The importance of vertical fiscal balance cannot be ignored or overstated when evaluating the effectiveness of Canada’s Equalization program. An imbalance within vertical fiscal relations occurs when there is a mismatch between the fiscal capacities of different levels of government and their spending responsibilities (Laurent, 2003). According to Laurent, a big reason for the ongoing intergovernmental conflict in Canada is that provinces feel as though they are victims of vertical fiscal imbalance. He points to the findings of the “Seguin Report”, which showed that the federal government recorded a budget surplus for the fifth consecutive year in 2002. More importantly, this government expected continued fiscal strength in the foreseeable future. Furthermore, Laurent found that, when the federal government was questioned about this fiscal imbalance, it's position was that said supposed imbalance does not in fact exist because the provinces have access to all revenue sources and even have a monopoly on lotteries and natural resource royalties.
Laurent proceeds to explain that prior to the distribution of these four main federal transfers, a vertical fiscal imbalance exists. In fact, all parties, including the federal government, agree on this point as the federal government amasses more in revenue than it spends, while the provinces’ own-source revenues are not quite sufficient to cover their expenditures. The debate is then about what is the best assignment of revenues and expenditures. Laurent takes this a step further when he juxtaposes the two opposing mechanisms of national solidarity and provincial autonomy as being fundamentally inherent to federal systems of government.
One thing Laurent makes clear is that economists recommend financial sustainability, which deals with assessing a government’s level of debt as well as its spending obligations. He seems to suggest that this process differs significantly from comparing federal and provincial budget balances. The reason that he provides for this is that the federal government faces a much greater fiscal constraint due to larger debt burden than any and all provinces combined.
Furthermore, Rodden (2002) illustrates the importance of concepts of commitment and inter-governmental transfers for analyzing the effectiveness of the Equalization program. He suggests that if multi-tiered governments face the problem of lack of cooperation between the levels of government a lower-level government may decide that a costly project is worth completing, irrespective of the impact on other governments. This usually leads to the lower-level government requesting financial assistance from a higher level of government in order to fund this project. This assistance can be seen as a bailout, which benefits the lower level of government while imposing a negative effect on taxpayers because the tax burden will fall on them.
Rodden implies that the negative externalities associated with the rejection of the bailout can influence the decision of the higher-level government towards the acceptance of the bailout. Moreover, it has been shown empirically by Winer (1980), Stein (1998), Rodden (2001a) and Rattso (2000) that high transfer-dependence leads to fiscal indiscipline at this more local government level, as this level gets more and more used to receiving transfer payments from higher-level governments in order to finance their activities and programs. Therefore, these lower-level governments less and less feel the need to generate their own revenue in order to fund said activities. As such, in time of an unexpected fiscal shock, those local governments may be unable to generate enough of their own income in order to counteract the shock, and they will thus depend on money coming in from upper-level governments. Subsequently, the lower-level governments will be indebted towards higher-level governments. Enough unpaid debt over a long period of time can lead towards a financial crisis for these low-level governments.
This will cause voters to pressurize higher levels of government to resolve this financial crisis, as these higher levels are the only ones that can do so. Again, this creates dependence on the high-level government. Low-level governments with dependence on the high-level governments usually have higher levels of vertical fiscal imbalance, which is defined as transfers as a percentage of total subnational (low-level government) revenue. Rodden, as assisted by Winer, Stein and Rattso, established the link between vertical fiscal imbalance and borrowing autonomy.
Finally, when more local governments have high subnational borrowing autonomy and low vertical fiscal imbalance, fiscal restraint is imposed by voters and creditors on the respective low-level government, as they want to avoid being transfer-dependent upon higher-level governments as this may lead to a massive financial crisis for this more local government after a fiscal shock.
Laurent, S. (2013, September 10). (Canada, Parliamentary Research Branch, Economics Division ). Retrieved April 1, 2017, from http://www.lop.parl.gc.ca/Content/LOP/ResearchPublicationsArchive/pdf/bp1000/prb0308-e.pdf
Rodden, Jonathan. “The Dilemma of Fiscal Federalism: Grants and Fiscal Performance around the World.” American Journal of Political Science, vol. 46, no. 3, 2002, pp. 670–687.
Picture entitled, "Canada", taken by Alex Indigo on December 21, 2006, obtained through Creative Commons (https://flic.kr/p/4eDBug)