Annex 4: A New Approach to Territorial Formula Financing (TFF)

Each year the territories receive funding through Territorial Formula Financing (TFF). The Panel was asked to provide advice on how this funding should be allocated amongst the territories, taking into consideration:

• the current Gross Expenditure Base (GEB) approach;

• the treatment of various territorial revenue sources, such as natural resources;

• the measurement of territorial tax effort;

• other approaches to measuring fiscal capacity, including those based on macroeconomic variables; and

• if appropriate, alternative indicators of expenditure needs.

This annex outlines the key changes to TFF proposed by the Panel, explains the methodology used to examine financial impacts, makes a number of comparisons and forecasts, and concludes with a discussion of stability and predictability.

The Panel’s proposed changes to TFF

The Panel recommends returning to a gap-filling formula to calculate TFF entitlements, determined separately for each territory, as follows:

New Operating Base

The New Operating Base portion of the formula is determined by two components, the Operating Base multiplied by the annual Population-Adjusted Gross Expenditure Escalator (PAGE).

The New Operating Base does not measure what a territorial government actually spends in a particular year. Rather, it is a proxy for the total fiscal capacity required to provide levels of public programs and services to territorial residents that are reasonably comparable to those provided by the provinces.

The Panel recommends that a New Operating Base be established, beginning in 2005–06. It would be equal to the sum of the TFF grant under the New Framework plus the value of the Revenue Block in that same year. To obtain the amount of the New Operating Base in 2006–07, the 2005–06 New Operating Base of each territory would be multiplied by the 2006–07 PAGE escalator.

PAGE Escalator

The initial New Operating Base should be adjusted annually for each territory based on the relative growth in population and provincial-local spending. This is the PAGE escalator used in the previous TFF formula. To ensure that it is responsive to changing circumstances in each of the territories, including population changes, the Panel recommends that the data used in the calculation of the PAGE escalator remain open for three years.

Revenue Block

In the previous TFF formula, the measure of eligible revenue capacity was comprised of a number of factors, including a Tax Effort Adjustment Factor (TEAF-composed of a Catch-Up Factor that measured territorial tax effort in 1992–93, a separate Keep-up Factor that updated the effect of the Catch-Up Factor each year, and a constant Northern Discount Factor) and a 20 percent Economic Development Incentive (EDI). The Panel’s measure of revenue capacity applies the National Average Tax Rate approach to measuring the value of seven revenue bases each year, with an inclusion rate of 70 percent.

Methodology used to calculate the financial impact of the Panel’s approach

The Panel chose to present the financial impact of its approach over the regular five-year renewal period, from 2005–06 to 2009–10. The financial impact of the Panel’s approach for each territory is compared with the TFF entitlements the territories received under the New Framework, and with the previous TFF formula.

The starting New Operating Base for each territory in the base year 2005–06 is the total of the 2005–06 TFF grant under the New Framework and estimated territorial revenues in that year using the Panel’s approach. Thereafter, the New Operating Base for each territory is adjusted annually based on the relative growth in the population of each territory compared to Canada, and growth in provincial and local spending as measured by the PAGE escalator. The estimates of the PAGE escalator for each territory were provided by Finance Canada based on Conference Board of Canada data.

To calculate the Revenue Block for each territory, seven revenue bases were estimated using the federal Representative Tax System (RTS). The sum of the seven revenue bases was then reduced by 30 percent to reflect the 70 percent inclusion rate recommended by the Panel.

Under the Panel’s approach, the revenues included in the formula would be less than the eligible revenues under the previous TFF formula, even after all of the adjustments to territorial revenues under the previous TFF formula have been made. For example, in 2005–06 the Revenue Block for the Northwest Territories would have been $152 million, compared with eligible revenues of $181 million under the previous TFF formula. The difference is due to a number of factors, including the change to the RTS measurement of revenues, the Panel’s revenue offset of 30 percent, and the exclusion of other federal transfers.

The financial impact of the Panel’s approach is also compared to TFF entitlements under the previous TFF formula. Estimates of TFF entitlements under the previous TFF formula were provided by Finance Canada.

Comparison of the Panel’s approach with the New Framework and the previous TFF formula

The financial impact of the Panel’s proposed approach was based on information available as of February 2006 and information from the joint territorial submission. The overall cost of TFF, and entitlements for each territory, will vary as more up-to-date data become available and as the economies and population of the territories change relative to Canada over time. For these reasons, the financial impact of the Panel’s recommendations, as depicted in this annex, should be considered as illustrative of potential financial impacts.

The Panel’s approach provides more funding to the territories than either the legislated New Framework or the previous TFF formula. This is because of the combined effect of the upward adjustment to the GEB for each territory, the reintroduction of the Population Adjusted Gross Expenditure Escalator (PAGE), and the 70 percent inclusion rate for territorial revenues.

The Panel’s approach compared with the New Framework: 2007–08

Table 1 compares total TFF funding under the Panel’s proposed approach to what the territories would receive under the New Framework, from 2005–06 to 2007–08. Under the New Framework, total funding to the territories would be $2.14 billion in 2007–08. In that year, the Panel’s approach would provide an additional $60 million for the territories.

Table 1 – Comparison of the Panel’s Approach with the New Framework, 2005–06 to 2007–08

The Panel’s approach compared with TFF formula: 2007–08

Table 2 shows that in 2007–08, the territories would receive an additional $123 million in funding under the Panel’s approach, compared with the previous TFF formula. The Northwest Territories would receive an additional $40 million, Nunavut an additional $48 million and Yukon an additional $35 million. On a per capita basis, that translates into a gain of $918 for the Northwest Territories, $1,591 for Nunavut and $1,126 for Yukon in 2007–08.

Table 2 – Comparison of the Panel’s Approach with TFF Formula for 2007–08

Note: Totals may not add since figures have been rounded up to the nearest million.

The Panel’s approach compared with announced entitlements: 2006–07

Table 3 shows that the territories would receive $133 million in additional funding under the Panel’s proposed approach in 2007–08 compared with 2006–07 entitlements announced in November 2005. The Northwest Territories would receive an additional $53 million, Nunavut an additional $53 million and Yukon an additional $26 million. On a per capita basis, that translates into a gain of $1,041 for the Northwest Territories, $1,548 for Nunavut and $779 for Yukon in 2007–08.

Table 3 – Comparison of the Panel’s Approach for 2007–08 with the New Framework, Announced Entitlements for 2006–07 by Territory

Note: TFF entitlements for 2006–07 were announced by the federal Minister of Finance in November 2005, based on October 2005 data. Totals may not add since figures have been rounded up to the nearest million.

The Panel’s approach compared with the New Framework: 2005–06 to 2009–10

Table 4 shows that over a five-year period, from 2005–06 to 2009–10, the Panel’s approach would provide $285 million more to the territories than the New Framework. Under the Panel’s approach, TFF entitlements would increase by 20 percent over this period, compared to 15 percent under the New Framework.

Table 4 – Comparison of the Panel’s Approach with the New Framework, 2005–06 to 2009–10

The Panel’s approach compared with TFF formula: 2005–06 to 2009–10

Table 5 shows that from 2005–06 to 2009–10 the Panel’s approach would provide $549 million more to the territories than the previous TFF formula. The Panel’s recommendations would increase TFF funding by four percent per year, in line with increases under the previous TFF formula.

Table 5 – Comparison of the Panel’s Approach with TFF Formula, 2005–06 to 2009–10

Stability and predictability

The Panel’s mandate calls for recommendations on how to improve the predictability and stability of TFF. Although the Joint Territorial Submission identified adequacy as the key issue, it is also important to reduce the volatility of entitlements and improve the ability of territories to predict those entitlements because they comprise the majority of territorial budgetary revenues. For example, in 2005–06, the TFF grant was between 64 and 81 percent of territorial revenues.

Stability and predictability have been particularly important recently to the Northwest Territories. As the following charts illustrate, total revenues have been more variable in this territory than in either Nunavut or Yukon.

Figure 1 – Trends in Revenue Sources for the Northwest Territories, 1984–85 to 2005–06

Source: Government of Canada, Statistics Canada, Financial Management System, 2005

Figure 2 – Trends in Revenue Sources for Yukon, 1984–85 to 2005–06

Source: Government of Canada, Statistics Canada, Financial Management System, 2005

Figure 3 – Trends in Revenue Sources for Nunavut, 1984–85 to 2005–06

Source: Government of Canada, Statistics Canada, Financial Management System, 2005

The Joint Territorial Submission indicated that while stability and predictability are important characteristics, it is more important that TFF entitlements be responsive to changes in territorial own-source revenues than be stable over time. The submission also indicated that since TFF is the largest revenue source for the territories, TFF grant entitlements need to be adequate and predictable for territorial budgeting purposes.¹

In reviewing these issues, the Panel focussed on two aspects of TFF: the complex estimation and payment system, and smoothing mechanisms to reduce year-over-year volatility in TFF entitlements. In the Panel’s view, one of the benefits of the New Framework was increased stability and predictability of overall TFF funding. However, the stability and predictability of individual entitlements were reduced, since changes in one territory’s own-source revenues affected the TFF entitlements of the other territories. In the Panel’s view, TFF entitlements for a given territory may be no more stable or predictable under the New Framework than under the previous TFF formula.

The Panel believes that the federal government and the territories would share more equitably in the financial risks of changes in the territorial economies under its new approach. In its view, the financial risk for the territories would be less under their proposal because the new measure of revenues would include only 45 to 67 percent of own-source revenues, at a 70 percent inclusion rate, and exclude other federal transfers.² This means that TFF would be responsive to changes in most of the major sources of territorial revenues.

On the issue of the estimates and payment system, the Panel believes that the TFF should be responsive to changes in territorial own-source revenues, provincial-local expenditures and population changes. The Panel recognizes that the principle behind the eight-estimate system is to allow current year entitlements to be based on available data for current year activities, with subsequent estimates revised as more accurate data become available.

Although the Panel recognizes that the TFF estimates and payment system is complex, they do not recommend changing the current process. To ensure that the PAGE escalator remains responsive to relative population changes, estimates of TFF entitlements should be revised until Census population and population undercounts are final. In the Panel’s view, a return to a formula-based TFF, coupled with three-year moving averages, should ensure that TFF continues to be responsive to changes in territorial circumstances. A three-year moving average calculation for the PAGE escalator also means that the financial impact of year-over-year changes in the PAGE escalator would be moderated in TFF entitlements.

1. Government of the Northwest Territories, Government of Nunavut, Government of Yukon. (2005). Joint Territorial Submission to the Expert Panel on Equalization and Territorial Formula Financing, p.  7.
   
2. This proportion is based on 2005–06 Revised Estimates of revenues for each territory.

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