Annex 3: Territorial Formula Financing: A Brief History

Territorial Formula Financing (TFF) is the main federal transfer to the territorial governments. It was established in 1985 to provide territorial governments with annual unconditional transfers from the federal government. This allowed territorial governments to offer their residents levels of public programs and services that are reasonably comparable to those available to other Canadians, at reasonably comparable levels of taxation, taking into account the higher cost of providing services in the territories and the territories’ more limited ability to raise revenue.

As illustrated in Figure 1, TFF grants to the territories are expected to be $2.07 billion in 2006–07. This amounts to between $16,274 and $27,396 per capita depending on the territory in question (see Figure 2). By way of comparison, in 2006–07, the highest per capita Equalization payment to any provincial government is expected to be $2,022 to Prince Edward Island in 2006–07.¹

Figure 1 – Total TFF Payments:1993-94 to 2006–07

Source: Finance Canada, 2006–07 Territorial Formula Financing entitlements announced by the federal Minister of Finance in November 2005 with calculations based on October 2005 data.

Figure 2 – TFF Grants by Territory, 1993-94 to 2005–06

Source: Finance Canada; 2006–07 Territorial Formula Financing entitlements announced by the federal Minister of Finance in November 2005 with calculations based on October 2005 data.

In 2005–06, TFF accounted for over 60 percent of Yukon’s and Northwest Territories’ budgetary revenues, and 81 percent of Nunavut’s.²

Before TFF was introduced in 1985, the federal government transferred funds to territorial governments, but not according to a formula. The Department of Indian Affairs and Northern Development financed territories on a program-by-program basis (e.g., education, infrastructure, housing, etc.). Territorial governments required federal approval for their spending decisions and could not be held clearly accountable by territorial residents for their spending decisions.

1985 to 2004

This method of funding for territorial governments (Yukon and the Northwest Territories) was replaced in 1985 by a gap-filling formula approach under the new Territorial Formula Financing arrangements. Under this new approach, each territorial government received an annual TFF grant (i.e., a single, large unconditional cash transfer) from the federal government, which it could allocate and spend according to its own priorities. From then on, territorial governments were held accountable to territorial voters for their policy choices and budgetary management, not to the federal government.

From 1985 to 2004, the TFF grant was governed by agreements between each territorial government and the federal government. These agreements were for a limited term, generally five years, and were renegotiated or renewed for the subsequent funding period. Although there were changes to the formula in each renewal, the basic structure of TFF remained intact until October 2004 when the New Framework was introduced.

Each year the amount of a territory’s grant was determined by a formula that:

• Proxied the value of how much a territorial government would need to spend in order to provide levels of public services that are reasonably comparable to those provided by provincial governments. This expenditure need proxy was referred to as the Gross Expenditure Base (GEB).

• Measured the territorial government’s ability to generate revenues from its own sources at taxation levels that are reasonably comparable to those set by provinces. These included not only the taxes and fees a territory could impose but also some of the other transfer payments received from the federal government. This measure was called Eligible Revenues.

• Computed a grant amount equal to the difference between the GEB, a proxy of expenditure needs and Eligible Revenues (see Box 1).

Gross Expenditure Base (GEB)

The GEB did not measure what a territorial government actually spent in a particular year. Rather, it sought to approximate the total fiscal capacity required in order to provide territorial residents with levels of public programs and services that were “reasonably comparable” to those provided by provinces. Separating the formula’s GEB (and therefore, the size of the TFF grant) from actual territorial spending was deliberate; territorial governments could not increase the size of their grant by spending more money. Similarly, their grant was not reduced if they reduced their actual spending. The same principle applies to Equalization, which measures the potential, not actual revenues raised by provinces.

A benchmark GEB value was based on territorial revenues of each territory in 1982–83. At that time, the GEB was considered adequate to meet expenditure requirements by the territories. This amount was considerably higher than the spending by provinces, reflecting the higher costs and unique circumstances of providing “reasonably comparable” programs and services in the territories.

This benchmark GEB was escalated annually to reflect the growth of government expenditures over time. The escalator assumed that, to ensure ongoing comparability, territorial government spending should keep pace with that of provincial and local governments providing corresponding programs and services “south of 60”. Starting in 1990, the formula’s GEB escalator also took into account the change in each territory’s population growth relative to that of Canada as a whole.

This basic GEB, described in Box 2, was subject to other adjustments.

It was raised each time the territories assumed new responsibilities from the Department of Indian and Northern Affairs (program transfers) or other federal programs (e.g., Labour Market Development Agreements).

• Technical adjustments were made to the GEB to ensure that grant amounts would not be unintentionally affected. For example, in the 1995 Renewal, an Economic Development Incentive (EDI) was introduced into the revenue side of the formula (as described below) and a consequential change was required in the GEB.

• The federal government reduced each territory’s 1996-97 GEB by five percent in its 1995 budget as part of overall federal budgetary restraint measures taken at that time.

• When Nunavut was established in 1999, the GEB of the former Northwest Territories was split between Nunavut and the post-division Northwest Territories based on the Historical Expenditure Ratio (HER) of 46 percent Nunavut and 54 percent Northwest Territories. The combined GEB was also raised at that time to take into account the diseconomies of scale involved in running two governments rather than one.

Eligible Revenues

Territorial governments have two types of revenues in addition to TFF: other transfer payments from the federal government and own-source revenues that they generate themselves. Both of these are considered in the Eligible Revenues component of the TFF formula.

While, the main transfer payment for territories is the TFF grant itself, territories also receive the Canada Health Transfer (CHT) and the Canada Social Transfer (CST). There are various other, smaller federal transfers, some of which were included as Eligible Revenues for TFF purposes. The majority of these smaller transfers, however, were not included as Eligible Revenues for the territories and therefore did not have an impact on the size of the TFF grant.

Revenues the territories generate themselves, own-source revenues, come in a variety of forms such as taxes, fees charged for permits issued or services provided and earnings on investments. While transfer payments entered the formula’s Eligible Revenues as the amounts the territories actually received, this was not the case for most own-source revenues. The majority of own-source revenues entering into the formula were measured as potential amounts a territorial government could collect if it exerted a reasonable tax effort. This amount was called a territory’s “Hypothetical Own-Source Revenues”.

This means that territorial governments could not increase the size of their grant by reducing their tax levels. Similarly, if territorial governments decided to increase their actual tax levels, their TFF grant was not reduced.

The formula measured potential Hypothetical Own-Source Revenues in the following manner:

• Calculate what actual revenues would have been if a territorial government had not adjusted tax rates since a particular base year (1992-93 in recent versions of the formula).

• Compute what revenues (at 1992–93 rates) would have been had the territory exerted a reasonable tax effort in that year. This was referred to in the formula as the Catch-Up Factor (CUF).

  • Part of this calculation required adjusting the tax effort measurement to recognize that territorial governments cannot be expected to make the same tax effort as provincial governments due to higher costs in the territories. For this reason, a 15 percent Northern Discount Factor was applied to the National Average Tax Rate to determine a reasonable territorial tax effort.

• Escalate 1992–93 ‘caught up’ revenues in line with how much provinces increased their tax effort over this period. Territories are expected in the formula to increase tax effort at the same pace to keep it reasonable. This adjustment is referred to as the Keep-Up Factor (KUF).

• The cumulative effects of multiplying the CUF, KUF, and the 15 percent Northern Discount Factor were known together as the Tax Effort Adjustment Factor (TEAF). The impacts of the TEAF led to the introduction of further adjustments as described below.

Some own-source revenues (e.g., court fines and interest revenues) were not wholly under the control of territorial governments and therefore were not subject to the actual-to-potential adjustment. For these revenue sources, actual revenues were included directly in the calculation of eligible revenues. A few revenue sources were excluded entirely from Eligible Revenues, including those introduced since the establishment of TFF in 1985, in order to encourage territorial governments to increase their own-source revenues. It also allowed territorial governments to benefit from new federal transfer programs without having them offset by reductions in the TFF grant.

Natural resource revenues deserve special mention. Constitutionally, authority for the administration and control of onshore territorial natural resources rests with the federal government, including the right to impose taxes and royalties. The Government of Canada is in the process of devolving these responsibilities as part of general policy supporting the political and economic development of the territories. This process is complete in Yukon, underway in the Northwest Territories, and the Government of Canada is committed to initiating similar discussions in Nunavut.

Following Yukon devolution, natural resource revenues collected by the territory are not included in TFF Eligible Revenues. Rather a separate revenue-sharing process determines how much resource revenues the territorial government retains after a separate offset against the TFF grant.

Additional TFF Features

Other intricacies introduced into the TFF formula over the years, prior to the introduction of the New Framework in October 2004, are briefly discussed below.

Ceiling – In 1988, a Gross Domestic Product (GDP) ceiling was added to the formula. The ceiling placed an upper limit on the annual growth of the Provincial-Local Government Expenditure Factor (P-L) in the Population-Adjusted Gross Expenditure Escalator (PAGE) escalator. The ceiling was calculated as the three-year moving average of Canadian nominal GDP growth. If the P-L growth rate exceeded the ceiling in a particular year, the lower GDP ceiling value was substituted into the calculation of the annual PAGE escalator. The resulting ceiling-lowered GEB would then become the starting point for calculating the following year’s GEB. In this way, if the ceiling applied in one year, the GEB and the TFF grant would be permanently reduced. This path-altering aspect of the ceiling was modified in the 1999 renewal and was eliminated effective 2002–03.

1995 budget cuts – The federal government announced two changes to the formula in the 1995 budget. First, the 1995–96 grants were frozen at the 1994–95 level. Second, the 1996–97 GEB was cut by five percent for each territory. The first change was a one time only action and did not affect the GEB or the TFF grant in subsequent years. The second change altered the GEB in 1996–97 and had an on-going effect.

Canada Health and Social Transfer (CHST)/CHT/CST enrichments – Starting with the 1999 federal budget, the Canada Health and Canada Social Transfers were increased. Normally this would not have financially benefited the territories since these transfers would have been included in Eligible Revenues and decreased TFF grant by exactly the same amount. However, it was agreed that the territories should share in the extra funding. Therefore, the definition of Eligible Revenues was modified to exclude the CHST/CHT/CST increases for 1999–2000 and following years.

Economic Development Incentive (EDI) – As part of the 1995 renewal, an EDI was added to the formula (see Box 4). The EDI was an adjustment to reduce the amount of Hypothetical Own-Source Revenues by 20 percent before the TFF grant was calculated. The EDI was forward-looking and not intended to provide an increase to the territories’ 1999–2000 TFF grants. Therefore, that year’s GEB was reduced by the same amount as Eligible Revenues, in order to make the implementation of the EDI revenue neutral in the first year (1999–2000).

Floor – In the 1999 renewal, a floor was added to the formula, to come into effect in years when provincial and local government expenditures fell by more than one percent from the previous year. The floor limited the resulting decline in the GEBs to one percent.

The last scheduled five-year renewal exercise took place in 2004. In the lead up to the renewal, an agreement was reached on a number of technical modifications to the TFF formula including the removal of the ceiling, as well as an increase in the GEBs of the three territories.

This renewal package was still being finalized in April 2004. TFF payments continued based on the 1999–2004 agreements and were to have been subsequently revised retroactively. As it happened, the New Framework announced in October 2004 superseded the April 2004 agreement, which was never finalized.

The New Framework

At the First Ministers’ Meeting in October 2004 the federal government announced a New Framework for Equalization and TFF. It set out a ten-year growth track for TFF and suspended its allocation formula, pending a review by the Expert Panel on Equalization and Territorial Formula Financing. The New Framework was legislated on March 10, 2005. More specifically:

• The normal workings of TFF, including the April 2004 renewal modifications, were put on hold. The formula parameters (i.e., GEB, Eligible Revenues, PAGE escalator, CHST/CST/CHT offsets and EDI) would not play a role in determining the TFF payments to territorial governments while the allocation formula was reviewed.

• The total TFF envelope for all three territories was set at $1.9 billion for 2004–05 and $2.0 billion for 2005–06. Thereafter, the total TFF pool would grow by 3.5 percent annually, with a review in 2009–10.

• For 2004–05 and 2005–06, grants would no longer be determined by three separate formulas in accordance with TFF agreements. Instead, the three territories received shares of the $1.9 billion in 2004–05 and the $2.0 billion in 2005–06 based on three-year moving averages. Territorial shares were determined by the relative sizes of the grants each territory received in 2002–03, 2003–04, and 2004–05, with the greatest weight placed on the most recent year.

• In November 2005, the federal Minister of Finance announced that for 2006–07 the allocation of the $2.07 billion would be based on the same methodology used to allocate 2004–05 and 2005–06, using the most recent data.

• Under the New Framework, TFF grants are now being determined in accordance with federal legislation, not on the basis of TFF agreements between the federal government and each of the territories.

1. 2006–07 Equalization entitlements announced by the federal Minister of Finance in November 2005 with calculations based on October 2005 data.
   
2. Calculations based on 2005–06 Revised Estimates contained in the 2006–07 budgets for each territory.

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