Putting Equalization back on track

Improving the Equalization formula

Within the context of the overall framework outlined above (a formula-driven approach based on a 10-province standard, measuring fiscal capacity but not expenditure needs) several important changes should be made to the actual formula for Equalization.

Throughout its consultations, the Panel consistently heard that the RTS approach should be retained. The key strength of the RTS approach is that it provides a more accurate measure of a province’s fiscal capacity, it reflects provinces’ actual tax practices, and it is more in keeping with the Constitutional commitment to “reasonably comparable” levels of taxation.

“For all its flaws and complexity, basing equalization entitlements on some measures of the tax bases that the provinces actually utilize is the preferred approach because it is based, however imperfectly, on what the provinces actually tax.” - Bev Dahlby20

One of the concerns with the RTS approach is its complexity. So-called “macro” measures have the advantage of being broader based, less detailed, and easier to measure. They focus solely on an overall indicator, such as Gross Domestic Product or personal income, as a measure of fiscal capacity. Essentially, a macro approach equates a province’s fiscal capacity with its taxpayers’ ability to pay taxes.

On the other hand, critics of macro measures suggest that they are a proxy rather than an accurate measure of a province’s fiscal capacity, that they do not reflect the provinces’ actual tax practices, and that they assume that every dollar of income is equally available to be taxed, regardless of its source.

Based on its review of the alternatives, the Panel recommends that the RTS approach should be retained on an overall basis.

The Panel’s recommendations simplify the formula and reduce the number of tax bases from 33 to five.

While there is strong support for maintaining the RTS approach, the Panel also heard consistent suggestions for simplifying what has become an increasingly complex series of tax bases.

When Equalization was first introduced in 1957, only three tax bases were included. Today, the number of tax bases has grown to 33. This growth in complexity raises a number of concerns. Adding complexity may not improve accuracy or reliability. It may increase the potential of creating incentives or disincentives that affect decisions by provincial governments. It certainly makes the program less transparent and more difficult to understand. As a result, there is less scrutiny of the program and more potential for special deals and ad hoc practices. Finally, continuing to add more and more tax bases to reflect changes in industries like oil and gas is likely not sustainable.

For these reasons, the Panel recommends that steps should be taken to
simplify the approach.

In order to choose which tax bases could be consolidated into a more
simplified approach, the Panel considered:

“While not perfect, Canada has a lot of experience and expertise with respect to the RTS system. We should work on resolving outstanding RTS issues ... rather than whole-scale replacement of something that is conceptually appealing and reasonably well-functioning.” - Tracy Snodden21

• Tax bases that are either small or involve only modest disparities
  among provinces.
• Tax bases where the tax practices among the provinces vary significantly, making it difficult for the RTS to arrive at a meaningful “representative practice” (e.g., payroll taxes, hospital and medical insurance premiums).
• Tax bases where there is no obvious way of measuring disparities
  (e.g., miscellaneous revenues base).

The result is the simplified approach shown in Figure 12. This approach uses four tax bases for all non-resource revenues: personal income tax, business income tax, property tax, and sales tax. All revenues (other than resource revenues) would be folded into these four bases. As explained later in this report, the Panel also recommends replacing the current 14 RTS resource tax bases with a single measure (actual resource revenues).

Further information on how the RTS system should be simplified is
included in Annex 4.

Figure 12 – Representative Tax System (RTS) Simplification

Property tax revenues make up the second largest source of revenues included in the Equalization formula. The measurement of a province’s fiscal capacity to raise property taxes has been one of the most controversial issues in the Equalization program.

The disagreements begin with fundamental questions about the nature of property taxes—whether they are a tax on wealth, a tax on the income of people who own the property, or not a tax at all but rather a user fee to cover the cost of services received in a municipality. These basic issues are complicated by the fact that there are large variations in property taxes across the country and the rate of tax varies substantially within provinces, with property tax rates generally being lower in areas where average market
values are higher.

In spite of the controversies and measurement problems, provincial property taxes were first included in the Equalization formula in 1967 and municipal property taxes were phased-in starting in 1973–74. Three types of property taxes were included: residential, commercial-industrial, and farm. The property tax base was measured on the basis of a multiconcept approach taking into account a mix of indicators and proxy measures including capital stock measures, provincial GDP, disposable income, agricultural land values, urbanization, and demographic changes. Most notable in this base was the absence of the very measure which, arguably, provincial and local governments actually tax, the assessed market values of property.

By the later 1990s, all provincial and local governments had adopted a
market value approach for assessing the value of residential property. As a result, Finance Canada began extensive work on a new approach for measuring the property tax base in the Equalization program. This “stratified market value” approach groups together all municipalities that have similar property values into the same “tax bracket.” It then assumes that all municipalities in that bracket are able to levy a similar average tax rate. The approach was extensively tested and discussed with the provinces.

Agreement had been reached with most provinces to implement this new approach on a phased-in basis, starting in 2004. However, with the introduction of the New Framework, changes to the property tax base were never implemented in legislation.

The Panel reviewed the various options and approaches for addressing concerns with the proposed stratified market value approach. Discussions were held with British Columbia and Québec officials to review their concerns and the particular circumstances in British Columbia.

The primary advantage is that it reflects the actual taxing practices of provinces and municipalities and, with stratification, it takes into account variations in market value of residential property in different municipalities across the country.

The Panel’s view is that the stratified market value approach has distinct advantages and should be implemented fully and consistently across all provinces. Its primary advantage is that it reflects the actual taxing practices of provinces and municipalities and, with stratification, it takes into account variations in market value of residential property in different municipalities across the country. In effect, for the purposes of Equalization, the fact that housing prices in cities like Vancouver or Toronto are higher than they are in Sudbury, Laval, or St. John’s does not really matter because they are grouped together in different brackets. The stratified approach also takes into account the substantial variations in property tax rates across provinces and within a particular province.

The Panel considered the issue of the special adjustment for British Columbia that was part of the 2004 Renewal. The Panel’s understanding is that the incorporation of this adjustment was a compromise position aimed at mitigating the impacts of moving away from the multiconcept approach. Given that the inclusion of this adjustment would not have a material impact on British Columbia’s Equalization entitlement under the Panel’s package of recommendations, the Panel believes it is neither necessary nor appropriate to include this special adjustment.

The Panel also examined the current commercial-industrial and farm tax bases. These two tax bases currently make up about 44 percent of the total property tax base. A multiconcept approach is used to measure provinces’ fiscal capacity for both of these tax bases. While there are some concerns with the current approach, developing a better conceptual framework for measuring the farm and commercial-industrial property tax bases would require considerable work and the development of extensive data to ensure comparability across provinces. For that reason, the Panel does not recommend any changes at this time.

Additional information about property taxes is included in Annex 5.

User fees are another controversial aspect of Equalization. Across Canada, provincial and municipal governments collect a broad range of user fees totaling more than $21 billion a year. User fees are charges paid for goods and services provided by the public sector. They cover water, sewer and garbage charges, permits and licences, fees for the use of skating rinks and recreational facilities, rents for low-income housing, parking fees, and a host of other miscellaneous charges.

Currently, half of the $21 billion in user fees charged by provinces and municipalities is included in Equalization. The broad range of fees charged by postsecondary institutions, health and social services organizations has not been considered part of the government universe for Equalization purposes and these fees are not included in the Equalization formula.

To assess whether or not user fees should be included, the Panel considered two key questions:

• Currently, some user fees are included in Equalization while others are not. Receiving provinces generally support including user fee revenues in Equalization.

  What is the conceptual rationale for including or excluding user fees?
• How would user fees be measured in an Equalization formula?

In answer to the first question, the Panel heard diametrically opposing views.

On the one hand, receiving provinces generally support including user fee revenues in Equalization. In their view, these fees are no different from other types of taxes. They are important sources of revenues that help offset the costs of providing public services. As a matter of policy, some provinces choose to charge lower fees for certain services while others opt to have higher fees but lower overall taxes. They argue that the Equalization program should not interfere with decisions made by provinces and, therefore, user fees should be included just like all other sources of revenues available to provinces. Including user fees also provides a direct benefit to receiving provinces. All receiving provinces would be entitled to more Equalization funding if user fees were included.

On the other hand, most academics who study these issues contend that user fees should not be included, except for the portion that represents a profit to provinces and could be used to pay for other public services.

To understand their arguments, it’s helpful to go back to the fundamentals of the Equalization program and what it is intended to achieve. The intent of the Equalization formula is to address disparities in the fiscal capacity of provinces, disparities that affect their ability to deliver reasonably comparable public services to their residents. That’s why regular taxes, including sales taxes, are equalized.

Sales taxes are a good example. Buyers are required to pay sales tax when they purchase taxable goods and services. The buyer gets nothing directly in return from the government for paying the tax on the purchase. The sales tax is simply a source of revenue for the government to use to pay for a wide range of public services such as health care and education. A province with a weak sales tax base has less fiscal capacity than other provinces and less ability to use revenues from sales taxes to provide services that are reasonably comparable to those in other provinces. In this case, Equalization would help to fill the gap.

Most academics suggest user fees that merely cover all or part of the costs of providing specific services should not be included in Equalization because they do not generate additional fiscal capacity for provinces or create disparities in the fiscal capacity of provinces.

User fees, though, are a different story. A user fee is essentially a payment for a good or service provided by the government. In return for the fee, people get a direct benefit—they get to skate at the local rink, they’re able to park, or they get their marriage registered. Since the fee is intended to offset the government’s cost of providing the service, the government is not left with additional money (additional fiscal capacity) that could be used to help them pay for health care or education.

Most academics suggest user fees that merely cover all or part of the costs of providing specific services should not be included in Equalization because they do not generate additional fiscal capacity for provinces or create disparities in the fiscal capacity of provinces.

On the other hand, some user fees go well beyond covering governments’ costs of providing the service. They generate profits that the government can and does use to provide other public services. These fees should be included in Equalization. A good example is alcohol sales. Provinces generate profits from the sale of alcohol. These profits are used by provinces to help support other public services. A province that has more profit from the sale of alcohol is in a better financial position to provide its citizens with public services than a province that makes less profit. Such profits from user fees should be included in Equalization.

There’s another important difference between taxes and user fees. Taxes such as income tax or sales tax are clearly defined. But in the case of user fees, there are few limits on what a province could choose to call a public service. Each province could have its own definition. It could choose to include a wide range of services, call them public services, and charge user fees for those services. If all of those user fees were included in Equalization, it would significantly increase the size of the program. In the Panel’s view, this is not consistent with the intention of Section 36(2) of the Constitution.

In the Panel’s view, user fees are different from other taxes. Unless they are intended to raise a profit, they do not generate disparities in fiscal capacity among provinces that need to be equalized.

The second question relates to how disparities in user fees could be
measured. The current approach for full and partial cost recovery of user fees is arbitrary and has no conceptual basis. It essentially includes 50 percent of user fees in the formula and uses a province’s overall fiscal capacity (excluding resource capacity) to determine entitlements. The choice of this arbitrary approach may reflect the fact that determining an appropriate way of measuring disparities in user fees is no simple task.

Under an RTS, a tax base or several separate tax bases would have to be
constructed, reflecting the practices of provinces and municipalities and intended to measure disparities in fiscal capacity resulting from user fees. The tax base or bases would assess how much revenue each province could raise if it levied a national average user fee for the thousands of activities for which they currently levy user fees. Developing this type of tax base would add tremendous complexity to the formula. Moreover, the results would be difficult to interpret.

The Panel recommends that user fees that do not generate profits not be included in the Equalization formula.

Clearly, this is a difficult issue given the very different views involved. However, in the Panel’s view, user fees are different from other taxes. Unless they are intended to raise a profit, they do not generate disparities in fiscal capacity among provinces that need to be equalized. Moreover, the challenge of developing appropriate measures and the additional complexity this would add are significant problems to overcome.

Therefore, the Panel recommends that user fees that do not generate profits not be included in the Equalization formula. Profits generated from the sale of alcohol, lottery tickets, and vehicle registrations should continue to be equalized.

Additional background on issues related to user fees is included in Annex 6.

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