Chapter 6. Adaptability, accountability and sustainability: Intergovernmental fiscal arrangements in Canada
Transfers from Canada’s federal government to provinces, territories and local governments account for about one-fifth of the revenues of those governments, and about one-third of federal programme spending. While central governments in federations typically raise more, and sub-central governments typically raise less, than they spend directly, large gaps and transfers to bridge them strain the federal principle that governments at each level are sovereign in their respective spheres. Transfers can help achieve national-scale public goods, address spillovers among provinces, and support minimum standards for public services and other programmes across the country – yet Canada’s present system does not consistently reflect these purposes. The potential of large transfers to undermine accountability and foster unsustainable fiscal policies should inspire caution about their current size, and discourage expanding them. Demographic change will dampen the growth of government revenues in Canada and push programme spending up, particularly at the provincial level. Responding effectively will require a mix of tax increases and spending restraint from provinces and ideally partial pre-funding of programmes such as drug treatments and long-term care. Such reforms are likelier if the federal government limits growth in intergovernmental transfers, and reduces its draw on common revenue bases – the consumption base in particular – that the provinces will likely need to exploit more in the future.
This chapter draws heavily on a previous C.D. Howe Institute Commentary (Laurin and Robson, 2015[1]). We are indebted to a number of colleagues and reviewers for their contributions to that paper. We are particularly grateful to our colleague Parisa Mahboubi for projections of demographically sensitive government programmes. We also thank participants in the June 2019 OECD-KIPF Fiscal Network Workshop on Ageing and Long-term Challenges across Levels of Government for their comments and discussion. Responsibility for any remaining errors and for the views expressed is ours.
Amounts spent and raised by different levels of government in Canada have never coincided: the federal government has always raised more, and provincial, territorial and local governments less, than required for their own programmes. Accordingly, transfers from the federal government to other levels of government have been a feature of Canadian fiscal policy since Confederation in 1867.1 Initially modest relative to Canada’s economy, intergovernmental transfers grew as the role of governments in providing services and redistributing income grew through the 20th century. They now occupy a major place in the budgets of Canadian governments: about one-third of the spending of the federal government, and almost one-fifth of the revenues of recipient governments. They are correspondingly prominent in public and official discussions.
Transfers from central to sub-central governments are common throughout the world. Because they are so visible in federations, commentators in federations, including Canada, have been prominent in exploring reasons for divisions of taxing and spending powers, and intergovernmental transfers for various purposes, including closing fiscal gaps created by any given division of powers. Being informed by history and current circumstances, that literature tended to blend both positive empirical statements with more normative ones.
This chapter begins by describing the history that shaped Canada’s current system, then reviews various insights about potential uses of federal-provincial transfers and comments on the degree to which they justify current practices. It next describes potential future evolution of spending and revenue at the federal and provincial levels, highlighting the extent to which demographic change will increase fiscal pressure on the provinces. It closes with comments on how different types of intergovernmental transfers may affect the efficiency, accountability and sustainability of Canadian fiscal policies and major programmes.
This survey highlights the importance of particular circumstances, including fiscal stresses at either level of government, and the political responses to those circumstances, in shaping Canada’s arrangements. Notwithstanding the insights from public economics about how intergovernmental transfers can address externalities and provide public goods on a national scale, nothing in economic logic dictates that the gap between revenue and spending at the federal and provincial levels should be as large as it is, nor that the transfers that bridge it should be structured along current lines.
This discussion of current stresses draws out the tension between the key principle that federal and provincial governments are sovereign in their respective spheres and the fact that federal-provincial transfers are large and complex. A greater focus on the provincial autonomy that is desirable in a federation, responding more effectively to challenges at each level of government and limiting potentially adverse influences of intergovernmental transfers on budgetary policy, would point toward smaller, simpler intergovernmental transfers. Especially in view of looming demographic pressures, there is a strong case for more closely aligned revenue-raising and spending powers of governments at each level.
Canada’s division of revenue and spending powers between the senior governments, and the transfers that reconcile gaps between revenue and spending at each level, have evolved in response to changing concerns and political pressures.
The 19th and 20th centuries
The British North America Act – now formally termed the Constitution Act, 1867 – and key political and legal decisions shortly after Confederation gave Canada a system in which the federal and provincial governments are sovereign in their respective spheres.
Looking first at responsibilities, some powers, notably related to defence, money and banking, navigation, relations with indigenous people, immigration and criminal law, became federal matters. Others, notably related to property and civil rights, natural resources, municipalities, charities, and what we now call health care and education services, became provincial matters.2
As for the resources to finance those responsibilities, the 1867 Act granted the federal government power to implement “any mode or system of taxation.”3 It granted the provinces “direct taxation within the province”4 – a formulation intended partly to preclude tariffs on interprovincial trade, but which has been interpreted elastically enough to allow a variety of indirect taxes and even charges levied on products from other provinces. As a result, the tax bases of the federal and provincial governments largely overlap. Both levels have legally unlimited power to borrow to finance any activity.
The 1867 Act provided for transfers from the federal government. Originally, these included funding for public administration as well as per capita transfers to reduce regional disparities. In addition, these transfers contained an incentive to control public debt.5
The federal transfers were originally fixed total sums or fixed dollar amounts per head. So growth of the economy and government budgets had reduced their importance in provincial revenues by the end of the century. From nearly CAD 6 in 10 dollars of provincial revenue in 1874, federal transfers had fallen closer to CAD 4 in 10 dollars by 1896 (Perry, 1997[2]).
Federal and provincial spending and revenues changed markedly over the course of the 20th century. The 19th-century model of relatively small governments mainly providing infrastructure and internal and external security transitioned to the post-Second World War welfare state. By the end of the century, health care, education and social services – areas of provincial responsibility – were major government programmes in Canada, as in other developed democracies.
On the revenue side, Ottawa introduced personal and corporate income taxes in stages during the First World War. Many provinces started taxing corporate and personal incomes for the first time in the 1930s to finance the needs of the Great Depression. After surrendering much of their autonomy in taxation during the Second World War, provinces progressively regained tax-policy autonomy, as long as they conformed to shared definitions of the base for taxable income. As provincial spending responsibilities grew, the provincial share of personal income tax revenues increased.6
Changes in intergovernmental transfers accompanied these changes in revenue and spending. In 1927, long before the 1951 constitutional amendment that made income supports for the elderly a federal responsibility, Ottawa began paying half their cost. The Great Depression tested many provinces’ access to credit, with Alberta defaulting in 1936. The federal government’s superior borrowing capacity, backed after the creation of the Bank of Canada by the power to monetise debt, increased its attractiveness as a subsidiser of provincial programmes. In particular, Ottawa provided extensive supports for the unemployed even before getting full responsibility for unemployment insurance in 1940.
During the late 1950s and 1960s, the appeal of federal support for national social programmes was strong in most parts of Canada, and rapid growth in the economy and federal revenues made relatively open-ended support of provincial programmes, including programmes that increased provincial exposure to demographic pressures, seem affordable. Federal payments geared to half of aggregate provincial spending on publicly funded doctor and hospital care developed during those years. Ottawa replaced direct grants to universities with transfers to provincial governments, likewise geared to half of aggregate provincial spending on post-secondary education. Ottawa also supported provincial welfare programmes through the Canada Assistance Plan (CAP), which underwrote half of relevant expenditures in each province individually.7
An exception to this general move toward conditional grants was the 1957 establishment of the formal Equalization programme. Equalization’s essence is to top up the revenues of provinces with lower-yielding tax bases.8
Another notable exception to the general narrative of federal inducements to provinces to expand their programmes by subsidising them was a series of federal offers, in 1964, and again in 1968 and 1973, to withdraw from certain cost-shared programmes and transfer tax room to the provinces instead. (At that time, all provinces but Quebec computed their income taxes as percentages of federal income taxes, which gave rise to the terminology of “tax points” – each percentage point being one tax point.) Most provinces preferred the shared-cost subsidies; Quebec was the exception. Since 1965, Quebec taxpayers have received a special “tax abatement” in lieu of cash transfers Ottawa would otherwise have made.9
The end of the rapid growth of the 1950s, 1960s and early 1970s put the federal budget under pressure and prompted changes to federal grants in support of health care and post-secondary education. New Established Programs Financing (EPF) arrangements replaced cost sharing with a formal transfer of tax base (“tax points”) and a cash transfer. These changes reduced federal subsidies and exposure to provincial decisions: no longer were the provinces collectively spending “50-cent dollars” on these programmes.10 To preserve its leverage over provincial health care policy, the federal government passed the Canada Health Act in 1984, empowering Ottawa to reduce transfers to provinces that did not adhere to the Act’s principles.
Ottawa’s fiscal problems intensified during the 1980s, and the economic downturn of the early 1990s pushed its deficit and debt up the national agenda. Measures to balance the federal budget in the second half of the 1990s had significant impacts on intergovernmental transfers. Ottawa first capped its Canada Assistance Plan (CAP) subsidies to several provinces. It then combined grants for health care and post-secondary education with the CAP in one block fund, the Canada Health and Social Transfer (CHST), eliminating the last of the “50-cent dollars” provinces had been spending on welfare programmes. The total CHST was initially smaller than its predecessor programmes – part of Ottawa’s effort to eliminate chronic deficits.
After increasing in line with the economy in the early 1990s (Figure 6.1), federal transfers fell sharply in 1996/97 and 1997/98. Although they grew again as Ottawa’s budgetary situation improved, provincial governments and other advocates were complaining of a “fiscal imbalance” as the 20th century drew to a close.
Note: Federal transfers to Quebec are increased by the value of federal income tax abated (13.5 tax points) under the Alternative Payments for Standing Programs (the Quebec tax abatement).
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; Receiver General for Canada (various years[4]), Public Accounts of Canada, Vol. I and II; Department of Finance (2015[5]), “Economic Action Plan”, Ottawa, April; Department of Finance (2019[6]), “Investing in the Middle Class – Budget 2019”, Ottawa, March.
The 21st century
In the early 21st century, the formal division of spending and revenue-raising powers, and the intergovernmental transfers that bridge the gaps between them, changed relatively little, but the dollar amounts changed markedly. In the 20 years from the early 1990s to the early 2010s, sub-central governments increased their share of consolidated government spending – excluding intergovernmental transfers – from 63% to 72%. They also increased their share of revenue, with their own-source revenues – that is, excluding intergovernmental transfers – rising from 56% to 60% of the national total (Figure 6.2).
Note: The federal transfers to Quebec are increased by the value of federal income tax abated under the Alternative Payments for Standing Programs (13.5 tax points) and the discontinued Youth Allowances Program (3.0 tax points), and Quebec’s revenues are reduced by the same amount.
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; authors’ calculations.
Programme spending by types
At present, and going a layer deeper, sub-central governments currently make about 85% of expenditures on operations – payments to employees, contractors, utilities, etc. – reflecting their role as public service providers. Sub-central governments also manage about 85% of public infrastructure expenses and hand out about 80 cents per dollar of business subsidies (Figure 6.3).
Ottawa continues to dominate transfer payments to households through employment insurance, benefits for seniors and families with children, and other purposes. About 70 cents per dollar of all government payments to individuals are now federal.
Revenues by tax bases
Turning to revenues (Figure 6.4), property taxes – still a field exclusive to the provinces – continue to raise a substantial amount of their revenue. By contrast, Ottawa’s exclusive jurisdiction over customs and other levies on international trade and transactions has become less important as international trade has become freer.
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; authors’ calculations.
Note: The federal transfers to Quebec are increased by the value of federal income tax abated under the Alternative Payments for Standing Programs (13.5 tax points) and the discontinued Youth Allowances Program (3.0 tax points), and Quebec’s revenues are reduced by the same amount.
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; authors’ calculations.
As for shared tax fields, Ottawa is still the largest collector of personal and corporate income taxes, raising about two-thirds of the total. The provinces collect about two-thirds of consumption tax revenues, up markedly over the last 20 years, thanks to rate cuts at the federal level and rate increases at the provincial level.
Miscellaneous non-tax revenues – mainly investment incomes, profits of government business enterprises, royalties, user fees, fines and other penalties, asset sales, and various other sources – are important for sub-central governments. The federal government collected only about one-eighth of such revenues in 2018.
Contributions to social insurance schemes and provincial payroll taxes that flow into consolidated revenue11 now yield roughly equal amounts to each level. Ottawa has recently collected something less than two-thirds of contributions to social insurance schemes related to employment, workplace injuries and health care, down from more than three-quarters in the early 1990s. This change reflects slower growth in federal employment insurance pay-outs and revenues than in provincial workers’ compensation and drug programmes.
Intergovernmental transfers
The fact that provinces have increased their share of spending more than their share of own-source revenues since the 1990s implies that federal transfers have increased and/or that their budget balances have deteriorated relative to the federal balance. Both developments have occurred.
Improved federal fiscal health and pressure for larger transfers spurred faster growth in payments after 2004. Ottawa split the CHST into a Canada Social Transfer (CST) and a Canada Health Transfer (CHT). The former continued to grow with the economy, but the latter – responding to the higher public profile of health care spending – grew faster. The net result was that federal transfers outpaced gross domestic product (GDP). They also rose relative to sub-central spending, from about 15% after the cuts of the mid-1990s to around 17% recently. They also rose relative to Ottawa’s resources: roughly one in three CAD dollars raised by federal taxes recently has financed intergovernmental transfers (Figure 6.5).
Note: The federal transfers to Quebec are increased by the value of federal income tax abated under the Alternative Payments for Standing Programs (13.5 tax points) and the discontinued Youth Allowances Program (3.0 tax points), and Quebec’s revenues are reduced by the same amount.
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; authors’ calculations.
Current transfers and commitments
That account brings us to the present and a review of the current configuration of transfers and their likely growth.
The largest single intergovernmental transfer is the CHT – CAD 37 billion in 2017/18. The CST is also sizeable – CAD 14 billion in 2017/18 (Figure 6.6). The CHT was legislated to grow by a 6% annual escalation until the 2016/17 fiscal year and thereafter increases at least 3% annually up to the rate of growth of the economy. The CST is legislated to continue its 3% annual growth.
Note: Federal transfers to Quebec are increased by the value of federal income tax abated (13.5 tax points) under the Alternative Payments for Standing Programs (the Quebec tax abatement).
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; Receiver General for Canada (various years[4]), Public Accounts of Canada, Vol. I and II; Department of Finance (2015[5]), “Economic Action Plan”, Ottawa, April; Department of Finance (2019[6]), “Investing in the Middle Class – Budget 2019”, Ottawa, March.
The CHT and the CST, paid on a per capita basis, are formally earmarked to support provincial spending on health care, post-secondary education, childcare, social assistance, and other social services. In practical terms, however, they resemble unconditional transfers. The money is fungible and can help provinces spend on anything, provide tax relief, or improve their budget balances. There are no recent instances of Ottawa withholding material amounts to penalise a province for deficiencies in its programmes.
Rounding out the three largest transfers are the Equalization and the Territorial Formula Financing (TFF) programmes – a combined CAD 21 billion in 2017/18. The Equalization formula reflects differing yields of tax bases among provinces; TFF reflects differing tax yields among all 13 jurisdictions. A desire to create a predictable obligation has led Ottawa to gear total Equalization payments to GDP since 2009.
Alongside these programmes, Ottawa transfers several billion dollars annually for public infrastructure, mainly through the Gas Tax Fund, the Goods and Services Tax (GST) Rebate for Municipalities, and recently programmes such as the “Building Canada Plan” and the “Investing in Canada Plan”. Infrastructure grants amounted to a few hundred million Canadian dollars per year for most of the 1990s up to the mid-2000s, after which they increased rapidly. With the multi-billion annual grants announced in phases 1 and 2 of the “Investing in Canada Plan”, infrastructure grants to sub-central governments are scheduled to exceed CAD 10 billion annually over the next ten years.
The major transfers and infrastructure grants just described make up about 80% of Ottawa’s transfers to other governments. The remaining grants are for a host of specific purposes, among them the Canada Quebec Accord on Immigration, Wait Time Reduction Transfers, payments to provinces regarding sales tax harmonisation and payments under Canada Job Fund Agreements.
Canada’s historical and current division of revenue and spending powers, and intergovernmental transfers, were not guided primarily by formal theories of federalism. Economists and others have, however, illuminated forces driving the evolution of federal systems, including Canada’s. We now turn to those – drawing insights from public economics about important goals that fiscal federalism can help achieve, and about the implications of practices that have evolved for other reasons.
Subsidiarity and the case for provincial/local government
It helps to start by asking why Canada, or any country, has more than one government. The high-level answer is that sub-central governments are better providers of many things people want. The division of powers at Confederation reflected a desire among many of the new country’s citizens for provincial management of numerous things they wanted governments to do.
The case for sub-central provision and regulation is stronger when sub-central tastes and conditions vary (Oates, 2005[7]). In Canada’s case, differences in language, religion and much else resulted in a federation that was less centralised than some founders wished, with the realities of negotiation among entities that could have remained separate if they chose making the desire for provincial control highly influential.
In a democracy with freedom of movement, organising public affairs at the most decentralised, competent level – a principle often referred to as “subsidiarity” – has a key further feature. People can move among jurisdictions in response to differences in government programmes and taxes. An influential early exploration of these dynamics by Tiebout (1956[8]) described how competition among sub-central governments levying taxes on their residents that are akin to prices for the programmes they provide could foster the efficient provision of public goods and services. Residents of one jurisdiction who prefer the benefits provided and prices charged by another one can move there, so people of differing tastes can locate in jurisdictions that suit them better.
A complementary dynamic noted by scholars who emphasise incentives and self-interest in the public sector – generally known as the “public choice” school – is that competition among jurisdictions can protect citizens from people in, and interest groups working through, government who seek to benefit themselves – see, for example, Brennan and Buchanan (1980[9]). This view sees horizontal competition among sub-central jurisdictions, as well as vertical competition between the two levels of government, as a spur to accountability, more efficient services, and support for democratic government more generally.
National interests and the case for federal programmes and taxation
What, then, determines what gets done at a central, and what at a sub-central, level? Classical public economics – a large part of what Oates (2005[7]) terms “First Generation Theory” of fiscal federalism – tended to stress four motives for assigning functions to the central government in a federation: externalities; different scales for the provision of different public goods; regional redistribution to achieve certain standards of public services and other programmes; and mitigating potentially harmful internal migration.
An uncontroversial example is defence against external aggression: a public good primarily organised on a national scale. Others are major elements of international trade and immigration policy. In countries with small pools of talent suitable for public administration, the central government may have an advantage in delivering services – as argued, for example, by Prud’homme (1994[10]). This argument has limited applicability to Canada.
On the economic front, most major countries give central governments exclusive control of currency and related financial regulation. Because monetary policy and fiscal policy are both tools of macroeconomic management, moreover, a substantial central-government capacity to tax, spend and borrow is widely seen as helpful in counter-cyclical demand management.12 A similar argument supports central-government responsibility for insurance against unemployment, more effectively pooling risk across sectors, and over time.
Public economics rationales for intergovernmental transfers
If subsidiarity alone dictated assignments of responsibility among different levels of government, locating responsibilities at the lowest level with the competence to discharge them and assuring that each level financed its own activities would make sense. Accountability at the sub-central level would spur sub-central governments to respond more fully to their citizens’ preferences, whether expressed by voting with ballots or with feet. Accountability at the central-government level would let citizens across the country express their preferences with their ballots, knowing the taxes they paid to the central government were financing services delivered by it. Both levels would budget knowing they would need to cover their own costs, now and later, promoting sustainable fiscal policies.
In practice, however, spending responsibilities and revenue raising do not align, and examinations of why not have generated extensive literature.
Economies of scale as a public good
The attraction of assigning some revenue raising to the central government, even when the programmes those revenues will fund are sub-central, is considerable. The reduced administrative and compliance costs of uniform national taxes on income and consumption, administered by one agency, have induced many countries, including Canada, to collect centrally at least some taxes that flow directly to sub-central governments.13
Realising the public good of more efficient revenue collection does not, however, require formal, budgeted intergovernmental transfers. The remittances from Ottawa to the provinces in respect of personal, corporate or sales taxes attributable to activity in the provinces appear neither as a federal spending programme nor as provincial transfer income. The focus here is not mechanical allocations of revenue, but formal budgeted programmes inspired by other goals.
Externalities
One such goal relates to public goods and services that generate benefits beyond the localities where they are provided – national transportation, for example. Inter-jurisdictional spillover benefits mean that people want more investment in such goods and services than sub-central governments, responding to the costs and benefits within their jurisdictions alone, will provide.
As for negative externalities, central-government-imposed penalties, which would take the form of reductions in transfers otherwise payable, could respond to a similar logic. Provinces can adversely affect each other in many ways, such as trans-boundary pollution, inadequate law enforcement that supports cross-border criminality, or violations of international agreements that trigger retaliation by foreign governments. Penalties levied by the central government could reduce negative externalities within the federation.
Redistribution, equity and rights of citizenship
Intergovernmental transfers also respond to two related notions: that sub-central governments need resources to discharge their responsibilities; and that citizens throughout the country have certain rights.14
Law enforcement, for example, is often mainly managed locally but has national dimensions beyond spillovers. If the alternative is direct central provision of functions in sub-central jurisdictions, subsidies for the sub-central governments are arguably better for a healthy federation.
Notions of citizenship rights can be quite expansive, getting into areas of “positive rights”. Many Canadians identify certain government programmes as coincident with citizenship. They therefore feel that Ottawa should finance them in whole or in part, to ensure that fiscal capacity to deliver those programmes exists across the country, and as a lever to punish provinces that fail to meet the standard they feel is appropriate.
Arguments around regional equity carry weight. They found expression in the Constitution Act, 1982, which expresses commitment to ensuring that provinces have “sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation.” Their principal formal expression is the Equalization programme, but per capita block transfer programmes such as the CHT and the CST also support fiscal equity in this sense.
The public finance literature that emphasises regional and citizen equity tends to argue for centralisation of taxation, especially income taxation. Mobile persons and businesses can more readily escape taxes levied by a sub-central jurisdiction; to escape central government taxes, they would need to emigrate. This dimmer view of the Tiebout model or the dynamic described by Brennan and Buchanan (1980[9]) sees centralised collection as preventing what would otherwise be a “race to the bottom” in tax rates and redistributive programmes.
Mitigating harmful migration
Another interpretation of the practice of subsidising sub-central jurisdictions with lower-yielding tax bases is that such transfers reduce incentives for internal migration by businesses or workers seeking better packages of taxes and programmes. In this view, actual or potential migration is economically inefficient – if, say, fiscal benefits differ from place to place because of unequal natural resource endowments, rather than reflecting the relative productivity of workers in the two regions (Boadway, 2006[11]).
A supporting argument rests on the observation that taxpayers move more readily among sub-central jurisdictions than across international borders. Without equalising transfers, this internal mobility could make the distortionary costs of taxation higher at the sub-central level than at the central level. So economic efficiency would justify centralising some taxation, combined with equalising transfers to sub-central governments (Dahlby, 2008[12]).
Conclusive evidence of significant differences in tax distortions between central and sub-central governments in the absence of intergovernmental transfers has been elusive, however. Even if equalising grants can reduce these distortions, moreover, they can also lower the perceived cost of taxation in recipient jurisdictions (Dahlby, 2008[12]; Dahlby and Ferede, 2011[13]). Furthermore, if underestimation of the social cost of raising additional revenues leads to higher sub-central taxes and spending, it will also lead to higher central taxes to finance the resulting higher equalisation grants.15
Recent experience and analysis
The experience of the very late 20th and early 21st centuries has prompted further thinking about the economics of federations and potential prescriptions.
One striking observation is the weak evidence for a race to the bottom in tax rates and public services. Even internationally, where central fiscal authority is weak or non-existent, tax rates, public services and redistribution tended to increase in the advanced democracies after the Second World War, and have been quite stable since, while rising in developing countries. Whatever the effects of competition on tax rates, the overall impact of citizens voting at the ballot box and with their feet seems to have been the convergence of taxation and spending around the levels established in the second half of the 20th century.16 In Canada, accelerations and decelerations of spending at the provincial level seem easier to explain with reference to the fiscal condition of particular governments than trends up or down in the intensity of tax competition.
Another noteworthy development during the latter 20th and early 21st centuries is decentralisation – in Canada, in the more advanced democracies,17 and many other parts of the world as well. Notwithstanding the economic and citizenship arguments for centralisation, other considerations, including the benefits of sub-central accountability and competition among jurisdictions – as described by Brennan and Buchanan (1980[9]), Oates (2005[7]) and Chandra (2012[14]) – seem to have forestalled any centralising trend.18
As for feelings of national identity and their expression in positive rights of citizenship, differences in the regional intensity of citizens’ tendency to identify as citizens of the country rather than as citizens of their province or region are persistent in Canada. As previously mentioned, only Quebec accepted a transfer of tax points rather than a full subsidy in the 1960s. Many programmes most Canadians would identify as national – such as the mandatory work-related retirement and disability schemes (the Canada and Quebec Pension Plans), Employment Insurance, and Medicare – do not work uniformly across the country. These differences are sometimes controversial: many see deviations from uniform treatment across the country as evidence that Ottawa is itself a tool for regionally based special interests to benefit themselves at the expense of Canadians elsewhere. Laudable or not, they indicate the limits of arguments based on rights of citizenship.
What about arguments for inter-regional transfers to mitigate economic shocks and inhibit inefficient migration? Recent literature underlines that regional insurance through open-ended transfers create moral hazard – among other things, reducing the incentive for sub-central governments to prepare for and adjust to economic shocks (Oates, 2005[7]). Boadway (2006[11]) argues for providing inter-regional insurance through programmes running on proper insurance principles.
Situations where fiscally induced migration into a resource-rich jurisdiction, or migration out of a resource-poor one, are economically inefficient are certainly plausible; so are situations where it is efficient. Many circumstances that let governments offer attractive fiscal packages – such as abundant natural resources, other geographic advantages or efficiency in delivering services – are likely to correlate with good job opportunities, so differences in net fiscal benefits do not necessarily induce inefficient migration.
Some dysfunctions in federations have also spurred new thinking. Inside Canada, the persistence of regional disparities, and evidence that some intergovernmental transfers create problematic incentives for recipients, showed that public choice considerations matter – see, for example, Courchene (1998[15]). Problematic behaviour by sub-central governments, in Argentina and Brazil, for example (Tanzi, 1996[16]), has directed fresh attention to the incentives intergovernmental transfers create, and negative externalities from them. Much of the provincial and local infrastructure spending supported by federal transfers in Canada, on public transit, for example, does not provide national-scale public goods or mitigate interprovincial externalities. A more straightforward explanation would be regional vote-buying.
Recent literature highlights the importance of “hard” versus “soft” budget constraints in fostering sustainable fiscal policy (Oates, 2005[7]). Decentralisation with open-ended transfers leads recipients to expect the provider to finance excesses, either because it has formally committed to do so, or because commitments not to do so will prove practically impossible to keep. If intergovernmental grants permit bailouts, the temptation will be to expand public programmes beyond levels that reflect public preferences or are sustainable over time (Rodden, 2002[17]).19
A key condition of efficiency and sustainability is that potential lenders must have a clear view of the creditworthiness of potential borrowers. One criterion is the ability of sub-central jurisdictions to raise the revenues they need to finance their expenditures. A second is intergovernmental transfers that are stable and consistent with budgetary discipline, rather than prone to ad hoc adjustments when a sub-central jurisdiction gets into trouble. The recent problems the European Union had with Greece, and concerns about larger sovereign debtors in the European Union, are reminders of the danger that a unit within a larger system might act on the assumption that it can force a bailout.
The philosophical cross-currents just discussed will continue to inform the Canadian debate, even as larger economic forces exert new pressures on the various levels of the Canadian government. Given current evidence, the biggest challenge in the coming decades will be the fiscal implications of demographic change.
Slower revenue growth
Looking first at revenue, a country’s workforce is a key determinant of its capacity to produce goods and services. Absent tax changes, total output and spending tend to affect government revenues proportionately (Drummond, 2011[18]). With the baby boomers leaving the workforce, and their descendants and immigrants barely replacing them, growth of GDP and the tax base is set to slow relative to growth of the total population.20
Upward pressure on spending
Demography also affects government spending. Publicly funded pensions, old-age transfers and health care will grow disproportionately as the boomers age. Publicly funded health care is strongly geared to age (CIHI, 2014[19]), and the growing importance of publicly funded drug programmes, which most provinces direct mainly toward seniors, may intensify that pressure. The population aged 65 and up relative to that of working-age Canadians is set to increase from about 1 senior per 4 potential workers today to around 1 senior per 3 potential workers in 10 years, and 1 senior for every 2.5 workers in 20 years (Figure 6.7). What is more, the youth dependency ratio – those aged 0-17 relative to the working-age population – is no longer declining. So the relief recently provided by the relative decline in the young population – on which governments spend less lavishly in any event – will not continue.
Source: Authors’ calculations.
Quantifying demographic pressures on government budgets
A demographic model with middle-of-the-road assumptions for fertility, immigration and cost inflation produces some important results for age-sensitive government spending relative to GDP.21 Our baseline shows age-sensitive spending in Canada rising from 16.2% of GDP in 2018 to 18.5% in 2038, and 19.8% in 2068 (Figure 6.8).
Source: Authors’ calculations.
Elderly benefits rise as a share of GDP until the early 2030s but decline thereafter, because they are indexed to prices only, and productivity growth expands the tax base by comparison. Child and family benefits decline throughout the projection because the share of young people in the population does not rise, and the benefits, like those for seniors, are indexed to prices. Publicly funded education absorbs a roughly constant share of GDP over time: the population of students stays roughly constant as a share of the total, and the cost of providing the service rises with productivity, with compensation of education workers keeping pace with compensation elsewhere in the economy. Publicly funded health care, by contrast, rises relentlessly, from about 7.1% of GDP today to around 8.9% in 2038, and 10.8% in 2068: a rising share of seniors in the population, with their higher per-capita costs, and the same productivity-driven increase in compensation of health care workers, explain this projection.
These projections have markedly different implications for the two levels of government. Ottawa will need to manage a temporary rise in the cost of seniors’ benefits (mainly Old Age Security and the Guaranteed Income Supplement). On the other hand, Ottawa’s support for post-secondary education will decline with the relative number of students, and its child-related transfers will fall significantly. Overall, absent changes in programme parameters, demography will reduce federal government commitments.22
The provinces are in a very different position. Their education costs will not decline the same way the federal government’s transfer programmes will because productivity growth raises those costs. Demography, mainly because older people tend to use more publicly funded health care services per capita than younger people do, will push health care costs up relentlessly.23
If current spending on demographically sensitive programmes, and current taxes to finance them, are thought of as two sides of an implicit political bargain, we can quantify the lower or higher future costs of these programmes as implicit assets or liabilities. The present value of the higher tax take to cover the incremental cost of all these programmes over a 50-year span – roughly the life expectancy of the average-age Canadian – is like a notional fund Canada would need to have set aside to cover the cost of this implicit bargain.24 That liability – the funds it would take to cover those costs without raising taxes over the next 50 years – is essentially all at the provincial/territorial level: some CAD 2.7 trillion, or about CAD 72 000 per person (Table 6.1).
Table 6.1 also shows the net debt – debt and other obligations minus financial assets – of the provincial/territorial and federal governments, relative to 2018 GDP. For the provincial and territorial governments as a whole, the implicit liability from demographically sensitive programmes – which is essentially the implicit liability from health care – is about four times larger than their net debt. The federal government, whose net debt is roughly the same as that of the provinces and territories together, is essentially hedged against demographic change, with an implicit liability related to seniors’ benefits offset by an implicit asset of child/family benefits. So it shows a small implicit net asset. For the country as a whole, the implicit liability from demographically sensitive programmes is about twice the size of the net debt of both levels of government.
Because the demographic outlook varies across the country – and, to a lesser extent, because their age-sensitive programmes are not the same – the situation of different provinces varies also. Some are ageing faster than others. The implicit liabilities tend to be larger relative to provincial and territorial GDPs and populations in the eastern provinces and the territories (Table 6.2).
Table 6.2 also shows the net debt of each provincial and territorial government relative to GDP. The troubling combination of relatively large implicit liabilities and relatively large net debt is mainly in the eastern provinces, especially Prince Edward Island, and Newfoundland and Labrador.
How might provinces react to this pressure? A review of the options shows why bigger intergovernmental transfers will be attractive for them, but problematic for the country.
Provincial fiscal consolidation
Given recent evidence, deficits are a politically acceptable way for some provinces to avoid addressing hard budget constraints. Borrowing, however, is not a feasible approach to the long-term fiscal challenge. Demographic pressure will persist for decades, and attempting to fill the gap that the implicit liability represents by issuing market debt would mean mounting interest payments, and likely exhaust the willingness of potential lenders. More durable budget management will rely on a mix of tax increases, spending control, and in some areas, potential pre-funding of programmes that involves a bit of both.
Provincial tax increases
As previously noted, provinces have increased their share of spending more than their share of revenue since the late 20th century. Provinces have access to the same major revenue sources as Ottawa, as well as exclusive jurisdiction over such sources as resource royalties, gaming and liquor profits, and property taxes. Recent slower growth of federal revenues – primarily due to consumption tax cuts and slow-growing employment insurance premiums – suggests that provinces could raise more without proportionate increases in total taxes relative to GDP (Figure 6.9). How might they do so?
In recent years, a politically attractive option to generate incremental provincial revenues has been to raise personal income tax rates on high-income earners.25 Starting with Nova Scotia in 2010, many provinces have increased their top tax rates, followed by the federal government in 2016. Quebec, Ontario, New Brunswick and Nova Scotia now have combined federal and provincial top tax rates exceeding 53% (Table 6.3). Eight of ten provinces now have combined federal and provincial top tax rates rounding to or more than 50%.
Note: Federal transfers to Quebec are increased by the value of federal income tax abated (13.5 tax points) under the Alternative Payments for Standing Programs (the Quebec tax abatement).
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; Authors’ calculations.
Shifting more of the tax burden to a relatively small number of people may be politically attractive, but it does not necessarily yield the desired revenue. Responsiveness of taxpayers to tax changes has been estimated many times in Canadian and international studies, with the highest sensitivity found among top earners. Starting from current top personal tax rates, middle-of-the-road assumptions about the impact of further increases on the tax base indicate that further rate increases would reduce revenues collected. Awkwardly, the fact that the personal income tax is a shared field creates an externality. The reduction of the base would only reduce the revenues of the government imposing the increase – a province, say – by about half relative to the projected yield with no reduction of the base. The other level of government – potentially the federal government – would see its revenues decrease by about the same amount that the first government’s revenues increased.26
Generally speaking, a consumption tax, especially a value-added tax like the Harmonized Sales Tax (HST), has less economically harmful effects on savings, personal and business investment decisions, migration of labour and firms, and work decisions, than personal or corporate income taxes. For provinces, the lowest-cost way to increase revenues from their own sources would be to tax consumption.27
The recent evolution of consumption taxes and personal/corporate income taxes reveals the effect of the 2% GST cut at the federal level (Figure 6.10). Federal and provincial income tax revenues have grown pretty much in line with GDP in the last 25 years, but federal consumption taxes have grown less. So the provinces could occupy room vacated by Ottawa. Although measures to tax high-income earners have had a higher profile, provinces have made some recent moves in this direction. Quebec raised its value-added tax by 1% in both 2011 and 2012. Manitoba increased its provincial sales tax by 1% in 2013. In 2014, Nova Scotia decided not to proceed with previously announced rate cuts to its HST. Newfoundland and Labrador hiked its HST by 2 percentage points in January 2016. If Ottawa reduced its presence in the consumption tax field further, provincial opportunity in this area would grow.
Because they affect behaviour less, consumption tax increases have the key advantage of bringing in amounts closer to what static calculations – that is, calculations assuming no behavioural impact – predict. If economic activity tips more toward consumption and away from investment as the population ages, moreover, consumption taxes will rest on a relatively robust base.
The fact that consumption taxes can be more politically awkward has a positive side. Taxpayers may require greater accountability for extra consumption tax revenues raised. So they may be the revenue source likelier to induce needed spending reforms.
Tighter spending control
Efforts to contain spending at the federal level earlier in this decade and in many major provinces more recently inspired so much commentary in Canada that the interested reader can easily pursue the details elsewhere. The key point worth underlining is familiar: containing spending is hard because of the numbers, and focused political energy of transfer recipients, and – especially at the provincial level – the power of governments’ direct employees and providers of publicly funded services such as health and education.
The greater political power of groups that benefit from government spending, compared to that of current and future taxpayers, makes spending restraint easier when the hard trade-offs are relatively immediate and easy to demonstrate. Those circumstances tend to apply when what previously appeared as a soft budget constraint, the need for no more discipline on the bottom line that what is needed to induce creditors to keep lending, becomes hard – as was the case in Saskatchewan in the 1990s, for example.
Note: Federal transfers to Quebec are increased by the value of federal income tax abated (13.5 tax points) under the Alternative Payments for Standing Programs (the Quebec tax abatement).
Source: Statistics Canada (2019[3]), “Statement of government operations and balance sheet, government finance statistics”, Table 10-10-0015-01, June; Authors’ calculations.
Sustainable social insurance reform
Provinces could respond to demographic pressure by partially pre-funding some age-sensitive social insurance programmes. An attractive model is the reforms that partially pre-funded the Canada Pension Plan (CPP) and the Québec Pension Plan (QPP) in the late 1990s to stabilise their costs over time. Those reforms combined near-term spending cuts with contribution hikes larger than needed to pay the current costs of the programme. The high profile of the projections determining whether the new contribution rate was stable over time has likely mitigated the pressure for benefit enrichment that always affects such programmes.
Analogous changes to publicly supported drug programmes or retirement and long-term care facilities would make potential future recipients pay extra in the near term, with funds not needed for current programme expenditures flowing into an investment account. Future drawdowns from that account to pay for the relevant services would supplement future tax or premium revenue, limiting the impact of ageing-related costs on the ensuing generations of taxpayers (Busby and Robson, 2011[20]). Such reforms would be challenging, but the C/QPP reforms, which were spurred by the prospect of having inadequate funding to pay benefits in a few years’ time, show that a suitably hard budget constraint can make them happen.
Federal intergovernmental transfers
For provinces, the soft budget constraint offered by further hikes in intergovernmental transfers will be tempting. Indeed, the growing importance of federal transfers in most provincial budgets (Table 6.4) has likely increased their focus on Ottawa as a possible solution to their fiscal challenges.
At a given moment, the formulas for these transfers may make them look firm – that is, provinces may appear to face hard budget constraints that oblige them to manage revenues and spending without a federal bailout. However, the many changes in the structure and size of these transfers over time make the appearance of a hard constraint deceiving.
The experience of repeated increases in transfers inevitably affects the way provinces manage their affairs. Provincial governments choose the gap between how much they spend and how much they collect. The more federal transfers appear to respond to provincial fiscal pressures, the weaker are the incentives for provincial governments to raise own-source revenues or manage expenditures efficiently.28 Also, the stronger are the incentives to deflect blame for any shortcomings in their programmes, or for the taxes they charge, onto Ottawa, and to devote time and energy they should devote to improving services to lobbying for bigger federal transfers instead.
It would be perverse if transfers widely seen as helping provinces perform their functions were actually undermining the provincial autonomy essential for a healthy federation. As Table 6.4 shows, however, major federal cash transfers make up two-fifths of the budget of many provinces and are in no case less than one-seventh. These average levels tell us nothing directly about the changes at the margin that affect decisions, but it is reasonable to worry that they induce provincial governments to direct too much attention towards Ottawa, at the expense of their own taxpayers and citizens.
In this context, proposals that Ottawa should establish a new pharmacare programme to subsidise, or even replace, provincial drug programmes look problematic on several grounds. One version envisions federal pharmacare replacing all drug benefits currently provided by provinces to citizens, and supplanting all employer-related drug benefits, including the relatively expensive drug benefits of provincial government employees (Morgan et al., 2015[21]; Gagnon, 2010[22]). The desirability of integrating drug programmes better with doctor, hospital and other provincially funded services, makes a comprehensive federal takeover undesirable (Wyonch and Robson, 2019[23]). Moreover, the immediate impact of a relatively fiscally healthy federal government underwriting drug costs would surely be to increase spending, rather than to support the discipline of provinces facing a harder budget constraint.
Notwithstanding arguments that federal taxes are less damaging than provincial taxes, moreover, the federal taxes that finance federal transfers are damaging, and therefore create negative externalities for provincial governments. Suppose Ottawa hiked high-income tax rates as Ontario has just done. That would shrink the relevant tax base across the country, hurting provincial revenues. Some responses to federal tax hikes are worse for the country than responses to provincial hikes. Whereas provincial hikes may induce income, and possibly taxable entities, to move from one province to another, movement of activity out of the country is a complete loss.
The problems created by soft provincial budget constraints may be worse in the future than what Canadians have experienced since the mid-20th century. The provinces that will experience above-average stresses from ageing tend to be the provinces that already have larger debt-to-GDP ratios. A heavily indebted province, especially a small one, might expect Ottawa to step in if it lost access to credit.
If a financing crisis did occur, however, the federal government would face a dismal choice. It could allow a default, risking contagion to other fiscally stressed provinces. Alternatively, it could bail the province out, setting a dangerous precedent, and potentially undermining even its own credit access, since a bailout of Quebec or Ontario would be much harder to manage than that of a small province. Far better is to ensure that each province sees its budget constraints as hard, and manages its taxes, costs and social insurance programmes to ensure that they are sustainable without additional federal help.
The striking changes in the practice and theory of fiscal federalism over time provide useful context for considering how spending, taxation and transfers among Canadian governments may evolve in the future. The insights from public economics about different transfers help in understanding their impact, but past changes from unconditional to conditional and back to unconditional grants reveal the importance of circumstances and the limits of normative guidance. In our view, the generally high standard of public services in the Canadian federation, even as federal grants have become less conditional, suggests that Canada would be well served by reforms that give provinces more capacity to raise their own revenues – notably by relying more on consumption taxes.
To the extent that different packages of taxation and spending in different provinces reflect different preferences among their citizens, the case for federal intervention weakens. Competition among provinces to offer – or not to offer – different packages of taxes and public programmes is a strength of a federation, not a problem Ottawa needs to offset. Intervening to reduce the tax cost of a given programme in one province at the expense of others that are charging less relative to the value they are providing reduces the incentive for each province to provide cost-effective programmes.
A focus on improving decision making at each level directs attention away from further increases in transfers from Ottawa. Measures to more closely align the revenue-raising and spending powers of governments at each level seem a more promising route to a healthy Canadian federation in the future.
References
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Notes
← 1. Our principal focus is relations and transfers between Canada’s senior, sovereign governments: federal and provincial. We treat federal transfers to local governments – which are, in a traditional phrase “creatures of the provinces” – as part of federal-provincial transfers. We note instances where the data we cite also include transfers to the territories, which are wards of the federal government, but in some respects function like provinces.
← 2. See sections 91-95 for the complete description of provincial and federal legislative powers. Available at http://laws-lois.justice.gc.ca/eng/const/page-4.html#h-17.
← 3. Constitution Act, 1867, Sec. 91(3).
← 4. Constitution Act, 1867, Sec. 92(2).
← 5. Constitution Act, 1867, Sec. 112, 114-116, 118, 119.
← 6. One formal change in tax fields occurred in 1980 when the federal government vacated the lottery and gaming field in return for an annual payment from the provinces (Desjardins, Longpré and Vaillancourt, 2012[25]).
← 7. This activity, not explicitly anticipated in the constitution, was justified by a federal “spending power” inferred from sections 91(3), 91(1A) and 106. See Hogg (1997[24]).
← 8. The Constitution Act, 1982 included a commitment in section 36(2) to “making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation.” This provision created a constitutional basis for the formal Equalization programme, and, arguably, for other major transfers as well.
← 9. The abatement was originally 23% of federal personal tax revenue. Changes to federal programmes over the years have reduced it to 16.5%.
← 10. For clarity, the EPF transfer was calculated with reference to aggregate provincial spending, so no single province enjoyed a 50% subsidy. The CAP transfers continued to be calculated with reference to individual provincial spending, continuing to create 50% subsidies for all.
← 11. The largest being the Quebec Health Services Fund Contributions and the Ontario Employer Health Tax.
← 12. The Euro area is an important counter example, but many argue that its separation of fiscal from monetary policy is a serious flaw that may ultimately doom the arrangement.
← 13. In Canada, further savings from centralised collection are likely possible. For example, the Canada Revenue Agency has estimated that tax administration costs could be more than CAD 500 million annually lower if Quebec’s tax collection services were consolidated with federal ones. This figure does not take into account the reduced compliance burden on Quebec taxpayers (Vailles, 2015[26]).
← 14. A classic pioneering investigation of redistribution within federations is Musgrave (1961[27]). Boadway (2006[11]) identifies three equity-related justifications for equalising transfers, in the absence of interprovincial mobility. Regional fiscal equity aims to provide citizens of different regions but in otherwise similar economic circumstances similar public services for similar tax costs. Inter-regional insurance aims to ensure sub-central governments against temporary shocks to their economies and capacities to generate tax revenues. National standards aim at uniformly high public services.
← 15. Smart (2007[28]) finds that equalising grants induce higher average effective tax rates by equalisation-receiving governments.
← 16. In OECD countries, public social spending to GDP increased from about 7.5% of GDP in 1960 to 22% in 2014 – see Figure 2 in OECD (2014[29]).
← 17. OECD (2013[30]) uses five measures of (de)centralisation to compare countries and over time: the ratio of sub-central to general government spending; the ratio of sub-central own-revenue to general government revenue; the ratio of sub-central tax revenue to general government tax revenue; sub-central autonomy in setting tax bases and rates; and a measure of decision-making authority over education. The OECD measures indicate that OECD countries have generally decentralised over the past 20 years. Spending decentralisation has outpaced revenue decentralisation, however, resulting in higher intergovernmental transfers.
← 18. Contrasts in fiscal arrangements around the world, and changes over time, have supported a great deal of empirical work – but no consensus – on whether centralisation or decentralisation has any systematic effect on the size of government (Feld, 2014[31]).
← 19. For a discussion of this problem as it relates to health-care-related transfers specifically, see Crivelli, Leive and Stratmann (2010[32]).
← 20. Immigration is not a solution to demographic woes [see Robson and Mahboubi (2018[33])]. Some mitigating factors include the possibility of labour-force participation rates rising to help offset the declining workforce population growth. Among older workers, retirement ages have been increasing in recent years as baby boomers choose to work a little longer than the traditional retirement age (Hicks, 2012[34]), but increases in participation rates by older workers sufficient to offset demographic ageing are inconceivable without radical policy changes.
← 21. For more detail on the assumptions and mechanics of these projections, see Busby, Robson and Jacobs (2014[35]).
← 22. The federal government’s health expenditures are relatively small and are focused on veterans, on-reserve indigenous people and regulatory activities. These amounts are far more sensitive to changes in policies than they are to changes in demographic structure.
← 23. A number of research studies have come to similar overall conclusions; for example, see Drummond (2011[18]) and Dodge and Dion (2011[36]).
← 24. This calculation treats the current tax take, measured as a share of GDP, as the cost the population currently accepts for those programmes. If the share of GDP taxed for the programme falls such that the present value of the difference over 50 years is negative, the promise to maintain the programme as is creates an implicit asset. If the share of GDP taxed for the programme rises such that the present value of the difference over 50 years is positive, the promise to maintain the programme as is creates an implicit liability.
← 25. British Columbia also raised its general corporate income tax rates from 10% to 11% in 2013, while Ontario delayed in 2012 a scheduled 1.5% corporate tax rate reduction over two years, from 11.5% to 10%, until the return to a balanced budget.
← 26. Laurin and Robson (2015[1]) elaborate this calculation.
← 27. For example, recent estimates of marginal costs of public funds for provinces show that raising an additional dollar of corporate tax revenue today may end up costing from an extra CAD 1.25 in the long run in Manitoba to a cost so large in some other provinces like Ontario that a small increase in corporate tax rates would be counterproductive, yielding lower revenues. The long-term extra cost of raising another dollar of personal income tax today in various provinces range from CAD 0.45 in Alberta to CAD 2.45 in Quebec – over and above the dollar raised – while that cost ranges from only CAD 0.13 to CAD 0.21 (excluding Alberta) for an extra dollar of value-added sales tax on consumption (Dahlby and Ferede, 2011[13]).
← 28. Provincial government officials who object to this view should review their own recent experience with recipients of their transfers. Hospitals are a case in point. If hospitals are able, as they often have been, to over-shoot budget targets and get bailed out by provincial transfers, they will not manage their budgets as tightly as they would if deficits directly affected their resources in subsequent years. Soft budget constraints are antithetical to good management wherever they exist.