Vancouver Institute Lectures

Reforming social policy: can the federal government deliver? [audiorecording] Boadway, Robin 1995

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620621Robin BoadwayREFORMING SOCIAL POLICY:CAN THE FEDERAL GOVERNMENT DELIVER?Dr. Robin BoadwaySir Edward Peacock Professor of Economic TheoryQueen’s UniversityE.S. Woodward LectureFebruary 25, 1995Biographical Note: Educated at RMC, Oxford and Queen’s Universities, Profes-sor Boadway is considered one of Canada’s leading experts on tax policy andfiscal federalism.  Former head of the Department of Economics at Queen’s, he iscurrently Associate Director of the John Deutsch Institute for the Study of Eco-nomic Policy. His books include Public Sector Economics, Welfare Economics,Canadian Tax Policy and Intergovernmental Fiscal Relations in Canada.I. IntroductionThe topic of this talk is one that is of considerable interest to thecommunity of Canadians — the reform of social policy and the roleof the federal government in that process. Interest in it is reflected ina recent survey reported in the Globe and Mail that showed that theaverage Canadian feels quite strongly that governments have an im-portant and indispensable role to play in the achievement of socialjustice.  However, they also think that governments are not deliver-ing. There is obviously much scope for reform. The issue to be ad-dressed is how the federal government can and should participate inthat process, especially in light of current fiscal realities.Let me start by stating what aspects of social policy I do notintend to address. The talk is not about the appropriate design ofsocial programs. That is, it is not about how unemployment insur-ance should be reformed, whether it should be two-tiered, whether itshould have a training component, and so on. It is not about how thewelfare system should be changed to address the problem of childpoverty or of the working poor. It is not about whether public pen-622sions should be targeted to those in need, or whether they should befunded according to actuarial principles. Nor is it about whether thestate should have a role in the delivery and financing of child care. Itis also not about whether principles of pricing and privatization shouldbe applied to health care, or whether students should bear a greaterburden of the financing of post-secondary education. More gener-ally, it is not about the relative role of cash transfers versus tax pref-erences versus the in-kind provision of goods and services as com-ponents of social policy. Finally, it is not about the implications ofthe current fiscal (debt) crisis for the funding of social programs,though all of these are important and relevant issues.Rather, it is about the nature of decision-making over socialpolicy issues in a federation such as Canada’s, one which is highlydecentralized by international standards. As the title suggests, it asks‘Can the Federal Government Deliver?’ rather than ‘What Can theFederal Government Deliver?’ or ‘What Should the Federal Gov-ernment Deliver?’  It is about the way that the responsibility forachieving social policy objectives is divided between (and sharedby) the federal and provincial levels of government, and how thismight be reflected in the policy instruments available to these gov-ernments. Obviously, this is not unrelated to the above questionsabout the design of social policy. Indeed, one of the themes of mytalk is that the social policy reform can be greatly constrained by afailure of the federal system to condone policy instruments com-mensurate with responsibilities at the two levels of government.Briefly speaking, my main thesis can be summarized in thefollowing line of reasoning:(1) We take it as a major premise that the federal government has alegitimate role to play in pursuing national standards of redistribu-tive equity or social justice, as well as national efficiency objectiveswhere:(a) national equity includes horizontal and vertical equity appliedon a national basis, which implies citizens are treated equiva-lently independent of province of residence; and equality of op-portunity;(b) national efficiency includes preservation and enhancement of the623Robin Boadwayefficient operation of the internal economic union, or commonmarket;  The issue is what implications for social policy reformfollow from that major premise.(2) Social policies (a) are integral components of national equitypolicies and (b) can have implications for national efficiency; socialpolicies include a wide array of policies and comprise much of whatgovernments do.(3) Some social policy instruments are federal (especially unemploy-ment insurance, largely pensions), some are jointly occupied (taxesand transfers), while others are ‘exclusive’ provincial responsibili-ties (health, education and welfare);(4) While there are very good economic reasons for decentralizingthe delivery and financing of social programs, such decentralizationcan lead to violations of national efficiency and equity norms:(a) lack of coordination among policy instruments and among prov-inces can lead to inefficiencies in the national economy (the in-ternal common market);(b) beggar-thy-neighbour policies of provinces can lead to adverseredistribution consequences (the ‘race to the bottom’);(c) fiscal decentralization leads to fiscal (horizontal) inequities amongprovinces, and to inconsistent standards of vertical equity;For these and other reasons, the system of fiscal arrangements be-tween the federal government and the provinces is an integral part ofthe social policy arsenal of the federal government; indeed, it is themajor source of federal influence.(5) Given the extent and nature of fiscal decentralization that hastaken place, and the fact that critically important instruments of re-distributive policy are the responsibility of the province, the abilityof the federal government to achieve its national efficiency and eq-uity objectives are on the verge of becoming seriously compromised.This has occurred gradually over the past three decades as a result ofpolicies undertaken with little regard for the longer-term consequencesfor fiscal federalism;(6) The fiscal foundations of the federation are now very fragile;federal policies in the next few years can undo in an irreversible waybenefits of the fiscal system that we have largely taken for granted,624so much so that we are on the verge of having to answer ‘no’ to thequestion posed in the title. The issue then is:(a) Should we worry about it; that is, do you accept the major premiseof my argument?(b) If so, what, if anything, could we do about it?I will suggest that, while the provinces have primary respon-sibility for the design and delivery of social programs, the federalgovernment can be viewed as having a legitimate role to play incoordinating social policy, establishing minimum national standardsand financing social policy, a role both based on sound economicpolicy reasoning and sanctioned in the Constitution. I will argue thatthe federal-provincial fiscal arrangements in the broadest sense formthe basis for the federal role in social policy.  The gradual decentrali-zation of fiscal responsibilities in Canada over the past quarter cen-tury has reached the point where the ability of the federal govern-ment to fulfill any role it might have in the social policy area, or evento achieve the minimal reforms set out in the recent Axworthy GreenPaper, is in jeopardy. We must now decide, perhaps as soon as thenext few budgets, whether we want to retain that role. My fear is thatthis issue has not been given proper airing. This is an attempt tocontribute to that debate.Before proceeding, I should make a couple more disclaim-ers. The topic I am addressing is large in scope, although it is alsoone that has not been widely debated in public. Since I am an econo-mist, and one whose work tends to be somewhat more formal thatthat found in policy debates, my focus will be on economic issues,especially on evaluating the use of the fiscal arrangements as instru-ments of desirable economic policy. I shall be less concerned withmatters of political feasibility, of political process, or of legality.Moreover, I shall have little to say about the relevance of the Quebecsituation for the topic, though that is obviously an issue of sometimeliness and importance. It may well be that the sorts of remediesthat might constitute good economic policy as I understand it maywell be compatible only with some sort of asymmetric arrangementwith Quebec.625Robin BoadwayII. What is Social Policy?Let me begin with defining what I take the term ‘social policy’ tomean.  Social policy is a synonym for redistributive policies, that is,policies whose objective is to address social justice or equity in allits dimensions. It involves both fostering greater equalities of oppor-tunities as well as greater equalities of well-being among Canadians.It comprises a wide variety of government programs and constitutesthe bulk of program expenditures by the public sector, both federaland provincial. Its components include:(1) Traditional income-based redistribution operated through the tax-transfer system (the progressive tax and various refundable credits);(2) Transfers to individuals delivered outside the income tax system,especially those made to the poor and the elderly;(3) Social insurance schemes intended to compensate for variousforms of misfortune that for various reasons are not insurable pri-vately, such as unemployment, illness, injury, disability and the like;(4) The public provision of goods and services, most of which areessentially private in nature but are provided through the public sec-tor for redistributive reasons (so-called in-kind transfers, such aseducation, health care, public housing, day care, etc.).Social policy in this broad sense might also be taken to in-clude inter-governmental redistributive transfers, such as equaliza-tion, of which we shall have more to say.While governments have obviously been involved in thesesorts of things for a long time, economists are only now coming torecognize the legitimate role to be played by social insurance andthe provision of public services alongside income-based transfers asredistributive instruments. Until recently, the general view was thatincome transfers were inherently superior to transfers in kind; and,social insurance schemes were justified by standard efficiency-basedmarket failure arguments. However, the ‘new public economics’ isnow very much cognizant of the fact that redistributive (i.e. social)policy is multi-faceted. This is an important change in perspective,for it suddenly implies that much of what governments do is redis-tributive in nature. Moreover, much more redistribution is accom-626plished through the expenditure side than through the tax side of thebudget. Contrary to the classical view of market failure that domi-nated the literature for so long, it seems quite reasonable to viewgovernments as largely being institutions for achieving collectiveequity goals rather than as being instruments for correcting marketfailure.Moreover, we need not necessarily bemoan the fact that rela-tively little redistribution seems to get done through the progressivetax-transfer system. Nor ought we to expect more redistribution tobe done in that way. The fact is that far more redistribution gets donethrough the provision of public services and social insurance, andthat is probably the way that it should be.The fact that redistributive or social policy is seen to consistof many components renders policy-making difficult. Every policydepends on other policies, and policy coordination becomes impor-tant to the success of the overall package. In a federation, the prob-lem becomes even more difficult.  For one thing, the assignment ofresponsibility for redistributive policy is not an easy matter, espe-cially since virtually all policies of significance have redistributiveconsequences. For another, different instruments of redistributivepolicy may have been assigned to different levels of government.Ultimately, the responsibility for redistributive equity will be sharedbetween levels of government. Not only does this cause problems ofcoordination, it also constrains each level of government in achiev-ing its redistributive goals, and may induce them to undertake non-optimal policies.These problems are particularly acute in Canada, where thefederation is highly decentralized by international standards. Manyof the instruments for redistribution are in areas of exclusive provin-cial legislative responsibility. Yet, the federal government retainsmajor responsibility for redistributive equity. The one possible wayout of this dilemma is through the imaginative use of the federal-provincial fiscal arrangements.  That is a topic explored in this pa-per.The argument is that as the federation becomes more decen-tralized as a natural and legitimate consequence of rationalizing the627Robin Boadwaydelivery of public services, the fiscal arrangements should assumegreater and greater importance. They are the only means by whichthe federal government can insure that national objectives of effi-ciency and equity are maintained.  Instead, precisely the oppositehas been allowed to occur. The fiscal arrangements have been al-lowed to deteriorate both in size and in design to the point where theability of the federal government to pursue its proper objectives hasbeen dangerously eroded, perhaps irreversibly. We consider someconsequences of that erosion.III. Roles of the Federal and Provincial Government in SocialPolicyA key to making progress in social policy is to sort out which levelof government is responsible for what. Since virtually everythinggovernments do has redistributive dimensions to it, that is not aneasy task.  Economists who study these things, and they constitute arelatively small number, have typically argued that in a federation,the federal government ought to have an overriding interest in redis-tributive equity on the grounds that citizenship in a country shouldimply that everyone has the same weight in society’s ‘social welfareordering’ regardless of where they reside. If one accepts that view,the implication is that there is a national equity objective of whichthe federal government must be steward.This objective would have a vertical equity dimension as wellas a horizontal equity dimension to it. The vertical equity dimensionwould involve norms of redistribution from the better-off to the lesswell-off, where relative well-being depends upon not only ability topay, but also other indices of well-being such as health status or dis-ability. Vertical equity also includes the notion of equality of oppor-tunity. Horizontal equity involves seeing that otherwise-equal citi-zens should be treated equally by the public sector broadly defined,regardless of where they reside.At the same time, there are very strong and widely acceptedeconomic reasons for decentralizing to the provincial level the re-sponsibility for the design and delivery of public services that serve628individual citizens.  The reasons include:(1) Cost effectiveness and the reduction of a layer of bureaucracy;(2) Ability to cater to local differences in need, cost and preferences;(3) Incentives to innovate in service provision;(4) Beneficial effects of inter-provincial competition;(5) Reduction in monitoring and agency costs involved in deliveringservices at the local level.Given the decentralization in fiscal responsibilities that thisentails, there is naturally scope for provinces to engage in their ownredistributive policies within their own borders. Purely provincialprograms can lead to a patchwork of programs that violate nationalstandards of equity and also induce distortions in the nationaleconomy.  For example, provinces might impose residency require-ments (like countries do) on the access to public services; they mightcompete with one another to attract high-income residents and dis-courage low-income residents; and they might have widely differingcapacities to provide public services. Given that the provision ofpublic services represents one of the major ways in which objectivesof social policy are achieved, the federal government obviously hasa great interest in the design of these programs, and in ensuring thatthey contribute to national equity objectives and do not violate effi-ciency in the internal economic union.Obviously there is scope for tension between the two levelsof government, this being greater the more do the two levels conflictin terms of the desired degrees, and forms of redistribution, and themore decentralized is the federation from a fiscal point of view. Partof the role of the fiscal arrangements is to facilitate the harmoniousco-existence of decentralized decision-making while at the same timeallowing the federal government to pursue its national efficiency andequity objectives.In the post-war period, as the welfare state has developedand reached maturity, the federal fiscal system in Canada has cometo conform broadly with this notion of the ideal division of responsi-bilities. The provinces are largely responsible for the delivery of publicservices as well as for their financing, especially at the margin whereit is more important. The federal government, through the fiscal ar-629Robin Boadwayrangements, has been able to maintain a satisfactory degree of na-tional horizontal equity through its system of federal-provincial trans-fers (Equalization, EPF and CAP). It has been able to implement areasonably uniform amount of progressivity in the tax-transfer sys-tem through its control of the income tax base and rate structure, andits participation in the field of transfers to persons.  And, there hasbeen a reasonable amount of harmonization among provinces in theprovision of public services like health and welfare, owing to thesystem of federal-provincial transfers, and the use of the spendingpower to encourage provinces to maintain certain minimal nationalstandards. In short, the system has evolved to one in which the re-sponsibility for delivery of many major public services is decentral-ized, while at the same time the system of fiscal arrangements isused imaginatively to offset those inefficiencies and inequities thatare a natural consequence of decentralization. Nonetheless, the sys-tem is not perfect, and some cracks are not only beginning to showbut are becoming wider. I return to this shortly.In looking at the ability and responsibility of the federal gov-ernment to pursue national equity and efficiency goals, and in par-ticular to ensure that social policies conform to these norms to anacceptable extent, it is worth looking briefly to what the Canadianconstitution has to offer.  Surprisingly few colleagues in my disci-pline, even those who dabble in fiscal federalism, are informed aboutthis. The basic responsibilities of the federal and provincial govern-ments are clearly enunciated in the Constitution Act as revised in1982. For the purposes of social policy, the most important featuresof these responsibilities are as follows.(1) Provincial Responsibility for Health and Education Programs:The provinces are given “exclusive” legislative responsibility forprograms in areas such as health and education (Section 92), andarguably for welfare services as well. Indeed, by virtue of provincialresponsibility for civil and property rights, the provinces can be takento be legislatively responsible for almost any public service to beprovided to individuals. Thus, to take a current example, day-careservices might be considered a provincial responsibility, as would630be others that might become relevant in the future. This means thatalmost all public services whose objective is redistributive equity,and which therefore are part of social policy, are the exclusive legis-lative responsibility of the provinces. This poses a serious questionfor the role of the federal government in the implementation of na-tional social policies, a question that is mentioned but not resolvedby the recent federal Green Paper.(2) The Joint Responsibility for Equity: The constitutional amend-ments of 1982 are best known for repatriating the constitution andimplementing a Charter of Rights albeit without the approval of theQuebec legislature. For our purposes, the package also contains someimportant provisions. Section 36(1), clearly states that both levels ofgovernment are jointly committed to at least part of the national eq-uity agenda, including providing equal opportunities, reducing dis-parities and providing essential public services to all Canadians. Weinterpret this provision, though it may be more a guiding principlethan a binding obligation, as providing support to the federalgovernment’s interest in the delivery of public services that are es-sential or that serve to equalize opportunities and reduce disparities.While on the surface, this might seem to be an obligation that is indirect contradiction to provincial exclusive legislative responsibil-ity, in fact the two provisions can be reconciled by the use of thefiscal arrangements, of which one facet is the following.(3) The Federal Spending Power: An extremely important federalpolicy instrument not mentioned explicitly but generally regarded asbeing constitutionally sanctioned is the so-called spending power. Ahigh proportion of federal government expenditures consist of trans-fers not only to other governments, but also to persons and busi-nesses, and reflect the exercise of this power. What is particularlyrelevant is that the spending power enables the federal governmentto make transfers to the provinces conditional on the way in whichthe provinces spend the moneys, even though the spending is in anarea of exclusive provincial jurisdiction. This will be of obvious rel-evance for our discussion on social policy since the spending power631Robin Boadwayis the only federal policy instrument available for achieving the ob-jectives set out in Section 36(1).  The spending power is what recon-ciles the joint federal-provincial responsibility for achieving equitythrough the provision of public services with exclusive provincialresponsibility.(4) The Federal Equalization Commitment: Complementary to thejoint commitment for providing essential public services and equalopportunities is the commitment imposed upon the federal govern-ment in Section 36(2) to make equalization payments to ensure thatall provinces can provide reasonably comparable public services atreasonable comparable tax rates. This can be viewed as a commit-ment to national ‘horizontal’ equity, that is, the principle that identi-cal persons should be treated equally by the public sector as a wholeregardless of where they reside.  The provisions of Section 36 maynot be justiciable; that is, the federal government cannot be forcedby the courts to act on them. Nonetheless, they can be interpreted asnot only committing the federal government to the principle of pur-suing national equity objectives, but also providing a powerful sanc-tion to the federal government to do so through such methods as thespending power.(5) Tax Authority: The federal government has unrestricted use ofthe tax system (with the possible exception of the taxation of naturalresources, a restriction that is of limited relevance for social policy).This implies that the federal government is not restricted in principlein achieving those equity goals that it can through progressive taxa-tion. However, since the provinces also occupy the direct tax fields,federal redistributive tax objectives could be thwarted to the extentthat provinces adopt independent and conflicting income tax sys-tems.  This becomes more likely the more income tax room the prov-inces occupy relative to the federal government.(6) Pensions and Unemployment Insurance: The notable exceptionsto the above are in the areas of pensions and unemployment insur-ance (UI). By constitutional amendment, the federal government632acquired the right to legislate in these areas. In the case of UI, theyassumed exclusive responsibility. However, in the area of pensions,there was to be joint occupancy, though with provincial paramountcy.(7) Internal Common Market. Though social policy is obviously eq-uity-oriented in objective, issues of national efficiency naturally arise.Economists especially put particular emphasis on fostering efficiencyin the internal common market, which includes ensuring the free andundistorted flow of labour, capital, goods and services within thenational economy. While it is commonly agreed that this is an im-portant national objective, it is nowhere explicitly stated in the Con-stitution Act, except to a very limited extent in Section 121 whichrules out inter-provincial barriers to trade in goods alone. It could betaken to be one of the natural components of Peace, Order and GoodGovernment that is mentioned in the Preamble to Section 91 as asuitable objective for federal legislation. The desire to foster the in-ternal common market can lead the federal government to pursuepolicies that lead to the harmonization of provincial service provi-sion so that provinces do not engage in wasteful and distortionaryprogram competition with one another, or at least so that any nega-tive consequences for the internal common market from healthy in-ter-provincial competition are offset. Again, the spending power isthe only instrument available to the federal government for this pur-pose. In principle, it can be used to provide financial incentives tothe provinces to take account of national equity and efficiency ob-jective in designing their programs. The criteria imposed by theCanada Health Act, 1984 are examples of this. Some of them are forequity reasons (e.g., accessibility), and some for efficiency (e.g.,portability of benefits).We can summarize this discussion of the allocation of re-sponsibilities.  The federal government has responsibility for objec-tives of a national nature, and these presumably imply both nationalequity and national efficiency objectives. The Canadian constitutionexplicitly recognizes the federal interest in equity in Section 36. Atthe same time, the federal government does not have direct access to633Robin Boadwayall the policy instruments necessary to achieve either national equityor national efficiency. Quite reasonably, the responsibility for pro-viding most public services that serve redistributive ends are the ex-clusive responsibility of the provinces. This decentralization of pub-lic service provision is in accord with federalism theory. However, itdoes pose an important dilemma for the federal government. Howcan it begin to achieve its legitimate social policy objectives whenmany of the instruments for doing so are in the hands of the prov-inces? The answer is clear: it can only do so with the use of thespending power. Otherwise, a national social policy is out of reach,and one must rely entirely on the provinces to accomplish socialpolicy objectives. And, given the geographical interests that the pro-vincial governments represent, even the most well-meaning behav-iour by decentralized provincial decision-makers is likely to violatenational norms of equity and efficiency. Thus, what becomes criticalin evaluating the fiscal arrangements as instruments for social policyis ensuring that the scope of the spending power is sufficient forachieving national objectives. It is almost as simple as that.One interesting case in which the provinces participate insocial policy without enjoying exclusive constitutional jurisdictionis in the area of social assistance (welfare payments as opposed toservices). The provinces are the sole occupants of welfare programs,albeit with a significant financial contribution by the federal govern-ment. This is not a constitutional requirement, but a matter of prac-tice, though not necessarily one that economics would advocate. Thefederal government through its spending power could as well imple-ment national welfare assistance programs; indeed, it could be saidto do so in part through the unemployment insurance system. It isuseful to remember this as we investigate options for the future be-low.IV. Suitability of the Existing Federal Fiscal System for Address-ing Social Policy IssuesIn this section, we review some of the features of the way in whichthe fiscal arrangements have evolved in recent years with a view to634evaluating their suitability as a system for supporting effective so-cial policy.The deficiencies of Canada’s social policy system have beenwell-documented, and proposals for reforming it have been frequentlymade, the federal Green Paper only representing the most recent,and perhaps least sweeping, of these. Perhaps the most comprehen-sive review was that of the Macdonald Royal Commission on TheEconomic Union and Development Prospects for the CanadianEconomy some ten years ago. We need not go over that ground again.For our purposes, it is worth observing the tendency in many of theseexercises to ignore both the real constraints and the real opportuni-ties resulting from the fact of federalism. For example, the GreenPaper dealt essentially with three of the many areas of social policies— unemployment insurance, post-secondary education and welfare.In each case, among the reforms addressed were those that by theConstitution or by accepted convention probably required provin-cial enactment. This is clearest in the case of welfare reforms, espe-cially those dealing with the provision of services to the poor ratherthan cash transfers. It is also true for post-secondary education; ameaningful system of income-contingent loans or of other mecha-nisms for inducing choice in publicly-supported education, such asvouchers, realistically requires legislation at the provincial level. EvenUI reforms may require the concurrence of provincial legislators tothe extent that it involves the use of training facilities. Yet there wasno indication how the federal government would induce provincesto engage in the proposed reforms.One such vehicle is the system of ‘fiscal arrangements.’ Thefiscal arrangements include a wide variety of forms of fiscal interac-tion between the federal government and the provinces. For our pur-poses, we concentrate on two main components: the major federal-provincial transfers and the system of tax harmonization. The formof both of these are critical in facilitating a coherent national socialpolicy. The major transfers include Equalization, Established Pro-grams Financing (EPF) and the Canada Assistance Plan (CAP). Thesystem of tax harmonization currently involves mainly the Tax Col-lection Agreements negotiated between the federal government and635Robin Boadwaythe participating provinces for the individual and corporation incometaxes. Its scope could potentially be widened to, say, sales taxes.All of these programs have been in place for a long time,despite some fairly significant and largely irreversible changes thathave occurred in the fiscal relationship facing the federal govern-ment and the provinces.  Most of these changes have been gradual,most have occurred without any conscious effort to manage or influ-ence them, and most are virtually irreversible. Some of the mostimportant changes that have occurred are the following.Growth of Provincial Expenditure Responsibilities. Those expendi-ture responsibilities that are growing most rapidly (e.g., health, edu-cation, welfare) are at the provincial level. In fact, the provinces havelong since overtaken the federal government in terms of programexpenditures, as well as in terms of expenditures on goods and ser-vices. For example, federal program spending (excluding inter-gov-ernmental transfers) is now only 4/5 of provincial program spend-ing; in the early 1960s, it was over 1-1/2 times larger. Even morestriking, federal spending on goods and services was 2-1/2 timesthat of the provinces in 1961; today it is only 70% of the provinces’.Moreover, the form of federal and provincial expenditures differconsiderably. While a high proportion of federal expenditures is ontransfers of various sorts (over 2/3 of program expenditures), pro-vincial expenditures involve a higher proportion on the provision ofgoods and services, many of them public services related to socialpolicy (about 2/3 of provincial and municipal program expendituresare on goods and services).Provincial Government Self-Reliance. At the same time as provin-cial expenditure responsibilities have grown, so too has their reli-ance on own-source revenues; that is, the vertical fiscal gap hasshrunk. For example, Nova Scotia and New Brunswick now receivejust over 1/3 of their revenues from transfers, compared with about1/2 in 1970. Similarly, Alberta receives about 14% now comparedwith 24% in 1970. And, British Columbia receives 11% now, thelowest in Canada, compared with about 18% in 1970. Thus, the fis-636cal system is becoming more decentralized as time passes. This en-tails not only reduced reliance on federal transfers, and therefore areduction in the opportunity for the federal government to influenceprovincial expenditure programs, but also an increase in the share oftax room occupied by the provinces. The latter implies that it may bemore difficult to maintain the effective system of income tax harmo-nization that we enjoy. Under the existing system of fiscal arrange-ments, the trend to provincial self-reliance is bound to increase sincemost of the transfers grow at a rate significantly less than the rate ofgrowth of provincial expenditures. However, federal policies them-selves has served to exacerbate the trend.Federal Deficit-Reduction Policies. The federal government has anobvious debt problem, and it is not surprising that reductions in trans-fers to the provinces have often been used as part of a deficit-reduc-tion strategy. The problem is that this transfer of the deficit to theprovinces, whatever its benefit in terms of inducing provinces tobecome more cost-effective, has longer run consequences from thepoint of view of federal-provincial fiscal arrangements. By cedingfurther fiscal room to the provinces, it reduces, in an almost irrevers-ible way, the remaining ability the federal government has to play apart in achieving national equity and efficiency goals. As the federa-tion becomes more and more decentralized, the role of the fiscal ar-rangements in achieving national economic objectives becomes morerather than less important.Tax Reform. The ability of the federal government to achieve na-tional equity and efficiency objectives may have been further com-promised by recent federal tax reforms. As with deficit reduction,these were undertaken seemingly without being unduly troubled bythe resulting consequences for fiscal federalism. The particular com-ponent of the tax reform that is most troubling from this perspectiveis the introduction of the GST. Most economists would heartily agreethat as indirect taxes go, this is a good tax. The documentation thatFinance Canada produced to accompany and justify its implementa-tion were by economic standards well-argued and reflected state-of-637Robin Boadwaythe-art thinking in the tax reform area.  However, the case for theGST was predicated on the presumption that the federal governmentneeded as part of its tax menu a general sales tax. Once the fiscalarrangements are taken into account, additional considerations arise.The main one is that the more revenue the federal government ob-tains from the GST, the less it will need from the income tax.  Therewill necessarily be a shift over time of income tax room in favour ofthe provinces, and this shift will be larger the more the federal gov-ernment comes to rely on the GST for its revenues. The upshot willbe less federal presence in the income tax, and a lesser chance ofmaintaining a harmonized system. The fact is that, given the extentof decentralization in Canada’s federal system, the federal govern-ment can dominate at most one tax base. With the implementation ofthe GST, it likely reduces its ability to dominate the income tax andtherefore threatens the continued viability of income tax harmoniza-tion (which is one of the instrument for achieving national equityand efficiency).Inter-Governmental Co-ordination Problems. Fiscal decentralizationhas many beneficial effects. However, it is a two-edged sword. Poli-cies taken by different levels of government can be in conflict; and,inter-jurisdictional competition can have distortionary effects on eco-nomic activity. Moreover, the assignment of responsibilities itselfcan induce conflicting behaviour. Examples of these sorts of prob-lems abound. At the federal level, the single most distorting policyfrom an economic point of view is undoubtedly UI. The problemseems to be that the federal government uses it not just as a socialinsurance system, but also as one of income support. A cogent rea-son for this is that, since welfare is a provincial responsibility, UI isthe next-best instrument that the federal government has available toit to pursue social assistance-type policies.  For their part, the prov-inces systematically undertake policies partly designed to exploit thefederal UI system, such as by funding short-term work or trainingschemes for persons who might otherwise draw welfare cheques.Inter-provincial competition has been alleged to have had beggar-thy-neighbour components to it in the welfare field, in bidding for638industry, and in access to post-secondary institutions by out-of-prov-ince students, examples that are all close to home here in B.C.These various events have changed the nature of the federa-tion immensely over the past two decades. There is evidence thatthis gradual decentralization is being increasingly accompanied bystrains within the federation. Policies being undertaken by differentlevels of government are more and more coming into conflict (e.g.,the federal unemployment insurance system with provincial welfareprograms, and the tendency for provinces to exploit the former). Prov-inces are engaging in forms of inter-provincial competition that havebeggar-thy-neighbour aspects to them — bidding for industry, tink-ering with welfare programs, restricting access to post-secondaryeducation programs to out-of-province students, etc. The income taxsystem is becoming increasing fragmented as provinces implementever-increasing numbers of exemptions, special incentives, and spe-cial tax bases. And, concern escalates over the federal governmenttendency to act unilaterally and without notice to the provinces inareas of transfers to the provinces as well as tax reforms that affectprovincial budgets. In short, the federation is becoming morebalkanized as it becomes more decentralized, and it is happeningwith scant regard being given to the longer-term consequences forthe federation, especially the increasing inability of the federal gov-ernment to use the spending power to encourage national standards.The major components of the fiscal arrangements themselvesare under some strain. This is due to a combination of neglect (mostof the programs have been unchanged structurally since they wereintroduced), piecemeal changes in response to events, and fiscal exi-gencies. It is worth looking briefly at each component in turn to iden-tify some of the major problems facing them. It will be difficult toimagine a successful social policy reform process in the absence ofrationalizing the system of fiscal arrangements, especially given thattheir purpose is largely to support the achievement of redistributiveequity.639Robin Boadway1. EqualizationThe Equalization scheme is the heart of the system of fiscal arrange-ments.  It is also the program whose design most closely suits itsobjective, and is the one that probably commands the most publicsupport. The purpose of Equalization is to fulfill the commitmentenunciated in Section 36(2) of the Constitution Act, which is to en-able provinces to be able to provide reasonably comparable publicservices at reasonably comparable tax rates. In a decentralized fed-eration, equalization is necessary to achieve both fiscal efficiencyand equity, and is thus an indispensable tool of the federal govern-ment. It enables provinces to have the tax capacity to be able to fi-nance some minimal level of social programs, and thus contributesimmensely to a national social policy.Though Equalization largely succeeds in its objective, it doesnot do so perfectly; nor is it the only policy instrument that contrib-utes to that objective. The main drawbacks to the current Equaliza-tion system are well-known, though they are largely matters of pro-gram design. Because the system is a net one, it equalizes the have-not provinces up, but does not equalize the have provinces down (atleast directly). It is based on a five-province standard rather than anational-average standard. While this may not make much differ-ence on average, it does have some odd effects in certain areas, espe-cially oil and gas revenues; for example, it effectively taxes new oiland gas revenues received by have-not provinces at confiscatory rates.It is also subject to a cap on growth that detracts from its effective-ness. These have been relatively minor defects. In fact, the existingsystem succeeds in equalizing the tax capacities of the have-not prov-inces up to over 95% of the national average.Perhaps a more serious shortcoming is the fact that it con-centrates only on tax capacity differences and neglects other sourcesof fiscal capacity difference such as different needs for public ser-vices across provinces.  This might be thought of as a potentiallyserious limitation of the program, given especially the significantdifferences in demographic make-up among provinces that translateinto different needs for things like education and health expendi-640tures. Any equalization that occurs on account of need does so throughmatching grants, and that is limited mainly to CAP.It is important to recognize not only what Equalization is in-tended to do, but also what it is not intended to do. It is a program forequalizing potential access to public services. It is not meant to be aninstrument for income redistribution. The common argument that‘people’ prosperity ought to supersede ‘place’ prosperity in design-ing government redistributive programs seems to be partly based onconfusion about the intention of equalization. Of necessity, it mustbe a transfer based on provinces since its purpose is to ensure that ina decentralized federation, different provinces are in fact able to pro-vide comparable public services at comparable tax rates. It is a pur-pose that is well-grounded in economic theory, as well as being aprinciple found in the constitution.2. Established Programs Financing (EPF)On the surface of it, EPF is a simple equal per capita block grant tothe provinces to support their expenditure responsibilities in the ar-eas of health and post-secondary education. As such, it is a usefulcomplement to Equalization, since by collecting federal taxes na-tionwide using the federal tax system and redistributing them on anequal per capita basis across provinces, it is a form of equalization.To that extent, it can be seen as a part of the means by which thefederal government satisfies its constitutional equalization commit-ment. At the same time, although it is a block grant, the paymentsare made with conditions attached. To be fully eligible to receivethem, provinces must maintain publicly administered health insur-ance systems that satisfy the criteria set out in the Canada HealthAct, most of which are carried over from the earlier medicare legis-lation of the mid-1960s. These include comprehensiveness of ser-vices, universality of coverage, accessibility and portability.  Prov-inces that fail to adhere to these minimum national standards may bepenalized by the federal government by having their grants reduced;to date, no such penalties have been imposed. As well, there are pen-alties for provinces that engage in extra billing and charge user fees.641Robin BoadwayI would not wish to defend the particular form of these con-ditions.  However, to my mind, these sorts of general conditions areprecisely the kinds of exercise of the spending power that are consis-tent with the notion of a federation that is decentralized in terms ofservice delivery and yet has incentives in place to induce provincesto deliver services in a way that is compatible with national stan-dards of equity and efficiency. Each of the general conditions couldbe rationalized in these terms. Yet they leave the provinces plenty ofscope for innovations uniqueness in service provision. In my mind,it is a model use of the spending power that one might contemplateapplying in other areas, such as education, welfare, day care, andtraining. Indeed, one might even argue that federation would be ex-tremely well-served if UI were decentralized to the provinces, butpartly financed by block grants with general conditions attached.At the same time, there are some fundamental problems withthe EPF system that threaten its very existence. The problems withthe EPF system arise from the two main features in its structure.First, the overall rate of growth of EPF transfers is limited to theannual growth rate of GDP, and in fact it has been temporarily re-duced even further in the past two decades in response to variousfederal government expenditure restraint efforts. This limitation ongrowth in EPF transfers in itself ensures that provinces must financehigher and higher proportions of their own expenditures in healthand post-secondary education, since both grow more rapidly thanEPF receipts.The second structural feature is even more consequential, andthat is that the EPF transfer as originally instituted in 1977 was di-vided between a cash transfer and a tax-point transfer component. Atthe time, the division was such that about half the ‘transfer’ was intax points and the other half in cash. Since then, because the value ofthe tax transfer has grown more rapidly that that of the overall en-titlement, the residual cash component has gradually fallen. It is dueto disappear entirely early next century. (Indeed, it will disappearmuch sooner for Quebec because more tax points were transferred toit in 1977. What happens when Quebec incurs a negative cash en-titlement is an open question.) As a result, the lever available to the642federal government for enforcing the conditions of the Canada HealthAct, or for encouraging provinces to adopt national standards in otherareas of expenditure will have been lost. For example, minimumnational standards in the area of post-secondary education, such asprohibitions on residency requirements or on out-of-province feedifferentials, will be difficult to implement.The inclusion of the tax-transfer component as part of theEPF transfer has always been anomalous, and becomes more so astime goes by. The fact is that once the tax points were turned over tothe provinces, they became part of the provinces’ own-source rev-enues for all intents and purposes.  The federal government lost com-plete control over those funds. Despite that, it continues to report theEPF transfer as including both the tax-transfer and the cash compo-nent, a practice that is more than a bit misleading. More than that, ithas become mischievous. Because the tax-transfer is allowed to en-ter the EPF cash calculation, and because the (equalized) tax-pointtransfer is worth different amounts to different provinces (becauseof both the gross nature of the Equalization scheme and the fact thatQuebec received more tax points than the rest of the provinces), theamount of cash that is paid to the have provinces (and to Quebec)differs in per capita terms from that paid to the have-not provinces.Moreover, the use of tax points alongside cash transfers in the origi-nal EPF transfer also directly contributed to the decentralization ofincome tax room to the provinces, a decentralization that couldthreaten the integrity of income tax harmonization.3. Canada Assistance Plan (CAP)The CAP remains the only significant matching grant program in theCanadian system. Provincial social service operating costs and so-cial assistance are shared 50-50 by the federal government. An ex-ception to this is the arbitrary limit currently imposed on the amounttransferred to the three have provinces (including B.C.), the so-called‘cap on CAP.’ For them, the transfer is effectively a lump-sum con-ditional grant as long as the cap is binding. CAP is also an obviouslyimportant program from the point of view of social policy reform643Robin Boadwayand was the subject of one of the thrusts of the federal Green Paper,despite welfare being a provincially exercised legislative power.There are two relevant aspects of CAP. One is the 50% match-ing rate, which has been widely criticized in economic policy circles.A standard justification given for the matching form of the CAP is tointernalize for spillovers arising from the fact that welfare recipientsmay be mobile among provinces.  Legitimate though this argumentmay be in qualitative terms, it is unlikely to be able to support full50-50 cost sharing; that would imply an enormous externality effect.An alternative argument for cost sharing is a more cogentone. It is that basing CAP on actual costs incurred in provincial wel-fare systems acts as a complement to equalization, effectively incor-porating differences in need into the system of fiscal transfers. Thus,it has allowed provinces to be able to provide more comparable lev-els of welfare systems despite the great differences in relative num-bers of recipients. The trouble is that, unlike the Equalization systemitself, it does so in a way that imposes potentially strong incentiveeffects on the provinces. The lure of 50 cent dollars are a clear in-ducement for provinces to overspend. The usual argument for in-cluding need factors in equalization systems calls for doing so usingindicators of potential need rather than actual expenditures.  Exampleswould include numbers of welfare recipients or demographic indica-tors.The second aspect of CAP are the conditions imposed on theprovinces for the receipt of funds. Though these are minimal, theyhave served to introduce some national standards into provincialwelfare schemes, such as the absence of residency requirements, thestipulation that the only eligibility requirement be need and the re-quirement that the basic needs of recipients be adequately met. Prov-inces have argued that these conditions have constrained them frompursuing certain strategies in their welfare programs, such as open-ing it to the working poor, integrating it with the income tax systemor requiring work from recipients. To the extent that this is true, it ismore a statement about the specific types of conditions that wereimposed in 1966 rather than the principle of imposing conditions tomaintain national standards per se.644These two aspects of conditionality in CAP, the cost-sharingcomponent and the imposition of minimal standards, are logicallyquite separate. It has long been argued that the sharing componentought to be dispensed with and the conditionality retained (and per-haps rationalized). This could be accomplished by transforming CAPinto a block grant along the lines of EPF, while retaining criteria forthe full receipt of funding. The distribution of funds across prov-inces need not be equal per capita; they could incorporate some ele-ment of need. The point is that some element of conditionality wouldseem to be the only way in which the federal government accom-plish national objectives in the welfare area, given the responsibilitythe provinces have for legislating there.(As an aside, one of the interesting consequences of the con-stitutional reform debate leading to the Charlottetown Accord wasthe seemingly broad consensus that existed among Canadians forthere to be national standards imposed on various social programs,at least partly to avoid them being eroded. Of course, the same peopleseemed to show some distaste for the use of the federal spendingpower. We would argue that these two attitudes are fundamentallycontradictory.)4. Tax Harmonization and CoordinationThe Canadian system of income tax harmonization has been a modellooked up to in other federations. It has combined the uniformity ofbase and rate structure, a single tax collection authority, and provin-cial discretion over rate levels. In other words, it has allowed fornational standards of equity, simplicity in terms of compliance andcollection costs, and fiscal responsibility at the provincial level. It isalso this system of harmonization that allows the income tax systemto be used as a vehicle for rearranging tax points between the federalgovernment and the provinces, and facilitates the use of equalizationbased on tax capacity.However, such a system is probably only sustainable as longas the federal government retains a significant share of the tax room.The less tax room does the federal government have, the more do the645Robin Boadwayprovinces wish to impose their own policies through the income taxsystem, and the less likely is it that the main features of harmoniza-tion are retained. As we have mentioned above, there has been agradual but persistent reallocation of fiscal responsibilities in favourof the provinces. This has resulted in the provinces occupying moreand more income tax room relative to the federal government.Whereas less that 10% of income taxes were collected by the prov-inces in 1961, they now collect well over 40%. Moreover, with theinstitution of the GST and with federal deficit-reduction policy partlytaking the form of restricting transfers to the provinces, this trend isbeing exacerbated.Not surprisingly, the result has been to erode the system oftax harmonization. The number of provincial tax measures (credits,exemptions, etc.) has increased dramatically as the provinces try toimplement their own policy interests through the income tax system.Many of these measures serve to distort the internal common marketas well as possibly violating national equity norms. Moreover, someprovinces, especially those in western Canada, are now floating theidea of withdrawing from the income tax collection agreements. Pres-sure for these sentiments is bound to rise if the federation continuesto evolve in a fiscally decentralizing way as it has in the past twodecades.Nor has the reduction in income tax harmonization been com-pensated for by an increase in sales tax harmonization. Only Quebechas undertaken a partial form of harmonization of its retail sales taxwith the federal GST.  However, even if sales tax harmonizationwere the norm, it could not compensate for the loss of income taxharmonization. The gains from income tax harmonization in termsof equity and efficiency outweigh considerably those from sales taxharmonization. As we argued earlier, the principles of federalismwould suggest that if the federal government can choose only onetax type to dominate, it should choose the income tax rather than thesale tax. The Carter Commission had it correct thirty years ago whenit argued that the federal government ought to have vacated the salestax field entirely in favour of the provinces, and concentrated in-stead on the income tax.646To summarize this section, the fiscal arrangements, whichrepresent an essential federal instrument for the pursuit of social policyobjectives, have been allowed to deteriorate dangerously in Canada,arguably to the point where the federal government is no longer ableto pursue its legitimate objectives of national equity and efficiency.The relevance of the fiscal arrangements becomes more and moreimportant the more decentralized is the federation. The Canadianfederation has become very decentralized, yet the fiscal arrangementsare virtually unchanged in form since their various components werefirst introduced. Though they have served us well, they are no longersuitable for supporting the sorts of national social and economic poli-cies that Canadians seem now to be demanding.V. Options for Policy and PracticeThe upshot of our discussion is that, given the responsibility of thefederal government for equalization and the shared responsibilitywith the provinces for the provision of adequate public services andensuring equality of opportunity, given the federal responsibility formaintaining efficiency in the internal economic union, and given thatthe provinces have exclusive legislative responsibility for the provi-sion of many key public services, the fiscal arrangements representone of the few policy instruments available to the federal govern-ment for pursuing national efficiency and equity objectives. Of thethree major roles the fiscal arrangements perform — equalization,the use of the spending power to encourage national standards andtax harmonization — only equalization remains on solid footing. Asa consequence, the ability of the federal government to assume itsresponsibility for social policy broadly defined is now in jeopardy.Given the pressing constraints imposed by the large stock of accu-mulated debt at the federal level, what options are available?At least in the short run, options are limited by the fiscal prob-lems of the federal government. There are essentially two options.Which of the two you prefer is largely a matter of individual values.More specifically, it depends upon whether you accept the majorpremise outlined earlier — that the federal government has a legiti-647Robin Boadwaymate role to play, as stated in the constitution, in pursuing nationalstandards of redistributive equity or social justice. If you do not sub-scribe to this premise, your preferred option will be to let events taketheir course. If you do subscribe to the major premise, you will pre-fer that policies be undertaken to both rationalize the existing systemand forestall it decline. Let us consider the options in turn.OPTION A: Let Events Take Their courseIn this case, the federal government would oversee the gradual oraccelerated demise of the system of transfers to the provinces. Indoing so, the consequences of federal fiscal actions for the fiscalarrangements and fiscal federalism more generally are simply not anissue. Letting events take their course could entail, among other things,keeping the cap on Equalization; continuing to let tax points counttowards EPF transfers thereby letting the cash component run downto zero; turning CAP into a block grant and reduce its rate of growth;amalgamating EPF and CAP into a single block grant and letting itrun down by allowing it to be eroded by tax points; removing orwatering down conditions in EPF and CAP; accelerating the runningdown of the cash transfer by cutting the size of federal transfers un-der EPF and CAP as part of the deficit reduction process; removingthe post-secondary education component from EPF cash transfers,and converting them to a student loan program. As a result of thesemeasure, the federal government will come to occupy less and lessof the income tax room.The consequences of this for the federation and for the abil-ity of the federal government to implement social policy would be asfollows: the federation will become more fiscally decentralized, withthe provinces even becoming more self-reliant and fiscally account-able. The federal government will become less able to fulfill the prin-ciple of joint responsibility for those aspects of redistributive equityas outlined in Section 36(1) of the Constitution Act, or more gener-ally to participate in broad social policy reforms. The use of the spend-ing power would be suspended, perhaps irreversibly, thus placatingQuebec and perhaps other provinces as well. Provincial public ser-648vice provision would become more balkanized, thereby further ren-dering the principles of Section 36(1) more difficult to achieve. Thesystem of income tax harmonization would be placed in further jeop-ardy with adverse consequences for the internal common market andfor vertical equity within the federation, while provinces are betterable to implement tax policies to meet provincial objectives. And,the system of Equalization would be more difficult to maintain sincefiscal decentralization leads to greater divergences in provincial fis-cal capacities. Of course, from a fiscal management point of view,federal deficit reduction would be made easier by the ability to usecuts in transfers to the provinces freely. At the same time, there isless pressure to rationalize the main federal social programs — un-employment insurance and pensions. But, more generally, there wouldbe a virtual end to the system of fiscal federalism as we know it.OPTION B: Forestalling Further DeclineThis option would involve the federal government taking action toprevent the vertical fiscal gap from reducing further, maintaining itsability to use the spending power, and keeping its share of incomeroom intact. Whatever ability still exists to pursue national socialpolicy objectives would be preserved, essentially buying time for amore considered reform of the system of fiscal arrangements.Policies that would be compatible with this objective wouldinclude: removing tax points as a component of EPF and allowingthe cash component to rise with GDP over time; maintaining generalconditions on the use of EPF funds, though not necessarily thosecurrently in place (e.g., penalties for extra billing and/or user fees);converting CAP into a block grant program, maintaining (or improv-ing) national criteria as conditions for full funding, and allocatingthe funds by province using need considerations (whether or not it isamalgamated with EPF is of relatively little concern, except to theextent that it increases the strength of the spending power); avoidingthe reduction of transfers to the provinces as part of a federal deficitreduction strategy; retaining the federal government’s share of in-come tax room; and rationalizing social policies delivered by the649Robin Boadwayfederal government.The consequences of this for the ability of the federal gov-ernment to deliver social policy would be to retain the, perhaps lim-ited, ability of the federal government to achieve the principles enun-ciated in Section 36 of the Constitution Act through Equalizationand the use of the spending power. As well, the erosion of the abilityof the federal government to maintain the system of income tax har-monization would be arrested. At the same time, the ability of thefederal government to cut the deficit by relying on expenditure cutswould be made more difficult, and it would have more incentive torationalize its own social programs.  Most important, this holdingaction would buy time for the federal government to sort out its ownfiscal problems before attention is turned to a more fundamental ra-tionalization of the federation in light of what the system is intendedto accomplish.Which of these paths we chose depends upon our vision ofwhat we want the Canadian federation to look like in the twenty-firstcentury. That is a matter of judgment. It would, however, be a greatshame if we let the choice be made by default, which is the coursewe have adopted so far.

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