This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

Abstract

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

VIII. Federal - Provincial Transfers--A Review and Assessment 1/

1. Introduction

The Federal Government’s responsibility to transfer resources to the provinces dates from Confederation and the British North America Act of 1867. This responsibility was originally intended to compensate for the loss by provinces of their ability to raise revenue through customs and excise duties. Since that time, however, the transfer system has evolved and grown considerably.

Most notably, in response to the Federal Government’s policy to encourage social welfare programs, federal-provincial transfers increased from an average of about 2 1/2 percent of GDP to about 4 1/4 percent of GDP from the late 1960s to the early 1970s. 2/ Since the mid-1970s transfers to the provinces have remained a roughly constant share of GDP, averaging about 4 percent, despite recent efforts by the Federal Government to constrain their growth.

The Government’s commitment to further fiscal consolidation and the fact that these transfers represent a substantial proportion of noninterest outlays (22 percent in 1994/95) likely will mean that further efforts will be made to limit their rate of increase. At the same time, concerns have been raised regarding the possibility that the system of federal-provincial transfers has fostered inefficient delivery of social programs and an overdependence of the provincial governments on federal resources. In the discussion below, the transfer system is briefly described and the various options for its reform are reviewed. The final section describes the reform proposals that were contained in the 1995 budget.

2. The federal-provincial transfer system

The largest federal-provincial transfer program is the Established Programs Financing (EPF) system, which was established in 1977 in order to consolidate existing federal support for health care and post-secondary education (PSE). EPF grants are provided on a block basis and the size of the grant is not adjusted in response to the amount of provincial outlays in program areas. 3/

Each province receives an equal per capita EPF grant. Since 1977, a portion of the grants has been paid in the form of shares of the Federal Government’s tax revenues or “tax points.” In particular, the provinces receive the receipts from 13 1/2 percentage points of personal income tax and 1 percentage point of corporate income tax. The remaining transfer is in the form of “cash”; only the cash portion is included in the public and national accounts measures of fiscal transactions. As a result, the fiscal accounts may be said to under-represent the full value of the EPF transfers.

The growth of the cash portion of the EPF grants was tied initially to the growth of nominal GNP, and in 1982 this escalator instead was applied to the total transfer. However, since 1986 progressively stricter limits have been placed on the growth of EPF grants. In 1990 per capita transfers were frozen in nominal terms for two years, and in 1991 this freeze was extended until 1994/95. 1/ In 1994 the Government announced its intention to reform the social welfare system and indicated that this process would include capping the sum of the PSE portion of the EPF and grants under the Canada Assistance Plan (described below) at its 1993/94 level after 1995/96.

The Canada Assistance Plan (CAP) was established in 1966 and requires the Federal Government to pay half the cost of provincial social assistance and welfare services. The shared-cost nature of the transfer contributed to a rapid growth in the CAP, and led to the imposition of a limit on the annual growth of CAP grants to the three highest income provinces (Alberta, British Columbia, and Ontario) of 5 percent in 1990 and subsequent years. The 1994 budget determined that starting in 1995/96, CAP transfers would be held at 1994/95 levels until superseded by the reform of the social security system, which was expected to be implemented in 1996/97.

Unconditional grants--termed equalization payments--compensate the provinces for differences in revenue-raising ability in order to permit the provision of roughly comparable levels of public services. 2/ The grants are based on a “representative tax system”, which calculates a province’s ability to raise tax revenues based on a common tax base and rate. 3/ Provinces whose revenue-raising ability falls below this amount receive grants to compensate them fully for the shortfall--provinces above the Canadian average (Alberta, British Columbia, and Ontario) do not receive the grants.

Additional transfers (totalling $3.8 billion in 1992/93) include those under the Territorial Formula Financing Agreements, which provide funds on a similar basis as the equalization grants provided to the provinces; municipal grants, which compensate municipalities for property taxes that are not levied on federal property; and fiscal stabilization grants, which compensate provinces for cyclical revenue shortfalls.

3. An assessment of the system and prospects for reform

As noted above, the constitutional basis for providing transfers to the provinces reflects a concern for regional equity--i.e., that Canadians should have equal access to government services regardless of residency. While difficult to judge, it would appear that access to government services is relatively uniform across Canada. However, it is clear that the distribution of federal transfers is not equal on a per capita basis. Indeed, transfers per capita vary substantially across the provinces--ranging from about $10,000 in the wealthier provinces to around $23,000 in the poorer Atlantic provinces. Nonetheless, the variation seems to be consistently related to the level of provincial income. As can be seen in Chart VIII-1 there is a close and inverse relationship between per capita transfers and per capita GDP. The only significant outliers are Saskatchewan, whose transfers appear to be well below average, and New Brunswick, which receives a greater than proportional share. Thus, with the exception of these outliers, the system would appear to be acting reasonably well to ameliorate regional income discrepancies.

Chart VIII-1
Chart VIII-1

CANADA Per Capita GDP and Federal Transfers 1/

Citation: IMF Staff Country Reports 1995, 046; 10.5089/9781451806823.002.A008

Source: Courchene (1994), Table 14 and Statistics Canada.1/ Data are for 1991.

However, an important concern with the transfer system has been with regard to its effects on economic efficiency. In particular, the rationale for such transfer systems usually centers on theories of “fiscal federalism.” Such theories would suggest that there are efficiency gains from centralizing the raising of tax revenues, including those resulting from a harmonized tax system and economies of scale. At the same time, it is argued that there are gains to be made by transferring resources to local authorities, who are best able to gauge local preferences for public goods.

Federal transfers to local governments also may alleviate potential externalities. 1/ An often-cited example is the case of education where, in the absence of federal transfers, local governments might not have the incentive to provide the optimal level of service because of concern that the well educated will migrate to other regions. Similarly, transfers from the central government may be necessary to ensure that local governments do not provide an excessive amount of other government services in order to encourage migration from neighboring regions.

However, the magnitude of the efficiency gains resulting from the Canadian federal-provincial transfer system is not likely to be substantial. 2/ Indeed, many commentators have expressed concern that the system has led to economic inefficiencies. For example, Courchene (1994) argues that a system that provides larger transfers to low-income, low-wage regions inhibits migration toward high-wage regions creating a situation of transfer dependency. At the same time, the transfer programs described above are said to have promoted the adoption of inefficient social welfare programs and inhibited appropriate provincial tax policies. The following discussion addresses these issues in more detail.

a. EPF grants health care reform 1/

Federal funding for health services under the EPF program has been criticized for offering inadequate incentives to control public and private health spending in Canada, which reached roughly 10 percent of GDP in 1992, the second highest ratio among OECD countries. However, constraints on federal transfers to the provinces have meant that EPF-health transfers have fallen as a share of provincial health spending from about 35 percent in 1990 to around 32 percent in 1993. This, in turn, appears to have encouraged the provinces to curtail health care spending and stabilized the ratio of health spending to GDP in 1993. 2/

However, fiscal constraints at the federal level suggest that further cost cutting may be needed. In this light, an important issue is the extent to which the Health Act’s prohibition against the use of copayments impedes the achievement of further economies. 3/ The prohibition is based on the view that such fees fall disproportionally on the poor and could limit access. However, as Blomqvist (1994) notes, this does not appear to have been an important factor in countries such as Sweden, Germany, and the Netherlands that have adopted modest user charges. Moreover, the income tax system could be used to mitigate the regressivity of user charges, while still providing a net increase in resources to the Government.

Many commentators suggest that user fees are not likely to affect the consumption of health services (see for example, Deber, et al (1994)). This invariance is said to result from consumers’ relative lack of information regarding the need for procedures, and the financial incentive that providers sometimes have to recommend tests or treatments. These factors are said to imply the need for controls over the supply of medical services rather than price increases to consumers in order to affect demand. Efforts in Canada along these lines include actions by the Ontario government to reduce medical school admissions and recent efforts by most provinces (especially Ontario and Newfoundland) to reduce hospital capacity.

Other measures to harden providers’ budget constraints have resulted in a trend in several provinces (including Quebec, New Brunswick, and Saskatchewan) toward “regionalism,” which involves bringing local hospitals under the control of regional governing boards that are better able to rationalize services. Other initiatives include efforts to move physicians away from a fee-for-service system of remuneration toward capitation arrangements (in which payment is on a per patient basis rather than on the basis of the service provided) or salary structures. Fee schedules also have been adjusted according to region in order to rationalize the distribution of providers. 4/

While efforts to curb the growth of health care costs would appear to have been successful to date, concern has been raised regarding their longer term implications for the Canadian health care system. As some commentators have cautioned, there is a risk that fiscal and other constraints on provincial health care outlays may lead to a “process of privatization by default.” This has led to concern that, as a greater proportion of health care spending moves into the private sector, the scope for containing the growth of costs and spending will be reduced. The rapid growth of private health spending (especially on drugs and other services, whose costs have been growing at near double-digit rates), highlights this issue. 2/

b. EPF grants and post-secondary education

Public and private sector spending on post-secondary education (PSE) in Canada is high by most measures. For example, Canada’s spending on PSE was 2.6 percent of GDP in 1991, the highest among OECD countries. By comparison, the OECD average was roughly 2 percent, and spending on PSE was 2.4 percent of GDP in the United States. 3/ This statistic results in part from a relatively large number of PSE students in Canada. Nonetheless, Canada’s PSE outlays still ranked third on a per student basis, behind the United States and Australia, and spending was roughly US$1,000 above the OECD average. Moreover, Canada ranks well above the United States and all other OECD countries in the number of students enrolled in PSE as a share of persons aged 5 to 29.

Additional federal and provincial support for PSE is provided indirectly through the income tax system, totalling roughly 0.1 percent of GDP. 4/ These include transferrable tax credits, partial tax exemption of scholarship income, tax incentives for educational saving plans, and deductions for charitable gifts to educational institutions. Moreover, many PSE institutions are partially exempt from GST and property taxes.

Despite relatively generous levels of spending, Canada’s education system has not performed especially well when education outcomes are assessed. Also, the Economic Council’s 1992 report on education suggests consideration of a diversion of government resources away from PSE to primary and secondary schooling, where the social rate of return could be higher. In this light, the report argued that the effective tuition subsidy for post-secondary education is too generous and may be encouraging inefficiencies and excessive use of the system. The subsidy is especially high in faculties such as medicine, engineering, law, and business administration, where expenses are relatively high and/or the return to enrollees in terms of future income are likely to be large. 1/

The Economic Council’s report also questioned the appropriateness of current PSE funding arrangements on equity grounds, noting that, since the preponderance of students were from higher income backgrounds, the tuition subsidy was inequitable. Similar concern could be raised regarding the interprovincial distribution of EPF-PSE transfers, which are provided on a per capita basis and do not account for differential needs among provinces arising from differing sizes of school-age populations, the cost of providing services, or income levels.

Suggestions for reform of the federal PSE transfer include a recent federal proposal to convert the existing cash portion of the EPF-PSE transfer to a student loan program. This proposal also included the possibility that repayment of the student loan would be income contingent--possibly monitored and administered through the income tax system. 2/ By transferring resources from the provinces to students, this scheme would have the benefit of encouraging an increase in tuition fees and a more efficient allocation of resources.

However, it should be noted that the implications for the federal fiscal situation of such a proposal would not necessarily be in the direction of an increase in public saving. Under the status quo, the cash portion of the EPF would have fallen to zero within ten years. 3/ Therefore, while converting current cash spending to a student loan scheme could provide near-term fiscal savings, the longer term effect would be to raise the fiscal deficit.

c. The CAP welfare reform

It has been argued that the provision of CAP transfers on a shared-cost basis has contributed to a substantial increase in general government outlays for social assistance. As noted by the OECD (1994), the increase over the 1985-89 period was particularly striking given that it came during a period of strong economic growth.

There is evidence to suggest that overall social welfare benefits (including benefits provided through the tax system) exceed the amount necessary to lift a “typical” family over the poverty line. For example, it is estimated that the total value of social assistance benefits to a single parent (zero-income) family with three children was about $32,000 in 1992. 1/ Moreover, social assistance programs are said to place significant disincentives on returning to the workforce. 2/ The generosity of the welfare system has been associated with a sharp increase in the number of welfare recipients, which rose from 1.2 million in 1968 (just under 6 percent of the population) to 3 million in 1993 (over 10 percent of the population). 3

An additional concern is that the distribution of CAP transfers among provinces has not necessarily evolved according to the needs of the provinces’ populations, but according to the ability and willingness of provinces to fund social assistance programs, again because the CAP is provided on a shared-cost basis. This feature has meant that wealthier provinces such as Ontario have received a disproportionate share of CAP resources. Conversely, Newfoundland’s share has been relatively small, and may have fostered an over-reliance of this province’s population on the unemployment insurance system for income support, contributing to substantial rigidities in the labor market.

Moreover, the criteria used under the CAP to determine whether a province’s program is eligible for shared-cost funding are said to be overly restrictive, and may inhibit innovations in social welfare programs. For example, “active” labor market policies (i.e., work-fare or training-fare programs) would not qualify. If the Federal Government is poorly placed to gauge where provincial priorities should lie in the area of social assistance, an alternative would be to provide the CAP on a block basis, or to target the transfer more narrowly in order to achieve federal policy objectives.

Proposals for reforming the CAP also include converting the program to a modified-block, or “needs-based” system, 4/ on the basis of the number of social assistance caseloads and the cost of delivering assistance. An alternative preferred by a number of commentators would be to eliminate transfers to the provinces in favor of direct income supplements administered through the income tax system. 5/ The advantage of this approach is that it would be easier to administer, and could be designed in a manner that ensured that incentives to work were maintained. The Federal Government’s recent discussion paper reviews these alternatives, and laid particular emphasis on the possibility of enhanced support for low-income families with children, working income supplements, and funding for persons with disabilities.

d. Equalization payments

The system of equalization payments has been criticized on a number of grounds. For example, since poorer provinces’ revenues are increased to a fixed five-province standard, the system is thought to create a disincentive for these provinces to develop their own revenue bases, and make them dependent on federal transfers. 1/ A further criticism of the system is that it acts somewhat procyclically in that economic shocks that affect tax receipts among the wealthier provinces will also affect equalization payments and cause the shock to be transmitted to the poorer regions.

A number of options could be considered to reduce disincentives to develop other revenue sources. For example, the equalization formula could be based instead on a federal tax base such as those for the federal income and sales taxes, so that payments would not be affected by changes to provinces’ tax bases. An alternative would be to continue to use the current formula, but to equalize only up to a proportion of the standard. In this way, the penalty for increasing provincial tax revenues would only be partial.

An additional issue is the financing of equalization payments. It often is argued that the burden of providing equalization resources should not fall on the Federal Government, but should be shouldered directly by the wealthier provinces (see for example Boadway, 1986). While this approach would seem to have merit on equity grounds, the agreement of the wealthier provinces, which likely would be difficult to obtain, would be needed to bring a self-financed system into effect.

4. The 1995/96 budget and the Canada Social Transfer

In the period leading up to the February 1995 budget, the Federal Government released discussion papers reviewing various options for the reform the CAP and EPF grants. In particular, the possibility that the EPF-PSE grant would be converted to a student-loan program was raised, and merits of converting the shared-cost CAP grant to a direct income supplement were reviewed.

The Government opted in its 1995 budget to combine the CAP and EPF grants into a single block grant, termed the Canada Social Transfer (CST), effective in 1996/97. The budget described the CST as providing the provinces with greater spending autonomy, at a lower administration cost. However, the budget noted that the CST still would be conditioned on the provinces’ adherence to the Canada Health Act and to their provision of social assistance without regard to residency. Moreover, the Government postponed defining a formula that would permanently set the size and allocation of the CST after 1996/97. The system of equalization grants was not amended, but the budget did place limits on the growth of Territorial Formula Financing.

Since the formula governing the amount and distribution of the CST remains to be determined, many of the issues raised in the previous section remain outstanding. Distributional issues will be especially contentious given the fact that budget constraints during the past several years have distorted the share of CAP transfers away from the wealthier provinces. A complicating factor is the large share of Quebec’s EPF-PSE grant that is received in the form of tax points. The status of these tax points, which the provinces have come to view as an entitlement, under the new system, has yet to be determined.

Finally, provincial fiscal deficits widened considerably in the late 1980s and early 1990s, mainly owing to the effects of the economic downturn and lax spending control. However, an important factor in the widening of these deficits was the constraints imposed by the Federal Government on the growth of its transfers to the provinces. 1/ Additional cuts in transfers would require a period of further adjustment by the provinces, especially in areas where user fees cannot be raised to achieve savings. Relatively early action at the federal level would enable the provinces to begin this process and reduce the risk that the adjustment would need to take place during an economic downturn.

References

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  • Watson, William G. “The View from the Right”, in William G. Watson, John Richards, and David M. Brown (eds.) The Case for Change: Reinventing the Welfare State (Toronto: C.D. Howe Institute, 1994), pp. 1-30.

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1/

Prepared by Christopher Towe.

2/

See Courchene (1994) and Richards (1994), for a detailed description of the transfer system. See also SM/94/97 (4/20/94), Chapter VII.

3/

Transfers may be withheld if provinces violate the principles of the Canada Health Act of 1984. For example, this provision has been used to enforce the proscription against provincial health plans permitting health providers to charge fees in excess of the provincial fee schedules.

1/

Under current legislation, EPF grants would increase at the rate of growth of GNP less 3 percentage points in 1995/96 and beyond, following the expiration of the nominal freeze.

2/

The federal government’s responsibility to provide these grants was enshrined in the Constitution Act of 1982, Section 36(2), which requires the federal government to provide “resources to the provinces in order to provide reasonably comparable levels of public services at reasonably comparable levels of taxation”.

3/

The representative provinces are Quebec, Ontario, Manitoba, Saskatchewan, and British Columbia.

1/

For a discussion see Atkinson and Stiglitz (1979), Lecture 17, and Rivlin (1992).

2/

Estimates suggest that the gains are relatively small. See SM/90/12, Supplement 1 (1/16/90), Appendix III for further details.

1/

See SM/94/223 (4/18/94), Chapter X, for a description of the Canadian health care system.

2/

For a discussion, see Boothe and Johnston (1993).

3/

The 1984 Canada Health care Act does not prohibit the adoption by the provinces of user or other fees but requires a reduction in federal transfers by an amount equivalent to the revenue from such fees.

4/

Nedde (1993) discusses these issues in relation to the U.S. health care system.

1/

See for example, Health Canada (1994), p. 7.

1/

See Courchene (1994) for a discussion.

2/

Such systems are already in effect in New Zealand and Australia.

3/

This results from the projected growth of the “tax points” portion.

1/

See Courchene (1994), p. 154.

4/

See Richards (1994), p. 82, and Courchene (1994), pp. 300-306, for summaries of various proposals.

5/

See OECD (1994), pp. 56-57, for a discussion. The OECD cites as an example Quebec’s Parental Wage Assistance program, which provides an income supplement, reimbursement of roughly half of day-care expenses, and housing allowances, and which is integrated in the provincial income tax system, in order to avoid disincentives to return to work. Proposed reforms to Ontario’s social assistance programs include means-tested guaranteed annual income for children.

1/

An increase in tax rates or tax bases among the five provinces who set the standard for equalization would be to raise transfers to the poorer provinces. See Boadway (1986) for further discussion.

1/

See Courchene (1994), Chapter 7 for a discussion.

Canada: Economic Developments and Policies
Author: International Monetary Fund