A new model to fund Canadian cities

In early January I was invited to contribute a memo to an initiative convened by the University of Toronto’s School of Public Policy and Governance on Problems and Solutions in the Federation. The memos, which covered a wide range of topics, were given to Deputy Prime Minister Chrystia Freeland. This happened before COVID-19 changed everything, but I think it remains a useful proposal.

Here is what I submitted:

Problem: The growing local fiscal gap

Solution: Federal-municipal general revenue sharing funded by a 1% increase to the GST

1. The problem

It is generally recognized that, especially in growing metropolitan centres but also in slow-growth and declining regions, local government own-source revenues are insufficient to meet growing expenditure demands. This fiscal gap is produced and exacerbated by three main factors.

First, the primary revenue source for Canadian local governments is the property tax—that is, a levy in proportion to the assessed value of real property, comprising both the land and structures built upon it. The property tax is a good tax for local governments because property, unlike capital and labour, is immovable. However, even if property value assessment is accurate and up to date, it is an imperfect proxy for economic activity and bears little relation to expenditure needs. Provincial governments have taken few steps to diversify municipal revenue sources, arguing (perhaps correctly) that doing so would expose municipalities to greater revenue volatility while exacerbating inequities of tax burdens and service quality between rich and poor places. 

Second, demand for capital expenditure by local government has increased in recent years. Urban infrastructure and facilities built during the postwar boom years are ageing and reaching the end of their operational life. At the same time, successive federal and provincial governments have transferred responsibility for infrastructure and facilities to local governments. (According to FCM, 60% of public infrastructure is owned by local governments.) In growing metropolitan areas, local governments often make tradeoffs between maintaining and replacing existing infrastructure, on the one hand, and constructing new infrastructure to accommodate population growth, on the other. Policies aimed at making “growth pay for growth” by hiking development charges and requiring developers to front infrastructure costs have gone some way toward addressing the latter shortfall (and reducing municipal debt exposure), but they have also eroded housing affordability in high-growth housing markets. The fiscal pressure is also acute in slow-growth and declining areas, where a steady-state or shrinking population must bear the cost of infrastructure renewal. While many local governments have not fully exploited their permitted borrowing room, the risk of doing so is real given that interest payments fall on the property tax and the future value of property (and especially non-residential property) is uncertain given macro-demographic and economic shifts, including an ageing society, postindustrialization, and automation.

Third, local government operating budgets (which by provincial law must be balanced annually) are increasing at rates faster than property values, and therefore property tax revenue, due to factors largely beyond their control, including escalating labour and fuel costs. In particular, municipal associations have highlighted how arbitrated settlements with labour unions have pushed up wage and benefit rates, especially for protective and emergency services workers.

The core policy dilemma is this: How can local governments both increase and diversify their revenues in order to meet rising expenditure demands, without also increasing the volatility of revenues and widening gaps in fiscal capacity between rich and poor places? 

2. The solution

A viable solution must meet four criteria:

  • It must increase the fiscal resources available to local governments.
  • It must diversify the revenue sources available to local governments by reducing reliance on the property tax.
  • As local governments cannot run operating deficits, and must fund debt repayment from current revenues, it must not expose them to undue revenue volatility.
  • It must not disproportionately reward local jurisdictions with high existing tax capacity while penalizing those with low existing tax capacity.
  • It must be done in such a way that maintains political accountability for taxing and spending decisions.

Transferring a share of the GST to municipalities maximizes these criteria better than many commonly discussed alternatives. It would add a stable revenue stream that is tied to economic growth and independent of the property tax. If apportioned by population, it would not exacerbate spatial inequalities. Applied nationally, it would not distort the location decisions of businesses and residents. If transferred with minimal strings attached, local governments would be politically accountable for how the money was spent, if not the decision to impose the tax in the first place. Unlike proposals for local or metropolitan sales taxes, raising the GST would generate minimal administrative costs, simply because the machinery already exists. 

Let us imagine that the federal government raised the GST by 1%. Given the federal government’s recent interest in providing support for capital infrastructure, the transfer agreement would require that a minimum of half the transfer had to be used for capital purposes. Municipalities, however, could choose to use the other half for operating or capital purposes as it saw fit. 

In 2018, one percentage point of GST revenues equaled $8.3 billion—the equivalent of $226 per Canadian.[1] This money could be transferred to municipalities using the same approach as the Gas Tax Fund: bilateral agreements with provinces, sometimes with municipal associations as parties, that allocate funds according to a formula and with modest reporting requirements. 

One possible formula would be to distribute funds to local governments according to their proportions of the national population. With 2.9 million residents, Toronto would receive on the order of $650 million per year—roughly the same as what is generated by the city’s unique Municipal Land Transfer Tax, the equivalent of a 10% residential property tax increase. If entirely devoted to capital purposes, this amount could leverage several billions of dollars of new debt—enough to bend the curve on the city’s transit infrastructure and social housing repair and expansion backlogs. Smaller cities such as London or Halifax would receive about $85 million.

Due to variation among provinces in the amount of commercial activity, and therefore GST revenue, per capita, it may be politically desirable to adopt an “eat what you kill” formula, whereby each province would be allocated funds in proportion to the amount of GST collected within it, which would then be transferred to municipalities in proportion to their share of the population. BC, Alberta, Ontario, and the three territories generate more GST revenue per capita than a national population formula would dictate; the other provinces generate less. BC and Alberta, for example, generate $258 of GST per capita, while PEI generates $191.

Why not simply grow the Gas Tax Fund, as advocated by the FCM? The Gas Tax Fund (which is no longer tied to the federal gas tax, despite its name) shares federal revenues with local governments through provinces in proportion to each province’s population. The GTF is dedicated to capital expenditures on infrastructure and has distributed approximately $2 billion annually since 2006. The City of Toronto, for example, received $160 million in 2017; Calgary received $69 million.

Since the GTF is no longer tied to a revenue stream, increasing it would require the government to impose higher income taxes or deficit spending, or both. Restoring part of the previous government’s 2005–2007 GST cut, however, and dedicating the increment to a specific and highly visible purpose, would mitigate the political risk. Polling shows that Canadians trust local governments more than national and provincial governments. Given the government’s long-term goal of decarbonizing the economy, it should consider rebranding the GTF as the Canadian Communities Transfer. The GST revenue stream discussed here could be rolled into it, establishing capital and operating substreams, or it could be kept separate. 

The bottom line: Canadian local governments need more revenue and more diverse revenue sources to perform tasks essential to Canadians’ quality of life and economic growth. The federal government has the tax capacity and ability to redistribute nationally to meet this need. The GST is an ideal source due to its stability, grounding in economic activity, and administrative simplicity. 

[1] Fiscal data are from CANSIM table 384-0047, Revenue, expenditure and budgetary balance – General governments, provincial and territorial economic accounts. Population estimates are from CANSIM table 051-0001, Population estimates on July 1st, by age and sex.