Livio Di Matteo: A brief and simple history of federal transfers from 1867 to 2021

As yet another Canada Day comes and goes, it is worth reflecting on fiscal features that have defined the Canadian federation over time.

Chief of these is the presence of federal transfers to the provinces and territories which in one incarnation or another have been part of Canada’s intergovernmental fiscal fabric since 1867.

Since Confederation, two trends have marked the evolution of intergovernmental fiscal relations. First, the evolution of federal-provincial taxing powers to cope with changing needs with provincial taxation powers expanding to all areas save customs duties. Second and more to the point, the evolution of the transfer system into a more comprehensive and formula driven if complex system of intergovernmental payments.

At the dawn of the Canadian federation, the loss of provincial revenues from customs duties and tariffs levied prior to 1867 resulted in compensatory federal transfers that were enshrined via a statutory per capita subsidy popularly known as the Dominion Subsidies. At about 80 cents per capita, these were significant for a number of reasons.

First, they were an acknowledgement of fiscal imbalance in that the federal power to tax by any means whatsoever was greater than provincial tax powers. Fiscal imbalance grew as spending over time rose more in areas under provincial jurisdiction, such as health and education, than for federal. Second, they enshrined per capita payments as the way to do federal transfers, which is a feature that has affected other transfer programs to this day. Third, they represented a substantial federal expenditure accounting for just over 20 percent of federal spending in 1867.

Between 1867 and the onset of the Great Depression, federal transfers to the provinces remained stable in real per capita dollars (inflation and population adjusted) but as a share of federal spending declined dramatically to less than five percent of federal expenditures as nation building spending soared particularly with respect to transportation and communications.

Along with the Dominion Subsidies, the needs of urbanization and other infrastructure as industrialization progressed resulted in various ad hoc federal grants to the provinces in areas such as education, electrification or road construction. The ad hoc nature was always a source of political contention.

The Great Depression placed an enormous strain on public finances at the federal and especially provincial level and the federal government assisted by providing conditional grants for welfare relief which was a provincial responsibility. The Great Depression spawned a royal commission to deal with the fiscal crisis facing Ottawa and the provinces, resulting in the Rowell-Sirois Report in 1940 that among other things recommended the creation of a more formal intergovernmental transfer program termed National Adjustment Grants. These grants were to be designed to take into account differences in both fiscal capacity as well as need and were supposed to be unconditional cash transfers. In essence, they were a proposal for an equalization program that equalized not only the revenue side but also the expenditure side.

The arrival of the Second World War interrupted the implementation of the Rowell-Sirois Report’s recommendations and the federal government’s fiscal needs regarding the war effort led to its own provincial finance arrangement, with the system known as the Wartime Tax Agreements. This involved the federal government essentially appropriating provincial income and inheritance tax revenue sources in return for providing them with a per capita cash transfer payment.

Essentially, the federal government rented provincial tax bases and many of the provinces actually found that their revenues under this arrangement were better than when they ran their own systems. Indeed, during the postwar period, tax rental agreements of this continued, although provinces with better tax bases, Ontario and Quebec in particular, gradually began to revert to running their own systems again.

In the period from 1939 to 1957, real per capita federal transfers to the provinces grew almost sevenfold and as a share of federal spending, transfers to the provinces rose from 3 percent to 7 percent.

The biggest changes were yet to come, and the new age dawned in 1957 with the first five-year federal provincial fiscal arrangement. It reflected the vision of the Rowell-Sirois report as well as the needs of provinces expanding their public health spending.

The tax rental system was left behind and equalization began with a formula that helped equalize revenues from three tax sources: personal income taxes (PIT), corporate income taxes (CIT) and the now defunct estate taxes. These were unconditional cash transfers. Essentially, if a province’s actual revenues from the source were less than what the formula based on average revenues provided, they would get a cash grant.

The other major change was the first formal health transfer based on cost sharing. Starting in 1957, the Federal Hospital Insurance and Diagnostics Act took effect providing a grant to the provinces that funded 50 percent of provincial public hospital insurance programs.

In the subsequent decade, there was an expansion of the equalization program in terms of the revenue sources included in the formula every five years as part of a broader Federal-Provincial Fiscal Arrangements agreement. The 1967 agreement in particular saw expansion to 16 revenue sources as well as the implementation of a ten-province average or what became known as the Representative National Average System (RNAS).

The RNAS system was designed to bring each province up to a national average revenue source and is essentially the approach used presently. As well, 1966 saw the Medical Care Act which expanded public health care to a universal system covering both hospitals and physicians with a 50 percent cost sharing funding approach. As well, the Canada Assistance Plan was introduced which provided a federal cost-sharing grant for social assistance.

The golden age of the booming late 1960s and early 1970s saw the full development and enrichment of the main federal transfer funding planks to the provinces that remain to the present: equalization, health, and social assistance. Ultimately there was also the extension of unconditional cash transfers similar to equalization to the Territories.

Between 1957 and 1970, real per capita federal transfers to provincial governments more than quadrupled and as a share of federal spending returned to the level of 1867 at close to 20 percent. The hallmark of this era aside from the expansion of transfer funding was the federal-provincial cost-sharing arrangement in health and social assistance. The end of cost-sharing in the 1970s became a cornerstone of provincial laments about federal funding as it was viewed as reneging on the terms in which the provinces were brought into medicare.

The 1960s and early 1970s quickly came to be viewed as a bygone golden age with the oil price shock of 1973 and the onset of inflation and low economic growth. The federal government faced the fiscal pressures of rising deficits and sought to limit its spending which affected the system of intergovernmental transfers.

In 1977 it decided to end 50 percent cost sharing for health and established what became known as the Established Program Financing (EPF) program. This was a cash grant that was to grow based on GDP growth rates and used to fund both provincial health systems and postsecondary education. As well, a number of tax points from both the PIT and the CIT were transferred to the provinces to soften the blow given their value would grow with the economy, but these essentially came to be viewed as own-source revenue by the provinces.

The oil price shock also played havoc with equalization because the inclusion of natural resources in the formula raised the possibility that Ontario, the wealthiest province, would receive substantial equalization as a result of the quadrupling of oil prices.

The ad hoc solution to this in the 1977 fiscal arrangements was the placing of a special provision stating that only half of natural resource revenues could be included in calculating equalization. Moreover, provinces with per capita incomes above the national average were not entitled to equalization, a provision known as the Ontario Override as it essentially ensured Ontario would not get equalization. Needless to say, Ontario felt singled out.

In the 1980s, the ad hoc nature of an override was dealt with by implementing a new equalization formula known as the Representative Five Province Standard (RFPS). This based equalization calculations on the tax bases of five representative provinces — Ontario, Quebec, Manitoba, Saskatchewan and British Columbia.

The exclusion of Alberta meant that you did not have to worry about the impact of high oil and gas revenues. The exclusion of the Atlantic provinces meant that the average would not be dragged down thereby reducing equalization payments. The new formula also made it unlikely that Ontario would ever get an equalization grant but without singling it out with a specific override.

This new system was the equalization formula until the late 1990s and it also saw the number of revenue sources for inclusion in equalization calculations eventually expand to 37.

The other major development with respect to transfers in the 1980s was enshrining the commitment to equalization in the 1982 Constitution Act as part of the process of repatriation done under Prime Minister Pierre Trudeau.

Committing the federal government to the principle of equalization payments to ensure provincial governments are able to “provide reasonably comparable levels of public services at reasonably comparable levels of taxation” without specifically defining what that meant was a bit of an odd thing to do. However, it has ensured that barring a major constitutional upheaval, in the end what will be the subject of debate is not the existence of equalization itself but rather what the amounts should be.

As a mechanism limiting federal transfer payment growth to the provinces, the RFPS system was successful and per capita transfers levelled off in the 1980s. Moreover, as a share of federal spending, transfers declined to 15 percent by the early 1990s. However, the 1980s also saw other changes resulting from the brewing federal fiscal crisis as debt and debt service costs rose.

The growth rates of EPF were reduced as the 1980s wore on. The recession of the early 1990s saw a freezing of EPF entitlements and limits to the Canada Assistance Plan (CAP). The coup de grace was the announcement at the height of the federal fiscal crisis in 1995 that EPF and CAP were to be eliminated. They were basically merged into the new Canada Health and Social Transfer (CHST).

This also came with a 30 percent cut in the cash component of the grant and the result was a serious crisis in health care funding in most provinces. Between 1990 and 2000, federal transfers as a share of federal spending fell below 15 percent while real per capita transfers plunged to a post 1970 low point.

As economic recovery returned in the 1990s, interest rates fell, and the federal net debt-to-GDP ratio declined ending the fiscal crisis, the clamour began for change. With respect to health, there was the report of yet another royal commission, the Romanow Report, and its call for renewed transfer funding for health in return for transformative change to the system.

The result was the First Ministers Accord on Health Care Renewal in 2004 which put in place a ten-year plan to boost health transfers at 6 percent annually. There were also increases in base funding at the outset as well as a restructuring of the CHST into a Canada Health Transfer (CHT) and a Canada Social Transfer (CST). Meanwhile, with respect to equalization, the federal debt crisis created an environment in which it was difficult to get agreement on a new formula so there were extensions of the formula of the early 1990s on an annual basis until 1999 when a five-year agreement was signed.

The 1999 agreement was less than satisfactory as equalization began declining as revenue for recipient provinces. In 2004, the 1999 equalization formula was replaced with a per capita cash transfer that was set to grow at 3.5 percent annually and an expert panel convened to review the system which reported back in 2006.

The new system which was implemented starting 2007 and which remains at present saw a return to a rules-based formula using a ten-province standard to calculate equalization. It also simplified the formula dramatically by reducing the number of sources to be equalized down to five: PIT, CIT, consumption taxes, property taxes, and natural resource revenues. Moreover, only 50 percent of natural resource revenues were to be included to determine the size of the equalization pool.

This new formula was in some respects a return to the late 1970s in that it included natural resources but in a more measured way. The flexibility of the new system saw provinces like Ontario get equalization in the wake of the 2008-09 financial crisis and recession while former recipients such as Newfoundland & Labrador stop receiving equalization as energy prices soared, though transition payments were provided. Indeed, stabilization or transfer protection measures to avoid sudden drops to equalization in response to changing economic circumstances had been a feature of many equalization formulas and federal-provincial fiscal arrangements.

With the onset of the Health Care Accord and the new equalization formula, growth resumed in both real per capita federal transfers as well as a share of federal spending. Real per capita transfers have risen since and are currently the highest ever while the intergovernmental transfer share of federal spending also rose peaking at about 22 percent but plunging in 2020 and 2021 as a result of the expansion of federal spending to deal with the pandemic. While the Health Accord expired in 2014, in 2011 it was announced the 6 percent transfer escalator would be extended to 2017 and then health transfer payment growth would revert to the growth rate of GDP subject to three percent growth floor.

If there are any themes with respect to the evolution of federal transfers to the provinces and territories over the course of 154 years, they are as follows. First, as economic and fiscal circumstances change, the system of intergovernmental transfers is also subject to change and reflected in a never-ending series of negotiations between Ottawa and the provinces. These negotiations can be acrimonious but that they occur is a testament to the strength of the federal system rather than a weakness. It is only when everyone stops talking that should there be real concern as to the future and stability of Canadian federalism.

Second, while the need for a transfer system that recognizes both revenue capacity and fiscal need has been articulated at various points in time, in the end it is easier to stabilize revenues rather than deal with who needs more in constructing a system of transfers.

The concept of provincial need can create a particularly open-ended system of ever rising federal transfers with the provinces always ready and willing to provide a creative case for why they need more. In some sense, 50/50 cost-sharing did partially reflect needs and it was abandoned during an era of fiscal difficulty.

Finally, the one remarkable constant has ultimately been the maintenance of the general principle of calculation and payout of federal cash grants via per capita entitlements. Even equalization assesses a province’s revenue generating ability against an average on a per capita basis.

This may reflect history but providing the same for everyone also deflects any discussion of implementing grant reforms based on need even when reasonably rooted in differences in provincial demographics such as in the case of health.

It should also reduce the tendency towards who-gets-what federalism which has particularly marked the debate over equalization given that Quebec over the years, with a much larger population than most equalization-receiving provinces, receives the largest total amount of equalization.