It is important to state at the outset that the issue of vertical fiscal imbalance (VFI) is at the heart of the cur- rent debate on the future of health care. It has also been the main irritant in intergovernmental relations for the past several years. Coming out of their annual confer- ence in Halifax last August, the premiers 130 reiterated that their ability to meet the health-care needs of Canadians was ”œat risk due to the fiscal imbalance existing in Canada.” The premiers’ call on ”œthe federal government to assume its fair share of responsibility” was the latest in a series of tit- for-tat interventions that began in 1997””when the provin- cial/territorial (P/T) ministers of finance first issued a back- ground paper on the growing fiscal imbalance between the federal government and the provinces. Since then, the provinces have even commissioned independent studies on VFI to support the validity of their case against the federal government. Each public statement by provinces on the issue has of course been met with equally vigorous federal counter-arguments.
Given the esoteric nature of this rather obscure con- cept, Quebec’s Premier Landry should perhaps be given credit for having come up with a people-friendly definition. The money is in Ottawa: the needs are in the provinces is an image that is fairly easy to grasp. Indeed, the central issue in discussing VFI is the relative capacity of each order of gov- ernment to raise its own revenues in order to fund its own expenditures. The notion of VFI is conventionally used to describe a common characteristic of federal systems where- by the central government has access to revenues in excess of its own spending needs, while the state or provincial gov- ernments are assigned significant expenditure responsibili- ties but with less than corresponding taxing powers.
This ”œmismatch” in the allocation of revenues and spending obligations can provide important benefits. Having more taxation take place via the central government fosters greater tax harmonization and reduces economic dis- tortions. The ”œexcess revenue” also enables the central gov- ernment to pursue certain economic efficiency and equity objectives at a national level by transferring rev- enues to state/provincial governments in variety of ways. On the other hand, having people-relat- ed public expenditures take place in a more decentralized fashion allows governments to bet- ter respond to local needs and preferences. The main drawback to this revenue/expenditure mis- match is that it may be less transparent to citi- zens in terms of who is responsible for what. This may result in less accountability and local auton- omy than would be the case if the government that spent was also the one that taxed.
This conventional interpretation of vertical fiscal imbalance typically applies to situations where sub-national governments have real con- straints on their capacity to generate revenue (i.e., they do not have access to certain important revenue sources). Measuring the extent of VFI in such cases is often simply a matter of measuring the relative importance of fiscal transfers in fund- ing sub-national government expenditures. Generally speaking, the more public spending is decentralized and revenue raising centralized, the more sub-national governments have to rely on the central government to supplement their own-source revenues. The imbalance is therefore defined relative to a situation where there is no revenue/expenditure mismatch.
Applying these concepts in the current Canadian context, however, is more problem- atic. First and foremost, the assignment of taxing powers as defined in the Constitution Act, 1867 bears little resemblance to the situation that has evolved over the past 135 years. Over time both levels of government have gained access to (and have come to rely on) all the major sources of rev- enue. For instance, the personal and corporate income taxes and the GST/retail sales taxes cur- rently account for 80 percent of federal tax rev- enues and 64 percent of provincial/territorial tax revenues. In addition both orders of government collect payroll taxes, fuel taxes, and tobacco and liquor taxes. In effect, Canadian governments’ abil- ity to raise revenue is only constrained by the need to maintain taxpayer consent and by economic (competitiveness and efficiency) considerations.
The same sort of argument applies on the expenditure side. The expenditure obligations of Canadian governments today are more or less related to the responsibilities or jurisdictions laid out in the constitution, but the extent and the manner in which governments choose to fulfil these obligations are matters of public policy and democratic choice. They are also subject to change over time. Moreover, since the federal government can intervene in areas of provincial responsibility not only through intergovernmen- tal transfers but also through its direct use of the spending power, it can be difficult to determine where its expenditure obligations end and where the VFI begins at any point in time.
Given these circumstances, it is difficult to assess objectively whether the current level of federal transfers to the provinces is adequate or appropriate. Moreover, what is really at issue in the current debate is whether there is VFI (a rev- enue/expenditure mismatch) once federal trans- fers have been taken into account.
A number of studies produced since the early 1990s have attempted to produce estimates of VFI in the Canadian context. These studies for the most part have taken a more direct approach to the mismatch issue, based on a comparison of the structural fiscal balances of each level of gov- ernment. In particular, Joe Ruggeri and his col- leagues have been doing work in this area for a number of years and have published a number of papers. More recently, Professor Ruggeri has updated some of this work at the request of provincial governments. Many of the arguments put forward by the provinces on VFI have been based on his reports.
The basic methodology consists of project- ing fiscal balances based on assumptions of steady growth and no change in policy. The object is to examine separately the implications of the current fiscal regime for the two orders of government in the absence of cyclical effects and discretionary government actions. In order to do so, the taxation and expenditure struc- tures of each order of government in the base year are taken as given, and their growth path projected based on the different built-in growth rates assigned to particular revenue sources and program expenditures. For each tax and expen- diture item the growth rate is assumed to be related in some particular fashion to growth in one or a combination of independent variables such as GDP, CPI, labour productivity, popula- tion growth or aging.
The Conference Board of Canada (CBoC), in its recent report prepared for provincial and terri- torial governments, uses a similar approach to project the public accounts of the federal and provincial/territorial governments to the year 2019-20. The Conference Board’s results are based on its own long-term economic forecasts for basic macroeconomic variables as well as two forecasting models which estimate specific changes in per capita spending on health care and education. The CBoC also adopts a status quo benchmark with respect to fiscal and budg- etary policy. But in contrast to Ruggeri’s 2001 study which assumes that debt charges remain constant, the CBoC base case assumes that gov- ernment surpluses in any given year are allocated entirely to debt repayment.
Chart 1 reports the aggregate expenditure and revenue growth rates and projected budget balances for each order of government resulting from both studies. Based on Ruggeri’s estimates, federal revenues are expected to grow an average of 4.1 percent per annum versus 3.6 percent for the provinces between 1999-00 and 2019-20. The discrepancy between the two stems primarily from the federal government’s greater reliance (47 percent versus 27 percent for the provinces) on the personal income tax, the fastest-growing revenue source, and the considerable share of provincial revenues that comes from slow-grow- ing federal transfers.
The opposite occurs on the expenditure side. Provinces have a relatively large share of their program spending in rapidly growing areas. On the expenditure side, the Ruggeri model assumes relatively high rates of growth for health and education (representing half of provincial spend- ing) and for Old Age Security (10 percent of fed- eral spending) but essentially assumes no real growth in the remaining categories. This, com- bined with constant debt charges (larger at the federal level) and slow-growing federal transfers, results in a faster projected growth rate for provincial expenditures. Overall provincial spending is expected to grow at an average annu- al rate of 3.5 percent over the twenty-year period relative to a growth rate of 2.2 percent for feder- al spending. Federal government revenues are thus expected to grow almost twice as fast as expenditures, while the provincial revenue growth rate is only marginally higher than that of expenditures.
As Chart 1 shows, these apparently small dif- ferences in revenue and expenditure growth rates have a substantial fiscal impact when projected forward 10 to 20 years. According to Ruggeri’s calculations, the federal surplus is expected to increase to $39 billion by 2009-10 and to triple to $126 billion ten years later, while the provinces only manage to achieve budget balance in 2009- 10 and a $5.5-billion surplus in 2019-20. Approximately 80 percent of the difference between the federal and provincial fiscal posi- tions stems from the divergent growth paths on the spending side.
The Conference Board’s aggregate growth rates and fiscal projection results are also report- ed in Chart 1. While federal budgetary revenues are expected to increase by 3.5 percent annually and program spending by 3.9 percent, the reduc- tion in interest payments from having the budg- et surpluses allocated to debt reduction has a dra- matic effect on the overall rate of growth of fed- eral expenditures, which is only 2.5 percent.
According to the Conference Board’s esti- mates, overall provincial and territorial program spending is expected to increase only at a slight- ly faster rate than federal spending (4.1 percent relative to 3.9 percent). However, since provin- cial/territorial governments collectively are unable to reduce their interest charges due to ongoing deficits, their budgetary expenditures increase by 4.0 percent per year over the twenty- year period compared to only 2.5 percent at the federal level.
The Conference Board results clearly illustrate the impact of both positive and negative fiscal dynamics at work. At the federal level, the results reveal a steady string of ever-growing budget sur- pluses reaching $16.2 billion in 2009-10 and $85.5 billion in 2019-20. As a result, the federal govern- ment is able to pay down more than 90 percent of its interest-bearing debt by the end of the forecast period (from $589 billion to $53 billion) and see its annual interest charges reduced from $42 bil- lion to $11 billion. The reduction of interest charges is largely responsible for the growing budgetary surplus and the fast decline in interest- bearing debt at the federal level.
Meanwhile, the combined provincial/territo- rial government budget balance is projected to remain negative throughout the forecast period, peaking at $12.3 billion in 2019-20. By that time the aggregate provincial/territorial debt level will have increased by 54 percent, from $251.5 billion to $386.9 billion, and debt-servicing charges will be 3.5 times those borne by the federal govern- ment. The Conference Board concludes that there is vertical imbalance in the current fiscal regime and that this imbalance will widen in the future in the absence of structural change.
Both the Ruggeri and the Conference Board analyses project fiscal balances based on the cur- rent fiscal structure of each order of government, assuming no policy change. Each attempts to model the particular growth path of each com- ponent of revenue and spending and its implica- tions for future government budget balances. However, each draws a quite different portrait of the fiscal landscape. This is a classic example of ”œsmall differences that matter.” Ruggeri’s esti- mates of the difference between the built-in growth rates in federal revenues and expendi- tures generate a federal surplus of $39 billion by 2009-10 and $126 billion by 2019-20 while assuming constant debt charges. The Conference Board study which assumes all surpluses go to debt reduction also reports growing federal sur- pluses, but of a lesser magnitude at $16.2 billion in 2009-10 and $85.8 billion in 2019-20.
As this brief overview of two recent studies of VFI in the Canadian context indicates, the results from such analyses need to be interpreted with caution. The underlying model specification and empirical assumptions must be understood and taken into account as the resulting fiscal projections are highly sensitive to these. As the authors themselves point out, their results are projections of given fiscal variables in a given year based on assumptions about trends in economic and demographic variables and not forecasts. This means that changes in the economy, which can have a determining and often long-term effect on government revenue growth and spending requirements, are not considered.
Moreover, the object of such analyses is to examine and compare the structural rather than the actual fiscal balances inherent in the current tax and expenditure configuration. In order to do this it is assumed that revenues and expenditures grow from their initial levels at the assumed built-in rate and that no policy change or adjust- ment takes place, even if a pattern of cumulative surpluses or deficits emerges which creates its own set of fiscal dynamics. For instance, the Conference Board study indicates that in the absence of cyclical fluctuations and policy changes, the federal government’s current fiscal structure would likely produce a steady stream of budget surpluses even under fairly conservative economic assumptions. But these surpluses can only materialize to the extent that economic growth is sustained, taxes are not further reduced, new spending measures are not implemented, and the entire surplus goes to debt payment thus reducing debt charges as projected. The reality, however, is that governments do adjust to both economic and fiscal circumstances on an ongoing basis. This has been amply demonstrated in the last three federal budgets with announcements of substantial tax cuts and new spending initiatives. The point is that the fiscal position of any government in any given year is inevitably the outcome of cumulative fiscal effects and adjustments to changing circumstances over time. Long-term fiscal projections thus have obvious limitations.
In terms of the current VFI debate, looking back may in a sense be as important as projecting forward. The reason why VFI has become an issue in the federal-provincial wrangling over health-care funding is that the current fiscal stance of both levels of government has been greatly affected by changes in federal-provincial fiscal relations over the past several decades. The manner in which major national social programs were first established in the postwar years, the changes in the respective role and relative importance of each level of government over time, and the various fiscal channels through which the actions of one level of gov- ernment affect that of the other have all played a role. Looking back on this history it is evident that intergovernmental fiscal relations in Canada have been in a constant state of flux and adjustment. In fact it is not clear that verti- cal fiscal balance was ever achieved.
Chart 2 shows the dramatic increase in the size of the public sector in Canada in the decades following the Second World War as governments laid the foundations of the welfare state and took on a more active role. Compared with similar trends elsewhere, in Canada most of that increase occurred at the provincial level where jurisdic- tion over health, post-secondary education and social assistance has been assigned. The establish- ment of major social programs not only caused a rapid expansion of the role of provincial govern- ments, it also led to a significant increase in their importance, relative to the federal government. In little more than a decade, the provinces became the dominant player in terms of public expenditures.
Chart 3 shows the sharp reversal in the rela- tive importance (both in terms of own-source revenues and expenditures) of each level of gov- ernment, which took place between 1953 and 1971. The federal government, which accounted for 68 percent of public expenditures at the beginning of the period, saw its share reduced to 39 percent by 1971, while provincial/local gov- ernments’ own expenditures had grown to 61 percent. The pattern is similar on the revenue side with federal/provincial shares more evenly split in the 45/55 percent range since 1978. Chart 3 also shows the steady decline in the relative importance of federal transfers to the provinces from the mid-1970s onward, dropping from 21 to 11 percent in 1998.
Between the mid-1950s and the early 1970s there was a rapid increase in federal revenues rel- ative to Ottawa’s own spending needs, which cor- responded with the implementation of major transfer programs to the provinces. By the early 1970s, federal revenues in excess of own expen- ditures were still in the 30 percent range although 1974 marked the beginning of a sub- stantial and prolonged deterioration of the state of federal finances. In most years from 1982 to 1995, federal revenues were not even sufficient to cover the government’s own spending and debt charges. It is interesting to note that with the dra- matic fiscal turnaround that took place post- 1995, federal revenue balances are once again in the 30 percent range.
Chart 4 shows how this actually played out in terms of the overall budget balances and debt burdens of both levels of government. As for the relative fiscal strength of the two orders of gov- ernment, the pattern over time is one of ebb and flow. Coming out of World War II, the fed- eral financial position was stronger, notwith- standing huge war debts. Ottawa chose not to abandon the revenue bases it had occupied dur- ing the war. Instead, through the carrot of cost sharing, it used its fiscal power to encourage provinces to create or expand social programs. The growth in federal transfer payments to the provinces did not necessarily improve provin- cial finances, however, as provinces were con- currently assuming major new expenditure responsibilities.
By the 1970s, however, Ottawa had become increasingly concerned that, as a result of cost sharing, provincial expenditure levels were deter- mining too much of its spending. This situation motivated the move to block-funding and other efforts to control the growth of transfer payments to the provinces. And although both orders of gov- ernment encountered fiscal problems in the early 1980s, at that time, the federal position was by far the weaker. If there was a vertical fiscal imbalance then, it favoured the provinces. Thus, the tide had shifted. Ottawa’s deteriorating financial position in turn led to several increases in federal taxes and a growing emphasis on expenditure restraint through the 1980s and early 1990s, including important cuts in planned levels of transfer pay- ments to provinces. With the 1995 federal budget, the introduction of the CHST and a more favourable fiscal environment, the federal govern- ment was able to turn the fiscal corner remarkably rapidly. By the end of the 1990s, Ottawa was once again in a strong financial position relative to the provinces, although this was due in good part to the impact of its expenditure restraints on provin- cial budgets. All of this is to say that the current strength of the federal position relative to the provinces follows a period in which their positions were reversed on two occasions.
Given these circumstances, and whether or not the term ”œvertical fiscal imbalance” is used to characterize the current situation, it is both timely and appropriate to have a public debate on the alternative uses of potentially sub- stantial federal surpluses in coming years. There are many competing claims to consider. Should the surplus be used to pay down federal debt or reduce taxes? Should it be allocated to new spending on children, on innovation or on the military and national security? Or, should it be used to improve public health care in partnership with the provinces? These are, of course, issues that entail political choice.
The prospect of a growing fiscal dividend at the federal level and ever-rising health-care costs at the provincial level inevitably raises issues of resource allocation. The adequacy of the federal contribution in maintaining a nationwide public health-care system has been the focus of federalprovincial disputes for several years. The provinces argue that Ottawa should be providing substantially more resources, and that it has the fiscal room to so. Meanwhile, the federal government maintains that it is doing its share within the means at its disposal.
But, however one assesses the VFI issue, there are a number of other imbalances or disconnects in the way intergovernmental fiscal relations in health care have evolved over the past two decades that also need to be addressed. The first is a dis- connect or imbalance between the role the federal government wishes to play with respect to the Canada-wide dimensions of health care and its cash contribution. Since 1999, the federal govern- ment has redressed this imbalance somewhat through increases in the CHST. At the same time however””and especially over the last year or so ”” it has also been attempting to discredit the provinces’ claim of fiscal imbalance by overstating its contribution to provincial social programs by resorting to clever fiscal arithmetic. As for the provinces, they also on occasion overstate the imbalance by ignoring the significance of the 1977 tax transfer and referring to the pre-1977 50 per- cent federal contribution under cost-sharing as a valid benchmark. Having worked through the rhetoric on both sides, however, the impression of a policy/funding disconnect remains. The federal government contributes insufficient cash to sus- tain the ability and the right to play the role it has historically played. Ottawa also does not share proportionately in the fiscal and political risks associated with the future of health care.
Second, and related to the last point, there is evidently a critical need to secure intergovern- mental agreement on what would constitute a ”œfair” federal cash contribution to provincial health care. At the present, there is simply no objective basis for determining what share of provincial health-care costs is covered by CHST cash (or should be covered). By hindering and detracting from the provinces’ planning process at a time when important restructuring is required, the ongoing federal-provincial dispute on what Ottawa’s contribution is (and what it should be) is highly damaging to the cause of health-care reform in Canada.
The same argument also applies to the issue of an escalator for federal health transfers. Under current arrangements, the annual CHST levels are established by law until 2006. But there is no explicit provision as to what is to come after 2006. Nor is there a set of principles that would provide general guidance to the provinces as to what they might expect. This lack of explicit longer-term arrangements undu- ly and unnecessarily complicates the task of long-range planning at a time when predictabil- ity is most essential. The current impasse over health-care financing and the lack of trans- parency regarding the federal contribution, therefore, are not only causing dysfunctional intergovernmental relations, they are hamper- ing the process of health-care reform. For this reason, a return to formal intergovernmental agreements for future fiscal arrangements may be required in order to move beyond the current impasse.
Third, there is also a disconnect between the expressed public desire for federal-provincial co- operation on public health insurance, on the one hand, and the way in which the federal govern- ment has made decisions regarding its financial contribution, on the other. Without being naive regarding the cost-sharing agreements of the 1950s and 1960s, and the 1977 EPF arrange- ments, it is fair to say that they were the product of a prolonged and genuine intergovernmental dialogue. In contrast, the experience since then has been one of unilateral action on Ottawa’s part. A return to a more collaborative approach to fiscal relations will be in order if Ottawa wishes to use fiscal relations to encourage a Canada-wide approach to health policy. This in turn would require that provincial finance ministers also engage constructively and realistically in negoti- ations with federal counterparts.
What should be the federal role in funding health care in the future? Actually, the answer is only partly related to the VFI issue. The full answer depends on how as a society we man- age to reconcile competing views about the nature of the Canadian sharing community and Canadian federalism. Independent of the out- come of this debate, however, there is currently a series of disconnects between Ottawa’s partner- ship discourse with respect to health care and its use of fiscal federalism instruments to pursue common objectives. In short, if the quality and sustainability of public health insurance and health care are to be improved, governments will have to begin reconnecting on fiscal relations, on political and fiscal risk-sharing, and on the way they manage intergovernmental disputes.
This article is adapted from a presentation to the 2002 Economic Outlook Forum, and is based on work conducted for the Romanow Commission.