Evaluation of federal transfers to the provinces

Bev Dahlby

The federal equalization program has its critics, as do federal equal per-capita block grants such as the Canada Health Transfer and Canada Social Transfer. But equalization helps to prevent outmigration from “have-not” provinces, while block grants in effect substitute federal taxes for less-efficient provincial ones. I study the effects of grants in a simulation model with (a) endogenous tax and expenditure decisions by provincial governments in response to the receipt of federal transfers, (b) co-occupation of a distortionary tax base by the federal and provincial governments, and (c) fiscally induced migration among the provinces by imperfectly mobile populations. The model shows that an increase in block grants would increase average welfare in all provinces. As well, the model shows that equalization can improve the well-being of the residents of the non-recipient provinces as well as the recipient provinces. Although the model does not incorporate all of the features of the current equalization program, it provides support for the principle, if not the practice, of fiscal equalization in Canada.

The equalization program has been the focus of many Albertans’ discontent with the Canadian federation, and they voted overwhelming for changes to the program in a referendum last fall. But concerns go well beyond equalization, which is only one component of the overall net fiscal transfers from the province and include the perceived lack of federal support for the provincial government since the decline in world oil prices in 2014, as well as the roadblocks that the federal and other provincial governments have created for expanding the oil and gas industry. As Premier Jason Kenney put it: “For millions of Albertans, equalization has become the most powerful symbol of unfairness of Alberta’s deal in Confederation.”[1]

The fiscal equalization program has been a key component of federal-provincial fiscal relations since 1957. Its importance was recognized in Section 36(2) of the Constitution Act, 1982 as a commitment by the federal and provincial governments “to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation.”

In her recent book, The Art of Sharing: The Richer versus the Poorer Provinces since Confederation, Mary Janigan (2020) extolls the virtues of the equalization program, claiming that it is “the improbable glue that holds the nation together.” Other studies, such McMillan (2012) and Mansell, Khanal, and Tombe (2020), show the degree to which the equalization program, as well as other components of the federal tax-transfer system, redistributes income and economic activity across provinces. Tombe and Winter (2021) use a model of interprovincial trade to quantify the extent to which the net fiscal transfers affects the location and aggregate level of economic activity in Canada by shifting employment to lower-productivity regions.

This finding of a negative impact on aggregate activity contrasts with the theoretical framework in Boadway and Flatters (1982) that provides an efficiency rationale for equalization transfers in a federation where a household’s location decision is influenced by the tax rates and public service levels offered in different provinces. A key assumption in the Boadway and Flatters model is that production exhibits a diminishing marginal product of labour due to a fixed input, such as land or mineral resources, in each province. To the extent that labour is attracted to regions that provide larger net fiscal benefits, the marginal product of labour will not be equalized across provinces, a condition that is required for an efficient allocation of labour across provinces.Transfers that reduce the differences in net fiscal benefits across provinces can generate a net economic benefit by improving the allocation of labour in the economy. Wilson (2003) estimated that the gains from reduced fiscally-induced migration due to changes made in the equalization program from 1971 to 1977 were $1.61 for each dollar of program cost.

The goal of this essay is to evaluate the welfare effects of a fiscal equalization and other federal transfers to the provinces based on a simulation model with (a) endogenous tax and expenditure decisions by provincial governments in response to the receipt of federal transfers, (b) shared taxation by federal and provincial governments, with distortionary impacts on the economy, and (c) fiscally induced migration among the provinces by imperfectly mobile populations. I simulate a stylized equalization program, without all the complex features of the actual program. The effects of equalization rules on the transfers received by each province are studied in the Finances of the Nation Equalization simulator, but that model is mechanical. My model instead captures the fiscal interactions between governments as tax rates change and people move in response to equalization.

I develop a simulation model based on the Sato (2000), and Boadway and Tremblay (2010) models of a federation with imperfectly mobile labour where the federal and provincial governments levy distortionary income taxes to finance their expenditures. As in the Boadway and Tremblay model, it is assumed that the marginal product of labour in each province is independent of its population. In this way, the model departs from the conventional assumption of most fiscal federalism models that the production technology exhibits decreasing returns to labour because of a fixed factor such as land or resources. The assumption of diminishing returns for an entire regional economy exaggerates the importance of fixed inputs that give rise to economic rents. To take a Canadian example, the resource sectors are highly capital-intensive and directly employ only a small fraction of the labour force in the resource-rich regions. It can be shown that if provinces are small, open economies in which the non-resource sector exhibits constant returns to scale, then the marginal product of labour will be constant and determined by productivity in the non-resource sector. This provides the rationale for treating the per-capita income in a province as independent of the size of the labour force.

Another key feature of the model is that the distribution of the population depends on the net fiscal benefit of residing in one province rather than another. However, the population mobility is limited because of local amenities, cultural affinity, or family ties to provinces.[2] Incorporating fiscally induced migration in the model introduces complexity, and it is not possible to model migration from each province to the other nine provinces. Accordingly, in the basic version of the model, I limit the migration responses of the five equalization-recipient provinces to a single composite province (NR) that reflects the economic characteristics of the five non-recipient provinces. However, to provide some details about the impact of the federal transfers on all 10 provinces, I also have a version of the model in which provincial populations are fixed. A technical appendix describing the theoretical framework, the equations of the simulation model, and the values of the key parameters of the model is available at www.bdahlby99.com

I use the simulation model to assess the impact of a $100 equal per-capita increase in a transfer to all of the provinces. I find that there are very large net economic gains in all provinces, as federal taxes substitute for more distortionary provincial ones. I also simulate the impact of eliminating a fiscal equalization program and find that, as expected, there are large losses to individuals in the equalization-receiving provinces. However, individuals in the non-recipient provinces are also made worse off because the federal tax rate increases to maintain its fiscal balance in the face of the decline in average national income. Accordingly, the model indicates that a fiscal equalization program can benefit Canadians in all provinces.

Simulating the impact of federal transfers to the provinces

Table 1:  Impact of a $100 per-capita increase in a lump-sum grant

PENSNBQCMBNR
Per Capita Program Spending ($)73.5472.4864.6373.9458.8083.74
Provincial Tax Rate (Percentage Point Change)-0.224-0.248-0.267-0.283-0.255-0.255
Per Capita Equalization Payments ($)-4.56-4.14-3.974.07-8.260.00
Population (Percentage Change)-0.258-0.125-0.013-0.003-0.0840.012
Per Capita Income ($)278.31302.68279.31299.89323.86362.59
Individual Welfare ($)283.48315.82254.71338.89236.84396.07

Table 1 shows the impact of an increase in an equal per-capita lump-sum transfer from the federal government to the provinces. The provincial governments’ fiscal adjustments maintain their existing deficits or surpluses and the federal government adjusts its tax rate to maintain its fiscal balance. In response to the $100 per-capita increase in lump-sum transfer, there are increases in per-capita program spending ranging between $58.82 in Manitoba and $83.74 in the composite non-recipient province denoted as NR. The average increase in program spending is $79.81, which is close to the stimulative effect of a lump-sum grant on provincial government spending in the econometric study by Dahlby and Ferede (2016). There are income tax rate reductions in all provinces, and the average provincial tax rate declines by 1.1 per cent. These tax-rate reductions result in increases in average per-capita incomes in all provinces, with the largest increase in the composite non-recipient province. There are modest reductions in the equalization transfers to the four provinces with average incomes below the national average. Quebec’s equalization transfer increases because its average income exceeds the national average. Therefore, the reduction in the average tax rate increases its equalization transfer while it reduces the equalization transfers for the other four recipient provinces. Because of the increases in incomes, the federal income tax rate also declines by a slight amount — even though it is providing higher transfers to the provinces. As a result of the program spending increases and the tax-rate reductions, the representative individual’s welfare improves in all provinces, with the largest increase of $396.06 in the composite non-recipient province. The differentials in the standard of living between the composite non-recipient province and the five recipient provinces increases, resulting in fiscal-induced migrations from the recipient provinces. However, these population reductions are quite small, especially in the case of New Brunswick and Quebec. The aggregate welfare gain is $13.92 billion. The ratio of the aggregate welfare gain to the increase in the total transfer, 3.72, is high because the marginal benefit from the increased provincial public services is based on the provincial governments marginal cost of public funds (MCFs) which are based on recent estimates by Dahlby and Ferede (2018).

Table 2:  Impact of eliminating equalization entitlements

PENSNBQCMBNR
Per Capita Program Spending ($)-1487-1046-1248-743-873-49
Provincial Tax Rate (Percentage Points)4.533.585.162.853.780.110
Population (Percentage Change)-15.12-7.66-0.49-0.160-1.850.56
Per Capita Income ($)-5148-4134-5046-2962-4513-510
Individual Welfare ($)-6906-5237-5537-3680-3800-310

Table 2 shows the impact of eliminating an equalization program. As expected, there are reductions in program spending in the recipient provinces, as well as increases in tax rates and declines in incomes. National income declines as a result of outmigration from the recipient provinces. In this balanced budget scenario, the federal tax rate increases, even though its expenditures on equalization transfers have been eliminated, because average national income declines. That is, a federal tax rate increase is required to maintain the federal budget balance because average national income has declined. The higher federal tax rate causes a reduction in the average income of the non-recipient provinces, which in turn leads to slightly higher provincial tax rates and a small cut in program spending. As a result of these fiscal adjustments, the individual’s welfare declines in all provinces including in the non-recipient provinces. There is outmigration from the five recipient provinces to the non-recipient provinces, with a 15.12-per-cent reduction in PEI’s population. Eliminating the equalization program results in an aggregate welfare loss of $55.4 billion or by 1.6 per cent.

Modelling the changes in the distribution of the population across provinces contributes to the complexity of the model. Given that the econometric estimates for the population parameters have large standard errors and that the proceeding analysis suggests that the population adjustments to the moderate changes in transfers are very small, I also have a version of the model where provinces’ populations are fixed. This simplifies the model and allows us to model the fiscal adjustments of all 10 provinces.

Table 3:  Impact of a $100 per-capita increase in a lump-sum grant with the fixed population model

NLPENSNBQCONMBSKABBC
Per Capita Program Spending ($)101.4178.6677.9269.4979.47113.8462.5180.6745.2497.52
Provincial Tax Rate (Percentage Point Change)-0.17-0.24-0.27-0.29-0.31-0.15-0.27-0.25-0.25-0.21
Per Capita Equalization Payments ($)0.00-6.99-7.13-5.251.160.00-11.290.000.000.00
Per Capita Income ($)342.33347.60374.70342.81366.39369.81396.13451.14434.04521.22
Individual Welfare ($)465.20317.68355.03288.39360.98836.98267.36319.55230.16480.41

Table 3 shows the impact of a $100 per-capita increase in a lump-sum transfer to the provinces with the fixed population model. The increases in program spending by the five recipient provinces are very similar to the responses in Table 1. However, there are big differences in the fiscal responses among the five non-recipient provinces with Newfoundland and Labrador, and Ontario increasing their spending by more than $100 per-capita and Alberta increasing its spending by less than $50 per-capita. These varied responses are in line with the differences among the provinces in their MCFs. Theory predicts — and the econometric analysis confirms — that the stimulative effect of a lump-sum transfer on provincial spending increases with the province’s MCF. See Dahlby (2011) and Dahlby and Ferede (2016). Tax rates decline in all provinces, with smallest reductions in Newfoundland and Labrador, and Ontario. As a result of these tax cuts, per-capita incomes increase in all provinces with especially large increases in the four western provinces. Equalization payments decline in four of the recipient provinces while there is a slight increase in payments to Quebec because of the decline in the average provincial tax rate. The federal tax rate also declines. Individual welfare improves in all provinces and aggregate welfare increases by $20.33 billion or a welfare gain of 5.43 per dollar of transfers.

Table 4: Impact of eliminating equalization entitlements with the fixed population model

NLPENSNBQCONMBSKABBC
Per Capita Program Spending ($)-39-1480-1040-1241-729-55-867-27-14-44
Provincial Tax Rate (Percentage Point Change)0.064.513.565.312.810.073.750.090.080.09
Per Capita Income ($)-3405101-4088-4998-2896-411-4462-357-334-498
Individual Welfare ($)-233-6868-5203-5498-3441-471-3772-160-140-283

Table 4 shows the impact of eliminating the equalization program under the assumption that provincial populations do not respond to differences in the standard of living between the provinces. As expected, the five recipient provinces cut spending and increase tax rates. Per-capita incomes decline in these provinces. Although equalization payments are eliminated, the federal government increases its tax rate to maintain its fiscal balance in response to the decline in average incomes. The federal tax-rate increase has a negative impact on income-generation in the five non-recipient provinces, and they respond by cutting program spending and raising their tax rates. As a result, individual welfare declines in all provinces, including the five non-recipient provinces. Aggregate welfare declines by $54 billion or 1.3 per cent.

Conclusion

I have evaluated federal transfers using a model that incorporates key features of the Canadian system — including federal financing of equalization transfers with a distortionary tax; vertical tax externalities between the federal and provincial governments because they levy taxes on the same base; endogenous fiscal policies of the provinces; imperfect labour mobility between provinces; provision of quasi-private goods by provinces; and marginal products of labour that are independent of the provincial populations because provinces are small, open economies with constant returns to scale in the non-resource sector.

The simulation model indicates that an equal per-capita increase in a lump-sum transfer to all of the provinces would result in modest reductions in provincial tax rates, as well as substantial increases in spending on provincial services. These fiscal responses, which are in line with the studies of the stimulative effect of intergovernmental transfers, imply that there would be large welfare improvements from an increase in lump-sum transfers to all of the provinces, and especially in the provinces that do not receive equalization transfers. The model also indicates that a stylized fiscal equalization program, based on differences in the fiscal capacities of the provinces that are proxied by per-capita incomes, improves the well-being of the residents of the non-recipient provinces as well as the recipient provinces. Although the model does not incorporate all of the features of the current equalization program, it does provide support for the principle, if not the practice, of fiscal equalization in Canada.

[1] Corbella: October referendum might just stop Canada’s cash cow (Alberta) from getting kicked

[2] Limited population mobility is modelled based on Mansoorian and Myers (1993) concept of attachment.

References

Boadway, Robin and Frank Flatters. 1982. “Efficiency and Equalization Payments in a Federal System of Government: A Synthesis and Extension of Recent Results.” Canadian Journal of Economics 15: 613–633.

Boadway, Robin and Jean-Francois Tremblay. 2010. “Mobility and Fiscal Imbalance.” National Tax Journal 63.4 part 2: 1023-54.

Dahlby, Bev. 2011 “The Marginal Cost of Public Funds and the Flypaper Effect” International Tax and Public Finance 18(3): 304-321.

Dahlby, Bev and Ergete Ferede. 2016.“The Stimulative Effects of Intergovernmental Grants and the Marginal Cost of Public Funds.” International Tax and Public Finance 23(1): 114-139.

Janigan, Mary. 2020.  The Art of Sharing—The Richer versus the Poorer Provinces since Confederation. McGill-Queen’s University Press.  Montreal.

Mansell, Robert, Mukesh Khanal, and Trevor Tombe 2020. “The Regional Distribution of Federal Fiscal Balances: Who Pays, Who Gets and Why It Matters” SPP Research Papers Vol 13:14. https://www.policyschool.ca/wp-content/uploads/2020/06/Federal-Fiscal-Balance-Mansell-Khanal-Tombe.pdf

Mansoorian, Arman, and Gordon M. Myers. 1993. “Attachment to Home and Efficient Purchases of Population in a Fiscal Externality Economy.” Journal of Public Economics 52 (1), 117–132.

McMillan, Melville. 2012. Alberta and Equalization: Separating Fact from Fiction. Mowat Centre, Toronto.

Sato, Motohiro. 2000. “Fiscal Externalities and Efficient Transfers in a Federation.” International Tax and Public Finance 7: 119-139.

Tombe, Trevor and Jennifer Winter. 2021. “Fiscal Integration with Internal Trade: Quantifying the Effects of Federal Transfers.” Canadian Journal of Economics

Wilson, Leonard S. 2003. “Equalization, Efficiency and Migration: Watson Revisited.” Canadian Public Policy 29(4), 385–96.

Bev DahlbyBev Dahlby is a member of the Fiscal and Tax Competitiveness Policy Council; a fellow-in-residence at the C.D. Howe Institute; a research fellow at the School of Public Policy, University of Calgary; and a senior fellow of the Fraser Institute. He was previously a professor of economics at the University of Alberta and a distinguished fellow at the School of Public Policy at the University of Calgary.

Print Friendly, PDF & Email