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Archived - Annex 2
Recent Evolution of Fiscal Balance in Canada
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This annex summarizes key developments in the evolution of fiscal balance in Canada over the last few decades, including:
- The return to surpluses by both federal and provincial-territorial governments after years of large deficits.
- The significant decline of debt ratios of both orders of government.
- The marked decline in both federal and provincial program spending ratios since the mid-1990s.
- The broad access of both federal and provincial governments to all major tax fields.
- The significant tax reductions made in recent years, especially in the case of federal taxes.
- The significant reinvestment in federal cash transfers to provinces and territories in recent years, after significant cuts in the mid-1990s.
- The significant narrowing of interprovincial economic and fiscal disparities.
Budgetary Balances and Debt Burdens
The past quarter-century has witnessed dramatic changes to federal and provincial-territorial budgetary balances. The 1980s and early 1990s were characterized by large, chronic federal deficits, which peaked at more than 8 per cent of GDP in 1984–85. Over this same period, provincial deficits were also significant but did not reach the same levels as those recorded by the federal government.
After some improvement in the late 1980s, the 1990–91 recession resulted in a deterioration of the fiscal situation for provinces and territories and a further setback for federal efforts to reduce its deficit. For both orders of government, spending control as well as the post-recession return to economic growth led to a significant turnaround from large deficits to surpluses.
The federal government recorded its first surplus in 1997–98 and provinces achieved a combined positive budgetary balance in 1999–2000 after decades of deficits. With the projected surplus in 2005–06, provincial-territorial governments will have recorded a combined positive budgetary balance in five of the past seven years.
Eight provinces are forecasting balanced budgets or surpluses in 2005–06 and 2006–07, with the remainder also seeing a considerable improvement in their fiscal situation over the last few years.
Substantial Improvement in Budgetary Balances in Recent Years
|(millions of dollars)|
|Sources: Federal and provincial-territorial Public Accounts and budgets.|
Reflecting improvements in budgetary balances, both federal and provincial-territorial debts have declined as a share of gross domestic product (GDP), with the federal debt ratio falling more dramatically. However, federal debt as a share of GDP still exceeds that of most provinces and remains significantly higher than the provincial average.
Lower debt-to-GDP ratios, combined with lower interest rates and an improved credit rating, have enabled both orders of government to allocate a smaller portion of revenues to debt interest payments and a greater portion to program expenditures, tax reductions and debt repayment. Both orders of government have also benefited from increased revenues generated by sustained economic growth.
Overall, Canadians witnessed an impressive fiscal recovery for both orders of government in the past decade. However, such a recovery was made possible only by making difficult choices in the mid-1990s to reduce spending.
Program spending expressed as a share of GDP provides a good measure of spending trends and of the size of governments relative to the economy. It is important to examine the data over a long period of time in order to distinguish between cyclical and structural trends.
Federal program spending as a share of GDP has declined significantly since 1983–84. As a result of spending restraint and strong economic growth, the ratio of federal program spending to GDP declined steadily throughout the latter half of the 1980s. The 1990–91 recession triggered increases in certain federal expenditures like employment insurance, which contributed to a rise in the program spending-to-GDP ratio. The federal government underwent a program of expenditure review and restraint between 1993–94 and 1996–97, which was an essential factor in its fiscal recovery.
Since 1983–84, provincial-territorial program spending has also declined as a share of GDP, but to a lesser extent. Provinces and territories were also hit hard by the recession, which caused a significant increase in spending on social assistance and social services in the early 1990s. Starting in the mid-1990s, most provinces undertook major restructuring to reduce or stabilize their program expenditures. The sustained job creation over the past decade has also significantly reduced provincial spending pressures in the areas of social assistance and social services.
The tighter spending control exercised by both orders of government during the 1990s reflected the need to rebalance government finances after a long period of large and unsustainable deficits.
Since 2000–01, program spending as a percentage of GDP has begun a modest rebound as both federal and provincial-territorial governments addressed significant spending pressures.
Health care has proven to be the number one priority in terms of new investments:
- From 2000–01 to 2005–06, provincial-territorial health care spending increased by an average of 7 per cent annually, compared to an average growth of 4.3 per cent for provincial-territorial revenues.
- The federal government increased its transfers to provinces and territories, in large part to support them in their efforts to address health care needs. Transfers increased by an average of 8.7 per cent annually between 2000–01 and 2005–06, compared to average growth in federal revenues of only 2.6 per cent.
Access to Revenues
Both orders of government have access to all major sources of tax revenue: personal and corporate income taxes, sales taxes and payroll taxes. Provinces have access to resource revenues, gaming and liquor profits, and property taxes while the federal government has exclusive access to customs import duties as well as taxes on non-residents.
Moreover, among major industrialized federations, only in Canada and the United States do sub-national governments have full control over their tax bases and tax rates—though in some cases, provinces in Canada have chosen to enter into harmonization agreements (notably in the area of income and sales taxes) in order to reduce compliance costs on Canadians and administrative costs.
Both Orders of Government Have Access to Major Tax Fields
|Common revenue sources|
|Personal income taxes||√||√|
|Corporate income taxes||√||√|
|Total in 2005 (billions of dollars)||192.0||130.0|
|Unique provincial revenue sources|
|Resource royalties within provincial jurisdiction||√|
|Gaming, liquor profits||√|
|Total in 2005 (billions of dollars)||30.3|
|Unique federal revenue sources|
|Customs import duties||√|
|Taxes on non-residents||√|
|Total in 2005 (billions of dollars)||8.4|
|Source: National Economic and Financial Accounts|
In Canada, sub-national governments raise the largest share of total government revenues among industrialized federal countries, which is a reflection of the high degree of decentralization of the Canadian federation.
Given their broad access to major tax fields and the control they exercise over their tax bases and rates, provinces and territories are more fiscally autonomous than their counterparts in other federal countries. In particular, they rely more on own-source revenues—and less on federal transfers—to fund their programs and policies.
Provincial revenues (including federal transfers) have generally exceeded federal revenues for more than 25 years, with the gap increasing in recent years. While governments have the legal authority to increase their revenues as required, concerns about competitiveness and the overall tax burden of Canadians limit the extent to which they can and should raise additional revenues in practice.
Starting in the late 1990s, most governments in Canada implemented tax reductions, primarily targeting personal and corporate income tax reductions. As a result, revenue-to-GDP ratios declined for both orders of government. For provinces and territories, the rebound in the revenue ratio in recent years is in large part attributable to increases in federal transfers and resource revenues. Federal tax cuts exceeded provincial tax cuts in dollar terms.
The Sharper Decline in Federal Revenues is Due in Part to Larger Federal Tax Reductions Since the 1996 Federal Budget
|(billions of dollars)|
|Personal income taxes||-31.5||-21.3|
|Corporate income and capital taxes||-5.3||-4.6|
|Employment insurance premiums/payroll taxes||-7.2||-0.4|
|Other revenue measures1||0.8||5.9|
1 Includes sales taxes, property taxes, health premiums, tobacco taxes, gasoline taxes and various measures to fight tax evasion.
Federal Cash Transfers
While Canadian provinces are less dependent on federal cash transfers than their counterparts in other federal countries, transfers still represent a significant source of revenue for the provinces and territories.
As part of its deficit reduction efforts, the federal government cut cash transfers to provinces and territories for health care and other social programs by 30 per cent between 1994–95 and 1997–98, from $18.7 billion to $12.5 billion. Equalization was not cut but a ceiling did temporarily constrain entitlements in 2000–01. Territorial Formula Financing (TFF) was also subject to a ceiling that limited the growth of grants from 1990–91 to 1993–94, and each territory’s Gross Expenditure Base was cut by 5 per cent in the 1995 budget.
Since the federal government balanced its budget in 1997–98, federal cash transfers for health and social programs have rebounded substantially:
- By 2002–03, the level of cash transfers was restored to 1994–95 levels.
- In 2006–07, cash transfers will reach $29.8 billion, an increase of about $17 billion since 1997–98.
- The Canada Health Transfer (CHT) has also been put on a long-term growth track. The 10-Year Plan to Strengthen Health Care signed in September 2004 (and legislated through to 2013–14) provides for annual increases of 6 per cent in the CHT cash transfers over the life of the agreement.
- Cash payments under the Canada Social Transfer will grow by nearly 3 per cent annually, on average, over the legislated period until 2007–08.
Equalization and TFF transfers were also put on a legislated 10-year growth track through to 2013–14 under a new framework announced in October 2004. However, the new framework constituted a departure from past practice, under which both the level and allocation of these transfers were determined by a formula. As a result, concerns have been raised about the ability of both programs to meet their objectives over the longer term. In particular, there is a broad consensus that the programs need to be returned to a formula-based approach for determining both the level and allocation of entitlements under these two transfers.
In all countries, there are differences in economic performance across regions. Given the diverse nature of Canada, substantial economic disparities exist.
The coefficient of variation, illustrated in the charts below, measures the magnitude of the disparities across provinces in each year, thus making it a useful indicator to track trends in disparities over time. Even though economic disparities between provinces are still substantial, they have nevertheless declined significantly over the past 25 years.
In federal countries—and especially in fiscally decentralized countries such as Canada—these economic disparities translate into fiscal disparities (i.e. differences in the ability to raise revenues) among sub-national governments. The pattern of fiscal disparities in Canada has largely mirrored the pattern of economic disparities.
While fiscal disparities (like economic disparities) have generally declined over the past 25 years, the recent rise in natural resource prices that began in 2000 has generated stronger economic and revenue growth in provinces with significant natural resources (notably Alberta, Saskatchewan, British Columbia and Newfoundland and Labrador). As a result, economic and fiscal disparities have widened somewhat, though they remain significantly smaller than in the early 1980s.
Most federal countries, including Canada, have fiscal equalization programs to help reduce fiscal disparities. The principle of equalization is enshrined in subsection 36(2) of Canada’s Constitution Act, 1982. Canada’s Equalization program significantly reduces fiscal disparities among the provinces (see Annex 3).
Federal Revenue-Expenditure Balances Across Provinces
In all federal countries, economic disparities and the implicit inter-regional redistribution that results from the operation of federal tax and expenditure policies result in different "balances" between federal revenues and expenditures in different regions. Generally speaking, the residents of more prosperous regions, taken as a whole, receive less federal spending and make larger contributions to federal revenues. The opposite is true in less prosperous regions.
Canada is no different in this regard. Because of their relatively higher incomes, citizens and businesses residing in more prosperous provinces, such as Alberta and Ontario, contribute relatively more to federal revenues than they receive from federal programs.
In Canada, as in other federal countries, the "gaps" between federal revenues and expenditures in different provinces reflect the structure of the tax and transfer systems of the federation, including the progressivity of federal taxes, the targeting of support to individual Canadians or families in need, and the commitment to the reduction of provincial-territorial fiscal disparities.
In particular, a number of factors determine the measured balance of individual regions at any given point in time:
- Budgetary position of the federal government: Measuring balances at a given point in time effectively ignores the impacts of deficits and surpluses on future tax and benefit levels. As a result, when federal deficits are large (as in the early 1990s in Canada), federal fiscal balances are distorted in all provinces: redistribution toward less prosperous jurisdictions is exaggerated and redistribution from more prosperous jurisdictions appears smaller. The opposite is true when the federal government runs surpluses (as has been the case in Canada in recent years).
- The degree of revenue and expenditure decentralization: The larger the federal share of revenues and expenditures, the greater the degree of redistribution among regions even with uniform federal taxation and expenditure policies. As a result, redistribution resulting from federal policies tends to be smaller in fiscally decentralized federations (such as Canada) than in more centralized federations (such as the U.S.)
- The degree to which federal policies are designed to be redistributive: For example, inter-regional redistribution increases with the progressivity of the federal tax system, the degree to which federal programs are targeted to low-income individuals or regions or other needs, and the extent of the national commitment to the reduction of fiscal disparities among provinces and territories.
Changes in the federal budgetary balance are particularly important in explaining recent changes in regional balances:
- In 1993, when the federal government recorded a $38.5-billion deficit, they were negative fiscal balances in all provinces but Alberta: that is, provincial residents were receiving more in federal services and transfers than they paid in federal taxes. The average balance was minus 4.6 per cent of GDP. Even in Ontario there was a negative balance totalling $1.4 billion.
- This situation was clearly unsustainable since the federal government was borrowing heavily to finance its activities. To address its budgetary deficits, the federal government raised its revenues and reduced its spending. Residents of all provinces contributed to this process of fiscal restraint.
- By 2003, federal fiscal consolidation resulted in the average balance rising by more than 5 per cent of GDP relative to 1993, to an average balance of plus 0.6 per cent of GDP. In Ontario, the fiscal balance increased by 4.5 per cent of GDP during this period. This generalized trend towards improved provincial balances explains the growth in what some observers have referred to as the Ontario "gap," which increased in aggregate from about $2 billion (in 1995) to $18 billion in 2003.
In effect, the resulting $18-billion Ontario "gap" is a reflection of the province’s greater prosperity relative to most other provinces. The "gap" can be decomposed based on the extent to which federal revenues and expenditures in Ontario deviate from the national average:
- About 42 per cent of the "gap" in 2003 is accounted for by above-average revenues collected in Ontario, reflecting above-average incomes and business activity in the province.
- About 14 per cent is accounted for by Ontario’s per capita share of federal debt reduction in 2003.
- About 23 per cent is accounted for by below-average transfers to the province, notably because it did not qualify for Equalization due to its above-average fiscal capacity.
- About 18 per cent was accounted for by below-average payments to Ontario residents for income-tested transfers to persons, such as the Canada Child Tax Benefit, elderly benefits and employment insurance. These reflect the province’s above-average personal incomes and below-average unemployment rate.
These four areas accounted for over 97 per cent of the "gap," with the remaining 3 per cent reflecting other smaller expenditures, some of which are more heavily weighted towards Ontario (such as federal spending on goods and services) and others that are not.
Federal fiscal balances in Canadian provinces are similar in size to those that would be observed across the United States if the federal government in both countries ran balanced budgets, even though the United States does not have an equalization program:
- As noted above, provincial and state "gaps" not only depend on the level of transfers from the federal government to provincial or state governments, but also on the relative size of the federal government, the progressivity of the federal tax system and the extent to which federal expenditures are income- or needs-targeted.
- The chart below therefore reflects the fact that the U.S. federal government’s revenues and expenditures are larger, as a percentage of GDP, than those of the Canadian federal government, as well as the different basis for allocating federal expenditures in the U.S. (e.g. the greater proportion of defence spending in the U.S. and its concentration in particular states).
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