The fundamental structure of the Canadian federation was established by the Constitution Act of 1867 which specifies the allocation of taxation powers and spending responsibilities among the federal and provincial governments. The federal government was initially intended to play a relatively dominant role in a fiscally centralized federation. Some of the areas that were exclusively assigned to the federal government included the regulation of trade and commerce, money and banking, public debt and property, criminal law, national defence, foreign affairs, postal service and navigation and shipping. Provincial governments were given exclusive responsibilities over the management and sale of public lands, hospitals, education, administration of justice and other matters of local nature including control of municipalities. At the time, the role of the government in the social policy sphere, including in the areas of health care and education, was very limited while regulating commerce, trade and banking were central to economic policy. Provinces were also given more limited taxation powers than the federal government. Over time however, and particularly with the development of the welfare state in the post-World-War II period, the role of provincial governments has expanded considerably. The growth of public spending in health care, education and social services has resulted in a federal structure which is much more decentralized today than what was initially envisioned. Provinces have also progressively occupied a greater share of the tax room resulting in a tax system today which is among the most decentralized in the world.

Provincial governments are now responsible for over half of direct public expenditures (Finance Canada, 2020a). They enjoy extensive autonomy in designing programs and regulations in key areas of social and economic policy, and fund a substantial share of their expenditures through their own taxes. At the same time, there are various mechanisms in place to promote policy harmonization and cooperation in matters that are important to the economic and social union. These include mechanisms to induce harmonization of tax policies and public services, as well as intergovernmental agreements in the areas of labour market, environmental and immigration policies, among others. There are also measures to maintain horizontal equity across provinces including an extensive equalization system designed to ensure that all provincial governments have the capacity to provide public services of comparable quality.

This chapter outlines key features of Canadian fiscal federalism as it operates today, it discusses some of the successes of the federal model as well as various tensions that exists and explores upcoming challenges.

1 General Features of the Country

The Canadian federation is composed of ten provinces and three territories. The latter are located in the northern part of the country and are sparsely populated, largely by First Nations. Territorial governments do not have powers specified by the Constitution. Their powers are delegated by the federal government. Despite that, the territories increasingly operate as provinces and are heavily involved in the development of relationships with First Nations. Local governments do not have constitutional status either. They are creatures of provincial governments. All powers of local governments are therefore mandated by the provinces.

The total population of the country was over 35 million in 2016. Approximately 60% of the population lives in the two largest provinces of Ontario and Quebec. There are two official languages, English and French. Quebec is the only province where French speakers constitute the majority, but there are significant francophone minorities in other provinces. The indigenous population represents close to five percent of the total population of the country. There are some indigenous self-governments that have been established through agreements with the federal and provincial governments. The powers and responsibilities of these self-governments are diverse, but they generally involve some control over land, resources and the provision of various public services.

Canada has a parliamentary system within a constitutional monarchy in which the British monarch is the official head of state and is represented in Canada by the governor general. There is a bicameral national parliament that includes an elected House of Commons and an appointed Senate. Executive powers are vested with the cabinet headed by the prime minister. The cabinet is responsible to Parliament. Democracy is exercised within a multi-party system although it has historically been dominated by two major political parties. Provincial legislatures have a single elected chamber. Elections at federal, provincial and municipal levels are held periodically, usually every four years. In recent years, the federal government and almost all provincial governments have adopted fixed election dates.

Various institutions promote accountability in Canadian governance including regular democratic elections at all levels of government. Moreover, federal and provincial governments are fully autonomous in their respective areas of jurisdiction and they have access to all broad-based taxes. Provincial governments are responsible for raising a high share of their revenues through their own taxes, they have essentially complete autonomy in setting their tax policy and are responsible for managing their budget balance and incurring public debt when necessary. These various dimensions of autonomy and responsibility lead to high accountability at both orders of government. There is also a high level of transparency in public accounts and in budgetary processes safeguarded by independent auditing mechanisms and an independent press. Basic rights, such as freedom of speech and religion, are guaranteed by the Charter of Rights and Freedom, which is written in the Constitution. The treaty rights of indigenous people are also protected by the Constitution.

Canada is among the world highest-income countries. Gross domestic product (GDP) per capita was equal to US$49,031 in 2019.Footnote 1 Although the economy is dominated by service industries, there are sizeable natural resource and manufacturing sectors. Natural resources, especially oil and gas, are mainly located in western provinces while the manufacturing sector is concentrated in the central provinces of Quebec and Ontario. This has important implications for fiscal federalism and different aspects of economic efficiency. The Canadian economy is highly open to international trade. Approximately 32% of domestic production was exported in 2019, although roughly three-quarters of exports are heading to the United States and a considerable share of total exports consists of primary commodities.

2 The Allocation of Expenditure Responsibilities

The Constitution sets the powers and responsibilities of the federal and provincial governments. While most areas of jurisdiction are assigned exclusively to one order of government, there are a few joint responsibilities. Both levels of government enjoy high autonomy in their areas of exclusive jurisdiction, although there are sometimes disagreements about jurisdiction in various areas. The allocation of functions is outlined in Table 1. In addition to functions that are clearly national in scope, such as defence, foreign affairs, regulation of trade, banking and monetary policy, the federal government is also responsible for unemployment insurance, criminal law and various other components of economic policy.

Table 1 Legislative responsibilities and effective allocation of functions
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Provincial governments have exclusive legislative authority over the main pillars of social policy such as health care, education and social welfare. In the cases of education and social welfare, some responsibilities are delegated to local governments who are usually involved, to various degrees, in the delivery of services. The federal government is indirectly involved in the financing of health care, post-secondary education and social welfare through the provision of transfers to provincial governments, as outlined later, and in the case of education, through the provision of scholarships, student loans and funding to post-secondary institutions. The federal government is also responsible for population health, for providing health care services to First Nations, for regulating pharmaceuticals, medical devices and food and contributes to research and innovation in the health sector.

Importantly, provincial governments have jurisdiction over natural resources. That comprises exclusive authority over exploration, development, conservation and management of non-renewable resources, forestry and electrical energy. It also includes regulation and management of resource exports to the rest of the country, as well as the exclusive right to tax renewable and non-renewable resources. This has profound implications for various dimensions of fiscal relations among governments, including horizontal fiscal balance and equalization, as well as for economic policy in the federation.Footnote 2 In recent years, it also led to conflicts between provinces over the construction of interprovincial oil and gas pipelines.

Provinces are responsible for cultural issues, which is particularly important in the French-speaking province of Quebec, although there are important federal agencies in the cultural sector including the Canadian Broadcasting Corporation, the Canadian Radio-television and Telecommunications Commission and the National Film Board of Canada, among others. Provincial governments have the power to regulate financial markets and labour markets. The Constitution also provides provinces with the authority to legislate on all matters of local nature. This has been interpreted to include various aspects of environmental policy and of transportation policy that are more local in scope, among others.

There are shared responsibilities in the areas of pensions, immigration and agriculture which, in practice, are exercised in a variety of ways. For example, the Canada Pension Plan is legislated by the federal government but any change to policies governing the plan requires the approval of at least seven provincial governments representing at least two-thirds of the Canadian population. Nine provinces participate in the plan. The Quebec government operates its own public pension plan.

In the case of immigration, the federal government has agreements with several provinces according to which provincial governments can select a given proportion of immigrants based on the particular labour market needs of the province, and can manage labour market integration programs. This applies essentially to economic immigrants, that is, those that are admitted through the merit-based system that takes into account various characteristics of immigration applicants including education and proficiency in one or both official languages. Even though all provinces can participate in such agreements with the federal government, the province of Quebec has been most heavily involved in immigration policy. Recently, the surge in the number of individuals claiming refugee status after crossing the border between Canada and the United States has exposed the need for additional federal-provincial cooperation in this area. This sudden rise in the number of refugee applicants has raised tensions between the federal government, which is responsible for managing refugee claims, and provincial and municipal governments which are providing various social services and housing to claimants. The provinces that are particularly affected have called for financial support from the federal government to help cover the additional costs.

Municipal governments are under the jurisdiction of provincial governments. In principle, each province has full discretion in determining which responsibilities to devolve to municipalities. In practice, however, the set of responsibilities transferred to the local level is relatively uniform across provinces. There are single-tier and two-tier local governments. Single-tier municipalities are responsible for providing all public services delegated by the provincial government, although some services are often provided jointly by neighboring municipalities, generally to take advantage of economies of scale. In two-tier local governments, the upper tier (e.g. region or county) is responsible for services that are more adequately provided over a broader geographical area, while the lower tier (e.g. town or village) are tasked with services that are more local in nature or for which potential economies of scale are more limited.

The extent of expenditure decentralization is highlighted in Table 2. Provincial and territorial governments carry out over three-quarters of total expenditures in health and over 90% of education spending. All sub-national governments combined account for well over two-thirds of expenditures in public order and safety, economic affairs, environmental protection, housing and community amenities, and recreation and culture.

Table 2 Share of expenditures (%) by functions and level of government, 2019
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Aside from the allocation of powers and responsibilities, the Constitution imposes on the federal and provincial governments joint obligations to provide basic public services to everyone and to pursue equality of opportunity and regional economic development. These constitutional obligations have been argued to justify some federal contribution to a wide range of public services and programs that have an important equity dimension, including in areas of provincial jurisdiction (Boadway and Hobson, 1993). This has been particularly important in the establishment of several provincial programs in the areas of education and health care. For example, in the 1950s and 1960s, the federal government provided cost-sharing grants to provincial governments to encourage the creation of public health care insurance programs and to guarantee the attainment of national standards, even though health care in an exclusive provincial jurisdiction.

The federal and provincial governments have the constitutional right to borrow. The borrowing ability of local governments, however, is limited by provincial governments in various ways. Typically, municipalities can only borrow to finance capital expenditures, they often face debt limits and are sometimes subject to strict conditions with respect to budget balance.

3 Taxation Powers

The federal and provincial governments have unrestricted access to the main broad-based taxes, namely personal and corporate income taxes as well as consumption taxes, as outlined in Table 3. Taxes on natural resources are restricted to provincial governments while the federal government has sole access to taxes on international trade. Local governments rely heavily on the property tax which is their main source of revenues. All levels of government impose various user fees, although the relative importance of user fees as a revenue source is much greater at the local level.

Table 3 Allocation of main taxation powers
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As indicated in Table 4, the federal government dominates the income tax field, which includes personal income and corporate income taxes, while provincial governments occupy two-thirds of the consumption tax base and local governments collect 85% of property taxes. The federal government also raises over 60% of social contributions, which at the federal level consist mainly of contributions to the Canada Pension Plan and to the unemployment insurance system.

Table 4 Share of revenues (%) by source and level of government, 2019
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The federal and provincial governments have their own distinct income taxes. However, there are intergovernmental agreements that facilitate tax collection and management and that promote tax policy harmonization. In the case of the personal income tax, the federal government is responsible for collection and management in all provinces except Quebec. The tax base is determined by the federal government but provinces retain high flexibility in setting tax policy. They can set their own structure of tax rates, and therefore determine the degree of progressivity, as well as province-specific tax credits and special provisions. In contrast, in Quebec, the provincial personal income tax is fully managed and collected by the provincial government. Nonetheless, it remains fairly well harmonized with the personal income tax systems of the federal government and of the other provinces.

The federal government also collects corporate income taxes in all provinces except Quebec and Alberta. As for the personal tax, the federal government sets the tax base, but provinces can choose their tax rates and credits. The tax collection agreement precludes provincial governments from using tax credits and special provisions that discriminate against corporate taxpayers from other provinces. As part of the tax collection agreement, there is also a formula-apportionment system used to allocate the taxable income of firms that have activities in more than one province. This greatly limits firms’ opportunities for tax-avoidance through profit-shifting. The formula is based on the allocation of sales and payroll of firms across provinces.

There are also tax collection agreements for the value-added tax in some provinces. In five of them—Newfoundland, Nova Scotia, Prince Edward Island, New Brunswick and Ontario—there is a single value-added tax, the harmonized sales tax (HST), which is managed and collected by the federal government. The tax base is set by the federal government and is therefore fully harmonized across the participating provinces. Each provincial government can set its own tax rate which is imposed on top of the federal rate—currently set at 5%. The federal government transfers to each province the provincial share of revenues on a derivation basis. There is also a tax collection agreement between the federal government and the province of Quebec, although in that case, both governments impose their own distinct taxes, and both are collected by the provincial government. Three provinces—Manitoba, Saskatchewan and British Columbia—collect their own sales taxes and one province—Alberta—does not have any provincial sales tax. In these four provinces, the federal government independently collects its own value-added tax.

The lack of sales tax harmonization across all provinces remains an important concern. It potentially imposes various types of efficiency costs on the Canadian economy. For example, the fact that the tax bases of the HST and of provincial sales taxes in provinces that do not participate in the tax collection agreement are defined differently likely distorts the efficient allocation of firms and economic activity across provinces as well as patterns of interprovincial trade. Moreover, the lack of harmonization tends to increase the compliance costs of firms that have activities in more than one province and the costs of tax administration and collection for governments (Boadway and Shah, 2009; Anderson, 2010).

4 Intergovernmental Fiscal Transfers

The system of intergovernmental transfers is composed of federal transfers to provincial governments, including equalization transfers and specific-purpose transfers, to municipal governments and to territorial governments, as well as transfers from provincial governments to municipalities.

4.1 Equalization

The equalization transfer system constitutes the main general-purpose transfer program. As stated in the Canadian Constitution, the federal government is committed to providing monetary transfers to ensure that all provincial governments have the capacity to provide reasonably comparable levels of public services at reasonably comparable levels of taxation. In practice, this commitment is achieved by providing transfers to provincial governments with fiscal capacities below the national average.

Five tax bases are included in the calculation of provincial fiscal capacities: personal income taxes, corporate income taxes, consumption taxes, property taxes and natural resource revenues. For all of these except natural resource revenues, the capacities of provincial governments to raise revenues are computed by applying the national average tax rate on the estimated size of provincial tax bases. Equalization entitlements are determined by the gap between the fiscal capacities of each provinces and the national average. Since equalization entitlements are based on fiscal capacities, payments to each province are related to their potential tax revenues, not their actual tax revenues. This ensures that provincial governments’ incentives to raise own-source revenues are preserved. It is also consistent with the broad objective of ensuring that provincial governments have capacities to provide comparable public services but without requiring them to undertake the same levels of public expenditures.

In the case of natural resource revenues, the calculation of provincial fiscal capacities is different. Half of actual resource revenues, not potential revenues, are included in fiscal capacities. Moreover, to guarantee that the equalization entitlement of any given province is not affected negatively by the inclusion of natural resource revenues, the actual entitlement of each province is equal to the maximum amount obtained by either including half of resource revenues in entitlement calculations or fully excluding natural resource revenues.

Equalization transfers are entirely financed out of the federal government’s general revenues. Provincial governments with fiscal capacities above the national average do not contribute to financing the system. Moreover, as discussed below, other federal transfers to provinces are largely unrelated to provincial fiscal capacities. This implies that there is no explicit equalization of fiscal capacities for provinces with above-average capacities. As a result, substantial fiscal disparities remain between provinces that receive equalization payments and provinces that do not. To guarantee that the system remains affordable for the federal government, a ceiling is imposed on the growth of total equalization payments. This ceiling is determined by the three-year moving average of the GDP growth rate.

In 2019–2020, five of the ten provinces received equalization. The non-recipient provinces were Newfoundland, Ontario, Saskatchewan, Alberta and British Columbia. For several years, and up until 2018–2019, the two largest provinces in terms of population, Ontario and Quebec, were recipient of equalization although in the case of Ontario the per capita amount was relatively small.

The equalization system is based only on the capacities of provincial governments to raise revenues. It does not take into account differences across provinces in expenditure needs or in the costs of providing public services. This is potentially important to the extent that the average costs of providing public services will vary with the demographic structure of the population and between urban and rural areas, for example. Even though the federal government supports provincial government expenditures in particular areas through specific-purpose transfers, it is sometimes argued that omitting expenditure needs and costs in the calculation of equalization entitlements limits the ability of the system to fulfill the equalization mandate set by the Constitution.

The equalization system is reviewed every five years following consultations with the provinces, although it is not clear that these consultations always had a large impact on the outcome. In effect, the federal parliament has full authority to change the parameters of the system. Therefore, changes are effectively determined as part of the budgetary process of the federal government, and without any formal requirement to obtain the agreement of provinces. This also applies to the specific-purpose transfers described below. In contrast to other federations, such as Australia India and South Africa, there is no fiscal commission in Canada with the mandate of providing recommendations on the intergovernmental transfer system. However, the Council of the Federation, which includes as members all provincial and territorial Premiers, sometimes serves to promote consultation and negotiations with the federal government on a wide range of issues including intergovernmental transfers. Finance ministers of the federal, provincial and territorial governments also meet regularly, as do deputy ministers, and fiscal transfers would often be discussed at such meetings. Intergovernmental relations also take place through sectoral meetings involving federal and provincial ministers and deputy ministers responsible for specific areas, some of which are highly relevant for the transfer system, such as health care.

4.2 Specific-Purpose Federal Transfers to Provinces

The main specific-purpose transfers are the Canada Health Transfer (CHT) and the Canada Social Transfer (CST). These contribute to the financing of provincial programs in health care, post-secondary education, social assistance and social services, early childhood development and child care. These transfers are allocated among provinces on an equal per capita basis. Therefore, they are unrelated to the actual level of spending by provincial governments in the programs that the transfers are intended to support. Given that the federal government collects more taxes, in per capita terms, in provinces with higher fiscal capacities, these transfers indirectly contribute to horizontal balance among provinces.

As for equalization, the CHT and CST are determined as part of the budgetary process of the federal government. The annual growth rate of the CHT is currently set equal to the three-year moving average of the GDP growth rate. A minimum growth rate of three percent applies if the three-year moving average of GDP growth falls below three percent. The annual growth rate of CST is currently set at three percent. The commitment of the federal government to the future growth of these transfers provides some stability and predictability to provincial governments in their own budgetary process. However, it has been argued that the growth rate of the CHT will fall short of the growth rate of provincial governments’ expenditures in health care in the next several years leading to a gradual retreat of federal support for health care.

There are some broad conditions associated with these transfers although in practice provincial governments retain high autonomy and flexibility in designing and delivering public services. For example, CHT requires that provincial health insurance systems satisfy five broad principles which are specified by the Canada Health Act: insurance coverage must be universal and accessible to all independently of personal income, it must apply to a list of insured health care services, it must be portable across provinces and the system must be administered publicly. In principle, financial penalties can be imposed on provinces that do not comply with the Canada Health Act, although in practice non-compliance issues are usually addressed through federal-provincial discussions.

When first introduced, federal transfers for health care and social assistance were structured as cost-sharing grants. Under the Hospital Insurance and Diagnostic Services Act of 1957 and the Medical Care Act of 1966, the federal government covered roughly half of provincial governments’ health care costs.Footnote 3 These costs sharing arrangements provided provinces with a strong incentive to establish public health care systems and all provinces had done so within a few years. Similarly, under the Canada Assistance Plan, established in 1966, the federal government covered half of the cost of provincial social assistance programs. These cost-sharing arrangements were eventually replaced by block transfers subject to general conditions, but unrelated to the level of spending by provincial governments. Part of these block transfers were cash transfers and part took the form of income tax points transfers.

There are also several federal transfer programs for infrastructure financing. These often take the form of matching grants or cost-sharing arrangements with subnational governments. Some of them are specifically intended for local governments. The Gas Tax Fund is one important example. It is a permanent federal transfer that represents an important share of the total federal contribution to municipal infrastructure. The amount of this transfer was originally determined as a share of the federal gas tax, although it is effectively financed from federal general revenues. The transfers serve to finance a wide range of municipal projects that includes infrastructure for transportation, water and waste management, recreation, culture, tourism, etc. The funds flow through provincial governments and are allocated across provinces and territories on an equal-per-capita basis.

There are several other programs such as the Building Canada Fund, the Canada Strategic Infrastructure Fund, the Green Infrastructure Fund, the Public Transit Infrastructure Fund, and the Clean Water and Wastewater Fund. These are all essentially structured as cost-sharing arrangements with provincial and local governments intended for projects of national, regional or local scope. Various types of infrastructure projects are eligible under these different programs including infrastructures for transportation, public transit, water supply, wastewater treatment, sport, recreation, culture, waste management, green energy, disaster mitigation, etc.

4.3 Territorial Formula Financing

The three northern territories do not receive equalization transfers, the Canada Health Transfer or the Canada Social Transfer. A different federal transfer program, called Territorial Formula Financing, is in place to guarantee that territorial governments have the capacity to provide public services of comparable quality as those provided by provincial governments. This transfer program is designed to reflect the higher costs of providing public services in northern territories where communities are often isolated and sparsely populated. The transfers received by each territorial government are determined by taking into account the capacities to raise revenues as well as measures of expenditure needs. These transfers are unconditional.

4.4 Provincial Transfers to Municipalities

Local governments rely heavily on transfers from provincial governments. Most are specific-purpose grants, usually intended to support municipal spending in transportation, recreation, culture and the environment. There are also provincial transfers to local school boards for the financing of primary and secondary education. School board expenditures are also partly financed with local property taxes although provincial transfers generally represent a much greater share of total expenditures. General-purpose grants usually account for a small share of municipal revenues. Importantly however, some of the general-purpose grants have an equalizing component, often meant to compensate for disparities in capacities to raise property tax revenues. The way that these equalization components are structured varies across provinces. Some take into account only disparities in fiscal capacities while other also consider expenditure needs. In all cases, however, given that general-purpose grants represent a small portion of municipal revenues, their equalizing effects are limited.

4.5 Vertical Fiscal Gaps

The extent of fiscal decentralization and vertical fiscal gaps are shown in Table 5. The federal government collected 40% of total own-source revenues of all government levels in 2019 while the shares of provinces/territories and local governments were approximately 47% and 13%, respectively. Decentralization is even more pronounced on the expenditure side. The direct expenditures (i.e. expenditures excluding transfers to other governments) of all subnational governments represented 73% of the total. The vertical fiscal gaps, measured by the share of transfers in total revenues, was equal to approximately 20% at the provincial/territorial level and 44% at the local level. Thus, local governments rely much more heavily on transfers from other governments than do provincial governments. In fact, compared to other federations, the share of federal transfers in subnational government revenues is relatively low.

Table 5 Fiscal decentralization and vertical fiscal gaps, 2019
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Table 6 shows the share of major federal transfers in provincial government revenues for each province. There is high variation in the extent to which provinces rely on federal transfers, although much of that variation essentially reflects the distribution of equalization payments. Major federal transfers represented between 8 and 14% of provincial revenues in the five provinces that did not receive equalization payments in 2019–2020. In contrast, major transfers accounted for over 30% of revenues in Prince Edward Island, Nova Scotia and New Brunswick where equalization payments weigh most heavily in provincial revenues.

Table 6 Major federal transfers as percentages of provincial governments’ revenues, 2019–2020
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The Canada Health Transfer and the Canada Social Transfers accounted for about 74% of major federal transfers to provinces. Thus, specific-purpose transfers were approximately three times larger than general-purpose transfers. However, as mentioned earlier, the conditions associated with the CHT and the CST are broad and have very limited impact on the effective autonomy of provincial governments.

5 Macroeconomic Management

Both senior orders of government are involved, in different ways, in macroeconomic management. Business cycle stabilization is most actively conducted by the federal government. However, given the extent of fiscal decentralization, both in terms of taxation and expenditures, the fiscal decisions of provincial governments can potentially have significant effects on aggregate demand and on the business cycle. Despite this, there is no formal mechanism or fiscal rules in place to coordinate fiscal policies among governments. Following the 2008–2009 financial crisis, the federal government led the charge to stimulate the economy although most provincial governments also adopted expansionary fiscal policies albeit without formal coordination. The federal government adopted a fiscal stimulus package in 2009 in which additional infrastructure spending was a key element. Much of the added federal funds required matching expenses by the provinces and municipalities, so the federal measures indirectly induced, to some degree, increased stimulus expenditures by subnational governments. However, this was not the result of a concerted effort by the federal and provincial governments, and the matching requirements imposed on subnational governments have been the source of some tensions. Much of the fiscal policy measures in the early stages of the Covid-19 pandemic were also conducted by the federal government.

Fiscal policy, for the purpose of economic stabilization, is sometimes conducted more actively by provincial governments, especially when there are negative economic shocks that affect specific parts of the country. In such cases, economic stabilization is best achieved with province-specific fiscal policies that are more difficult to implement by the federal government.

Monetary policy is conducted by the Bank of Canada which is a federal crown corporation although it is, in practice, largely independent from the federal government. It generally operates in a framework of inflation targeting even though its official mandate gives it broad responsibilities to regulate credit and the national currency in order to promote national economic well-being, to mitigate business cycle fluctuations and to protect the external value of the Canadian dollar. The Bank of Canada responded fairly aggressively to the financial crisis of 2008–2009, complementing the expansionary fiscal policies that were put in place at the federal and provincial levels. The Bank’s key interest rate was kept very low for an extended period and quantitative easing measures were used to further stimulate the economy. As in the United States, housing prices had increased significantly in the pre-crisis period, and continued to do so to some extent during the economic recovery, although price increases and market over-heating were very uneven across different provinces and metropolitan areas. Regional asymmetries in the evolution of the housing market during the recovery and in the period that followed complicated somewhat the conduct of monetary policy which inevitably establishes credit market conditions that apply in the country as a whole. The Bank of Canada also react swiftly and very aggressively when the Covid-19 pandemic started in Canada, initially by lowering its key interest rate near the effective lower bound.

The federal and provincial governments manage their public debts independently and with complete autonomy. There are no rules or restrictions governing debt accumulation at either government level. Of course, all governments are subject to credit ratings which affect their borrowing costs and influence decisions over debt management. There is no contemporary tradition of bail-out by the federal government for provincial governments facing budgetary difficulties so the latter have strong incentives to manage debt accumulation prudently.

In the 1990s, the federal government debt-to-GDP ratio was considerably higher than the average provincial debt-to-GDP ratio. However, as a result of a dramatic fiscal turnaround, the federal debt was lowered from close to 70% of GDP in the mid-1990s to below 30% of GDP just before the start of the 2008–2009 financial crisis. The expansionary federal fiscal policy that was implemented in response to the financial crisis and the recession that followed had a relatively limited impact on the federal debt. The federal debt-to-GDP ratio increased to approximately 34% by 2012–2013 before starting to decline again. In contrast, the provincial governments’ debt-to-GDP ratios have increased since the mid-1990s in most of the non-oil producing provinces, including in the three most populous provinces, namely Ontario, Quebec and British Columbia. The immediate fiscal implications of the Covid-19 pandemic are much more important than those of the 2008–2009 financial crisis and will have a sizeable impact on debt-to-GDP ratios at both the federal and provincial levels.

Given the high degree of tax decentralization in the Canadian federation, tax policy harmonization is central for the efficiency of the internal economic union. The tax collection agreements between the federal and provincial governments greatly facilitate harmonization. For instance, the fact that provinces are precluded from discriminating against firms from other provinces in setting corporate tax policy is important for the efficiency of the common market. Moreover, the formula-apportionment system used to allocate corporate taxable income across provinces is important for mitigating incentives for tax competition among provincial governments and for tax-motivated profit-shifting by firms. This is critical for preserving the ability of governments to raise significant revenues from the corporate tax in the Canadian economic union in which there is high mobility of goods, investment and firms.

There are intergovernmental agreements intended to foster the good functioning of the internal common market. Of particular importance is the Canadian Free Trade Agreement (CFTA) that took effect in 2017 in replacement of the Agreement on Internal Trade adopted in the mid-1990s. The CFTA establishes rules that govern internal trade and investment and that are intended to prevent, or mitigate, frictions to the mobility of goods, services, labour and investment within the internal common market. For instance, it includes measures to promote regulatory harmonization across provinces and eliminate regulatory barriers to interprovincial trade. It promotes labour mobility and the establishment of a common labour market by encouraging the harmonization of occupational standards and credential recognition practices across provinces. It also establishes common practices in public procurement meant to level the playing field across provinces and promote broader competition for government contracts.

6 Response to the Covid-19 Pandemic

All three levels of government have been heavily involved in implementing response measures to the Covid-19 pandemic. While provincial governments are responsible for health care, all levels of governments have responsibilities with respect to public health. The Public Health Agency of Canada, which is a federal government agency, is responsible for preparing and responding to health emergencies, preventing and controlling infectious diseases and coordinating communications and responses during health crisis situations. The federal government is responsible for air transportation and border control and in the weeks that followed the start of the pandemic has implemented control measures in airports, closed the land border with the United States to non-essential travel and enacted the Quarantine Act requiring international travellers to self-isolate for 14 days after returning from abroad. Provinces have their chief medical officers and have all established their own public health response measures such as restrictions on gatherings, imposition of lockdowns, non-essential business and school closures, testing and tracing strategies, self-isolation rules, etc. This relatively decentralized approach has led to extensive variations across provinces in response measures and strategies. Arguably, this has been quite effective given that the spread of the virus and outbreaks have been uneven across provinces and have required province-specific reactions and response measures.

Both orders of government have also contributed to economic response measures although the federal government shouldered much of the effort. The federal government quickly implemented the Canada Emergency Response Benefit program to provide income support to workers, as well as loan, rent support and wage subsidy programs for businesses. It also provided income support through tax payment deferrals as well as income support for students, among other measures.

As a result of the pandemic, provinces have intensified pressure on the federal government to increase transfers for health care, both in the short run to help cover the immediate health care costs of the pandemic and on a more permanent basis. Before the pandemic, provinces had been demanding that the federal government increase the Canada Health Transfer to help them cope with the rapidly rising health costs associated with population aging. The pandemic has certainly made requests for higher CHT transfers more urgent, at least from the perspectives of provinces.

7 Challenges to Canadian Fiscal Federalism

Apart from immediate challenges raised by the Covid-19 pandemic, there are a number of other longer term challenges to fiscal federalism in Canada that call for reforms of fiscal arrangements, or for the adoption of new elements in the federal fiscal architecture, as well as additional cooperation among governments. Some of these issues are briefly outlined below.

Like many other countries, Canada is facing a demographic challenge. Population aging will continue to exert substantial pressure on public finances through both revenue and expenditure effects. A lower proportion of working-age individuals will lead to downward pressure on total employment and on government revenues. At the same time, the increase in the old-age dependency ratio will induce increased spending on health care, public drug programs, other social services and income-support programs including publicly funded pensions. In fact, according to Robson and Laurin (2015), age-sensitive expenditures are projected to increase from 13.0% of GDP to 15.6% of GDP between 2014 and 2035. Given the allocation of responsibilities between orders of government in Canada, these projected revenue and spending pressures could potentially be quite disruptive to fiscal balance across the federal and provincial governments.

Pressures from demographic changes on the finances of the federal government will be relatively limited, at least on the expenditure side. The Canada Pension Plan is the main federal program sensitive to population aging. However, given that the program is now largely funded, the impact of aging on the cost of pension benefits to the government will be relatively limited. On the other hand, most of the programs in which expenditures are highly sensitive to the old-age dependency rate are under provincial responsibility, including health care which represented 37% of total program spending by provincial/territorial governments in 2016 (Canadian Institute for Health Information, 2018).

Demographic trends will therefore require additional expenditure and revenue decentralization in the Canadian federation. Further revenue decentralization could be implemented by increasing federal transfers to provinces, by transferring tax room to provincial governments, or in other words, by decentralizing taxation, or by adopting revenue-sharing arrangements that could serve to increase provincial government revenues without further decentralizing taxation. The additional revenue decentralization required could be reduced by pre-funding some of the provincial public services that are highly sensitive to the old-age dependency rate, or by lowering provincial debt levels so as to create future fiscal room, although any efforts on those fronts will not eliminate altogether the need to decentralize revenues. Adapting to this pressure will be one of the key challenges to fiscal relations and the particular approach that will be used to achieve federal-provincial fiscal balance will potentially have profound effects on the efficiency and distributional properties of the Canadian tax system (Tremblay, 2012).

In the area of health care, there have been long-standing discussions to adopt a national public insurance program for prescription drugs, either as complement or as replacement to existing provincial programs. Currently, the costs of drugs are supported by public insurances provided by provincial governments, employer-provided insurances, and out-of-pocket expenses incurred by individuals. However, provincial programs generally cover a limited range of prescription drugs and a considerable proportion of the population is not covered by employer-provided insurances. One recent proposal, supported by an advisory council established by the federal government, is to introduce a new national drug insurance program that would provide universal and harmonized coverage across provinces. This would be a publicly funded program that would cover the costs of a wide range of prescription drugs deemed medically necessary. According to that particular proposal, the program would be administered by a federal agency that would be responsible for setting the list of covered drugs and negotiating drug prices with pharmaceutical companies. The introduction of a single-payer system would potentially reduce the costs of prescription drugs, and the adoption of a nationally-set list of covered drugs would ensure some uniformity of coverage across provinces. Although the program could include some co-payments by individuals, it would increase the share of total costs supported by the public sector.

Given that health care is a provincial jurisdiction, provincial governments would need to agree to participate in this new program, and the establishment of the program would require a high level of cooperation among governments. One option that has been put forward would be to implement it through a new dedicated federal transfer to provinces that would cover at least the additional costs to provinces relative to their current programs. As with the establishment of public health care insurance in the 1950s and 1960s, the federal government would likely have to play a leadership role by offering a conditional, and financially attractive, transfer to induce provinces to participate. Nonetheless, as in other areas, provinces could also be given the option to opt-out of the program. Opting-out provisions, leading to asymmetric arrangements across provinces, have worked relatively well in the past, with respect to labour market programs for example, and have sometimes facilitated the establishment of new programs.

The contentious issue of carbon pricing has been at the forefront of federal-provincial relations in the last few years. To achieve the emission reduction target of the Paris Agreement on climate change, the federal government has committed, in 2016, to implementing a carbon-pricing system across the country, and has later adopted a plan under which a carbon tax is imposed in all provinces that do not have a carbon-pricing system. The federal carbon tax includes a consumer levy on fuel and a tax on large industrial emitters. It has now been imposed in four provinces, while the other six have implemented a carbon price, either through a carbon tax or a cap-and-trade system.Footnote 4 In order to be exempted from the federal carbon-pricing backstop, provincial systems must meet benchmarks specified by the federal government with respect to the level of emission coverage and the pricing level (Environment and Climate Change Canada, 2017).

While the system is so far succeeding at imposing a carbon price across the country, despite court challenges launched by some provincial governments, there will remain considerable dis-harmonization along various dimensions. Among the provinces that have their own carbon-pricing system, there are substantial variations in coverage of carbon sources as well as in pricing (Dobson et al., 2019). Moreover, while federal carbon tax revenues will be returned to households as tax rebates, that is not the case in some of the provinces that adopted their own carbon-pricing system. While the fact that revenues from the federally imposed carbon-pricing backstop are returned to citizens is arguably consistent with accountability principles (Snoddon, 2018), it does raise distributional issues given that revenues are not returned to citizens under some of the provincial carbon-pricing system. In any case, it is not clear that all the efficiency and equity benefits of a fully national system are obtained under the current approach.

Maintaining horizontal balance in the Canadian federation is always a challenge, although with the relatively low prices of oil and gas in the last few years, the issue has not been as salient as in the past. Nonetheless, any substantial increase in oil and gas prices in the future will surely bring back the question of horizontal balance at the forefront of federal-provincial fiscal relations and generate pressure to reform the equalization system. Many features of the system remain controversial. First, the treatment of natural resource revenues is a source of tension, partly because of the fundamental conflict between the provincial ownership of resources, as stipulated by the Constitution, and the constitutional mandate of equalization imposed on the federal government (Dahlby, 2014; Boadway et al., 2015). Second, some provinces, notably Ontario, have argued that the equalization obligation of the federal government cannot be properly met with an equalization system that does not take into account differences across provinces in expenditure needs or in the costs of providing public services. To address this issue, there have been proposals to include in the calculation of equalization entitlements measures of costs based on indicators of public sector wages, construction costs and percentage of the population living outside metropolitan areas, as well as measures of needs based on demographic and expenditure indicators (Gusen, 2012; Courchene, 2013).Footnote 5

There are intense fiscal pressures on municipal governments arising from several different sources including increased urbanization, growing demand for locally provided services to citizens and businesses, as well as infrastructure needs. At the same time, local governments do not have access to a diversified set of tax bases. They rely largely on property taxes, user fees and transfers from other governments, mainly provincial governments. Moreover, many of the services that they provide must meet standards set by the provincial government, or are defined by provincially set mandates. Limited flexibility on both the revenue and expenditure sides of their budget makes it difficult for municipal governments to respond to changing circumstances and to address some of the challenges they face. Given the increasingly important role of municipal governments in promoting growth and competitiveness, especially through the provision of infrastructure, there is growing interest in providing more revenue autonomy to municipal governments, whether that is achieved by diversifying their tax bases or through revenue-sharing arrangements with other government levels.