The Art of the Impossible - Fiscal Federalism and Fiscal Balance in Canada By Hugh Mackenzie
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July 2006 The Art of the Impossible Fiscal Federalism and Fiscal Balance in Canada By Hugh Mackenzie
Acknowledgements
The author wishes to extend thanks to Sheila Block,
David Mackenzie, Kerri-Anne Finn, Marc Lee, Ellen
Russell, Bruce Campbell, Ed Finn, Mike McCracken
and Michael Mendelson for helpful advice,
comments and suggestions and to Natalie Mehra of
the Ontario Health Coalition who commissioned the
project that became the germ of the ideas explored
isbn 0-88627-501-6
in the paper. None of the above is responsible for
any errors, omissions or disagreeable opinions
This report is available free of charge from
presented in this paper. The findings reflect the
the CCPA website at www.policyalternatives.ca.
work of the author and do not necessarily reflect
Printed copies may be ordered through
the views of the Canadian Centre for Policy
the National Office for a $10 fee.
Alternatives.
410-75 Albert Street
About the Author
Ottawa, on k1p 5e7
Hugh Mackenzie is a Research Associate of the
tel 613-563-1341 fa x 613-233-1458 Canadian Centre for Policy Alternatives. He is
email ccpa@policyalternatives.ca principal in Hugh Mackenzie & Associates, which
www.policyalternatives.ca provides economic consulting services to the trade
union movement and the not-for-profit sector. He
co-chairs and is principal economist for the Ontario
Alternative Budget project. In that capacity, he has
written extensively on a wide range of budgetary
issues in Ontario, including tax and fiscal policy,
elementary and secondary education finance
and postsecondary education finance. He has
also researched and written major reports on the
financing of hospital capital for the Canadian Health
Coalition and on the budget of the Government of
Newfoundland and Labrador for NUPGE. From 1991
to 1994, he was Executive Director of the Ontario
Fair Tax Commission. He was one of the founders
of the Alternative Federal Budget project of the
Canadian Centre for Policy Alternatives.5 Introduction
7 Fiscal federalism in historical context
11 Fiscal imbalance
14 Fiscal federalism and the development of the
public economy
16 The development of the modern public
economy in Canada, 1961 to 2005
30 Implications of the 1961–2005 overview
32 The post-1991 meltdown
41 Lessons from the post-1989 period
42 Current misconceptions of “fiscal imbalance”
46 What’s on the agenda?
56 NotesIntroduction
Fiscal imbalance has become a Canadian po- track of the issue that lies behind the fiscal imbal-
litical classic: a term which is equally useful to ance debate, however fiscal imbalance is defined:
people and interests who don’t actually agree how do our fiscal arrangements affect our ability
about what it means, much less what should be to pay for the public services we want?
done about it. Depending on who is talking and The purpose of this paper is to confuse this
for what purpose, fiscal imbalance can refer to: overheated and often misleading debate with
some facts. It explores the data that describe
• the division of powers between the federal
the development and financing of public serv-
government and the provinces;
ices in Canada. Using statistics from Canada
• the fact that the federal government has national accounts data, it tracks key measures
been running surpluses since 1999 while of public revenue and expenditures at all three
some provincial governments have been levels of government as a share of the total econ-
running deficits; omy (GDP).
• a mismatch between revenues and In the course of this exploration, it exposes
expenditure responsibilities; critical misconceptions about the development of
• inequities among provinces in their ability the Canadian public economy — misconceptions
to generate sufficient revenue to meet that are leading us to avoid the real issues.
public services needs; It is commonly believed that the federal gov-
ernment was primarily responsible for the devel-
• the balance, province-by-province,
opment of the modern Canadian public econo-
between federal government revenue and
my through the exercise of the federal spending
expenditures;
power in areas of provincial jurisdiction.
• and so on. The data show that, while growth in federal
In the fog created by the inter-provincial and government transfers may have served as a cata-
federal-provincial rhetorical wars, it is easy to lose lyst for increased provincial government expen-
ditures, the principal driver of the growth of the
the art of the impossible fisc al feder alism and fisc al bal ance in canada Canadian public economy from the mid-1960s to sector between 1975 and 1995, reductions in
its peak in the early 1990s was the willingness of own-source revenue as a share of GDP as a re-
provincial governments to tax their own citizens sult of tax cuts have created the fiscal pressures
to pay for improvements in public services. provinces now face.
It is commonly believed that one of the rea- Fiscal imbalance, defined as a shortfall of
sons we currently face fiscal pressures on pub- revenue raising capacity relative to spending
lic services is that Canada didn’t pay for these responsibility, is largely a problem inflicted by
services as they were being developed, relying the provinces on themselves through tax com-
instead on deficit financing. The data do not petition.
support this view. Most of the growth in pub- In fact, the data demonstrate that the real
lic services as a share of the economy had taken fiscal imbalance involves local governments, not
place before deficits began to emerge as a major provincial governments.
public issue. These conclusions have significant implica-
It is clear from the evidence that the growth tions for the current debate. They suggest that
in deficits and debt service costs can be attrib- the fundamental issue facing Canadian feder-
uted to the recessions of 1981 and 1991, together alism today is not a decline in federal govern-
with the 20-year period of high real interest rates ment transfers to provinces, but the erosion of
that began in 1981. It is also clear that, just as provincial fiscal capacity as a result of negative
economic recession and high real interest rates tax competition among provinces. None of the
were responsible for the growth of the deficit, recent public reviews of federal-provincial fiscal
economic recovery and lower real interest rates relationships addresses this issue. The report of
were responsible for its decline. the Council of the Federation’s Panel on Fiscal
The data also support a contrarian view of Imbalance at least acknowledges the issue but
what happened to the financing of public services then ignores it in its recommendations. The Ca-
in Canada in the late 1990s. The cuts in federal nadian Council of Chief Executives “Bronze to
government transfers to provincial governments Gold” report from February 2006 ignores the is-
in the 1990s were matched almost exactly as a sue entirely and makes recommendations virtu-
share of GDP by cuts in transfers from provin- ally guaranteed to make the situation worse.
cial governments to local governments. Recommendations for change that avoid
In other words, at the same time as they were the issue of interprovincial tax competition are
complaining bitterly about federal government doomed to fail. This paper concludes with sug-
transfer payment cuts in the second half of the gestions for change in fiscal arrangements to
1990s, provincial governments were insulating strengthen provincial fiscal capacity and to ad-
themselves from those cuts by reducing their own dress the issue of fiscal imbalance involving lo-
transfer payments to local governments. cal governments.
The real force behind the fiscal pressures cur- It also suggests an approach to fiscal equali-
rently faced by provincial governments is com- zation to shift the debate away from the inter-
petitive tax-cutting by provincial governments provincial revenue squabble that it has become
intent in getting ahead in the race to the bot- to a focus on the program’s real purpose — to
tom. Just as increases in provincial own-source ensure an acceptable standard of services under
revenue as a share of GDP were the principal provincial jurisdiction for all Canadians.
drivers of the growth in the Canadian public
c anadian centre for polic y alternativesFiscal federalism
in historical context
It is often said by Canadian constitutional schol- United States — a reading that supported federal
ars comparing the federalisms of Canada and government activities in spheres ranging from
the United States that the framers of the U.S. labour and securities market regulation to the
constitution set out to create a highly decentral- creation of the Interstate Highway system — had
ized system of government and ended up with a no counterpart in Canadian constitutional in-
highly centralized system, whereas the “fathers terpretation.
of confederation” set out to create a centralized Residual powers — those not specifically item-
system of government and ended up with a highly ized in the constitution — have also been treated
decentralized one. differently in Canada and the United States. In
At Confederation, the responsibilities assigned Canada, constitutional interpretation of pro-
exclusively to the federal government were con- vincial powers over property and civil rights
sidered at that time to be the most important, has effectively created a second residual clause
and the revenue source — indirect taxation — as- encompassing matters similar to others under
signed exclusively to the federal government was provincial jurisdiction alongside the general fed-
statistically the most important source of gov- eral residual clause. In the United States, juris-
ernment revenue in Canada. diction over issues not thought of by the framers
The evolution of Canadian federalism from of the constitution has generally come down on
a structure seen to be centralist to one seen to the side of the federal government.
be decentralist has been driven by a number The fact that the U.S. federal government
of factors. Judicial interpretation of the British retained ownership and control of public lands
North America Act tended towards a decentral- as the United States expanded westward is of
ist construction of our formal constitutional ar- fundamental importance in explaining differ-
rangements, as contrasted with the evolution ences in the evolution of the federalisms of the
of judge-made constitutional law in the United two countries.
States. For example, the broad reading of the Furthermore, the impetus towards decentrali-
power to regulate interstate commerce in the zation in Canadian federalism driven by Québec
the art of the impossible fisc al feder alism and fisc al bal ance in canada nationalism stands in contrast to the resolution through the establishment of the Royal Com-
in the Civil War of the issue of competing na- mission on Dominion-Provincial Relations in
tionalisms within the United States. 1937 (the Rowell-Sirois Commission).
Constitutional arrangements and their inter- The Commission reported in 1940, recom-
pretation are not responsible by themselves for mending sweeping changes which, taken to-
the differences in the role of the federal govern- gether, would have shifted Canadian federalism
ments of Canada and the United States. What towards a radically more centralized model. It
is expected of government in the 21st century is recommended constitutional changes to permit
dramatically broader than what was expected the establishment of a national system of unem-
in the 19th century. And whereas in the United ployment insurance and a national pension sys-
States the federal government found itself with tem. More controversially, it recommended that
either exclusive constitutional authority or the the federal government assume responsibility for
right to pre-empt state authority in many if taxation of income at both the corporate and in-
not most of the spheres of government activity dividual level. In return for provinces giving up
whose importance grew during the 20th century, this constitutional jurisdiction, the federal gov-
in Canada growing spheres of activity generally ernment would assume responsibility for exist-
fell within provincial jurisdiction. ing provincial public debts, serve as a vehicle for
The constitutional weakness of the federal future provincial borrowing, and establish pro-
government in the face of changing demands grams for revenue-sharing with the provinces.
for public services became clearly evident in the These would include both general revenue-sharing
period between World War I and World War II, measures to enable provinces to finance programs
when the inability of the federal government to within their jurisdiction and fiscal equalization
respond to the poverty, economic insecurity, and measures designed to offset differences in fiscal
dislocation caused by the Great Depression of the capacities among provinces. It was noteworthy
1930s became a significant public issue. that, while the Commission focused on the need
In an atmosphere of both national and in- to ensure a common basic standard for services
dividual economic crisis, Canadian federalism under provincial jurisdiction across Canada, it
sailed into what amounted to a constitutional chose to base its equalization recommendation
perfect storm. Canadians needed and increas- on relative fiscal capacities rather than on prov-
ingly demanded a public policy response to the inces’ ability to raise the revenue needed to pay
crisis of the Depression, and looked to the activ- for a specified standard of service.
ist role played by the federal government in the These recommendations were the focus of a
United States as a model. Federal policies mod- federal-provincial conference in Ottawa in Janu-
eled on the American “New Deal” were ruled ary 1941. The conference failed to get an agree-
“ultra vires” by the courts. Yet, having succeed- ment from the provinces on a plan of action in
ed in defending their jurisdiction in the courts, response to the Rowell-Sirois recommendations,
the provinces failed to fill the resulting public but the report still had a profound impact on
policy gap. Indeed, their own finances had been Canadian fiscal arrangements for a generation
so substantially weakened in the Depression that after its publication.
several were on the brink of insolvency. Two major issues were resolved through con-
The Depression set the stage for a broader stitutional amendments authorizing the creation
debate over the appropriate role for the federal of national pension and unemployment insur-
government in provincial finance in general, and ance systems: the first (unemployment insurance)
in areas of provincial jurisdiction in particular, in 1940; the second (pensions) in 1950. With re-
c anadian centre for polic y alternativesspect to federal-provincial fiscal relationships, ments to protect fiscal room from which provinces
while the provinces were unable to agree on a could finance services under their jurisdiction,
constitutional arrangement for change, fiscal and fiscal equalization to offset inter-provincial
and political reality in practice trumped con- disparities in revenue-raising capacity.
stitutional principle. In the second phase, the federal government
Thanks to the need to raise additional rev- acted as a policy initiator and banker, using its
enue to finance the war effort and post-war re- spending power and its substantial fiscal capac-
construction, the federal government emerged ity to initiate the development of the social pro-
from World War II with a revenue system that grams that formed the foundation for the mod-
was significantly more robust than that of the ern Canadian state.
provinces. That reality, coupled with political In the third phase, the federal government
demands for expanded public services, led to adopted a strategy of fiscal disengagement. Hall-
the establishment of federal-provincial finan- marks of this role were:
cial arrangements that mimicked many of the
• withdrawal from formal cost-sharing
more controversial recommendations of Row-
reduced funding for programs under
ell-Sirois.
provincial jurisdiction and elimination of
The device of tax rental agreements for per-
conditions with respect to the use of that
sonal and corporate income tax between the
funding;
federal government and provinces served as a
substitute for the formal jurisdictional transfer • use of the tax system to deliver programs
and revenue-sharing recommended by Rowell- in areas of provincial jurisdiction directly
Sirois. The principle of fiscal equalization among to individuals and families, bypassing
provinces was established in the 1950s. The rules provinces and their institutions;
have been changed repeatedly since then in re- • substantial weakening of the tax system
sponse to changing fiscal and economic circum- design requirements for provincial
stances, but the fundamental point of depar- participation in tax collection agreements
ture — equalization of revenue-raising capacity thereby weakening those agreements’
as opposed to service provision capacity — has moderating impact on tax competition
remained unchanged to this day. among provinces; and
What is noteworthy is that, in a political sys- • reduced federal fiscal capacity through tax
tem that has frequently resorted to Royal Com- cuts for individuals and corporations as a
missions as a way to attack difficult issues and response to emerging budgetary surpluses.
bridge public policy gaps, and in a political and
economic environment in which federal-provin- The culminating act in the era of federal gov-
cial financial relationships consistently dominate ernment disengagement was the $100 billion tax
the political agenda in Canada, there has been cut announced by then Finance Minister Paul
no systematic study of federal-provincial fiscal Martin on the eve of the 2000 federal election.
relationships since Rowell-Sirois. Coming at a time when all of the major servic-
During that period of 60+ years, federal-pro- es under provincial jurisdiction — health, edu-
vincial fiscal relationships have evolved through cation, social insurance, and public infrastruc-
three phases in which the Government of Can- ture — were under extreme financial pressure,
ada played distinct fiscal roles. that dramatic cut in federal fiscal capacity was
In the first phase, the federal government an eloquent declaration that the federal gov-
acted as a fiscal enabler, using tax rental agree- ernment had no interest in assisting provincial
the art of the impossible fisc al feder alism and fisc al bal ance in canada governments in the funding of services under for health care and early childhood education,
their jurisdiction. the series of bilateral arrangements with indi-
The era of disengagement ended — at least vidual provinces fell far short of the rhetoric, re-
temporarily — with growing pressure for national sembling more closely the enabling role of the
action in response to the financial crisis facing 1950s and early 1960s. Furthermore, even as the
health care, but no coherent successor role for federal government talked of re-establishing na-
the federal government has emerged. In some tional programs and priorities, elements of disen-
respects, the strategy of the federal government gagement persisted as successive federal budgets
from 2000 to 2006 resembled the policy initiator proposed further tax cuts, and thereby further
and banker role which dominated federal-pro- reductions in federal fiscal capacity.
vincial fiscal relationships in the 1970s, withered The election in January 2006 of a Conserva-
during the 1980s, and died in the early 1990s. The tive minority government has given new impe-
Martin government’s attempts to establish na- tus to a strategy of disengagement and reducing
tional standards for health care and to establish the size and role of the federal government — a
a national early childhood education system are strategy that was pursued with vigor by the Lib-
cases in point. In other respects, however, ele- eral government in the 1990s, continued only
ments of the enabler role and of disengagement inconsistently in the early 2000s, and finally
persist. While the government’s political rheto- abandoned by the Liberals in the minority Par-
ric stressed the importance of national standards liament of 2004–5.
10 c anadian centre for polic y alternativesFiscal imbalance
The post-war eras in federal-provincial financial enue or spending capacities and responsibilities
relations that began with the federal government in isolation from one another.
as fiscal enabler in the 1950s and continued with Second, while the question of fiscal imbalance
the federal government as policy initiator and clearly has its roots in constitutional arrange-
banker in the 1960s and 1970s may be seen, with ments, the evolution of the issue has more to do
hindsight, as strategies for dealing with what is with economic and political considerations than
now labeled as “fiscal imbalance.” The policy of with the Constitution per se. The requirement that
disengagement that characterized the 1990s re- provincial governments raise revenue only from
flected either a denial of the existence of fiscal direct forms of taxation imposes no meaningful
imbalance or a willingness to live with the nega- constitutional limit on the ability of provincial
tive consequences of a failure to deal with it. governments to raise revenue. So, from a con-
Before analyzing the post-war experience stitutional perspective, there is no meaningful
in that light, however, some conceptual issues fiscal imbalance as between the federal govern-
must be addressed. ment and the provincial governments. Provin-
First, fiscal imbalance, properly understood, cial governments are free to make decisions in
is a relative term. It refers to a mismatch between their areas of public policy jurisdiction and to
governments’ revenue-raising capabilities and determine for themselves how to raise the rev-
their public policy responsibilities. The fiscal bal- enue needed to pay for programs to implement
ance changes in response to changes in both the those decisions.
revenue-raising environment and public policy Provincial governments face practical limits
spending expectations. Federal-provincial finan- on their ability to raise revenue to the extent that
cial arrangements became important in the mid- their revenue needs exceed those of other prov-
dle of the last century because provincial gov- inces. These limits may be political, as provincial
ernments’ spending responsibilities had grown governments encounter resistance to levels of
relative to the capacities of their revenue-raising taxation which exceed those in other jurisdic-
systems, not because of any change in either rev- tions, and which are not associated with iden-
the art of the impossible fisc al feder alism and fisc al bal ance in canada 11tifiable differences in public services. The limits velopment of national public policy projects. If
may also be economic. In varying degrees, de- an issue is considered to affect the national in-
pending on the nature of the tax base, taxpayer terest — even if it is exclusively under provincial
and tax base mobility within Canada may limit jurisdiction — Canadians will generate political
the ability of any province to generate additional pressure on the federal government to act in the
revenue from taxes which exceed the norm. national interest.
Taken together, these factors contribute to a Consequently, even if there were no equiva-
kind of political-economic “prisoner’s dilemma” lent to a prisoner’s dilemma influencing prov-
for provincial governments. While the best solu- inces’ ability to act, and even if there were no is-
tion for all provinces might be to raise taxes to sue of differences in provinces’ ability to pay for
the level needed to meet their public policy ob- public services, national public policy projects
ligations, the political and economic pressures that arise from national political considerations
experienced by each individual province make would raise the question of fiscal balance.
it impossible for any province to reach that solu- Third, fiscal balance is not simply an issue
tion. The political and economic interplay among between the federal government and provin-
provinces means that differences in revenue-rais- cial governments. The growing economic role
ing capacities relative to costs of service delivery of cities and the corresponding expansion in the
among provinces will translate directly into dif- relative importance of their governments ranks
ferences in public service levels. 1 along with the expansion of the public econo-
The national political and economic perspec- my generally as the most important structural
tive on fiscal imbalance arises in part from the changes in Canada since Rowell-Sirois. Canada
provincial prisoner’s dilemma outlined above. is far more urban today than it was in the 1940s.
The federal government may not have the con- And the economic role of cities has changed
stitutional authority to establish public policies just as dramatically. Cities may have been seen
in areas under provincial jurisdiction, but it does in the past as existing to serve the needs of the
have the ability to resolve the prisoner’s dilemma wealth-generating hinterland (in the case of re-
that would otherwise lead each provincial gov- source industries) or as merely the places where
ernment to spend less on the programs within wealth-generating activity takes place (in the
its jurisdiction than it should. As the national case of traditional manufacturing industries),
government, it also has the ability to address the but that view is out of date. Canadian cities are
public service consequences of inter-provincial viewed as the engines of Canada’s future eco-
economic differences. nomic growth; our public policy view of cities
That, however, is only part of the national has barely changed from the days when cities
political-economic story. Political engagement were where farmers, fishermen, forestry work-
is not constrained by constitutional law. The fact ers, and miners did their shopping.
that criminal law is a federal responsibility does All of the considerations addressed above
not prevent the issue of safety on the streets of with respect to the relationship between the
our major urban areas from becoming an issue federal government and provincial governments
in local elections. Likewise, the fact that the fed- apply with equal or greater force to relationships
eral gun registry is an exercise of the constitu- between local and provincial governments and
tional authority of the federal government does between local governments and the federal gov-
not prevent it from becoming a provincial po- ernment.
litical issue. And, by the same token, constitu- Beyond that, there are particular issues of fis-
tional law cannot and does not prevent the de- cal imbalance that apply to local governments
12 c anadian centre for polic y alternativesalone. The fact that local governments are, con- cal public services driven by urbanization and
stitutionally, “creatures of the provinces” means provincial downloading of financial responsi-
that, in principle, fiscal imbalance should not be bility, local governments have a much stronger
an issue for local governments. In practice, the case with respect to fiscal imbalance than do
temptation to use local taxes and fees as rev- provincial governments.
enue sources — for which they do not have to Fiscal imbalance is meaningful only in the
take political responsibility — is too great for context of the evolution of the public economy in
provincial governments to resist. Indeed, when Canada and the development and maintenance
one considers the restrictions on local revenue- of the fiscal capacity required to fund the public
raising capacity imposed by provincial legisla- services Canadians want.
tion across Canada, increasing demands for lo-
the art of the impossible fisc al feder alism and fisc al bal ance in canada 13Fiscal federalism and the
development of the public economy
This conceptual framework set out in the pre- riod 1961 to 2005. That overview identifies the
vious section gives rise to a series of questions early 1990s as a pivotal period in the develop-
related to the development of Canada’s public ment of the public economy. The second sec-
economy and the role of fiscal federalism in that tion narrows the focus to the period from 1990
development: to 2003, during which the momentum behind
the development of the public economy died
• How has Canada’s public economy
and shifted into reverse, and explores possible
developed, in the aggregate?
explanations for the change. The third section
• What role has each of the orders of provides a critical analysis of three recent inter-
government played in that development? ventions into the debate over “fiscal imbalance”:
• What policy areas have been the major Ontario Premier Dalton McGuinty’s campaign
drivers of that development? against the so-called “$23 billion gap” between
• How has the development of the public federal government revenue from Ontario and
economy been funded? federal government expenditures in Ontario;
the Canadian Council of Chief Executives’ call
• How have the major sources of revenue for
for a devolution of revenue-raising capacity to
the public economy changed?
the provinces as its solution to the problem of
• What roles have transfer payments fiscal imbalance; and the report of the Advisory
between governments played in the Panel to the Council of the Federation on fiscal
development of the public economy? imbalance. The final section draws on the con-
These questions are addressed in the next clusions from the analysis in the paper to explore
four sections of this paper. The first looks at the options for the renewal of the fiscal side of Ca-
development of the modern public economy in nadian federalism.
Canada through the lens of the National Ac- Data used in this analysis are drawn from two
counts government sector accounts for the pe- primary Statistics Canada data sources: govern-
ment sector accounts in the National Accounts,
14 c anadian centre for polic y alternativesfrom 1961 to the present; and detailed govern- the present. Gaps in data from these main se-
ment revenue and expenditure data, by order of ries are supplemented by data from Historical
government, covering the period from 1989 to Statistics of Canada, 1983.
the art of the impossible fisc al feder alism and fisc al bal ance in canada 15The development of
the modern public economy
in Canada, 1961 to 2005
In this analysis, the term “public economy” re- 1990s. It expanded rapidly between 1965 and 1975,
fers to all of the activities of government, includ- and then stabilized in the range 35% to 37% for
ing program spending — direct expenditures on nearly 15 years before it spiked to over 40% in the
goods and services, transfers to persons, trans- recession of the early 1990s. Program spending
fers to business, and transfers to other orders of currently represents 32% of GDP.
government, the capital investment activities of
government and interest payments on the pub-
lic debt on the expenditure side and direct and How did we pay for that growth?
indirect taxation, transfer payments from oth- Chart 2 shows revenue for all three orders of gov-
er orders of government and sales of goods and ernment as a share of GDP for the period 1961 to
services on the revenue side. It does not include 2005. Revenue increased steadily as a share of
transactions related to the Canada and Quebec GDP from the mid-1960s to the early 1990s. The
Pension Plans.2 increase in revenue as a share of GDP was suf-
Following the convention used traditionally ficient to pay for the expansion in the program
in international comparisons and by the Govern- spending over that period.
ment of Canada, the size of the public economy Beginning in the mid-1970s, however, a grow-
is measured in relation to GDP. ing share of the costs of program expansion was
paid for through deficit financing.
Chart 3 shows the combined fiscal balance for
How did program spending grow? all three orders of government over the period.
Chart 1 shows program and capital spending by After fluctuating between an overall balance
all three orders of government in Canada com- and a deficit of 2% of GDP from 1961 to the mid-
bined, as a share of GDP.3 1970s, the deficit increased to 4% of GDP, jump-
Program spending began to grow as a share ing to 9% of GDP at the deepest point of the re-
of GDP in the mid-1960s, from 28% in the ear- cessions of the mid-1980s and the early 1990s,
ly 1960s to a high of just over 40% in the early
16 c anadian centre for polic y alternativeschart 1 Total program spending, % of GDP, 1961–2005 (all government excluding CPP)
43%
41%
39%
37%
35%
33%
31%
29%
27%
25%
chart 2 Own-source revenue, % of GDP, 1961–2005 (all government)
43%
41%
39%
37%
35%
33%
31%
29%
27%
25%
the art of the impossible fisc al feder alism and fisc al bal ance in canada 17chart 3 Balance, total government, % of GDP, 1961–2005 (surplus⁄ [deficit])
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
chart 4 Debt service costs, % of GDP, 1961–2005 (all government)
12%
10%
8%
6%
4%
2%
0%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
18 c anadian centre for polic y alternativesrebounding to surplus over a two-year period throughout the period under study. Whereas the
between 1995 and 1997. overall public services crunch in Canada begins
Chart 4 helps to explain the development in the 1990s in the aftermath of the recession,
of the deficit in the 1980s. It shows public debt the widely-acknowledged crisis in public infra-
service costs as a share of GDP. structure in Canada had its origins nearly three
Driven initially by deficit funding of public decades before.
services in the late 1970s and then by the inter- Chart 6 presents the sum of the same data
action of growing deficits and the historically as in Chart 5.
unprecedented period of high real interest rates
in the 1980s and early 1990s, debt service costs
increased from 4% of GDP in the mid-1970s to Intergovernmental features of the
more than 9% of GDP at their peak between development of the public economy
1991 and 1995. Although the aggregate data help in understand-
In the aggregate, then, the fiscal crunch of the ing the overall development of Canada’s public
early 1990s was not caused by a failure of gov- economy since the 1960s, they mask significant
ernment revenue to keep pace with increases in trends in the relative importance of the three
the costs of delivering public programs; it was orders of government and the role played by in-
caused by the fact that the revenue-raising sys- ter-governmental transfer payments.
tem was not enhanced to reflect the increased A comparison of the evolution of the public
costs of financing the public debt. That failure economy across the three orders of government
fed on itself through the accumulation of fur- in Canada requires that inter-governmental
ther deficits, which in turn were financed at high transfers be taken out of the calculation. One ap-
interest rates. proach is to focus on the direct program activity
Chart 5 shows the development of the ma- of each order of government, excluding transfer
jor components of the public economy over the payments to other governments from expendi-
period. tures. This provides a measure of the evolution
Direct program expenditures and transfers of program delivery responsibilities.
to persons followed essentially the same pat- Chart 7 shows spending on programs and
tern, expanding steadily from the mid-1960s capital as a share of GDP, net of transfer pay-
to 1990 and then declining rapidly thereafter. ments to other orders of government.
Debt service costs followed a similar pattern, This chart highlights a number of signifi-
reflecting growing reliance on deficit finance af- cant trends in the public economy over the past
ter the mid-1970s, historically high real interest 40+ years.
rates in the 1980s and early 1990s, and the im- First, the provincial governments collectively
pact of the precipitous drop in program spend- have eclipsed the federal government as the or-
ing after 1993. der of government with the most significant di-
One exception to this pattern was in transfers rect program delivery responsibilities. From an
to business, whose decline as a share of GDP be- opening position substantially larger than the
gan in the early 1980s as active business subsidies provinces as a group, the position of the federal
fell out of favour ideologically and began to run government has declined to the point where its
afoul of international trade agreements. direct program delivery responsibilities — in-
The most notable exception to the pattern, cluding transfers to persons — are barely 1.7
however, is in non-financial capital acquisi- percentage points of GDP greater than those of
tion, which declined steadily as a share of GDP local governments as a group.
the art of the impossible fisc al feder alism and fisc al bal ance in canada 19chart 5 Distribution of total expenditures, % of GDP, 1961–2005
Goods and services Transfers to persons Non-financial capital aquisition
Debt service Transfers to business
30%
25%
20%
15%
10%
5%
0%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
chart 6 Distribution of total expenditures, % of GDP, 1961–2005
Goods and services Transfers to persons Non-financial capital aquisition
Debt service Transfers to business
60%
50%
40%
30%
20%
10%
0%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
20 c anadian centre for polic y alternativeschart 7 Program net of intergovernmental transfers, % of GDP, 1961–2005
Federal Provincial Local
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
chart 8 Program funded from own-source, % of GDP, 1961–2005
Federal Provincial Local
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
the art of the impossible fisc al feder alism and fisc al bal ance in canada 21Second, while only the provincial governments A second conclusion of interest is that fed-
gained consistently as a share of GDP over the eral government transfers peaked as a share of
period from 1961 to 1991, all three orders of gov- GDP in the early 1970s at just over 4.5% of GDP,
ernment saw their program expenditures (other and fluctuated in the range of 4% to 4.5% of GDP
than transfer payments to other governments) consistently until the mid-1990s when they col-
decline as a share of GDP in the 1990s. lapsed to a low of 2.8% of GDP in 1997.
Another treatment of transfer payments is
to credit inter-governmental transfers to the or-
der of government making the payments. This How we paid for the growth
produces a measure of expenditure activity of of the public economy
each order of government financed by that or- In essence, the difference between the two ways
der of government’s own revenue sources and of looking at the public economy by order of gov-
its own debt. ernment set out above is that one looks at trans-
Chart 8 presents program spending financed fer payments as an expenditure item, while the
from own-source revenues and debt for each or- other looks at transfer payments as a source of
der of government, from 1961 to 2005. revenue.
Because transfer payments generally run In aggregate, the other sources of revenue
from the federal government to the provinces for each order of government are own-source
and from provinces to local governments, the revenue — taxes, sales of services, profits from
picture changes somewhat in that the provincial government enterprises — and debt.
public economy does not surpass the federal pub- Chart 10 shows own-source revenue (revenue
lic economy until the mid-1990s, while the local not including transfer payments) as a share of GDP
public economy financed from its own sources for each of the three orders of government.
has changed relatively little since 1961.4 Provincial government revenue increased as a
Chart 9, which shows inter-governmental share of GDP continuously over the period from
transfers as a share of GDP over the period, of- 1961 to the mid-1990s. Federal government rev-
fers further clarification. enue increased from the mid-1960s to the mid-
Over the period from 1961 to 2005, provin- 1970s, from less than 15% of GDP to a peak of
cial transfers to local governments as a share of nearly 19% of GDP, and then stabilized in a range
GDP tracked federal government transfers to between 17% and 18% until the late 1990s, when
provinces. Direct transfers from the federal gov- it dropped abruptly to 16% of GDP.
ernment to local governments remained trivial Own-source revenue of local governments
throughout the period. peaked in 1993, and has declined continuous-
Indeed, despite constant provincial govern- ly ever since. Local governments responded to
ment complaints about the fiscal pain caused the downward trend in provincial transfer pay-
by the Chrétien-Martin cuts in federal gov- ments, not by increasing revenue to replace the
ernment transfers in the mid-1990s, provincial lost transfer payment income, but by reinforc-
governments essentially neutralized those cuts ing the negative impact of transfer payment
by matching them with corresponding cuts in cuts through own-source revenue reductions
provincial transfers to local governments. And relative to GDP.
it is worthy of note that provincial governments The third principal source of financing for
have not responded to the most recent upturn in public services is the issuance of debt.
federal government transfers by increasing their
transfers to local governments.
22 c anadian centre for polic y alternativeschart 9 Intergovernmental transfers, % of GDP, 1961–2005
Federal Provincial Local
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
chart 1 0 Own-source revenue, % of GDP, 1961–2005
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
the art of the impossible fisc al feder alism and fisc al bal ance in canada 23chart 11 Surplus⁄(deficit), % of GDP, 1961–2005
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
Chart 11 shows deficit financing by each or- cit led to a substantial increase in debt service
der of government as a share of GDP for the pe- costs which, in turn, placed increased pressure
riod 1961 to 2005. on the public economy.
Several interesting observations flow from The high and persistent deficits at the feder-
this picture. First, contrary to the impression al level from 1975 to 1997, and at the provincial
created by the federal deficit fighters of the level beginning in the late 1980s, are incessantly
1990s, the federal government’s deficit peaked cited as the poster children for fiscal misman-
as a share of GDP in 1985 and had been cut in agement. The rhetoric, however, ignores the fact
half as a share of GDP by the beginning of the that this situation was by no means unique to
1991 recession. Canada and that, during this anomalous period
Second, it is evident in comparing Charts 11 of extremely high real interest rates, large defi-
and 12 that the triggering factor in the growth in cits occurred in almost every country. Indeed,
the federal government’s deficit was a sharp re- in the absence of those deficits, public services
duction in the federal government’s own-source would have suffered and Canada’s recovery from
revenue in the late 1970s caused by a combination the 1981 recession would have been delayed at
of federal government tax cuts and the transfer great cost to our economy.
of tax points to the provinces. That period fea- Chart 12 shows debt service costs, broken
tured an equally sharp increase in the federal down by order of government.
deficit as a share of GDP. The third general conclusion that can be drawn
In combination with substantially higher from these charts concerns local government. Lo-
real interest rates in the 1990s, that initial defi- cal governments’ reliance on borrowing — which
24 c anadian centre for polic y alternativeschart 12 Debt service costs, % of GDP, 1961–2005
7%
6%
5%
4%
3%
2%
1%
0%
chart 13 Goods and services, % of GDP, 1961–2005
14%
12%
10%
8%
6%
4%
2%
0%
the art of the impossible fisc al feder alism and fisc al bal ance in canada 25by law in most jurisdictions in Canada can only fully to their pre-1991 level — the only segment
be for capital financing — has declined steadily of program expenditure to have done so. As we
since the 1960s from a peak of approximately 1.1% will discuss in more detail later, this phenome-
of GDP in the early 1970s to essentially zero for non may be driven by the same inter-provincial
most of the 1980s and 1990s. competition that is leading to competitive tax
So far, we have looked at two of the major com- cuts at the provincial level.
ponents of public expenditure broken down by Direct transfers to business by local govern-
order of government: inter-governmental trans- ments are prohibited by law in most jurisdictions
fers and debt service costs. Charts 13–16 break in Canada. Consequently, such transfers at the
down the other major components: purchases local level continue to be insignificant.
of goods and services (direct program delivery); There would appear to be a downward trend
transfers to persons; transfers to business; and in transfers to persons and to a lesser extent in
non-financial capital acquisition. transfers to businesses. Furthermore, evidence
Chart 13 — Direct Program Expenditures on the program side — most notably cuts in EI at
As the data show clearly, virtually all of the the federal level and in social assistance benefits
growth in direct program expenditures as a at the provincial level — would tend to support
share of GDP in the period 1961 to 1991 was pro- that conclusion. However, the close relationship
vincial and local. Provincial and local govern- between the tax and transfer systems compli-
ments’ direct program delivery expenditures cates the analysis, particularly as it relates to the
surpassed those of the federal government as a federal government for transfers to persons and
share of GDP in the mid-1960s and are now sub- to both the federal and provincial governments
stantially higher as a share of GDP than the fed- for transfers to business. Benefits which are de-
eral government’s. Direct program expenditures livered through the tax system perform exactly
dropped in all three orders of government after the same function economically as direct trans-
1991, although the relative decline was greatest fers. Examples include the refundable credits for
at the local level. post-secondary education and contributions to
Chart 14 — Transfers to Persons registered charities in the personal income tax,
Transfers to persons increased steadily as a and various credits and allowances available as
share of GDP at both the federal and provincial tax expenditures in the corporate income tax.
levels from 1961 to 1991, and increased sharply at Thus, it is likely that the decline in the federal
all three orders of government during the 1991 government’s transfers to persons is not as steep
recession. Since that recession, federal govern- as the transfer data alone would suggest. Simi-
ment transfers to persons have dropped to levels larly, the use of the tax system to deliver sub-
not seen since the 1970s. Provincial government sidies to business has undergone a resurgence
transfers to persons have dropped to the levels in recent years for both federal and provincial
of the mid-1980s. governments, after nearly 20 years in which the
Chart 15 — Transfers to Business prevailing policy objective was to reduce the use
As one might expect, given the trend against of tax-delivered subsidies.5
subsidies in international trade agreements, trans- Chart 16 — Capital Expenditures
fers to business have declined as a share of GDP One look at a chart showing government
since their heyday in the 1980s. Interestingly, acquisition of non-financial capital assets as a
however, that decline has been entirely at the share of GDP, and the explanation of Canada’s
federal government level. Subsidies to business multi-jurisdictional infrastructure funding crisis
at the provincial level have already recovered is apparent. Governments in Canada have been
26 c anadian centre for polic y alternativeschart 14 Transfers to persons, % of GDP, 1961–2005
8%
7%
6%
5%
4%
3%
2%
1%
0%
chart 15 Transfers to business, % of GDP, 1961–2005
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
the art of the impossible fisc al feder alism and fisc al bal ance in canada 27chart 1 6 Capital spending (non-financial capital aquisition), % of GDP, 1961–2005
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
chart 17 Shares of net capital stock, 1955–2003
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
28 c anadian centre for polic y alternativesinvesting less in physical infrastructure. Moreo- ernment and local governments had virtually re-
ver, the decline in investment in physical assets versed their positions. The federal government
as a share of GDP is not a phenomenon of the owned 30% of the stock; the provinces 29%; and
1990s, although the downward trend certainly municipalities 41%.
continued in the 1990s. The three orders of gov- This shift has had a profound effect on our
ernment bear a shared responsibility for a marked ability to sustain funding for public infrastruc-
decline in infrastructure investment. ture. Responsibilities for public capital have
Investment in public capital as a share of GDP been shifting steadily from the federal level of
reached its peak in the late 1960s, reaching 4.78% government (with the most robust and flexible
of GDP in 1967. After the 1967 peak, public capital revenue system) to the local level of government
investment declined steadily as a share of GDP, (with the weakest and least flexible revenue sys-
with its most precipitous drop occurring in the tem). Furthermore, much of the capital invest-
1970s. After a brief period of growth in the GDP ment responsibility of provincial governments
share in the early 1980s (the result of counter- is exercised through agencies — universities,
cyclical investment during the 1981 recession), colleges, regional health authorities, hospitals
public capital investment resumed its relative de- and school boards — operating with varying de-
cline in the early 1980s, albeit at a lower rate. The grees of independence from those governments
recovery between 1999 and 2003 merely brought but with limited access to revenue from sources
the share back to the downward trend line after other than transfer payments.
its abrupt drop between 1993 and 1999. Changes in accounting rules have eliminated
While the percentages involved do not look the irrational bias against capital spending for
large, the aggregate implications are substan- governments’ direct capital expenditures by re-
tial. quiring governments to amortize capital spend-
The difference between the 4.5% of GDP range ing over the useful life of the asset rather than
that was typical of the 1960s and the 2.5% range charging it as a current expense. However, the fact
that has became the norm in the late 1990s rep- that all transfer payments are treated as current
resents $24 billion in missing annual investment expenditures means that governments continue
in public capital. to treat transfer payments for capital projects as
The difference between a capital stock valued if they are current expenditures. This accounting
at 45% of GDP, as would have been typical from practice acts as a political dead weight against
the mid-1960s to the mid-1970s, and the 30% fig- attempts to support the renewal of public infra-
ure we see today represents missing public capi- structure through transfer payments.
tal with a current value of $180 billion. For most of the period during which public
The problem of public infrastructure financ- capital has been in decline, the political atmos-
ing in Canada is tied closely to the problem of phere in Canada has been hostile to the deficit
financing local government. financing that traditionally provided the fund-
Chart 17 shows the evolution of the share of ing for capital investment at all levels of govern-
the public sector capital stock owned by each of ment. The emergence of local governments as the
Canada’s three orders of government between most important providers of public infrastruc-
1955 and 2003. ture exacerbated the problem. Senior govern-
It reveals a remarkable pattern. In 1955, the ments have had powerful political incentives to
federal government owned 57% of the Canadian cut back on the transfer payments to local gov-
public capital stock; the provinces owned 26%; ernments needed to compensate for the shift in
local governments 17%. In 2003, the federal gov- responsibility to the local level.
the art of the impossible fisc al feder alism and fisc al bal ance in canada 29Implications of the
1961–2005 overview
The period from the early 1960s to the early 1990s Second, it is also apparent from the data
covers essentially the entire period of the devel- that deficit financing of the growth in public
opment of the modern Canadian public econ- services did not play an important role in the
omy. Program and capital spending combined early development of Canada’s public economy
increased from less than 30% of GDP in 1961 to and was not an important causal factor in the
more than 40% by the early 1990s. Although fiscal problems that came to dominate public
the government sector account data confirm debate by the early 1990s. It is evident from the
the institutional history of the period in broad data that fiscal deficits grew as a consequence
strokes, they also call into question some of the of the economic recessions of 1981 and 1991 and
assumptions that are often made about how the unprecedented high real interest rates between
Canadian public economy grew. 1981 and 1996.
First, it is apparent from the data that, while Third, over the period, the federal government
increasing federal government transfers to pro- lost its position of leadership among the orders of
vincial governments clearly served as a catalyst government in direct program delivery respon-
for the development of the modern Canadian sibilities. It is now the smallest of the three or-
public economy, they cannot be said to have ders of government as measured by the share of
been the engines of its growth throughout the GDP represented by their direct program deliv-
period. Federal transfer payments increased ery responsibilities. When transfers to persons
sharply as a share of GDP from the late 1960s and transfers to business are taken into account,
to the mid-1970s. But after that initial period of the federal government moves into second place.
growth, federal transfers stabilized as a share of Only if transfer payments to other governments
GDP. The fiscal capacity to support the develop- are taken into account does the federal govern-
ment of Canada’s public economy came from a ment approach the program expenditure scale
steady but continuous growth in provincial own- of the provinces, collectively.
source revenue as a share of GDP from the 1960s Fourth, the expenditure pattern with re-
to the early 1990s. spect to capital spending on public infrastruc-
30 c anadian centre for polic y alternativesture is quite different from the pattern for cur- provincial governments were closely matched by
rent program spending. Capital spending has changes in provincial transfers to local govern-
been in a period of steady relative decline since ments. This suggests that the fiscal room created
the mid-1960s at all three orders of government. by increases in federal transfers in the 1970s was
Canada’s infrastructure funding crisis is not of used largely to increase support for local public
recent origin. services rather than to provide core financial
Fifth, it is clear from the data that a funda- support for provincial public services.
mental shift took place in the mid-1990s. Gov- It also undermines the complaints from prov-
ernments generally did not respond to the fiscal inces concerning the decline in federal govern-
squeeze created by high interest rates and the re- ment transfers after 1995, since those cuts were
cession of 1991 the way they had responded to the almost perfectly matched by cuts in provincial
previous recession in 1981. Revenue was not in- transfers to local governments. And, notably,
creased. Instead, all orders of government reduced the increase in federal government transfers
both program spending and transfers payments. since the late 1990s has not been matched by in-
And when lower interest rates eased the budg- creases in provincial transfers to local govern-
etary impact of debt service costs, governments ments — the most significant departure from
used the fiscal room to cut taxes rather than to pattern in more than 40 years. Dog chases cat.
recover lost ground in public programs. Cat eats mouse. Mouse has run out of options.
Finally, the pattern of aggregate spending by Just as the data on public capital investment dis-
the federal government on transfers to the prov- pel any mystery surrounding our infrastructure
inces, and by the provinces on transfers to lo- funding crisis, the data on provincial transfers
cal governments, calls into question some com- to local governments should dispel any mystery
mon assumptions. The data show clearly that, as to why local governments are under more fi-
over the first 35 years of the period from 1961 to nancial pressure than either the federal or pro-
2005, changes in federal government transfers to vincial governments.
the art of the impossible fisc al feder alism and fisc al bal ance in canada 31You can also read
