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Public ECON - Lecture 10 - 12 Final Exam (Equalization Payments)
Terms in this set (29)
Economic theory of fiscal federalism
- what is the definition by Wallace oats?
federalism is a "public sector with centralized and decentralized levels of decision making in which choices made at each level concerning the provision of public services are determined largely by the demands for services of residents of respective jurisdictions"
aka the definition is a public sector with both centralized and decentralized levels of decision making
What is the opposite of a federal state?
How is government divided in these two states?
What about property taxes?
a unitary state where everything is centralized (a central government who makes all decisions)
in a federal state there are levels (federal, provincial, municipal)
a unitary state still has these levels but the mayor, governor, premier, etc. is appointed by the president/prime minister and does not win his position through elections
for a federal state, property taxes are collected by the city however for a unitary state they collected by the central gov and then distributed back to the local gov
Tiebout (1956) formulated the first economic analysis of federalism
He asked 2 questions, what were they?
1. what services should local or lower levels of government provide and what should be left for the federal government? in other words, what is the optimal allocation of public expenditures between federal and local governments
2. what taxes should various levels of government collect?
What were the 3 conclusions he had made?
that local governments should focus on expenditures with no externalities, spill over effects, or economies of scale (ex. road repairs, street cleaning, etc.)
in a world with externalities the actions of several independent agent is inefficient because they ignore the externalities that they impose on each other
local governments should provide a limited role in providing public goods that have large spill over effects (ex. healthcare, education, etc.) or anything that has a large economy of scale like national defence, or risky projects like satellites
Benefits of decentralization or federalism (4)
1. it promotes social cohesion and peaceful co-existence ex. Quebec and Canada
- in a unitary state it is too centralized and some groups may feel as though they are not treated well and want to leave the system which leads to war and fights
- in a federal state this can still happen but its less likely because each group has some form of autonomy to make their own decisions
2. Fosters intergovernmental competition- what happens in other local communities can be used to judge the performance of local officials
- in a unitary state you can't really do this because everything is so centralized, if you call one city out you're just calling out the federal government
3. tailors public service to local taste
4. promotes accountability and reduces the cost of public vigilance
- because guelph is small it is easier to hold their mayor accountable for small things that happen in the city
Disadvantages of decentralization (3)
1. spill over effects are ignored
- for example in the US, where there is a problem in one state it is that states problem because it has its own rules
2. lack of economies of scale
3. inefficient tax competition to attract firms and capital to each region
- tax reduction is important but provinces overdo it from an efficient point of view
Both Canada and the US are decentralized, but how do we know which one is more decentralized?
define Ef as total expenditure by the federal government and Ep as total expenditure by the provincial government
the centralization ration is = Ef/Ef+Ep = c
where Ef+Ep is total expenditure for all of Canada (public sector)
the higher Ef, the higher is centralization
A higher c is an indication of a less decentralized system of government because a unitary system would have Ep = 0 and therefore c=1 indicating centralization
BUT a smaller Ef may not imply a weaker federal government (it could be that the federal government has the power to tax then distributes the money back to the provinces, so the provinces will spend more)
What is Canada's fiscal equalization system?
it is transfers of payments from the federal government to the provincial government
Is this the only transfer that the federal gov gives to the provincial gov?
NO! there is the CHT (Canadian health transfers) which covers provinces healthcare needs based on their population
CST (Canadian social transfers) which includes funding for education and social welfare programs based on population
territorial financing - for the territories
equalization payments (which is not based on fiscal need unlike the others)
What are equalization payments?
what does the equalization formula focus on?
they are transfers from the federal government to provinces to equalize fiscal capacity not fiscal need
the equalization formula focuses on one thing in particular, comparable levels of taxation, this is where it will try to equalize fiscal capacity
Equalization payments are based on 5 tax bases which are:
personal income, corporate income, consumption, property, and natural resources
Was the system always based on these five?
no it was reduced from 34 to 5
when it was first established, it only controlled income taxes
before 1982 we had a ___ province standard, but from 1982-2006 we had a:
from 2007 to present we have:
5 province standard which excluded Nova Scotia, New Brunswick, Newfoundland and Labrador, PEI, and Alberta
- because the east coast provinces are too poor and Alberta is too rich so they can't be included in the national standard
we have a 10 province standard again
What is the formula for equalization payments?
consider province i (which goes from 1-10 for the provinces) and tax base j (which goes from 1-5 for the tax bases)
let bcj= standard (national) per capita tax base for revenue source j
bij = per capita tax base revenue source j in province i
tcj = standard (national) average tax rate for tax base j
province i's per capita equalization payment for tax base j is:
Eij = tcj(bcj-bij)
Eij = tcjbcj-tcjbij
Let Ni = population of province i
Let tij = average tax rate for base j in province i
Bij = total tax base for revenue source j in province i
Then we will substitute
where the first part is the national per capita tax revenue for base j in all 10 provinces
and the second part is the per capita tax revenue for tax base j in province i IF the province had applied the national average tax rate on base j in that province (the second part is where equalization payments equalize fiscal capacity and NOT fiscal need)
Why is Alberta upset about equalization payments?
because they don't have a sales tax so because of that they have this huge tax base of consumption that doesn't get taxed so the second part of the equation is going to be much bigger than the first part resulting in them not getting anything
Alberta is upset because the system penalizes those provinces that don't tax enough, however the only reason the system does this is to create an incentive for them to tax citizens so that the government doesn't have to bail them out
if Eij > 0
then province i has a per capita revenue short fall for tax base j relative to the national per capita revenue tax for base j
then province i doesn't have a per capita shortfall for base j
Given the 5 tax bases used, province i gets a total per capita equalization transfer of:
Total equalization payment to province i is:
where k is natural resources and Eij>= 0
What is the reason that natural resources is only equalized by 50%?
in the constitution, all natural resources belong to the province and the federal government cannot equalize what it does not tax
Why do we not require a budget balance?
because we are not necessarily taking money from the provinces to give it to others (although indirectly this is what is happening)
but since the federal government has the power to tax the provinces, the money was actually never theirs to begin with
For the sake of analysis, consider a single tax base j per capita revenue after equalization payment is:
Fij=tijBij/Ni + Eij
the first part is the actual tax revenue that province i raised per capita
and the second part is the equalization payment
then Fij = tcjbcj if tij=tcj
Fij = tcjbcj if tij<tcj
tcjbcj is the national per capita tax revenue for base j and if your actual provincial tax rate on that tax base is equal to the national average tax rate, then after equalization payments, you will be equalized fully
but if your provincial tax rate is below the national average tax rate then you will still receive a tax revenue below the national per capita tax revenue and will never be fully equalized
The program is designed so that provinces don't:
choose low tax rates to gain the system, this is why Tcj not Tij is used in the formula
Why doesn't Alberta have equalization payments? (use the example of consumption tax)
what about Quebec?
Alberta's Bij, the value of their consumption is high but they have a relatively smaller population
so the gap between the two will become negative and Alberta will get nothing because it doesn't have a sales tax
the gap for Quebec is much larger because they have a higher tax rate than the national average and is why they receive payments
Why is full or perfect equalization impossible? (4)
1. not all revenue sources are equalized for fully equalized (ex. lottery revenue and only 50% of natural resource revenue is equalized in the formula)
2. average national tax rates, not own provincial tax rates are used
3. Alberta has no sales tax and therefore gets no transfers
4. the equalization budget may be less than the computed equalization payment
- there is an independent formula to determine the budget
total equalization payments cannot grow faster then:
the GDP of canada
what happens if total equalization payments exceed the budget? what if there is excess?
then all payments are reduced appropriately & if there is excess the surplus is shared according to a formula
How can a province game the equalization formula? Give an example
by manipulating its tax base
for example in Quebec the provincial government owns the hydro companies and they may understate their profits because they sell electricity at much lower prices
the issue here is Quebec is selling at lower than market rates resulting in low profits but it will allow them to get a larger equalization payment because the gap will be larger
Is there a cap on transfers?
YES! there is to ensure that equalization payments do not raise a provinces per capita revenue above that of a non-receiving province
what does the formula TpBp/TnBp <1 tell us?
Those below 100% are those who's natural tax rate is therefore greater than the provincial tax rate
- for Quebec Tp>Tn which is why they get transfers
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