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Other Negotiated Agreements. Variousother negotiated agreements exist between the federal government and theprovinces that attempt to ensure that provincial and federal fiscal policiesare used in a way that is in the interest of the internal economic union.There is an Agreement on Internal Trade that sets out guidelines on governmentbehaviour to ensure that efficiency in the internal common market for goods,services, labour and capital is not violated. The Social Union FrameworkAgreement (discussed above) involves the implementation of social policieswhose objectives are shared by both orders of government. It isespecially concerned with agreeing on the use of conditional federal-provincialtransfers in areas of provincial legislative jurisdiction— the so-called federal spendingpower. There are also agreements in areas of immigration and theenvironment, as well as a recent agreement on the provision of transfers tofamilies with children through the National Child benefit.

These fiscal arrangements taken togetherserve to facilitate fiscal decentralization and provincial accountability,while at the same time ensuring that national objectives are notcompromised. Much of the literature on fiscal federalism is devoted tostudying how decentralized fiscal decision-making might lead to violations ofnational economic objectives, such as efficiency in the internal economic unionand national equity objectives. The fiscal arrangements can be seen asmeans by which the possibility for such violations is contained. In part,this is by preserving the ability of the federal government to oversearesponsibility for national objectives, for example through its use of thespending power. But also it involves cooperative agreements between thetwo levels of government. These agreements may involve both negative andpositive measures. Negative measures are those that require governmentsto refrain from policies causing damage to national goals, such as thoseinterfering with the free flow of products or factors of production acrossprovincial borders. Positive measures are agreements to undertake somemeasures in order to attain some national objective, such as harmonizing tax ortransfer policies or labour standards.

In the remainder of this section, the firsttwo categories of the fiscal arrangements are discussed in more detail, whiletax harmonization is discussed in the next section. The first twocategories involve transfers between the federal government and theprovinces.42 These transfers fulfill a number of roles, all of whichcontribute to the objectives of the fiscal arrangements as outlinedabove. Four particular roles are typically emphasized in the fiscalfederalism literature.

Correct Inter-Provincial Spillovers.Provincial expenditures programs may provide spillover benefits to residents ofother provinces. Education and training programs may train workers whosubsequently migrate to other provinces. Highways and other publicinfrastructure programs may benefits non-resident households and firms. Welfareprograms may attract low-income persons from other provinces. Healthprograms and benefits for the elderly may be available to persons whose workingand taxpaying years were spent in other provinces. Federal-provincialconditional transfers are one means by which provinces can be provided with theincentive to provide public services and infrastructure that may be of generalbenefit to residents of the nation regardless of where they live.

Close the Fiscal Gap. Provincialspending responsibilities may exceed their revenue-raising capacities.That is, the case for decentralizing expenditure responsibilities may begreater than the case for decentralizing tax responsibilities.Decentralizing spending may enhance the efficiency of provision by allowingprovinces to cater better to the needs and preferences of their residents,while decentralizing taxation may lead to a fragmented taxation system thatdoes not reap the advantages of a single collection system. For thesereasons, it is common in federations for the federal government to retain morerevenue raising than it needs for its own purposes, and to transfer the excessto the provinces. The exact balance between provincial revenue-raisingability and federal transfers is very much one of judgment, and differentfederations resolve it in very different ways.

The Achievement of Fiscal Efficiency/Equity.The decentralization of fiscal responsibilities typically leaves differentprovinces with different capacities for providing public services to theirresidents. If these are not corrected, incentives will exist forbusinesses and households to move to provinces with greater ability to providepublic services at given tax rates. To the extent that migration occursin response to fiscal incentives, efficiency in the allocation of resources inthe internal economic union is compromised. To the extent that migrationdoes not occur, households in otherwise identical circumstances will be treateddifferently in different provinces, leading to a violation of horizontal, orfiscal, equity. The system of equalization transfers is intended toaccount for this.

Use of the Spending Power to AchieveNational Objectives. Some important public services, such as those in theareas of health, education and welfare, are responsibilities of provincialgovernments. To the extent that the design of these programs hasimplications for national economic and social objectives, the federalgovernment has an interest in how they are delivered. The main instrumentavailable to the federal government is the spending power, which in this caseinvolves transferring funds to the provincial government conditional on thedesign of the programs.

Federal transfers influence the ability ofthe provinces to deliver services for which they are responsible or provideincentives for the provinces to choose certain design features. Thisgives rise to inevitable tensions in the federal system between the exercise offederal prerogative regarding the spending power and the fiscal independenceand legislative autonomy of the provinces. Increasingly, the Canadianfederation has evolved in the direction of the latter. Provincialautonomy has gradually increased, and there has been more reliance onfederal-provincial consultation and agreement to resolve potential conflictsand achieve shared goals. Of course, some tensions remain. Many provincesremain very skeptical about the federal spending power, at least partly becauseof a perception (well-founded) that the federal government has taken someunilateral decisions in the recent past that have been unannounced and have hadadverse effects on provincial finances and programs. In addition,tensions remain over the federal role in tax harmonization, a subject we returnto in Section D –Systems of Tax harmonization and Tax Collection.

1. Nature Of Programs Focused On VerticalImbalances

As mentioned, two transfer programs comprisethe bulk of federal-provincial transfers — Equalization and the CHST.Both serve to some extent to close the fiscal gap, but the CHST is really themain vehicle for so doing. In the case of Equalization, addressingvertical imbalances is only incidental. Its primary focus is onhorizontal imbalances: only the low-income provinces receive Equalizationtransfers.

The CHST was instituted in fiscal year1996-97, replacing the EPF (Established Programs Financing) and CAP (CanadaAssistance Plan) transfers that existed at that time. The CHST is in itsearly stages, so the precise formula for its evolution is not yet inplace. It is an equal per capita bloc grant whose magnitude is determinednot by formula but as part of the budget plan of the federalgovernment.43 The annual allotments of these transfers from 1993-94 asprojected until 2003-04 and those for Equalization are as shown in TableC.1.44

Table C.1 Equalization and Block Grant Allotments 1993-2003($billions)

EPF/CAP Equalization

1993-94 18.8 8.1

1994-95 18.7 8.6

1995-96 18.5 8.8

CHST

1996-97 14.7 9.0

1997-98 12.5 9.7

1998-99 12.5 9.6

1999-00 14.5 9.8

2000-01 15.5 9.5

2001-02 15.6 10.0

2002-03 15.5 10.3

2003-04 15.5 10.7

The CHST is nominally intended to supportthe financing of provincial expenditures in the areas of health, post-secondaryeducation, social services and social assistance, all areas of provinciallegislative responsibility. The funds are in no way tied to provincialexpenditures in these areas: they are completely fungible. Thereare, however, some conditions that provincial programs must satisfy in order tobe eligible for the full amount of the transfer. Health programs mustsatisfy five very general criteria. Provincial health insurance systemsmust be i) publicly administered, ii) comprehensive, iii) universal, iv)accessible, and v) portable. In addition, there can be no user fees, anddoctors may not extra-bill patients over and above the fees paid by the publicprogram. Violation of any of these conditions can lead to financialpenalties being imposed by the federal government. Such penaltiesare a last resort, but from time to time they have been imposed. Given that theconditions are quite general, there are bound to be disagreements about how tointerpret them.45 The only otherconditions imposed apply to welfare (social assistance and socialservices). Welfare programs should not interfere with the mobility ofwelfare recipients across provinces. Otherwise, provinces are free todesign their welfare systems as they see fit. No conditions apply toprovincial post-secondary education programs.

The CHST thus provides provinces withconsiderable independence in determining the size and design of their socialprograms. The influence of the federal government exists by virtue of thefact that it provides some (conditional) financing in support of provincialprograms. But this influence is limited. Not only are theconditions attached to the fund very general, but also the federal governmentcontribution is relatively small, of the order of one-fifth of total programexpenditures. This makes it difficult for the federal government to havethe authority to insist on detailed design features. This is a relativelyrecent phenomenon. The CHST evolved from a system of shared-costtransfers in which the federal contribution was much higher.

Prior to 1977, the federal government fundedapproximately 50 percent of provincial health costs.46 In thecase of welfare, the federal government matched each provinces’ spending on approved socialassistance and social services operating costs under the CAP.47Transfers to the provinces for post-secondary education spending were based onthe number of eligible students in the province. In 1977, the health andpost-secondary education transfers were converted into a bloc transfer, theEPF, partly in recognition of the fact that the programs were now well‘established’. The EPF transfer had three features that differed from theprevious shared-cost programs. First, the transfer was converted fully toan equal per capita transfer.48 Second, the rate ofgrowth of the transfers was changed to the rate of growth of GNP rather thanthe rate of growth of provincial program expenditures. The implicationwas that the federal share of health and post-secondary expenditures was boundto fall gradually over time since program expenditure was growing in aggregatemuch more rapidly than GNP. Indeed, this was a major purpose of thechange. Third, the equal per capita transfer was nominally dividedbetween a cash component and a tax-transfer component. The federalgovernment instituted the latter by reducing its personal and corporate incometax rates, thereby allowing the provinces to increase theirs. The effectof this was further to restrict federal cash contributions both initially andover time. In 1977, half of the EPF transfer took the form of cash andthe rest of tax-transfers.49 As time passed by, thetax-transfer component rose more rapidly than the total EPF allotment implyingthat the cash transfer as a proportion of the whole fell.

When the CHST was instituted, the legacy ofthe EPF system was strongly felt. The CHST replaced both the EPF and theCAP, and in its initial years it replicated two features of thoseprograms. First, the allocation among provinces reflected the totalshares of provinces in the previous EPF and CAP systems, and this was quitedifferent from equal per capita. Indeed, the three highest-incomeprovinces received less per capita than the other provinces leading the formerto argue that this represented an unnecessary addition to equalization.Second, the federal government continued to calculate its contribution to theCHST as including the tax-transfer that had been affected twenty yearsearlier. As the total CHST transfer was considerably less than the EPFand CAP programs it replaced (as part of the federal deficit reduction program)and as it was not intended to grow, the cash component of the CHST wouldgradually fall.

Subsequently, the CHST was reformed to avoidthese problems. It was converted into an equal per capita grant in 1999,and its amount was defined fully in terms of a cash transfer. (The abovetable includes only federal cash contributions.) The federal governmentdoes, however, continue to count the tax-transfer as part of its contributionto federal social programs, even though these funds are now fully in the handsof the provinces as part of their own-source revenues.

2. Nature of Programs Focused on HorizontalImbalances

The CHST has an equalizing effect. Asan equal per capita transfer financed by federal general revenues, iteffectively transfers from the high-income to the low-incomeprovinces.50 But, the main program designed for correcting horizontalfiscal imbalance (HFI) is the Equalization program. The basic design ofthe Equalization system goes back to the early post-war period, although it hasundergone many changes in detail since then. As mentioned earlier, itfocuses entirely on equalizing tax capacity differences across provinces. Thereis no equalization of provincial expenditure needs. Unlike with the CHST,equalization transfers are completely unconditional.

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