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Budget '98: Reports -- Ministry of Finance and Corporate Relations -- Province of British Columbia

Report F: Federal Spending Power, Fiscal Imbalance, and Risks to Health Care and Education


The federal government's practice of delivering funding or programs in areas of provincial jurisdiction stems from its "spending power". This is the product of a vertical fiscal imbalance in Canada -- the outcome of federal government decisions over several decades to collect for itself more revenues than needed to fund programs for which the federal government has constitutional responsibility. This excess has traditionally been returned to the provinces in the form of transfers.

This fiscal imbalance has given the federal government two budgetary advantages: access to Canada's highest-yield revenue sources and the ability to cut transfers to provinces as a first resort in times of fiscal difficulty. The federal government has made full use of these advantages over the past several years and they have made possible the achievement of a balanced federal budget. However, there has been a disturbing consequence: the vitality of the provincially-delivered programs Canadians value most -- health care and education -- is seriously at risk.

The Federal Spending Power

Spending power is not specifically mentioned in the Constitution of Canada but there is little doubt that it exists in law. Through its spending power, the federal government can make gifts or transfers to any recipient, including another government. As well, the federal government may attach conditions to the transfer.

Federal use of the spending power has, over the years, become a method of effecting significant changes in confederation -- particularly in establishing Canada-wide programs. Many of these have been in fulfilment of national policy goals and were instituted with broad public support. However, exercise of the spending power has also caused significant problems between the federal government and the provinces.

1. The Problem of Overlap and Distorted Priorities

The spending power has come to rival constitutionally-allocated jurisdiction as a tool of governmental power, enabling the federal government to "compete" in provincial areas of jurisdiction. This intrusion has a tendency to cause program overlaps and complexities that can interfere with efficient program delivery.

Federal spending in areas of provincial jurisdiction can also distort provincial priorities through the attachment of program conditions to provincial transfers that provinces must meet in order to maintain federal funding.

2. The Accountability Problem

With more than one level of government providing funding and/or programming in major policy areas, it becomes difficult for the public to know which government to hold accountable when program performance is inadequate. Because provincial governments have primary responsibility in major social areas -- such as health care and education -- and are closer to hand, they are often blamed for program results caused by federal funding changes.

3. The Problem of Financial Insecurity for Provinces

Over the past several years, the insecurity of federal transfers has become, for the provinces, the most prominent consequence of the federal use of its spending power. Provincial governments are very vulnerable to reductions in intergovernmental transfers. The federal government can, at its sole discretion, reduce or eliminate any federal spending power program. Further, as judicial decisions have reinforced, this power to terminate spending arrangements cannot be fettered by contracts or federal-provincial agreements.

The essential question that governments in Canada are currently endeavouring to address is the extent to which it remains appropriate for the federal government to use spending as a mechanism for controlling programs -- such as health care and education -- in areas of provincial constitutional jurisdiction 1.

1 This is one of the main agenda items in the current attempt by the provinces to negotiate a framework agreement with the federal government on planning and managing the social union in Canada.

The Foundation of the Spending Power:
Federal Control of More Revenue Sources
Than Needed for Federal Programs

What has given the spending power its meaning is the financial capability to exercise it. For this reason, the history of the spending power is intimately connected to the history of taxation and the division of tax room. The order of government that has a meaningful spending power is the order of government which sets out to raise revenues higher than necessary to fulfil its own jurisdictional responsibilities.

Thumbnail of Chart F1 CHART F1
[ Click to view larger image of Chart F1 ]

The federal government's dominance of the spending power in Canada can be traced back to World War II when, as shown in Chart F1, the federal government dramatically increased its tax effort to meet the wartime emergency. In support of the war effort, the provinces ceded to the federal government all of their revenues from two major tax sources: personal and corporate income tax.

After the war, the federal government did not allow its tax collection efforts to fall back to pre-war levels. Its post-war vision was that it would keep its tax revenues high, use cash transfer payments to support the provinces, and become a major presence in both social policy, and provincial government finances. This vision was not supported by the provinces at the Dominion-Provincial Conferences on Reconstruction of 1945 to 1946. It was nonetheless gradually implemented over the post-war decades. The federal government continued to occupy most of the available tax room and maintain a position of fiscal dominance. It used the spending power this generated to develop national social programs, and to entice reluctant provinces into a series of tax rental agreements and subsequent transfer payment arrangements.

Thumbnail of Chart F2 CHART F2
"Own-Source" Revenues Compared with Own Programming
[ Click to view larger image of Chart F2 ]

Spending Power and Vertical Fiscal Imbalance

Federal revenue dominance created a federal-provincial fiscal imbalance in Canada. This is often called a vertical fiscal imbalance and denotes a situation in which the federal government's access to revenues exceeds its spending responsibilities. Conversely, provincial own-source revenues are not sufficient to meet provincial spending responsibilities. Chart F2 illustrates a recent history of the federal-provincial fiscal imbalance in Canada 2.

Historical revenue and spending data cannot provide an exact measure of the underlying fiscal imbalance since they already incorporate governments' responses to the imbalance itself. Hence, the data series in Chart F2 is terminated in 1992 because in the years since then many provinces have made significant reductions in social program spending in response to major cuts in federal transfers.

Chart F3 shows this imbalance in 1997/98.

Thumbnail of Chart F3 CHART F3
[ Click to view larger image of Chart F3 ]

The existence of a vertical fiscal imbalance is not necessarily detrimental to a federation. Indeed, until about fifteen years ago, the shortfall in provincial "own-source" revenue raising capacity was adequately offset by federal transfers.

The Recent Effect of Fiscal Imbalance

What has made vertical fiscal imbalance a rising Canadian issue is the manner in which the federal government has attacked its fiscal problems over the past fifteen years, and particularly since 1990. The federal government has admitted that the provinces were not implicated in the creation of federal fiscal problems. However, the fiscal imbalance has created a situation in which the provinces have been made major, involuntary contributors to the federal government's balanced budget.

Thumbnail of Chart F4 CHART F4
[ Click to view larger image of Chart F4 ]

Chart F4 shows -- in order of magnitude -- the three main factors contributing to the achievement of a federal budget balance over the three year period from 1994/95 to 1997/98:

1. revenue growth;

2. cuts in transfers to provinces; and

3. federal restraint applied to its own programs.

The current vertical fiscal imbalance has greatly helped the federal government by making possible, or facilitating, the two main components of its balanced budget efforts:

1. Federal Revenue Growth

About two-thirds of the deficit reduction since 1994/95 is attributable to federal revenue growth. As Chart F5 shows, this primarily reflects personal income taxation growth, and the recovered vitality of corporate income tax, following the recession of the early 1990s.

Thumbnail of Chart F5 CHART F5
[ Click to view larger image of Chart F5 ]

In other words, the income tax dominance gained by the federal government is conferring special fiscal benefits. Chart F6 illustrates the effect of the dominant federal share of personal and corporation income tax revenues on the federal total mix of revenues. In contrast, the revenue mix of provinces means that fiscally, these governments are significantly less buoyant.

Thumbnail of Chart F6 CHART F6
[ Click to view larger image of Chart F6 ]

2. Cuts in Transfers

The most visible effect of the vertical fiscal imbalance is that it created a situation whereby the federal government could compel provinces to bear a significant proportion of federal deficit reduction efforts on the spending side. This was accomplished through the simple expedient of making steep reductions in federal transfers to provinces.

For provinces and territories, the federal government's introduction of the Canada Health and Social Transfer (CHST) 3, was accompanied by reductions in major social transfers of 33 per cent or $6.2 billion between 1994/95 and 1997/98 4. The reduction for British Columbia was $670 million, and followed several years of discriminatory Canada Assistance Plan (CAP) transfers in which British Columbia was prevented from receiving its fair share 5.

Further, by the time the CHST was introduced all provinces had endured over a decade of growing restrictions on transfers (in addition to the discriminatory CAP restrictions).

All in all, major social transfers from the federal government have declined from 2.9 per cent of GDP in 1985/86 to only 1.4 per cent of GDP in 1998/99.

3 The CHST combined the previous Established Programs Financing (EPF) arrangement for health care and post-secondary education, and the Canada Assistance Plan for social assistance.
4 This amount differs from the size of the reduction noted in Chart F4 because the latter includes equalization, territorial financing and other transfers, and was calculated on a public accounts, not entitlements, basis.
5 Ontario and Alberta were similarly discriminated against.

Thumbnail of Chart F7 CHART F7
Cuts in CHST Compared to Federal "Own-Program" Spending
[ Click to view larger image of Chart F7 ]

Chart F7 compares the large reductions in the CHST with changes to federal "own-program" spending (i.e. federal program spending excluding all transfers to provinces) since 1994/95.

This emphasizes the disproportionate role of transfer cuts in federal deficit reduction. Between 1994/95 and 1997/98, the CHST was reduced by 33 per cent, while federal "own-program" spending fell by only 6 per cent. In other words, cuts to the CHST have been proportionately almost six times deeper than cuts to other federal programs.

Conclusion -- Fiscal Imbalance and National Priorities

Current trends are exacerbating the inconsistency between access to revenues and program responsibilities of the federal and provincial orders of government.

The federal government is the main beneficiary of these trends by:

In contrast, the provinces have to deal with a quadruple disadvantage:

Failure to address the fiscal imbalance is having a very serious consequence: key national priorities are being overlooked or distorted. As federal budgetary surpluses produce a "fiscal dividend", the following unfortunate results are becoming especially conspicuous:

Until fifteen years ago, a federal-provincial fiscal imbalance was generally accepted in that the imbalance essentially consisted of transfers to provinces, transfers which maintained an adequate federal contribution to major social programs. This system has now failed. In future, addressing this imbalance will have to involve a fundamental redesign of federal-provincial fiscal arrangements, including the division of revenues. This would go a long way toward resolving problems associated with the federal spending power. The remaining issues could be addressed by much more precise rules governing the application of this spending power.

At stake is whether the provinces collectively will be able to maintain programming in keeping with the very high priority given by Canadians to health care and education.




F&CR BC Ministry of Finance and Corporate Relations

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