Annex 4: Representative Tax System Simplification

Since the Equalization program was introduced in the 1950s, there have been a number of changes in how the program operates. The current approach for measuring provincial revenue-raising capacity uses the Representative Tax System (RTS). The Panel considered whether the RTS should be retained, and if so, whether it could be simplified without compromising accuracy.

Should the RTS be retained?

The RTS

Canada’s Equalization system is essentially a gap-filling formula. The formula determines how much revenue a province could raise on its own if it levied national average tax rates, and compares this to a given standard. If a province’s per capita revenue-raising capacity falls short of this standard, Equalization fills the gap. In this way, consistent with Canada’s Constitution, a province then has sufficient revenues to provide “reasonably comparable levels of public service” if it levies “reasonably comparable levels (rates) of taxation”.

To measure how much revenue a province can raise on its own, the Equalization formula uses the RTS. It simulates how much revenue a province could raise if it levied national average tax rates on virtually all revenue sources currently used by provinces. To do this, revenues are grouped into 33 Equalization bases (e.g., personal income tax, business income tax, property tax, lottery revenues, etc.). For each base, a capacity to raise revenues at average tax rates is calculated. When aggregated, the 33 bases give a measure of how much revenue a province could raise if it levied national average tax rates on each of these bases.

There is no expectation or obligation for a province to use national average tax rates or to take advantage of all 33 revenue sources. Provinces are free to choose their own approach as to whether they want to levy high, average or low tax rates, and which tax fields they want to occupy. The RTS, however, simulates average
taxing practices, to allow for a fair and objective comparison of provincial revenue-raising capacity.

The macro approach

Another approach for measuring a government’s ability to raise revenue is called the macro approach (short for macro-economic indicator-based approach). Rather than measuring what a province could raise if it levied average rates of taxation, it focuses on what is available to be taxed (the income of a province), and how much revenue a province could raise if it levied a uniform tax rate on all measured income within a province. The choice of the macro base varies, but is typically a measure such as Gross Domestic Product (GDP) or total personal income. As with the RTS, Equalization would then fill in the gap between what a province could raise and the standard.

The Panel’s recommendations

The Panel undertook considerable research to compare the two systems and discussed the desirability of moving to a macro approach with academics and federal and provincial finance officials. While the simplicity of the macro approach appealed to the Panel, it recommends that the RTS should be maintained for two reasons.

First, within the Canadian context, each dollar of economic activity is not taxed uniformly by governments. For example, the Canadian tax system recognizes that people with higher incomes have a greater ability to pay taxes. Therefore, all provinces have adopted a personal income tax system with a progressive structure. Similarly, certain types of consumption are typically taxed across Canada, while others (e.g., most food sold in grocery stores) are not taxed. Ideally, the Equalization formula should take these realities into account, if it can be done in a transparent and reasonably simple way. By modelling actual taxing practices, the RTS (unlike the macro approach) can reflect the fact that two provinces with identical aggregate income, but very different economic activity, would raise very different levels of tax if they adopted the kind of tax systems generally accepted in Canada.

Second, a macro approach does not adequately deal with tax exportation. While a measure such as GDP can conceptually capture what income is available to be taxed, it does not reflect the fact that the burden of some taxes can be shifted by one provincial government to another province or even another country. Take for
example two provinces with identical aggregate income, with one province deriving its income from oil extraction (through exporting its oil to another country) and collecting more revenue than the other province. Under the macro approach, the two provinces have identical aggregate income and would therefore be considered to have the same revenue-raising capacity. The RTS approach, however, recognizes that the province rich in oil is able to collect royalty revenues, partially paid by owners of oil and gas companies, which reduces the tax burden on its citizens. While adjustments could be made to a macro approach to reflect tax exportation, it would defeat the primary advantage of the macro approach, its potential simplicity.

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