Equalization in Canada versus Equalization in Australia - Essay Example

English 5th Mar 2006 Equalization in Canada verses Equalization in Australia The Equalization program introduced in Canada and Australia,allows individual provinces of each nation to raise revenue to provide comparable levels of service at approximately similar levels of taxation (Dept of Finance Canada). This paper sets out to explain equalization in two mature federations Canada and Australia, compare the differences, similarities and determine the success rate of this program in both nations. Equalization in the basic terms is a federal transfer program that allows all provinces, irrespective of their ability to increase revenue, to offer roughly equal levels of services at similar taxation levels. The program's goal is to ensure that citizens in all provinces have access to roughly the same level of social services - such as education and social assistance - without spending excessive levels on taxation. Equalization is one of four major federal transfer programs. The others are the Canada Health Transfer, the Canada Social Transfer, and the Territorial Formula Financing (the main source of revenue for territorial governments). Equalization is the federal government's main device for reducing fiscal inequalities between the 'have and have-not' provinces (Mapleleafweb). The grant to receive equalization funding is calculated by a formula assessing each province's revenue raising ability against a five-province standard. Presently eight Canadian provinces receive equalization: Quebec, Nova Scotia, Newfoundland, British Columbia, Prince Edward Island, Manitoba, New Brunswick, and Saskatchewan. This program is the Canadian government's most important initiative for reducing fiscal discrepancies between provinces (Equalization Program). Equalization payments allow less prosperous provincial governments to offer their residents public services such as hospital fees, electricity, water and other basics that are comparable to those in other provinces and at similar taxation levels. Each province receives unconditional equalization payments. That means the receiving provinces are at liberty to spend the funds on high priority public services. So far equalization program has transferred close to $10 billion a year to provinces over the period 1999-2000 to 2003-04. For 2005-06 eight provinces are expected to qualify for $10.9 billion in equalization entitlements. The provincial governments may spend the equalization money they receive in any way they desire, unlike conditional transfer payments such as the Canada Health and Social Transfer. The equalization payments guarantee equal levels of health care, education, and welfare in all the provinces. Equalization payments do not involve payment transfers from wealthy provinces to poorer provinces. Instead the federal treasury provides the funds for these payments. In other words, for example, a wealthy citizen from a poorer province like New Brunswick, pays more into equalization than a poorer citizen in wealthy province like Ontario. Since Ontario has a bigger population and wealth, the citizens of Ontario as a whole pay more federal taxes and therefore their total contribution in equalization payments is greater than that of New Brunswick. Equalization payments also aid by encouraging national unity. Quebec, the most populous of the poorer provinces, is the largest single beneficiary of the payments. 70% of the 10 million Canadians of the poorer provinces reside in Quebec when British Columbia and Saskatchewan are removed. The history of Equalization dates back to Confederation and the Constitution Act of 1867. Two basic principles that Canada's founding fathers based the separation of legislative powers: 1) The central government must retain much of its revenue generating power for the purpose of building railroads 2) 'Coordinate federalism' in which provincial governments act independently and autonomously within predefined powers and must be the basis for the division of powers between provinces and the central government. The great depression of the 1930's bankrupted most provinces and the federal government established the Rowell-Sirois commission. The report concluded that the constitution offered provinces not enough taxing powers to satisfy their constitutional responsibilities in the social policy area they were responsible for due to inherent systemic difficulties. Canada's founders never anticipated the skyrocketing costs associated with running the education and public welfare systems. Between 1874 and 1937 these cost rose from $4 billion to $360 billion (Royal Commission on Dominion-Provincial Relations). The commission report opposed constitutional changes that would amend division of powers and instead suggested consolidating taxation powers with the federal government, also provide provinces a guaranteed annual income. The commission outlined three key recommendations: 1) Control of unemployment and insurance and old age pension would rest with the federal government. 2) Collection of major taxes including income tax, taxes on property and assets etc should be undertaken by the federal government. 3) Compensation for the lost tax revenue by paying annual "National Administration Grants" must be borne by the federal government. These grants would aid provinces offer sufficient services without heavy taxation. Equalization has changed considerably since its enactment in 1957, when it was intended to level the per capita tax revenues of all provinces with that of the two richest provinces at the time - Ontario and British Columbia. Later, changes were made to bring poor provinces up to the average of all 10 provinces. In 1982, the national average was dropped and the average of five designated middle-income provinces - Quebec, Ontario, Manitoba, Saskatchewan and B.C. - was adopted instead. That same year, equalization was enshrined in Canada's Constitution. Section 36(2) of the 1982 Constitution Act reads: "Parliament and the government of Canada are committed 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." The total amount of equalization the federal government pays out is directly tied to the performance of the Canadian economy (Mapleleafweb). When Canada's Gross Domestic Product (GDP) falls below a certain level, the amount of equalization paid out is reduced accordingly (Section 9 of the Federal-Provincial Fiscal Arrangements Act ). For 2003-04, equalization ensured that at least $5,994 was available per person of each province to pay for public services. In order to determine which province gets how much, Ottawa compares more than 30 taxes in each province. From this, a national standard is calculated revealing the amount of tax revenue that a province could raise per capita. If a province falls below the standard, it receives money. In October 2004, Ottawa forged a deal providing equalization payments totaling $10.8 billion with an increase of 3.5 per cent every year. This changed how money was distributed. Some of the money would be paid using the old formula based on the average tax revenue of the five "middle class" provinces. The other half would be distributed based on per capita. Equalization has its issues. The formula and the philosophy of wealth transfer to the poorer provinces has received criticism (Mapleleafweb). Since 1957 when the first federal-provincial equalization agreement was introduced, several concerns have arisen regarding equalization and the program's structure particularly the question of how many provinces should make up the National Standard. A province's economic capacity is calculated against a national standard comprised of the mean taxing capability of a number of provinces. Since 1957, the number of provinces making up the national standard has changed several times. In that year, the average taxing capacity of Ontario and British Columbia (being at that time Canada's two richest provinces), was used to measure a province's fiscal capacity. In the 1960s, the federal government altered the calculation to incorporate ten provinces. In 1970's the inclusion of oil-rich Alberta in the calculation posed problems when world oil prices soared. Alberta's tax revenues raised the average to the point where even Ontario would have received equalization. In 1982 Alberta and the poorer provinces were removed from the calculation. Today's national standard is based on the average taxing capacity of five 'middle income' provinces - Ontario, British Columbia, Saskatchewan, Quebec and Manitoba. Several provinces claim that the five-province standard unjustly lowers their entitlements, and want a restore the ten-province standard. Some have deemed equalization as unfair to the richer provinces. The fact is equalization is federally funded, so all provinces pay into the equalization program. All provinces benefit from federal transfer payments. While the province of Alberta has not received equalization since 1964, in the 2004-05 fiscal year federal transfer payments will make up 13 percent of its provincial revenues (source: Government of Alberta web site). (Mapleleafweb) Several experts have argued that the formula should be simplified. Since the beginning, the number of monetary elements used to calculate each province's fiscal capacity has risen from the three items contained in the original tax rental agreements (personal income tax, corporate income tax and succession duties) to 33. Detractors contend that this complicates the program making it hard to understand, and raises the likelihood of error. The Evolution of Constitutional Federalism in Australia. Due to interest in fiscal federalism and fiscal decentralization many mature federations continue to develop towards greater centralization. The evolution of federalism in Australia is influenced by incompleteness of contracts. Due to this, certain agreements about taxing powers and the Commonwealth's political strength have all encouraged a firm drive to the process of centralization (Bhajan Grewal and Peter Sheehan). Equalization transfers are required to surmount the vertical fiscal imbalance between different government levels and certain states. In 1933, the creation of Commonwealth Grants Commission made arrangements for offering assistance to particular states. The revenue amount the central government raises is larger than its own purpose outlays require. In contrast, the states own expenditure exceed the revenues they raise. This results in a vertical fiscal imbalance. Fiscal transfers from the central government to states address the VFI. Presently 60 percent of the transfers are united funds ie. funds states can spend at their own discretion. The remaining 40 percent are specific purpose payments that must be used for the purposes they are given. United funds include the revenue raised from Goods and Services Tax (GST) passed to the states. The GST pool is estimated at $42 billion (2004-05) and represents about 35 percent of the state's gross operating cost. The GST revenue allotted to each state can be spent according to the state's priorities which the Australian government has no control over. National policies are agreed by states who follow the specific purpose payment (SPP) provided by the Australian government. 120 SPPs exist in areas such as health, education, housing, social welfare, transport etc. Grants are provided for government schools, home and community grants are also funded. The objectives of horizontal fiscal equalization (HFE) in Australia assert that state governments receive funding from a pool of goods and service tax revenue such that if each worked to raise revenue using its own sources and operated at similar efficiency levels, each would have the capacity to provide the same service standards. The commission advises the central government on the share of GST pool that each state should receive. The emphasis is on equalization of the states' fiscal capacities not their performances. Fiscal equalization gives states the opportunity to provide the same standard of service but not compulsorily. The essential feature of intergovernmental transfers of GST revenue being distributed among states is united under the control of states. The implementation of HFE requires using historical financial data to construct a general picture of the states past revenue successes over the last five years. National per capita averages are calculated and this information is deduced from state budgets and government finance statistics. States are equalized to what on average they actually do. The commission then compares the differences in states' per capita costs of providing services and per capita capacities to raise revenue. The standard per capita expenses of a state on a function are calculated when these per capita needs are added to the standard or subtracted from it. The standardized expense per capita represents the amount of state the commission considers as requiring to spend to provide the average level of service. If one state has a smaller revenue base than another and applying average rates of tax does not to raise revenue, then it has greater need for GST revenue. The standardized per capita revenue of a state is the amount calculated by the commission to raise. Mathematically the commission's model is represented as: A state's per capita share of GST revenue = its per capita share plus its assessed needs per capita (expense and revenue), less per capita due to SPPs. A state's share of the GST revenue indicates the amount required to spend to offer standard level of services after accounting for the revenue it would raise from its own sources. Australia has the world's most complex and complete federal system of fiscal equalization grants (Mike Nahan 2004). With a wealth of economic resources its federal system has grown into a nationalized system of state dependency that is inefficient and costly. The Australian Constitution rooted a diverse governmental system of combining American style federalism with British style centralism. It included strong state powers but reserved the central government the most profitable tax sources. This disparity was born with the introduction of national income and sales taxes. The central government's compensation programs delivered equalization grants which were formalized into a complex formula containing perverse incentives for poorer states. These states and territories could develop their federal endowments with policies that penalized economic growth, but could not expand them with policies that encourage it. Though some states eventually overcame the problem, the state of Tasmania suffered its worst effects. Tasmania has become more dependent on Commonwealth aid, less responsible for its own policy failures and future, and more focused on working the funding system than repairing its economy. Its dependence on Commonwealth income has swelled to 67 per cent of total revenue. These external transfers have permitted Tasmanian governments to set up regulatory tax regimes unfriendly to commerce. The result of this trouble-free external money flow forced the state to raise taxes and restrictive labor and environmental legislation - all in the midst of an hastening depletion of entrepreneurs and young people, the life-blood of a thriving economy. Also the state's economic performance is far below the Australian average. Despite shortcomings such as high complexity, the Australian system has become the reference model for creating an ideal equalization system (Paul Spahn). The approach is complete, sound, feasible, and quite transparent. The large number of criteria that makes the Australian system so cumbersome stem from political wrangling, not from a poorly designed system. The fact is that the Australian system for general transfers is burdensome in terms of information requirements and technical expertise that cause to be it complicated, to use in other countries having poor data gathering facilities and weak administrative capacity. However it remains the yardstick against which all equalization apparatus have to be verified for their susceptibility to manipulation and perverse incentives. Both Canadian and Australian systems of federal fiscal transfers following the equalization principle are somewhat different. Canada's philosophy of equalization has been enshrined in the constitution itself. The Australian principle of equalization has been defined to say that 'States should receive funding, such that if each made the same effort to raise revenue from its own sources and operated at the same level of efficiency, each would have the capacity to provide services at the same standard. It can be observed that it is only the capacity that is equalized and not particularly the actual level or standard of service, which would depend on the priorities and allocations among different heads, which remain the privilege of the states. The way this principle has been applied in Australia, particularly regards to efficiency, involves detailed evaluation of expenses to take account of the cost disabilities. In the Canadian constitution, equalization payments are intended to 'ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of services at reasonably comparable levels of taxation'. In Canada, in determining equalization payments, no evaluation is made of the expenditures of the provincial budgets. However, these transfers are balanced by the equally important health and social service transfers, where expenditure requirements are taken into account generally on a per capita basis. The northern territories with large cost disabilities are separately treated under Territorial Formula Financing. In Canada, the transfers for any one year remain 'open' for four years and as new data come in, entitlements are reworked on principles that have already been determined. In Australia, there is a five yearly cycle of 'Review' whereby the Commonwealth Grants Commission devises the methodology of determining the 'relativities', but the calculation is done on an annual basis using latest available data, which are called 'Updates' (Twelfth Finance Commission). Have federal transfers stabilized regional government revenues Evidence from Australia and Canada suggests that the impact of federal transfers does not stabilize revenues of regional provinces. With regards to Australian state revenues, there is little evidence of even minor stabilizing impact of federal transfers. For Canada, there is evidence of larger impacts (Bhajan Grewal, Peter Sheehan) A 2002 critique of the equalization system in Australia recognized similar problems facing Canada. It refers to bureaucratic "game-playing" which redefines activities to exploit equalization payments. The system creates a propensity toward a reduced effort on cost-reducing reform -- a phenomenon called the "flypaper effect." Money transferred to state governments tended to stick, even though households would benefit if the money was passed on to them through lower taxes. In Australia, while the level of dependency fell slightly in later decades as the States introduced a number of legal taxes, it remained above what Australia's founding fathers had envisioned and far above the standards of other federal countries. For example, the Canadian provinces collectively depend up Ottawa for only about 15 percent of their total revenue. The disparity between the central government and the states increased once more in 2000 when the Commonwealth introduced a 10 percent GST. Full earnings went to the provinces, with the provision that they eradicate seven of their own taxes. This deal gave the states access to a large growth tax. They also, however, became more dependent upon the Commonwealth for funding. Now, their dependency ratio is back up to its immediate post war high. To aid equalization, intergovernmental forums have been set up to assist discussion among various orders of government and strike a balance among opposing interests and mediate disagreements. Such institutional arrangements are commonplace in federal countries. In Australia an independent agency has been assigned a powerful role in intergovernmental fiscal relations. Intergovernmental forums review and decide on independent agency recommendations. Canada relies solely on intergovernmental forums for decisions on fiscal transfers. Has equalization worked A 2002 study by the Atlantic Institute for Market Studies concluded that equalization was responsible for income taxes in poorer provinces being about 33 percent higher. While this conclusion has been disputed, if true, it goes directly against the equalization program's intended goal of providing "reasonably comparable levels of service at reasonably comparable levels of taxation." (Mapleleafweb) There are arguments that equalization encourages dependency among poorer provinces. These provinces have little incentive to develop their natural resources if money earned through increased resource revenues is taken away by reduction in equalization payments. These concerns are addressed by built-in generic solutions but some experts believe that reliance on equalization encourages dependency by rewarding a province for raising its income tax rates. Works Cited CBC News (2.5.05) Equalization Payments. Retrieved 4th Mar 06 Department of Finance, Canada. (2003.01.28) Retrieved 3rd Mar 03 Equalization Program. What is Equalization Department of Finance, Canada. (2005.04.04) Retrieved 3rd Mar 04 Grewal, Bhajan. Sheehan, Peter. Vigneault, Marianne.(2004) Symposium on "Fiscal Fedralism" Public Finance and Management. Retrieved 4th Mar 06 Mapleleafweb (Apr 20, 05). Equalization Issues. Retrieved 4th Mar 06. Mapleleafweb (Apr 20, 05). Equalization Payments in Detail. . 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