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Some observers have suggested thatdecentralization could go much further on the revenue-raising side, arguingthat provinces should be responsible for raising virtually all their ownrevenues rather than being reliant on the federal government fortransfers. Indeed, the main opposition party in the federal Parliamentespouses this position. They argue that this would make the provincesmore autonomous and therefore fully responsible and accountable for their ownactions to their electorates. Such autonomy would also minimize thepotential for the federal government interfering with provincial fiscaldecision-making. This school of thought tends to place considerableemphasis on inter-jurisdictional tax competition as an inducement forgovernments to be more efficient and responsive to the preferences of theirelectorates. At the same time, it de-emphasizes the role of transfers inachieving national equity and efficiency objectives.

Fiscal Arrangements as Facilitators ofDecentralization

Decentralization carries with it thepotential for interfering with the efficiency of the internal economicunion. Part of the role of the fiscal arrangements is to offset thesepotential inefficiencies of decentralization. There are two maindimensions to this. The first concerns the efficiency of the internaleconomic union. The second concerns the effect of theprovinces’ fiscalposition on the allocation of resources among provinces.

Efficiency in the EconomicUnion

Decentralized decision-making can affect theefficiency of the internal economic union by distorting the free flow of goods,services, labour and capital between provinces. Provincial tax andexpenditure policies can inadvertently impose barriers to trade.Provinces may engage in explicit beggar-thy-neighbour policies to attractbusiness and households from other provinces. Provincial policies maydiscriminate in favour of resident firms or households.

Various measures can be taken to mitigate thepossibility that provincial policies will distort the internal economicunion. Tax harmonization reduces the possibility of the tax system beingused in ways that are inefficient. Conditional grants may be conditionalon provincial programs being designed in ways that do not distort markets inthe economic union. The political or legal systems may also be used toenforce measures that improve the efficiency of the internal economicunion. Intergovernmental agreements may be negotiated that precludeprovinces from engaging in distortionary or discriminatory policies.There may be constitutional provisions that preclude provincial governmentsfrom implementing such policies. Or, the federal government may have theauthority to oversee provincial policies from this point of view, withenforcement coming through the power to disallow policies that violateefficiency or the power to disallow provincial legislation.

In the Canadian case, measures of varyingeffectiveness exist for maintaining the efficiency of the economic union.Tax harmonization is reasonably successful in the income tax area. Theequalization system removes some of the need for differential tax policiesamong provinces. The bloc grant system of the CHST includes some generalconditions that contribute to the efficiency of the internal economic union,such as the mobility/portability provisions required of provincial health andwelfare systems. But, the effect of these provisions is quitelimited. For example, there is little harmonization of provincialeducational programs. There are also measures that deal with thepotential for provincial policies of various sorts to distort the internaleconomic union. The constitution itself contains very little: it doesgive the federal government the power to disallow provincial legislation but ithas become a well established constitutional convention that this power is notused. The main vehicle for addressing efficiency in the internal economic unionis an Agreement on Internal Trade recently signed by the federal and provincial governments. Itcontains provisions for both negative integration (discouraging provincialmeasures that distort the internal economic union) and positive integration(encouraging provinces to engage in harmonization that furthers efficiency),and covers various areas of provincial policy (e.g. procurement, labour marketregulation, investment, environment). But, its effectiveness remains tobe proven. Its main defect seems to be the absence of an effectiveenforcement and dispute resolution mechanism.

Fiscal Efficiency

Decentralization in itself inevitably leadsto differences in the ability of provinces to provide public services to theirresidents. They will have different sizes of tax bases per capita fromwhich to raise revenues. They will also have different needs for publicexpenditures since the demographic composition of their populations willdiffer. The consequence is that, in the absence of countervailingmeasures, provinces will be unable to provide comparable levels of publicservices at comparable tax rates. That is, there will be different netfiscal benefits (NFBs) depending on the province of residence. This willprovide a purely fiscal incentive for businesses and households to locate inprovinces with higher NFBs, leading to a misallocation of productive resourcesacross provinces. This misallocation, referred to as fiscal inefficiency, can be corrected bya system of equalization that makes transfers selectively to provinces suchthat they can, if they so choose, provide comparable levels of public servicesate comparable tax rates.

In Canada, fiscal inefficiency is deterred bythe system of Equalization transfers. This system equalizes the taxcapacity of the have-not provinces up to that of the five-provincestandard. The result is a reasonably complete equalization of taxcapacities across provinces. There is, however, no mechanism forequalizing differences in provinces’ expenditure needs. To thatextent the system is imperfect.

There may be other sources of policy-inducedinefficient allocations of resources. For example, in Canada some federalpolicies systematically favour the have-not provinces (Employment Insurance,regional development grants, agricultural subsidies, etc.). Someeconomists have argued that the combination of Equalization and otherregionally preferred policies over-compensate have-not provinces for their NFBdeficiencies. The result is that too many productive resources could beencouraged to stay in have-not provinces rather than moving to more productiveuse in higher-income provinces.

2. Impacts on Equity

As with efficiency, there are varyingdimensions to equity. It is useful to distinguish three aspects that areparticularly relevant in a federal setting. The first concerns equityachieved through the provision of public services. These especially servethe equity objectives of equality of opportunity and economic security (socialinsurance). The second and third are the complementary notions ofvertical and fiscal equity of the tax-transfer system.

Equity and PublicServices

Important public services like education,health and social services are provided through the public sector essentiallybecause they serve equity objectives. Otherwise, they could be left tothe private sector. In many federations, these services are decentralizedto lower orders of government. Yet, the federal government may have aninterest is seeing that they satisfy some national standards so that citizenshave comparable access to such services regardless of their province ofresidence. Reconciling the desire to achieve national standards with thedesire to decentralize provision to the provinces is one of the most importantissues that federal systems must address.

In Canada, the balance has been achievedreasonably effectively until now. The provinces have considerableindependence to design these programs to suit their own perceived needs.The federal government has historically exercised some oversight via itsspending power. It has financially supported provincial provision of theseservices with grants in return for the provinces adopting certain features intheir program design. The conditions attached to the transfers have beenfairly general, leaving detailed program design to the provinces (as discussedabove).

There is some debate about the extent towhich national standards should or could be achieved in the future. Asdiscussed above the federal government now finances a relatively smallproportion of provincial public services, and there is some issue as to whetherit continues to have the political and moral authority to enforce nationalstandards. Some observers suggest that this is as it should be.They stress that the provinces are in a better position to set their programsto suit their residents’ needs and preferences, and that any harmonization to a nationalstandard can be achieved by inter-provincial agreement.

Vertical Equity

Vertical equity refers to the progressivityof the tax-transfer system. Value judgments are necessarily involved inchoosing the degree of progressivity, and reasonable observers candisagree. In a federal context, the additional problem arises as to whichlevel of government ought to be primarily responsible for determining theprogressivity of the system. On the one hand, it can be argued thatprovinces can better choose tax-transfer systems that reflect the preferencesfor redistribution of their residents. On the other, decentralizingredistribution to the provinces can give rise to destructive tax competition (a‘race to thebottom’) in whichredistribution gets competed away. As well, to the extent that thefederal government determines redistribution, it can ensure that all citizensare subject to the same standards of redistribution throughout the country, aproperty that might be compatible with notions of citizenship. Economistshave tended to be somewhat agnostic about assigning the responsibility forredistribution, recognizing that while the federal government might have aninterest in some minimum national standards of vertical equity, there is roomfor the provinces to augment that in a way that suits theirconstituents.

In Canada, the compromise solution has beenadopted. Both the federal and provincial governments have access to themain instruments for income redistribution. The federal governmentmaintains a dominant share of the income tax room, and can choose its ratestructure and credits to achieve the degree of progressivity that it thinks isappropriate from a national point of view. At the same time, theprovinces can choose to abide by the federal government’s rate structure.Alternatively, they can adopt their own income tax rate structures, even ifthey abide by the federal base. This seems to be a reasonablecompromise.

Horizontal Equity

The criterion of horizontal equity suggeststhat persons who are equally well off ought to be treated the same by thepublic sector. It is of particular relevance in a regionally diverseeconomy where persons of similar real incomes might reside in differentregions. In the fiscal federalism literature, the principle thatotherwise equal persons ought to be treated similarly in different regions isreferred to as fiscal equity. In a parallel way to fiscal inefficiency, fiscal inequitywill occur in a decentralized setting if provinces have differing abilities toprovide public services. Persons of any given level of income willreceive higher NFBs in wealthier provinces than in less wealthy ones. Aswith fiscal inefficiency, this can be avoided if a system of equalization is inplace that enables all provinces to provide comparable public services atcomparable tax rates.

The use of fiscal or horizontal equity as aguiding principle of fiscal federalism and its implications for equalizationmay not be universally accepted. Those who advocate it see it as a basicprinciple of fairness or entitlement that comes with citizenship in afederation. It is the economic equivalent to the legal concept of equaltreatment. Others do not support the argument that residents of oneregion have entitlements to the wealth of another, especially if regions arepolitically distinct entities and belong to a loosely knitfederation.

In practice, most countries do haveequalization systems in place, reflecting at least some commitment to thenational sharing of resources. In the case of Canada, the principle ofequalization is embedded in the constitution. As we have seen, theEqualization system substantially equalizes provincial differences in taxcapacities. But the system is not written in stone and continues to relyon political goodwill. As the federation becomes more fiscallydecentralized, the demands on Equalization and the support for it couldwane. So far, the system has held up well.

3. Political Aspects

1. Impact on Stability

The processes of intergovernmental relationsand fiscal arrangements have been both a stabilising influence and a source ofconflict in Canada.

2. Areas of Consensus

Equalisation: Onearea in which there is relative political consensus is the program of fiscalequalization. All of the provinces have endorsed this system of unconditionaltransfers from the federal government to the seven less-wealthy provinces inorder to help these provinces provide a comparable level of public services atreasonably comparable levels of taxation. Equalisation has also contributed toa narrowing of regional difference in economic conditions. Chart E-1 indicatesa reduction in regional differences by comparing provincial trends in GDP percapita from 1961 to 1996.

Chart E1: Average Annual Growth Rates by Province,1961-96

All of the provinces receiving equalization,except Manitoba, are above the national average for growth rate of GDP percapita.

The use of equalization transfers has alsomeant that social programs have developed as a cooperative project between thetwo orders of government.

3. Areas of Dispute

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