A new approach to Territorial Formula Financing

The Panel’s Recommendations

Through its review, the Panel heard several consistent and compelling messages:

• The idea of a fixed pool does not work for the territories; pitting one territory against another is in no one’s best interests.

• The differences among the territories are substantial and should be reflected in the overall design of the TFF program.

Most submissions, including the Joint Territorial Submission, agreed that the underlying basic formula approach that had been used from 1985 to 2004 was sound and should be retained. The Panel agrees.

• The original concept of TFF was to fill the gap between expenditure needs and revenue capacity and this general approach continues to be sound.

Most submissions, including the Joint Submission from the three territories, agreed that the underlying basic formula approach that had been used from 1985 to 2004 was sound and should be retained.²⁹ The Panel agrees.

Perhaps the most consistent concern the Panel heard was that TFF funding was inadequate, particularly given the unique challenges and the higher costs of providing public services in the territories.

The GEBs for each of the territories should be adjusted to reflect funding increases in the New Framework.

In the New Framework, additional funding was allocated to TFF ($100 million in 2004–05 and another $100 million in 2005–06). The Panel recommends that the GEBs for each of the territories should be adjusted to reflect these increases. These adjustments will go a long way to accommodating the territories’ concerns about the adequacy of TFF base funding.

The Panel also recommends that the GEBs be renamed “New Operating Bases” for each territory. This would effectively set a new base for each territory. The additional funding provided to the territories through the New Framework means that the previous GEBs are no longer proxies for historical expenditure needs.

The Panel considered a number of different approaches for measuring revenue-raising capacity in TFF including using actual revenues adjusted as in the previous formula, using a Representative Tax System (RTS), and so-called “macro” measures.

The RTS is a better way to measure revenue capacity than the number of adjustments included in the previous TFF formula.

In the previous TFF formula, revenue capacity was measured using a number of different calculations and adjustments including a Tax Effort Adjustment Factor (TEAF — Keep-Up Factor, Catch-Up Factor, and Northern Discount Factor) and an Economic Development Incentive.

In the Panel’s view, there are a number of difficulties with this approach, including the lack of clear incentives, undue complexity, and lack of transparency. Concerns have been expressed about complexity and inconsistencies in the measurement of revenues in the TFF formula, particularly with respect to the TEAF. Also, in the Panel’s view, there is no evidence that any of the adjustments to revenues used in the previous TFF formula accurately reflect territorial tax effort or the capacity for the territories to raise their own revenues. And it is debatable whether accuracy is improved by using actual revenues adjusted by a number of factors.

An RTS approach and National Average Tax Rates should be used to measure revenue capacity.

The Panel also rejected the use of macro measures for the territories. Although macro measures have the advantage of being broader based, they equate a jurisdiction’s revenue capacity with its taxpayers’ ability to pay taxes. They do not reflect either actual taxing practices or the ability of that jurisdiction to raise revenues.

Consistent with the approach used in the Equalization program, the Panel recommends that an RTS approach and National Average Tax Rates be used to measure revenue capacity. An RTS approach takes into account both the ability to raise revenues as well as the willingness of governments to tax. This approach provides a number of benefits for both the territories and the federal government, including reasonable comparability, administrative simplicity, greater transparency, and sound incentives. In the Panel’s view, the RTS is a better way to measure revenue capacity than the number of adjustments included in the previous TFF formula. Furthermore, it provides appropriate incentives for territories to tax at levels comparable to the national average.

In the territories’ Joint Submission to the Panel, one of the options for measuring revenue capacity involved using five tax bases to establish a measure of revenue capacity. Payroll taxes, property taxes, and alcohol taxes were excluded, primarily due to problems in measuring these tax bases appropriately.

Seven of the largest tax bases should be used to calculate each territory’s revenue capacity. That would include: personal income tax, corporate income tax, payroll tax, gas, diesel, tobacco, and alcohol tax revenues.

The Panel recommends that seven of the largest tax bases be used to calculate each territory’s revenue capacity for the Revenue Block to be included in TFF. That would include: personal income tax, corporate income tax, payroll tax, gas, diesel, tobacco, and alcohol tax revenues.

In the Panel’s view, the use of seven tax bases is warranted since it reflects sound incentives and meets the principle of measuring revenue capacity without introducing undue complexity. While five tax bases would cover between 36 and 64 percent of the territories’ own-source revenues, these seven tax bases represent between 45 and 67 percent of their own-source revenues.³⁰ Including less than 100 percent of a territories’ revenues in TFF is appropriate and reflects the lower capacity of the territories to raise revenues from non-resource tax bases.

In their Joint Submission, the territories indicated that the 20 percent Economic Development Incentive (EDI) has resulted in only a small net fiscal benefit for the Northwest Territories and it has had no benefit for either Yukon or Nunavut. These results indicate that the EDI is not a very effective incentive for territories to promote economic development and grow their own-source revenues. In addition, the net fiscal benefit is difficult to predict because it depends on a number of factors beyond the territories’ control. The TEAF is also a source of ongoing friction between the territorial and federal governments and its impact and accuracy are debatable. And it is uncertain whether the Northern Discount Factor accurately reflects the reduced ability of the territories to raise revenues because of the higher cost of living in the North.

Seventy percent of the value of the Revenue Block would be included in TFF, with no other adjustments on the revenue side.

The Panel’s new approach simplifies the measurement of revenue capacity in TFF by eliminating all of the current adjustments on the revenue side. To determine the value of the Revenue Block to be included in TFF, 70 percent of the seven territorial tax bases measured at National Average Tax rates would be included, with no other adjustments on the revenue side.

This approach provides sound and transparent incentives for the territories to promote economic development, expand revenue sources, address social issues, and foster self-sufficiency.

In effect, this results in an Economic Development Incentive of 30 percent. Each territory also gets to keep all its own-source revenues from tax bases that are not measured or included in the formula without seeing a corresponding drop in its TFF grant. This approach provides sound and transparent incentives for the territories to promote economic development, expand revenue sources, address social issues, and foster self-sufficiency.

The Panel also considered the treatment of other revenue sources in measuring revenue capacity for TFF, including other federal transfers. The Panel believes that the territories should be treated in a manner similar to the provinces with respect to other federal transfers. The Panel recommends that any increases in other federal transfers to the territories (e.g. Canada Health Transfer, Canada Social Transfer) that are provided outside of TFF should not be included in the measure of revenue capacity for calculating TFF entitlements.

As noted earlier, unlike provinces with natural resources within their borders, the federal government has Constitutional authority for natural resource development and management in the three territories.

The territories should benefit from the devolution of responsibilities for natural resources from the federal government to the territories. In principle, the net fiscal benefit to each of the territories should be similar.

All three territories see natural resources as a key source of substantial economic development opportunities. But agreements on devolution and resource revenue sharing with the federal government are in place only in Yukon. Discussions with the other two territories are in progress.

In principle, the Panel believes that the territories should benefit from the devolution of responsibilities for natural resources from the federal government to the territories. In principle, the net fiscal benefit to each of the territories should be similar.

The new approach to TFF recommended by the Panel is flexible enough to accommodate any devolution and resource revenue sharing agreements in the territories.

The new approach to TFF recommended by the Panel is flexible enough to accommodate the devolution and resource revenue sharing agreements currently in place in Yukon. In Yukon’s case, it means that resource revenues would continue to be addressed outside TFF. A number of approaches to devolution and resource revenue sharing in the Northwest Territories and Nunavut could be accommodated in the Panel’s new approach.

There’s a general understanding and much anecdotal evidence to show that both costs and needs are substantially higher in the territories compared with southern Canada. But there are few consistent, measurable, and evidence-based indicators of expenditure needs in the territories.

Since the TFF formula was first established, expenditure need was determined based on what the territories spent in 1982–83 then adjusted annually by the PAGE escalator. The Panel heard that the GEBs used in the previous TFF formula was not a real measure of expenditure need, but simply an approximation based on historical information dating back to when TFF was first established. There also is concern about how to translate expenditure needs and cost measures into a TFF formula.

The Panel believes that while a study of expenditure needs and the cost of providing services in the Territories may be useful in the longer term, it would be complex, costly, and time-consuming.

Some have suggested that there should be a systematic and thorough study done of expenditure needs in the territories to establish new expenditure bases and to determine how much money is adequate to meet the territories’ needs. Similar work is done in Australia, where the Commonwealth Grants Commission collects and compiles ongoing evidence of spending and needs in each of the Australian states.³¹

Evidence of the costs of providing public services in the territories should be compiled on an ongoing basis and reported in an annual report to Parliament.

On balance, the Panel believes that while a study of expenditure needs and the cost of providing services in the territories may be useful in the longer term, it would be complex, costly, and time-consuming. And it is questionable whether this extensive work would result in any better measures of what the territories need than a combination of history, political judgements, and proxy measures. For these reasons, the Panel suggests that an extensive and detailed study of expenditure needs in the territories may not be useful at this time. The Panel also recommends that evidence of the costs of providing public services in the territories be compiled on an ongoing basis and reported in an annual report to Parliament.
Further information on expenditure need is provided in Annex 2.

While the Panel does not recommend an extensive study of expenditure needs in the territories in order to adjust the funding base for TFF, information reviewed by the Panel clearly indicates that the case for assessing expenditure needs in Nunavut is substantially different. Initial evidence points to serious disparities in outcomes for health, education, housing, and social well-being compared with other Canadians. Nunavut is a new government with many challenges including the need to build the necessary capacity, particularly in public administration, to provide adequate and effective programs and services, and, at the same time, meet expectations for transparency and accountability in government.

The case for assessing expenditure needs in Nunavut is substantially different. Initial evidence points to serious disparities in outcomes for health, education, housing, and social well-being compared with other Canadians.

When Nunavut was established as a territory on April 1, 1999, TFF funding was not designed (nor was it adequate) to address existing deficiencies in health, housing, education, and social infrastructure, programs, and services. The Panel’s recommendations on TFF are intended to provide adequate funding for all three territories through both an initial adjustment to each funding base and ongoing escalation in TFF funding tied to relative growth in population in each of the territories. However, these adjustments do not sufficiently address the challenges and gaps in Nunavut.

Further work should be done to assess expenditure needs in Nunavut as a starting point for addressing those needs on an urgent basis.

For that reason, the Panel recommends that further work be done to assess expenditure needs in Nunavut as a starting point for addressing those needs on an urgent basis. This study could provide a template for reviewing expenditure needs and costs in the other territories in the longer term. However, the immediate objective should be to identify the specific needs and costs in Nunavut and to determine the most appropriate actions to be taken. The Government of Nunavut and the federal government should undertake this work jointly. Any additional funding necessary to address the challenges in Nunavut should be provided through targeted programs rather than through adjustments to the TFF formula.

The Joint Territorial Submission and other submissions made a strong case that the 3.5 percent annual escalation of TFF funding built into the New Framework was inadequate and inappropriate. They also contend that a fixed growth rate is not responsive to changes in population growth, expenditure needs, or the cost of providing public services in the territories. In the Panel’s view, the 3.5 percent annual growth rate is affordable and is in line with long-term growth in federal revenues.

The Panel recommends a separate Population-Adjusted Gross Expenditure Escalator (PAGE) be used to determine annual adjustments for each of the territories.

Historically, a Population-Adjusted Gross Expenditure Escalator (PAGE) was used to determine annual adjustments to the GEBs of each of the territories. In the 10 years prior to the introduction of the New Framework, the average formula escalator (PAGE) was 3.2 percent.³²

The Panel recommends that a separate Population-Adjusted Gross Expenditure Escalator (PAGE) be used to determine annual adjustments to the New Operating Bases for each of the territories. In their Joint Submission, the three territories indicated that this escalator is a reasonable measure of changes in their expenditure needs, if it is measured separately for each territory and there is no ceiling. To ensure that it is responsive to changing circumstances in each of the territories, the Panel recommends that the PAGE escalator remain open for three years in order to adjust for population changes.

The Panel recommends that the PAGE escalators remain open for three years in order to adjust for population changes.

It is difficult to predict the future impact of the PAGE escalators due to the variability in its components. But it is unlikely that, on average, the PAGE would grow at a much faster rate than in the past, particularly since population growth rates may be slowing in the Northwest Territories and Yukon. For this reason, the Panel believes that the PAGE escalators will continue to be affordable in the medium-term for the federal government.

Three-year moving averages should continue to be used to calculate the PAGE escalators, as in the previous TFF formula.

The approach recommended by the Panel may not provide as much stability or predictability as the New Framework with its fixed pool and fixed annual escalation rate. To address this ongoing concern, the Panel recommends that three-year moving averages continue to be used to calculate the PAGE escalators, as in the previous TFF formula. Under this approach, the territories and the federal government share both the upside and downside financial risks of changes in the territorial economies.

The Panel heard several concerns about the lack of transparency in the TFF process, about discussions held and changes made behind closed doors, and about the lack of timeliness in getting issues addressed and resolved. Moreover, the Panel heard from the private sector and Aboriginal leaders that timely resolution of devolution and resource revenue sharing issues is critical to provide a more stable and certain investment climate necessary to promote economic development in the territories.

The Panel heard from the private sector and Aboriginal leaders that timely resolution of devolution and resource revenue sharing issues is critical to provide a more stable and certain investment climate necessary to promote economic development in the territories.

The Panel considered the option of establishing an independent governance mechanism for TFF. On the one hand, an independent commission could provide increased visibility, neutrality, and credibility to the decision-making process. It could provide an unbiased process for resolving disputes, produce regular reports, or engage in ongoing research on issues such as assessing expenditure needs.

On the other hand, there are concerns with accountability from both federal and territorial governments. TFF, like Equalization, is a federal program. Consequently, an independent commission could only make recommendations to the federal government, not make final, binding decisions. In terms of the territories, there is potential for an independent commission to further delay decisions. Information on commissions in other countries suggests that they are costly, can require substantial administrative structures, and can negatively affect efficiency.

The Panel recommends that the territories and the federal government continue to use the current process for discussing and revising TFF.

The Panel therefore recommends that the territories and the federal government continue to use the current process for discussing and revising TFF. In particular, the Panel believes that a five-year renewal period for TFF is sufficient to ensure that ongoing changes in territorial circumstances are reflected in TFF. This approach is likely the best reflection of Canada’s federation. While there have been problems in the past, particularly with timeliness, this approach has served Canada well and should be retained.

At the same time, the Panel believes that several steps should be taken to improve the transparency and accountability of the current process for
discussing TFF among the federal and territorial governments.

Several steps should be taken to improve the transparency and accountability of the current process for discussing TFF among the federal and territorial governments.

• The new approach to TFF should be legislated, rather than addressed through agreements between the territories and the federal government.

The New Framework introduced in October 2004 was the first time TFF was legislated and the Panel believes this provides significant benefits to both the territories and the federal government. It minimizes the chance of ad hoc changes to the program. It increases transparency for all Canadians, including northerners. And it provides opportunities for both public and Parliamentary reviews of the program at regular renewal periods.

• Annual reports on TFF should be required from the federal government and those reports should be tabled in Parliament.

The Panel recommends that the federal Minister of Finance table an annual report on TFF in Parliament.

Although TFF is discussed in the context of the federal government’s budget, there is very little visibility for TFF in spite of its importance to the territories. The Panel recommends that the federal Minister of Finance table an annual report on TFF in Parliament that would address such things as:

• The history of the TFF program and its current design

• The total amount of funding provided to TFF as well as other federal transfers provided to the territories

• The amount of TFF allocated to each of the three territories and how that funding allocation was determined

• Comparisons of TFF total funding and allocations to territories over time, particularly comparisons with previous renewal periods

• Any changes in how the program is structured or designed

• A list and current status of any outstanding issues between the federal government and the territories

• Key indicators of expenditure needs, costs of providing public services, and revenue capacity in the territories

The territories may want to consider tabling similar reports in their respective legislative assemblies as part of their budget processes.

• Prior to the regular, five-year renewal of TFF, Finance Canada should issue a discussion paper identifying key issues and proposed changes to TFF. This should be accompanied by an open, Parliamentary committee review process.

Too often, the Panel heard that decisions about changes to TFF and Equalization are made behind closed doors, with discussions taking place at the officials level. There is no doubt that many issues can be and are successfully resolved through discussions among officials from both territorial and federal governments. However, the result is very little open public discussion and debate about TFF, little awareness of the nature of changes, and intermittent public squabbling when agreement can’t be reached at the political level.

A more open process would be beneficial to both federal and territorial governments, to northerners who see the impact of adequate or inadequate resources, and to all Canadians who want to know how their taxes are being used and what benefits are achieved.

The Panel believes that a more open process would be beneficial to both federal and territorial governments, to northerners who see the impact of adequate or inadequate resources, and to all Canadians who want to know how their taxes are being used and what benefits are achieved.

In addition to a commitment to a five-year renewal of TFF, a discussion paper would highlight useful background information, issues, and options. It would provide the federal government with an opportunity to raise important issues for public discussion. It would provide an opportunity for territories and interested Canadians to state their own cases publicly and openly. And a Parliamentary review process would also give all parties a forum to state their views.

29. 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.  29.
30. This proportion is based on 2005–06 Revised Estimates of revenues for each territory from each of the three territories 2006–07 budgets.
31. Government of Australia, Commonwealth Grants Commission. (2006). 2006 Update Report, Introduction.
32. Data provided by Finance Canada.

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