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Table of contents

Preface from the President of the Commission
Signatures of the Commissioners
Summary
List of Tables and Diagrams
List of Charts
Introduction: The Commission's mandate and its approach

PART ONE - The nature of the problem


CHAPTER 1 - Definition and scope of fiscal imbalance
1. A major issue
2. The notion of fiscal imbalance
3. The current and projected scope of fiscal imbalance

PART TWO - The causes of fiscal imbalance


CHAPTER 2 - Imbalance between expenditures and access to sources of revenue
1. The provinces are subject to considerable pressure in respect of spending

1.1 Service delivery: the provinces are bearing the pressure
1.1.1 Health care
1.1.2 Education and training
1.1.3 Defence
1.1.4 Other spending
1.2 Transfers exert limited structural pressure
1.2.1 Limited pressure on federal old age security programs
1.2.2 Employment insurance is subject to less extensive structural pressure
1.2.3 Transfers to the provinces are designed to limit pressure on federal spending
1.2.4 Income security

2. Revenue division does not reflect the spending dynamic

2.1 An occupation of taxation fields that puts the federal government at an advantage
2.2 Federal government control over the provinces' revenues

3. Debt repayment and fiscal imbalance

CHAPTER 3 - Inadequate intergovernmental transfers
1. The canada health and social transfer

1.1 A conditional transfer program
1.2 A program whose terms create problems
1.2.1 The federal government's arbitrariness
1.2.2 The CHST allocation penalizes the less affluent provinces
1.3 A program from which the federal government has disengaged
1.3.1 Evaluation of the size of federal disengagement
1.3.2 The federal government's point of view

2. Equalization

2.1 Terms of application that prevent the program from fulfilling its objective
2.1.1 The current standard is not satisfactory
2.1.2 The ceiling on equalization entitlements
2.1.3 Tax bases that are poorly defined or incomplete
2.2 The variability of equalization payments
2.3 Tax-back
2.3.1 Base tax-back
2.3.2 Rate tax-back

3. The fiscal arrangements formulation process

3.1 Public information
3.2 Institutions and mechanisms

CHAPTER 4 - The "federal spending power" and its implications
1. Various forms of "federal spending power"
2. Québec and the "federal spending power"

2.1 An instrument of the federal government whose constitutionality has not been established
2.2 Proposals defended by Québec

PART THREE - The consequences of fiscal imbalance and solutions

CHAPTER 5 - The consequences of fiscal imbalance
1. Citizens' needs are ill-addressed
2. Less efficient delivery of government services
3. The provinces' decision-making and budgetary autonomy is Threatened

CHAPTER 6 - Recommendations
1. Restore fiscal balance within the federation

1.1 Additional financial resources for the provinces
1.2 Elimination of the CHST and a new division of tax room
1.2.1 The financial impact for Québec
1.2.2 Advantages and disadvantages of each scenario
1.2.3 impact on the federal government
1.3 Enhancement of the equalization program
1.3.1 Technical procedures governing the equalization program
1.3.2 The equalization program's ability to satisfy its objectives
1.4 Counteract the "federal spending power"

2. Respond to all new causes of imbalance

2.1 Systematic, transparent monitoring of the fiscal imbalance dynamic
2.2 Broaden exchanges and discussion with the other provinces

CONCLUSION

APPENDIX

LIST OF TABLES AND DIAGRAMS

LIST OF CHARTS

PREFACE FROM THE PRESIDENT OF THE COMMISSION
Less than a year ago, the Québec government set up a commission to study the fiscal imbalance between the federal government and Québec. The Commission on Fiscal Imbalance has now completed its work and the results are contained in this report.

Fiscal imbalance is a difficult concept, encompassing complex issues tied to established fiscal relations between the federal government and the provinces, with both qualitative and quantitative dimensions. Its very definition had to be clarified, and of course, the Commission had to be in a position to assess and analyse the phenomena tied to fiscal imbalance with the necessary depth and rigour.

The Commission adopted an approach based primarily on deepening its understanding and analysis, extending the studies and assessments already available, and systematically examining the hypotheses submitted to it, all the while avoiding any a priori positions in its deliberations. At the same time, the Commission tried to remain as close as possible to the practical issues, since fiscal imbalance directly concerns Quebecers, and the Commission had no intention of losing sight of this reality at any time.

Specific studies were undertaken to answer certain precise questions. The Commission received analyses from many experts, including specialists from other countries. Public hearings also provided an opportunity to hear the views of many spokespersons of various groups and citizens interested in the debate.

In addition to confirming the existence and showing the scope of the fiscal imbalance, the Commission's work produced a set of recommendations to correct the situation.

The recommendations were formulated constructively, from a practical concern to advance the debate. They are important recommendations that outline what could become a new structure of financial and fiscal relations within the Canadian federation. At the same time, the Commission has examined ways of responding in the future to any new cause of fiscal imbalance and has made a number of suggestions in this respect.

Now that the Commission has concluded its work, I want to acknowledge the remarkable cooperation and contribution of each commissioner and the secretariat staff. The Commission on Fiscal Imbalance consisted of people from very different backgrounds, but experts in their respective fields. The report is the result of a joint effort stemming from approaches and concerns that often differed, but were always relevant, contributing to its depth and its interest.

The Commission is convinced that it has at least shed light on key facets of a topic as complex and important as fiscal imbalance and that it has fulfilled its mandate.

YVES SÉGUIN
President of the Commission on Fiscal Imbalance

SUMMARY
The Québec government formed the Commission on Fiscal Imbalance on May 9, 2001 to identify and study the causes of fiscal imbalance between the federal government and Québec, its actual consequences and the practical solutions that could be implemented to correct it.

The Commission's report deals with these issues first by confirming the existence and scope of fiscal imbalance. The Commission considered that its deliberations were situated within the current constitutional framework, and that when relevant and possible, the analysis had to be broadened to all provinces of Canada.

Nature of the problem

Fiscal imbalance has been one of the major issues of the Canadian federation since the mid-1990s. At that time, the federal government made major cuts to payments under the Canada Health and Social Transfer (CHST), while provincial social spending was rising sharply.

Broad consensus on its existence

Though the federal government disputes the existence of fiscal imbalance, the public hearings held by the Commission confirmed a broad consensus in Québec in this regard. A survey conducted on the initiative of the Commission in Québec and in Canada as a whole confirms this fact: the public and the players most directly involved in the debate are aware that there is a significant fiscal imbalance to the detriment of the provinces.

Projections by the Conference Board of Canada

The current and projected budget balances of the two orders of government provide an initial direct expression of this imbalance and its scope. The study carried out by the Conference Board of Canada at the Commission's request is revealing in this regard: according to these projections, if current revenue and program structure is maintained, the Québec government would post recurring deficits averaging $3 billion each year until 2019-2020. At the same time, the federal government would achieve ever-greater surpluses reaching almost $90 billion in 2019-2020.

The causes of fiscal imbalance

The fiscal imbalance between the government of Canada and the Québec government and, more generally, between the federal government and the provinces, stems essentially from three separate causes, namely imbalance between spending and access to sources of revenue, the inadequacy of intergovernmental transfers from the federal government to the provinces and the "federal spending power."

Imbalance between spending and access to sources of revenue

In its study, the Conference Board of Canada explicitly identified the first cause of fiscal imbalance: there is a structural difference between the federal government and the Québec government from the standpoint of revenue and spending.

- In the case of the federal government, the current positive discrepancy between revenue and spending will grow steadily because of the debt repayment that the discrepancy will make possible.

- For Québec, the balance between revenue and spending is much more precarious, which explains why the government cannot reduce its debt and the projected budgetary balance is negative throughout the forecast period.

- Total Revenues and Expenditures of the Federal Government
and the Québec Government, 2000-2001 to 2019-2020
(average annual change in per cent)

Sources: Conference Board of Canada.

A more detailed, systematic analysis of the main categories of expenditures and revenues of the two orders of government confirms that the provinces are subject to considerable pressure as regards spending, while the division of revenue does not reflect this dynamic.

Furthermore, debt service and repayment, which the federal government often mentions to justify its budget surpluses, in fact exacerbate fiscal imbalance by allowing the federal government to increase its leeway year after year.

Inadequate intergovernmental transfers

Transfers between the federal government and the provinces, the second cause of fiscal imbalance, explain many of the problems currently plaguing the Canadian federation in terms of fiscal relations among governments.

- The CHST is the most problematic transfer program. It applies to fields of jurisdiction attributed to the provinces, and its attendant conditions, as well as its defining terms, clearly limit the provinces' decision-making and budgetary autonomy in these fields of jurisdiction. The federal government's cuts in recent years confer a particular dimension on these difficulties.

- Equalization, whose purpose is to reduce disparities in fiscal capacity among the provinces, fails to eliminate major differences in the fiscal capacities of the provinces because it applies a five-province standard. The ceiling on equalization entitlements imposes an arbitrary limit on payments, further impeding it from achieving its objective. The formula for allocating the impact of the ceiling on equalization payments is inequitable and particularly penalizes Québec.

The tax bases used to determine equalization entitlements are ill-defined or incomplete. For instance, the property tax base is calculated using a formula that does not correspond to the actual situation of property values, which deprives Québec each year of about $800 million. Equalization payments sometimes vary considerably over time and this variability is caused in part by the mechanics of revising the data and technical changes, which is difficult to accept. Furthermore, "tax-back," with which the Commission dealt specifically, can exacerbate fiscal imbalance for the provinces concerned.

The "federal spending power"

Conditional transfers, such as the CHST, are one expression of the "federal spending power" the federal government invokes to intervene in provincial fields of jurisdiction.

- Given the amounts in question, federal intervention through the "federal spending power" has a considerable impact on provincial policy in the provinces' fields of jurisdiction. This impact had a destabilizing effect when the federal government withdrew from several programs or, more broadly, when it reduced social transfers overall.

This impact is likely to recur in new sectors of federal government intervention, for example, in health care and education, where direct, one-off, visible expenditures are preferred to system-wide expenditures, which are largely the provinces' responsibility.

In a broader perspective, federal initiatives distort the provinces' budgetary choices by favouring certain sectors or approaches to the detriment of other options.

- Federal government initiatives in conjunction with "federal spending power" in the provinces' fields of jurisdiction are, ultimately, only possible because of the resources available to the federal government, which exceed those that it needs to assume its jurisdiction.

The "federal spending power" is therefore directly tied to the division of tax fields between the two orders of government. A fiscal gap in favour of the federal government can only aid and abet intervention in the provinces' fields of jurisdiction since it can mobilize substantial resources and allocate them at its discretion in fields that it deems strategically or politically worthwhile.

Québec's traditional responses to the "federal spending power" reflect the logic of fiscal balance and the means by which the current fiscal imbalance could be brought to an end.

Consequences of fiscal imbalance

Fiscal imbalance, because of its scope, has a significant impact on provincial government operations and accordingly the delivery of public services. Furthermore, the practical result of the encroachment on the provinces' decision-making and budgetary autonomy is that in the provinces, the choices of people are not taken into account precisely where they should be.

Needs are poorly addressed

During its public hearings, the Commission heard many accounts that confirm the impact of the fiscal imbalance and the resulting lack of resources for Québec, as far as the adressing of needs is concerned.

Less efficient delivery of services

However, the consequences of the fiscal imbalance are not measured solely in terms of unaddressed or poorly satisfied needs. The various dysfunctions in fiscal relations between governments mean that the delivery of public services is less efficient than it could be.

The definition, administration and delivery of social programs and public services suffer directly from the problems identified, particularly the operating terms and conditions of transfer programs.

- There is uncertainty concerning the size of the amounts transferred.

- Some transfer payment procedures introduce a dynamic that distorts the priorization of needs.

- Federal interventions in provincial fields of jurisdiction are costly in terms of efficiency because of the resulting duplication. The Commission places particular emphasis on the problem of accountability raised by the simultaneous presence of two orders of government in the same field of intervention.

Compromised decision-making and budgetary autonomy

At an even more basic level, fiscal imbalance raises the whole question of respect for the provinces' decision-making and budgetary autonomy, and accordingly of people's capacity to make their own choices in fields defined by the Constitution - which is the very basis of federalism.

Québec, with its specific needs and collective preferences tied to its unique situation in North America, is obviously very sensitive to the ability to make its own choices in such basic areas as health, education and social assistance.

Recommendations

Fiscal imbalance thus constitutes a dysfunction of the federal system. To eliminate it, major transformations are needed in intergovernmental fiscal relations within Canada. The transformations identified by the Commission provide a blueprint of what would be a Canadian federation that respects more closely the principles of federalism, in the short and medium term.

Restore fiscal balance within the federation

- The provinces must have additional financial resources to address the needs within their fields of jurisdiction. In Québec's case, such resources are estimated at an annual $2 billion in the short term, $3 billion in the medium term, and at least $8 billion for the provinces overall.

- The terms and conditions governing the existing division of resources must be changed, by eliminating the CHST and freeing a new tax room for the provinces.

- The Commission recommends the elimination of the CHST and its replacement by a new division of tax room, because of the assured and predictable nature of the source of funds to which the provinces would have access, its unconditional nature and the greater accountability that would result.

- The Commission expresses its preference for an occupation of the GST field by the provinces. In light of the financial objective adopted, the federal government should entirely relinquish the GST in favour of the provinces. However, the Commission does not wish to reject the scenario calling for a new division of the personal income tax field.

- In both instances, the new division of tax room would focus on the equivalent of between $26 and $27 billion for Canada as a whole, i.e. the amount of the existing CHST, to which would be added the additional financial resources freed for the provinces.

- The Commission believes that the new division of taxation must not lead to federal government deficits. This is possible if the new division is implemented gradually and account is taken of actual federal government surpluses. Priority should be given to allocating future surpluses to the new division of tax room in favour of the provinces.

The new division of tax room the Commission is recommending would restore funding previously supplied by the CHST: the tax room Québec would obtain would represent from 18.4% to 19.7% of funding for health, post-secondary education and income security in 2005-2006, whereas the CHST provided 19.8% of this funding in 1994-1995, subsequently falling to 11.9% in 2000-2001.

Note: CHST including special Québec abatement and excluding federal trust accounts.
Sources: Commission on Fiscal Imbalance; Gouvernement du Québec, 2002-2003 budget; Conference Board of Canada.

- The equalization program must be improved.

- The Commission is of the opinion that equalization payments must be defined using a standard that reflects the average fiscal capacity of all of the provinces, i.e. the ten-province standard, which would replace the existing five-province standard. The shift to the ten-province standard should be effected gradually to allow for the impact of this change on federal public finances and prevent it from leading them into deficit. However, the federal government should clearly consider the ten-province standard as the objective to attain by indicating the percentage of equalization paid in relation to the amount that would result from its full application.

- The Commission recommends the elimination of the "ceiling" and "floor" provisions so that the equalization program can satisfy its objective more adequately and to improve its equity.

- The Commission requests total compliance with the representative tax system approach, which is the very basis for the measurement of the provinces' fiscal capacity. At the next renewal of the equalization program, fiscal capacity for the property tax base must be measured on the basis of property assessment rolls. Similarly, the full amount of revenue from the sale of goods and services must be subject to equalization.

- The Commission recommends that any new method or data be submitted to the provinces and subjected to satisfactory study before being applied. No change in methodology or data should be implemented during the five-year period following a renewal of the equalization program.

- To counteract "federal spending power."

- The Commission wishes to emphasize that the new division of financial resources that it recommends would limit future federal government initiatives under the aegis of "federal spending power" by reducing the financial leeway available for this purpose.

- The Commission also recommends that:

- Québec vigorously reiterate its traditional stance concerning the absence of a constitutional basis for "federal spending power" since this "power" does not respect the division of powers stipulated in the Constitution;

- Québec maintain its demand to exercise an unconditional right to opt out with full financial compensation in respect of any program implemented by the federal government in a field falling under provincial jurisdiction.

Respond to all new causes of imbalance

Fiscal imbalance hampers in the functioning of a federation. For this reason, procedures must be implemented to respond rapidly to new causes of imbalance.

- We must engage in an ongoing, reliable assessment of the conditions surrounding financial relations between the two orders of government.

- The Commission recommends that the federal government significantly enhance the information available to the public concerning fiscal balance in the federation and intergovernmental fiscal arrangements.

- The Commission is of the opinion that, given the issues at stake, the federal-provincial analysis of fiscal balance and transfer programs should be revitalized and made much more transparent.

- The Commission believes that the National Assembly should engage in systematic monitoring of various facets of fiscal imbalance through discussion by a parliamentary committee of a report submitted annually by the Minister of Finance and including the advice of a Committee of experts.

- A genuine process of exchanges and discussion between the two orders of government should be initiated on all facets of intergovernmental fiscal relations. The Commission recommends that the Québec government pursue its efforts to ultimately establish with the other provinces a genuine, permanent and effective process of exchanges and discussion between the two orders of government on intergovernmental fiscal relations.

The Commission is convinced the recommandations it has formulated would correct the fiscal imbalance that is currently a feature of intergovernmental fiscal relations wihin the canadian federation.

The restoration of fiscal balance will directly benefit individuals since they will receive from the provinces an adequate level of services in sectors they consider a priority. Moreover, it will fully enable them to make the choices to which they are entitled in the fields stipulated by the Constitution as under provincial jurisdiction.

The ability to make choices in clearly identified fields is at the very heart of the federal system. It is a cornerstone of federalism, to which Quebecers are especially sensitive. The restoration of fiscal balance in Canada through a new division of financial resources must respect and guarantee it.