Key Issues for the Review of Equalization and Territorial Formula Financing

ANNEX B: How TFF Works: A Brief History

How TFF Works: A Brief History

Territorial Formula Financing (TFF) is the main federal transfer payment to the territorial governments. TFF was established in 1985 to provide Territorial governments with sufficient revenue to offer Northern Canadians basic services that are reasonably comparable to those available to other Canadians, taking into account the higher costs of services in the North as well as the more limited ability to raise revenue.

As illustrated in Chart 1, TFF will transfer $2 billion from the federal to the territorial governments next year (2005-06).

TFF accounts for over two-thirds of Yukon's and Northwest Territories' budgets, and 85 per cent of Nunavut's receipts.

The Early Years

TFF was introduced in 1985. Previously the federal government had transferred funds to territorial administrations, but not according to a formula. Rather, the Department of Indian Affairs and Northern Development (DIAND) financed territories on a program-by-program basis (education, infrastructure, housing etc.) Territories required federal approval for their spending decisions and could not select, act upon or be held clearly accountable by territorial residents for their choices.

1985 to 2004

This funding scheme was replaced in 1985 by a formula approach - Territorial Formula Financing. Under this new regime, each territorial government received an annual "block" TFF grant (i.e. one large unconditional cash transfer) from the federal government, which it could allocate and spend according to its own priorities. Territorial governments were henceforth accountable to territorial voters, not to federal authorities, for their management of the funds.

The TFF grant was governed by agreements between each territorial government and the federal Finance Minister. These agreements were of a limited term, generally five years, and subject to modification when they were renegotiated or renewed for the subsequent period. Although each renewal brought changes to the formula, the basic structure of the TFF has remained in place since its inception.

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

• looked at how much the territorial government needed to spend on providing reasonably comparable public services. This expenditure need measure was referred to as the Gross Expenditure Base (GEB).
• evaluated the financial resources the territorial government had at its disposal from sources other than the TFF grant. These included not only the taxes and fees it could impose but also most other transfer payments it received from the federal government. This measure was called Eligible Revenues.
• computed a grant amount equal to the difference between the GEB (what a territorial government needed to spend) and Eligible Revenues (the resources it could tap to fund that spending) (see Box 1).

Gross Expenditure Base (GEB)

The GEB did not measure what a territorial government actually decided to spend in a particular year. Rather, it sought to capture what each territorial government needed to spend in order to provide its residents with "reasonably comparable" public services. The formula's GEB and hence the size of the TFF grant was not linked to actual territorial spending. As a result, territorial governments could not increase the size of their grant by spending more money. Similarly, their grant was not reduced if they lowered their actual spending.

A benchmark GEB value was determined by examining actual expenditures made by each territory's government in 1982. This amount was considerably higher than the comparable spending by provinces, reflecting the higher costs and unique circumstances of providing "reasonably comparable" programs and services in the North.

This benchmark GEB was then escalated year-by-year to reflect the growth of needs for government expenditures over time. The escalator was set by assuming that territorial government spending needs should keep pace with outlays of provincial and local governments in the rest of Canada. Starting in 1990 the formula's GEB "escalator" also took into account the change in each territory's population relative to Canada as a whole.

This "basic" GEB, described in the Box 2 example, was subject to certain other adjustments over time:

• To allow the formula to keep up with the growing responsibilities that the territories took over from DIAND over the years (program transfers) , the GEB was raised by a negotiated amount each time a new function was assumed.
• 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 was introduced into the revenue side of the formula (described subsequently) and a consequent change was required in the GEB.
• The federal government reduced each territory's GEB by five per cent in the 1995 budget, which restrained the growth of TFF grants. This was part of the 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 the new Nunavut Territory and the continuing Northwest Territories. The combined GEBs were also augmented at that time to take into account the extra expenses involved in running two governments rather than one.

Eligible Revenues

Territorial governments receive two types of revenues -- transfer payments from the federal government and own source revenues that they generate themselves. Both transfer payments and own source revenues are considered in the Eligible Revenues segment of the TFF formula.

The main transfer payment for territories is the TFF grant itself. But Territories also receive the Canada Health Transfer (CHT) and the Canada Social Transfer (CST). There are various other, smaller transfers. The amount of CHT, CST and other non-TFF transfers that territories receive can be either included as Eligible Revenues or excluded, depending on arrangements for each of those revenues. Naturally, the TFF grant is excluded when measuring Eligible Revenues, since the formula is designed to capture the size of each territory's funding gap to be filled by the TFF grant. This gap must therefore be evaluated without TFF grant revenues.

Own source revenues come in a variety of forms - e.g. taxes, fees charged for permits issued or services provided, earnings on investments. While the transfer payments included under Eligible Revenues are entered as the amounts the territories actually receive, this is not the case for most own source revenues. The bulk of own source revenues are measured in the formula in terms of the potential amount a territorial government could collect if it exerted a "reasonable" tax effort. The measurement of what is a reasonable tax effort has been a complex and controversial issue throughout the history of the TFF (the so-called "Tax Effort Adjustment Factor" or TEAF, discussed below).

If a territory increases its tax levels beyond this point, it reaps revenues that are not offset by the TFF (the same principle applies to Equalization, which measures the potential -- not actual -- revenues raised by provinces). Again, as with Equalization, this is to avoid creating an incentive for receiving governments to increase their grant by reducing their tax levels.

The formula measures potential own source revenues (Hypothetical Own Source Revenues and Recoveries in the formula) in the following manner:

• Start with actual revenues
• Calculate what those actual revenues would have been had the territorial government not adjusted tax rates since a particular base year (1992-93 in recent versions of the formula).
• Compute what "at 1992-93 rates" revenues would have been, had the territory exerted a "reasonable tax effort" in that year. "Reasonable" for formula purposes is 85 per cent of the national average tax rates of provinces. This adjustment is meant to recognise that, because of the differences in the Northern and Southern Canadian economies, the same tax rate would represent a higher effective tax burden on Northern Canadians because of the higher costs of living in the North. This is referred to in the formula as the Catch Up Factor.
• Escalate 1992-93 "caught up" revenue in line with how much provinces have 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.
• The combination of the Catch up and Keep up factors is referred to as the Tax Effort Adjustment Factor (or TEAF); it is one of the more complex components of the TFF formula.

Revenue Exceptions

While a number of smaller own-source revenues are excluded from the formula, natural resource revenues deserve a special mention. The federal government initially retained authority over territorial natural resources, including the right to impose taxes and royalties. Over the years, the mandate for the management of certain natural resources has been devolved to the Yukon. Negotiations are currently under way for transferring control over natural resources to the Northwest Territories. A commitment has been made to open discussion with Nunavut in the near future,

As part of devolution, an offset, or "net fiscal benefit" was provided to the Yukon and is part of the current NWT discussions. The "net fiscal benefit" provision ensures that some of the natural resource revenues collected by the territories are excluded from the TFF formula's Eligible Revenues. Thus, a separate revenue-sharing process determines how much of the resource revenues the territorial governments retain and how much is remitted to the federal government.

Additional TFF Features

The foregoing discussion of the GEB and Eligible Revenues is a simplified view of TFF as it stood prior to October 2004. Some of the intricacies introduced into the TFF formula over the years are discussed here briefly.

Ceiling - in 1988, a "GDP ceiling" was added to the formula. The ceiling placed an upper limit on the annual growth of the GEB. It was calculated as the three-year moving average of Canadian nominal GDP growth. The ceiling was introduced by the federal government to restrict its TFF grant outlays in an era of large increases in provincial and local government spending. If the GEB hit the ceiling in a particular year, the ceiling-lowered GEB would then become the starting point for calculating the following year's GEB. In that sense, a one-year encounter with the ceiling permanently reduced the GEB and the TFF grant. This "path altering" aspect of the ceiling was modified in the 1999 renewal, and the ceiling itself was subsequently eliminated effective 2002-03.

1995 budget cuts - As part of Program Review's across-the-board spending reductions, the federal government announced two changes to the formula in the 1995 budget. First the 1995-96 grant was frozen at the 1994-95 level. Second, the 1996-97 GEB was reduced by five per cent. The first change was a "one time only" action and did not affect the GEB or the grant in subsequent years. The second, having altered the GEB in 1996-97, had an on-going effect.

CHT/CST enrichments - Starting with the 1999 federal budget, Canada Health and Canada Social Transfers were increased. Normally this would not have directly increased territorial revenues. The formula would have adjusted the TFF grant downward by exactly the amount that the CHT/CST rose. However, it was agreed that the territories should share in the extra funding. Therefore, the definition of Eligible Revenues was modified to exclude the CHT/CST increases of 1999 and all subsequent CHT/CST investments.

Economic Development Incentive (EDI) - As part of the 1995 renewal, the EDI was added to the formula (see Box 6). The EDI was a final adjustment to reduce the amount of Hypothetical Own Source Revenues by 20 per cent before the TFF grant was calculated. The EDI was forward looking and not intended to provide a boost to the territories' 1999 grants. Therefore, that year's GEB was cut by the same amount as Eligible Revenues, neutralizing the effect on the grant in 1999.

Floor - In the 1999 renewal, a floor was added to the formula, to come into effect in years when provincial and local government expenditures were falling from the previous year by more than one per cent. In the absence of the floor, the GEB would fall along with provincial and local spending. The floor however limited to one per cent the extent to which provincial and local spending declines could affect the GEB.

April 2004 Renewal of TFF

The usual five year renewal exercise took place and agreement was reached on a number of technical modifications to the TFF formula as well as

• an increase in the GEB of the three territories, amounting to an incremental $150 million over 5 years, and
• removal of the ceiling on GEB growth

The new agreements were still being finalized and were superseded by the announcement of the New Framework in October 2004.

October 2004 New Framework

In the Fall of 2004 the federal government announced at a meeting of First Ministers a New Framework. It set out a ten-year growth track for TFF and set aside its allocation formula, pending review by an Expert Panel on Equalization and TFF. The New Framework was legislated on March 10, 2005. More specifically:

• The total, all territory, TFF grant was set at $1.9 billion for 2004-05 and $2.0 billion for 2005-06. Thereafter, the TFF overall will grow by 3.5 per cent per year, with a mid-term review point in 2009-10.
• The normal workings of TFF, including the April 2004 renewal modifications, are set aside for 2004-05 and 2005-06. The formula parameters (GEB, Eligible Revenues, ceilings, CHST offsets, EDI, floor) no longer play a role in determining overall TFF payments to territorial governments.
• For 2004-05 and 2005-06, grants are no longer determined by the formulas in the three separate TFF agreements. The three territories will receive fixed shares in the $1.9 billion in 2004-05 and the $2.0 billion in 2005-06. Territorial shares were determined by the relative sizes of the grants each territory received in 2001-02, 2002-03 and 2003-04, with the greatest weight placed on the most recent year.
• The Expert Panel is tasked with, among other things, recommending an allocation formula for 2006-07 and onward.
• TFF grants are now being determined in accordance with federal legislation, not on the basis of the agreements between the federal government and each of the territories.

Last Updated: 2012-02-04		Important Notices