Key Issues for the Review of Equalization and Territorial Formula Financing

3. Why do we Need Equalization and TFF?

In a country with a single central government, there is generally less need for equalizing grants such as Equalization or TFF. The central government is able to levy all taxes on a consistent basis and to provide equivalent public services in all parts of the country. In a country with more than one order of government, and particularly in a highly decentralised federation like Canada -- where provinces are attributed important spending responsibilities by the Constitution -- geographical size, incomes, access to natural resources and location advantages differ greatly among provinces and territories. Accordingly, provincial-territorial governments have very different fiscal capacities and hence abilities to provide public services. Equalizing grants become more necessary to ensure that provincial-territorial public services and levels of taxation remain reasonably comparable for all Canadians, wherever they live.

At the same time, the principle of federalism requires that the central government respect the different preferences of regions with respect to tax and service levels. The purpose of equalizing grants, therefore, is not to impose common standards onto provinces and territories, but to enable them financially, if they wish, to provide reasonably comparable public services without having to resort to disproportionately high levels of taxation. That is why these grants have no conditions and come with no strings attached. Of course, a province or territory that wishes to provide above average services is always free to do so, as long as it is willing to raise higher than average revenues.

It is important to distinguish equalization grants from transfers such as the Canada Health Transfer (CHT) or the Canada Social Transfer (CST). These are federal transfers to all provincial-territorial governments, linked to the achievement of shared national goals, in priority areas such as health care, post-secondary education and social programs and services. Finally, equalization grants are to be distinguished from federal transfers to persons, such as Old Age Security, Employment Insurance or the National Child Benefit. Their purposes are quite different, since they are directed at disparities in personal incomes.
Arguments are often made that Equalization has failed to equalize the incomes of Canadians in different regions or that Equalization should address economic disparities between regions. Others argue that Equalization should help less wealthy regions catch-up with the infrastructure of wealthier regions. Yet, Equalization is not primarily intended to do these things, although it may contribute indirectly to those goals (for instance if public investments in education and public infrastructure close the revenue gaps between residents of different regions). This point deserves further explanation (see box and figure 2).

Equalization is sometimes criticized on the grounds that it - like other federal expenditures - results in transfers of federal tax revenues raised in some regions (notably the better-off regions) toward the funding of services in less well-off regions. This is inevitable. For example, a progressive (and even a proportional) tax system that applies to all Canadians equally will result in more revenues being raised from regions with above-average individual incomes. When these revenues are spent on federal programs across the country, they will inevitably result in income transfers between regions.

Figure 2: Equality of Opportunity and Equalization-TFF Grants

Components of the Well-being of Canadians Economic Opportunities (e.g. employment incomes)   Federal Services and Transfers (net of Taxes)   Provincial-Territorial Services and Transfers (net of taxes)                 Role of Equalization and TFF

Finally, it is important to note that Equalization is not primarily directed at resolving issues of "vertical fiscal balance" among orders of government. Any federation will have debates about whether each order of government (federal government, provincial-territorial governments collectively) has access to revenues in line with its spending responsibilities. This is called by experts "vertical balance". In Canada, vertical balance is maintained through federal transfers to all governments (e.g. the CHT, CST), through changes in tax levels by either or both orders of government and through shifts in spending priorities. Equalization is essentially concerned with the fiscal capacity of governments at the same level (e.g. provinces, or territories) to offer reasonably comparable public services at reasonably comparable levels of taxation. Experts call this "horizontal balance".

Panel members acknowledge the public debates in Canada about vertical fiscal balance. However, these are outside the Panel's mandate.

Last Updated: 2012-02-04		Important Notices