers would increase. That attractive aspect was thrown away in the 2004 reforms in an attempt to develop a nominal stability and surety but, I think, a much less attractive overall stability in the after-transfer fiscal resources of the provinces.
Senator Fox: There seems to have been a change in the outlook of some provinces toward the program in not considering that it is indeed an equalization program and so payments should increase or decrease according to the provinces' respective fiscal capacity. In the 1980s, the previous government decided that it had to cut programs. The provinces are talking about returning to that base level plus inflation since that time. In terms of equalization, they considered it the same — a base amount ought not to decrease while the shares should increase. We seem to be getting away from the fundamental concept of equalization. Perhaps we have to change the vocabulary because the words "fiscal imbalance " seems to have become charged with political significance across the country. Once equalization was included in the Constitution, I assumed it would operate over a period of time and that because it was equalization, the transfer amount would decrease or increase based on the developed formula.
Is there a better way to describe the current problems than by using the emotionally and politically charged words "fiscal imbalance, " which lead some to deny it? We are talking about a fluid concept that changes over a period of time depending on the changing fiscal capacities of the provinces.
Mr. Smart: I hope there is a way to deal with this. Senator, you have hit the nail on the head. This is about putting the genie back in the bottle. There has been a fundamental change over 10 years in the way in which the provinces with these issues, including fiscal imbalance but I do not know how to change that. An environment has been created in which there has been apparent fiscal slack at the federal level, whether that is the result of anticipated or unanticipated surpluses or the way in which funds are allocated. As long as that exists, I am not sure that the provinces can be convinced to think about the issue in any other way. That is a fundamental reason why tax point transfers — taking the money off the table and flushing the excess cash out of the system — have potential to change the way in which governments talk about this issue. That being said, there are important aspects to the comments of some provinces. It makes sense to talk about these issues.
Senator Stratton: As you approach this problem and try to resolve it, if you solve this problem you walk on water. It is a huge problem. If you approach this purely on the basis of principle and you establish a set of principles, what would they be? Then from that set of principles, what would be the pragmatic approach you would use? I do not expect an answer today necessarily, but it is important for us to know your opinions with respect to that set of principles and then from there go to a pragmatic approach to solutions.
As soon as you start playing the game of going to the municipalities, going to the resource-based formulas and one province being short-changed or perceived to be short-changed and others arguing that is not the case, I would be fascinated to see what your position would be with respect to the set of principles and the pragmatic approach. It would help us to hear that. I put that to you because I am fascinated by your comments with respect to the O'Brien approach. Would you care to comment?
Mr. Smart: You are giving me an opportunity before an august panel to completely design the equalization system in my mind and then decide whether it is a pragmatic approach. I will certainly not turn down that opportunity. It is a useful thing to do.
I will tell you that the principle I did not talk about directly, which would govern the ideal system in my mind and in the minds of a lot of academics, is a full net, 10-province equalization system in which we brought provinces up to the average and down to the average. You are familiar with the idea that the excess of Alberta's fiscal capacity over the average is something that, in principle, we might well want to reduce by asking Alberta to pay into a system. I said the magic words.
Then we turn to pragmatism and we realize that there is absolutely no chance of that, certainly not now. If you are going to make a reform like that, clearly it has to happen when the price of oil is low, not when it is high. In principle it makes sense; in pragmatic terms, the fact that other countries have important elements of that net scheme, contributions by above average governments, should tell us it is not entirely impossible. However, it is impossible today in Canada.
Then the question becomes where does that crazy principle take you in terms of the pragmatic approach? Unfortunately, it leaves a lot of this in the eyes of the beholder. It means that different approaches can be reasonable. In other words, we have two horizontal gaps to worry about — that between the average of the current receiving provinces and Ontario, Ontario being right about the standard that we used to equalize to; and the second upper gap between Alberta and that standard.
Which one do you want to address more? They are both important. It is reasonable to think that additional resources should be devoted to either one or the other. You have to recognize that the first gap between the receiving provinces and Ontario is today much smaller than the second gap. That could make you think that we should be concentrating on the second gap in additional reforms. Doing that would mean these kinds of vertical imbalance considerations — deciding what should be done for all 10 provinces in a roughly equal per capita way instead of transfers that focus on the have not, receiving provinces.
That is where I get with the crazy principle that when it comes to devoting additional federal resources to these programs in the future, whether in cash or in tax transfers, we should be focusing on the vertical gap not the horizontal gap.
Senator Stratton: Is there a paper that has been prepared about how other countries handle the situation of equalization? Do you know of examples, or is there somewhere we can go to find out about other countries? How does Germany handle it? If they do it, do they do it successfully? Is there a resource we can go to where we can get that information?
Mr. Smart: I am not aware of many general surveys of these things. Let me commend one in particular, which was a background paper done for the Séguin commission in Quebec in 2002. It takes the major federal comparatives and goes through a lot of the details of their system. That information is somewhat dated, but I think the commission got the basics right in all of these formulas. The paper deals with how the transfers are calculated, how tax powers are divided and the decision-making process, the political element, as well.
Senator Stratton: That is the one that interests me. The decision-making process would help us around here.
Mr. Smart: I noticed recently that the Séguin commission still maintains a website four or five years after the report was written. It might be worth reading.
I will offer the comment that it is worth looking at these arrangements; we can learn a lot by thinking about how these systems differ. We should always remember that Canada is quite a different environment than many of these other major federations in that there is so much decentralization in tax and spending powers in this country. The provincial governments are such strong entities compared to state governments in federations like Australia, and even Germany. I think the considerations are quite different here. This is the most developed federation in the world and we have to take a slightly different line as a result.
Senator Stratton: I do not disagree. I am more concerned about whether there is an independent body appointed or elected to make the decisions. That is the part that interests me — to take it and depoliticize it as much as possible. Is it working in some countries or is it not? That is the area we should be exploring.
Mr. Smart: It is worthy of further exploration. There is relatively little about that in the Séguin commission document. There is relatively little, as well, on fundamental decision making in the two excellent council and federal panel reports. They do not address the question of the decision-making process in such a direct way.
The other source that is certainly worth looking at is the Forum of Federations. You might want to hear from George Anderson or other people from the forum in this process in the future. I am not aware of any particular survey document on the decision-making arrangements that they have done but they certainly have a great deal of knowledge of how this is done around the world.
The Chairman: I would like a clarification on the first point about equalizing down. You said that would require a province to pay into the system rather than receive from the system. You said, of course, that could not happen. Why did you not consider a similar situation, when you were speaking with Senator Eggleton and you talked about the tax point transfer in Ontario and the equalization there, by reducing the entitlement under the vertical social transfers? That is another way of equalizing down, is it not?
Mr. Smart: Yes; if you are willing to touch that third rail, I encourage you to do it.
The Chairman: It would be easier than asking a province to pay up.
Mr. Smart: You are absolutely correct. In fact, there are a few references to that approach in the panel report. They are brief and may be even somewhat buried. You would find some supporters on the panel to taking that perspective.
With respect to the obvious issues, there is certainly a view that the existing cash transfers for health and other social programs from the federal government are serving a role. They are there to do something. Many of us disagree on what that thing is. However, if we start taking away these payments from provinces with above-average capacity to any substantial degree, we will have to ask whether those other goals of the existing cash transfer program will still be met.
With respect to anything that reduces the tax transfers, we have to ask whether we are losing something as a result.
In the case of reducing CHT transfers to Alberta, for example, to tax back its excess fiscal capacity, if you want to take that approach, most people think we would need to think about the Canada Health Act and whether the provisions in the act are still in some sense being supported and defended by the existence of cash payments to all 10 provinces. Then we would have to think about whether that was something that we wanted to continue in the current environment of reforms in that process, and I am not sure at this point whether I have a clear view on any of that. Whether we could continue to run a system where the federal government set important standards and objectives for social service programs but did not have any cash to back it up for at least some of the provinces is clearly a problem.
The Chairman: Thank you for the clarification.
Senator Mitchell: Dr. Smart, this has been interesting and stimulating, and I appreciate your comments and thoughtfulness.
I am interested particularly in the issue of tax point transfers, and you have just alluded to them yet again. Clearly, one of the advantages of tax point transfers is the alignment between the people who raise the money and the accountability for spending it. The problem with transfers in general is that somebody gets to spend money he or she does not have to raise. In this political environment of accountability in everything, that has a certain amount of appeal. However, it has some serious difficulties, one of which is political. The provinces would much rather have the federal government be their tax collector just as the municipalities would rather have some other level of government be their tax collector. Ultimately, you could get around the differential value of tax points by formula calculation and that kind of thing.
What concerns me is the role of the federal government in establishing national standards, which are profoundly important to Canadian unity and the substance of Canada as a country. It seems to me that giving away tax points can erode that unity. Giving away money without guidelines, as is the case in a large part of the transfers now, is a real problem.
Could you pursue that further for me? What is the role of Canada's central government in establishing unified standards? What is the minimal limit at which the government does not spend enough money to influence that? In Alberta, it was said they were only getting $1.8 billion for health and it does not amount to very much, but, of course, it does, and it has an impact.
Mr. Smart: This is the core of the tax point transfer issue, as Senator Murray suggested as well in the previous intervention. This is very political and, frankly, sufficiently political that I am not entirely comfortable as an economist in making pronouncements about it. I agree with everything you said about the accountability benefits of a tax point transfer.
The political problem is that there is an opposition to that among provincial governments. I believe we are agreed that that political opposition is a symptom of the problem that we sometimes call "fiscal illusion, " namely, that provincial governments seem to be convinced that they can spend money that is not generated through taxes on some taxpayers somewhere in the country. The Ontario communications strategy in the last couple of years is a prime example of fiscal illusion. If the province is mainly concerned in its proposed reforms about the situation of the Province of Ontario and Ontario taxpayers per se, it does not make sense to me that Ontario would push for anything other than tax point transfers. It does not make sense that the province would evince support for increased per capita transfers from the federal government when we know that each dollar in transfers received from Ottawa costs, on average, the Ontario taxpayer something like $1.15 to $1.20. In that environment, it seems to me that a government that says it wants more per capita cash is just evidence that fiscal illusion is a problem, this disconnect between the people spending the money and the people who are setting the taxes to finance it. We have to do something about it.
The other problem is a horizontal problem. Let me underline my position that this can only be done if we agree that the tax points that are transferred will be fully equalized up and down as in the past. It is problematic for the federal government because it had led to these debates since 1977 over the value of those points, and that has not been fun for anybody.
One possible solution to that is a kind of tax rental agreement in the opposite sense of how we meant it in the past. In the World War II era, a tax rental meant that the federal government was borrowing tax points from the provinces for a temporary period that lasted forever. Now a rental would be in the opposite direction. The federal government would rent points to the provinces. There would be a clear kind of contractual basis. We would agree on the worth of the points, and each province, if it did not like the way the arrangement evolved over time, would have the option to hand back the tax points in exchange for some amount of cash that would grow in some way. In other words, it would be an attempt to put it on a contractual basis where we would no longer debate what these things were worth and who promised what when. That is a tentative proposal, but one that might be considered.
You asked about national standards, which is a very difficult question, and again, reasonable people could differ on the federal role in these programs. The federal government will always have a predominant role in the regulation of the economy in this country and in the important system of redistribution of income among citizens. There is no question the federal government plays an important role in the economy.
With respect to individual social programs and the national standards that the cash may be supporting, have we reached a point where we are willing to trust the provincial governments to provide the services that their own residents are demanding, and does the federal government need to get involved in that relationship between provincial governments and provincial electorates? That is a question I believe we should be asking. Sometimes the answer is that we do need a federal role, and as an economist, let me just allude to the idea of externalities and spillovers among the provinces. There are important decisions an individual province will make that will have implications for the economy and the country as a whole and for the fiscal situation of other provinces in the country. Education might be a good example of that. Education, particularly post-secondary education, has a big impact on the quality of the work force in the country as a whole. Mobility among provinces is relatively high in this country. That certainly supports the idea that we should have a federal role in financing education and even regulating education and research and development activities in all provinces. What form that intervention should take needs to be thought about further. Whether a specific carved-out cash transfer for post-secondary education can achieve what national objectives in that particular field ought to be is an open question. We used to have a system in which many of these grants were delivered through cost-sharing arrangements, a kind of matching grant where the more that was spent by provincial government, the more they received in transfers from the federal government. That kind of matching arrangement has gone out of fashion over the last 25 years. However, it made sense in an environment where we were trying to develop programs at the provincial level in particular emerging areas of importance. It is important for the federal government to say to the provinces, "We will subsidize that activity, if you on it..., " and in the old days it was health, social assistance and so on. The federal government would say, "We will give you financial support. For each dollar you spend, we will give you something. " The current environment is one in which we only have block grants. We simply say, "Here is a chunk of cash, " which may be equal per capita or not, "a fixed block amount, and it is for education. You must spend it on education. " That kind of conditionality, without changing fundamental economic incentives, as in a cost-sharing program, has got us into some of the problems we are in now. Block grants have led to a deterioration of feeling a common objective at all levels of government.
Senator Mitchell: I agree. You hit on one point with respect to education, which is the issue of productivity, which is an issue for Canada. Education is a key variable, given in particular that our corporate sector spends much less on educating its workforce than does the United States. At the national level, Canada has to play a role in that issue. As you have said, block grants have really eroded that area.
It is interesting that you say Canada has one of the most decentralized federations in the world, which is true. That may be because it does not have an elected Senate. An elected Senate would not do what many of its proponents would have it do, which is to decentralize further. It would actually centralize and allow us to focus more on national standards. That might not be a bad idea.
With respect to productivity, New York just had a Jane Jacobs day. Jane Jacobs has always drawn the relationship between strong city economies and overall strong economies. You cannot diminish the impact of rural Canada and its importance on our economy; however, cities are exceptionally important, especially in regard to productivity. They have a funding imbalance. If ever there is a fiscal imbalance, it exists in the cities.
Maybe this is absolutely impossible, but the previous government's initiative was to give money from the gasoline tax, if I understand it correctly. Could the federal government get out of that room and give tax points to the municipalities and say, for example, "You, Edmonton, tell us how much you want to raise in gasoline tax, and we will raise it for you. We will make it clear you have requested it so people know you are doing that. " The money could be returned in that way. Is there a way to allow the municipality to say, "We are going to move out of the federal gasoline tax amount for X points? You can have them. "? They could raise them.
Mr. Smart: On this last point, we should look for ways to move in that direction, differentiated tax policies that support greater infrastructure investments within cities. It can be very difficult to implement that kind of tax.
In a sense, the gas tax sharing arrangement was just a cash transfer of the old type. It was tied to the yield, the revenues from a particular tax base. It was not a fundamental reform in the way in which we do these things. It is hard to imagine how you could transfer tax powers of that kind in any real way to the cities. It is very difficult to structure a tax, in particular on something as mobile as gasoline, in a way that would allow different cities to impose different rates. The collection costs and the compliance burdens would tend to be relatively high. The potential for consumers to avoid that tax simply by shopping elsewhere, of course, would be of primary concern.
When you get to designing tax policies at that very local level — and I distinguish from the provincial level where those issues are not nearly as important — it is hard to see which tax powers can be truly decentralized and differentiated among the cities in a way that will not have great economic cost. As I said before, when you look around at other countries you see things like special income taxes or income surtaxes for workers employed in or resident in a particular city. You also see special sales taxes. It is worth exploring those things. It is a difficult road to go down for the administrative and the economic reasons. We have to start thinking about revenue-sharing arrangements, but hopefully ones that are designed to lead in the direction you have just described.
Senator Murray: I do not know exactly where the present government may come down on the question of transfer of tax points. However, I think you know, and I think we all know, that for some time now the federal government institutionally has been opposed to the transfer of further tax points. As your friends in the Department of Finance will tell you, once they are gone, they are gone. Second, there is the political problem of their lack of visibility. Third, there is a problem of a potentially reduced federal influence in some of these fields to the extent that the tax points reduce cash transfers.
I am quite attracted to your idea of the federal government renting tax room to the provinces. I am even more attracted to your idea of a contractual arrangement between the federal government and the provinces on some of these matters, which I think is vastly preferred to trying to bring the hammer down by federal legislation in areas of provincial jurisdiction. Nowhere is the system, it seems to me, more incoherent than in the field of post-secondary education. Health care has demanded and received the most attention because of the block grant system. Thus it has taken the lion's share of such incremental money as there is from the federal government. As a result, post-secondary education has gone begging. In the meantime, the federal government has been spending twice as much on post- secondary education in direct federal payments to individuals and institutions than it has been putting into the transfers to the provinces for post-secondary education. Some people in the academy may think this is fine, but it is not fine. It is not good for the system if you are depriving the core program, which is the program by which provinces support the upkeep, the salaries, and all the rest of it, of universities. There may be a lot to be said for the kind of recommendation you have made, and we should explore it a lot further.
Federal governments have never liked equalization. Politicians do not like it because of its lack of political visibility. Finance officials in particular do not like it to the extent it is an open-ended demand on the fisc. As you say, the provinces prefer equalization, but that has never stopped them from demanding the enrichment of the social transfers. Of course they prefer equalization because it is unconditional. They know when they get into that room they are at a disadvantage because it is an entirely federal program. They are totally at the mercy of the federal finance minister and the government as to what they will get. Thus they are at that disadvantage on equalization.
That does have a constitutional basis. One or two of the provinces have had a lot of legal research done to find out whether they could successfully take the federal government to court on equalization. None of them have done so, which tells us something about the justiciability of the constitutional provision relating to equalization. The provinces have somewhat more leverage when they get into the room with the federal government on the social transfers because they must deliver the programs.
You mentioned health. I think health is not too badly off. The federal government, as of the last arrangements the Martin government made, is committed to a 6 per cent per annum increase in the health transfer until 2014, or thereabouts, which is pretty realistic. It provides some incentive for the provinces to try to keep the increased costs of health within that order of magnitude, provided the federal government does not try to micromanage the health system of which they know very little in any direct way.
There have been three reports on equalization. With all due modesty, I might mention the report that this committee brought in on equalization in 2002. Mr. Al O'Brian will be here next week; he chaired the federal panel. The third report came from the Council of the Federation panel of which I was a member. The Council of the Federation panel had a rather wider mandate. It was to look into both the vertical and horizontal imbalance, whereas the federal panel was restricted to equalization, as was the Senate committee.
There is quite a large degree of commonality in both the approach and the recommendations of the three committees. One was that equalization should be based on the relative fiscal capacity of the provinces, that the best way of measuring relative fiscal capacity was a 10-province standard, and that the best way to measure it was to have all tax revenues in and to have a representative tax system and all resources in. Where we differed is in a matter of detail, and technical detail at that. The federal panel agreed that all resources should be in, as you have said. That is, 100 per cent of the resources should be included in order to measure relative fiscal capacity and to measure the relative entitlement of the various recipients. They then addressed the federal affordability problem by saying that only 50 per cent of resource revenues should be included in determining the payout. That would not lessen the proportional payout as among the provinces. The provincial panel said, "Go with 100 per cent. If the federal government thinks there is an affordability program, scale back proportionately and do it in the sight of man and God and take the heat for it, defend it. " That is the main difference on that point.
I would like to ask you, because I have not had a chance to reflect on it or study it very closely, why you support the recommendation of the federal panel, the O'Brian panel, that we should go from 32 or 33 revenue sources down to five. Why would we want to get locked into five? Some of us have felt we should go in the other direction. You mentioned the property taxes that do not get skewed to the disadvantage of British Columbia. You mentioned user fees, and such matters as — not to too fine a point on it — certain provincially owned hydro companies and their rates and resources.
Why would we not be going in the opposite direction and taking a larger number of revenue sources with a 10- province standard in order to have a good, proper measurement of relative fiscal capacity?
The Chairman: Mr. Smart, would you like to comment on any of those points and answer the last question?
Mr. Smart: There is a lot to answer. It is all interesting and I concur with much of what the senator said. I will try to pick a few spots to answer the various issues that you have raised.
Let me go right back to the issue of education, the issue of tax point transfers versus cash and if you like the games that have been going on between the orders of government in the last few years. As an employee of an Ontario university, I cannot tell you there was anything wrong with the federal government spending money directly on education. I do not think I would anyway. It may be true, as you suggested, that could be some skewing of priorities in that environment where the federal government is figuring out where constitutionally and administratively, it can spend directly on education instead of giving transfers to the provinces.
Senator Murray: It is the incoherence that troubles me and the fact that there is very little, if any, consultation between the federal government and the provinces as to what we should do and you should do in support of higher education.
Mr. Smart: I do not disagree. In the current environment the vertical overlap, that is, both levels of government raise taxes and there are transfers going from the federal to the provincial level, is problematic. Negotiations in transfer reform were difficult over health between 1997 and 2004. In that environment, I can see a federal government saying, " Transfer reform is very difficult here. We have objectives that may differ from those of the provinces. We do not think that, through transfer reform, we will be able to arrive at a coherent, consistent plan that combines our various objectives, so let us carve out an area where we will do the least harm in terms of incoherence. " By focusing on research and development, both constitutionally and practically, they made a reasonable attempt to say, "We do not want to rely on additional transfers in this area at this point. We do not think that will work. Let us find an area where the potential for conflicts is the lowest possible. " The reality was that, in the absence of that additional federal spending, the situation in Canadian universities over that time and, indeed, today would be fairly dire. It may be worth looking for that kind of horizontal, carving out of policy areas for the federal government, in addition to tax point transfers. That is all I want to suggest.
Health is not too badly off. This is really the same issue. You are correct; the 2004 health accord was a fundamental change in the federal government's attitude toward financing health care. Certainly, that file is not live in the way it was prior to the 2003 agreement. My concern is with the way we got there, between the 1995 to 1997 cuts in social transfers and that, more than restoration, the additional funds were triple the amount that was cut out in the first place.
You have put your finger on a key issue, namely, whether there is incentive for provincial governments to control costs in the current environment. If we have a stable transfer formula, those incentives are much stronger than an environment where additional cost pressures create additional arguments for additional transfers. In that sense, yes. In just a looking-forward sense, there is nothing about the nature of that grant that will prevent similar considerations from arising in the future. You may be right that the federal government has gained a lot of credibility in terms of here is a grant once and for all for health by putting a lot of money into it, but I do not think the fundamental process has changed.
On the Council of the Federation report, that is right. There is a parallel between those various recommendations that you talked about, namely, the idea that we should have a formula and the idea that we should have a 10-province standard, which is one area where I disagree with both. On inclusion, the panel's attitude — and, Al O'Brian will tell you this next week — towards 50 per cent inclusion was different. It was on a principle basis and not as Senator Murray and I believed, namely that it was mostly about affordability. I think that he will talk about things like provincial ownership and Senator Rompkey's type of concerns about how benefits should accrue to provinces that have these resources and about this argument that there are costs of development that should be deducted.
I frankly do not find any of these arguments strong and do think it is about affordability and re-jigging provincial allocation, good for some, bad for others.
The more important difference between the council report that talks about 100 per cent inclusion but a new framework global cap on the expenditures in the program if necessary, and the panel report that talks about starting from the other direction, adding more but with 50 per cent inclusion maybe having a cap, is that the starting point matters for those discussions. You will recall the cost of 100 per cent inclusion in 10-province standard. It is on the order of $25 billion, I believe.
Senator Murray: You are in the ballpark.
Mr. Smart: It is certainly an amount that most of us would consider an unaffordable number for the federal government. I have difficulty with the process. It starts with that as the principle base number and scales back. I am much happier with a five-province standard, as in the old days, and the new framework approach of putting in more money. The important thing is, as with the federal panel, those additional funds should be added in or taken out on an equal per capita basis rather than with the proportional scaling.
I think that the main argument for five bases is that it would work. It would be possible to get reasonably close to the allocation of funds that we have seen in the past and in which we would deem to be fair allocation across the provinces and to do it in a way that only required a simple calculation involving five inputs for each province, as the report suggests. I would distinguish that issue from the numbers that go into the allocation formula and the question of the size of the pool of revenues or the pool of federal funds that we start with to determine how high we are going to equalize in all cases.
For example, you talked about whether it would be desirable to put user fees into the calculation, to include 100 per cent of the user fees collected by all 10 provinces in the national average tax rate or the national pool of revenues that was used in the old 2004 formula to determine the standard. I am not against that in principle; however, one issue is that there are serious arguments why user fees do not really represent a tax capacity that differs across provinces. It is much more like a business transaction between a government and its citizens than a tax.
The second issue is this question of the size of the pool. That is quite separate from how many calculations we have to do to allocate it among provinces. If we think user fees should go into the calculation we can still do that with the panel's five number type approach. The whole question of how big the pool should be becomes irrelevant as soon as you accept there will be a global cap.
There has been heat about whether we should go from a five-province standard to a 10-province standard. Anyone who accepts there will be a cap on the total expenditures imposed by the federal government should recognize that it becomes entirely irrelevant how we determine the standard. We have gone from a system in which the standard of actual practices of some five or 10 of the provinces determines total spending to a new system where we say we do not care about the actual practices for determining the pool but we care about affordability; then we need a formula for that.
Senator Murray: That is why they do not like the new framework. It bears no relationship to the relative fiscal capacity of the provinces.
Mr. Smart: It is a new framework in that it introduces the idea of a hard global cap. That was a big departure and struck a lot of people as the wrong way to go. I am here to suggest it is equalization in that it targets the scarce federal resources to the provinces who need it most in the sense of lowest fiscal capacity but instead of saying, let us use the actual practices of five or 10 provinces to determine the overall pool of funds, it says we are going to start with a pool that we consider affordable for the federal government. There are elements of that in the systems in other countries. One thing that is common that we have not seen in any of these proposals in Canada is that the amount of money that the federal government is willing to spend on the program will be the yield of a function of its own tax bases. Many countries set aside some tax bases and indicate that they are earmarked to finance an equalization system. We could do that in Canada and have a third way so that it would not be that the total amount of money would be determined by the provincial yields or by negotiations among first ministers, as in the new framework which is problematic and difficult. The third way would be to say we are going to pick a number which is key to some notion of affordability to the federal government, federal revenues themselves or some components of that, and then allocate the funds, so determined, and we will use the funds using the old formula to allocate. The panel, the council, the Department of Finance and I agree that we use RTS to allocate. I am now much more open to different approaches for determining the pool.
Senator Murray: The number as to the 10-province standard with 100 per cent revenue coverage in 2005-06 would be $15 billion and that would represent a $5.7 billion increase over the five previous formulas in 2005-06.
Mr. Smart: That includes the potential for payments to Ontario or not?
Senator Murray: No. It is the 10-province standard with 100 per cent increase. No, Ontario is out.
Mr. Smart: That is the key then for anyone considering these options in the future, 10 province 100 per cent, makes real the possibility that Ontario would again become formally eligible for equalization.
Senator Murray: They are just barely over the standard, which is 6.9.
Mr. Smart: The point I would raise in that context is then it becomes harder to predict the total cost of the program because even a small increase in Alberta's revenues that raises the standard $10 has to be paid to Ontario in respect of all 12 million residents, $120 million, just because of a relatively small change due to oil prices.
Senator Murray: We will have other witnesses such as Mr. O'Brien here next week.
The Chairman: Unfortunately our time has run out for today and we appreciate Professor Smart being here and posing points for us consider, especially the practicalities of the politics as they impact on the economic analysis.
The committee adjourned.