Incomplete Contracts and the Evolution of Canadian Federalism
Grewal, Bhajan S., Public Finance and Management
Even though the British North American Act 1867 established the Canadian federation with a dominant federal government, Canadian provinces today enjoy much greater fiscal autonomy than they inherited from the constitution. Provincial governments have access to virtually all taxes, raise more in tax revenue than the federal government and enjoy a high degree of autonomy in respect of priorities for public spending. Canada's fiscal decentralization is in contrast to Australia's experience, which has evolved over time towards greater fiscal centralization. This paper examines the evolution of Canadian federalism from the perspective of incomplete contract theory, according to which residual rights over policies are a source of political influence when negotiating intergovernmental fiscal arrangements. In both countries, federal and subnational governments have been engaged in the same kind of conflict for greater power over policies. The difference between the two countries has been, however, that unlike the Australian States, the Canadian Provinces have successfully resisted the pressures put by the federal government and have regained their fiscal power that was once lost in the wake of the Second World War.
This paper complements the existing literature on the evolution of fiscal federalism in the mature federations, particularly Mathews and Grewal (1997), and Grewal and Sheehan (2004). The main focus of their work has been on documenting and explaining major shifts in fiscal balance in Australia since the Second World War. In Grewal and Sheehan (2004) it was suggested that although the mainstream economic theories of federalism shed little light on the evolutionary process of federations, the theory of incomplete contracts offers some promising insights for gaining a better understanding of the evolutionary process of fiscal federalism. In identifying the key drivers of the evolution of fiscal federalism in Canada, the purpose of this paper has been to see whether the same insights can be applied to the Canadian case.
In Australia, the States established a Commonwealth Government in 1901 by a voluntary agreement, reflected in the Commonwealth Constitution in which legislative authority over only a few functions was assigned to the Commonwealth while the remaining (unallocated) powers were reserved for the States. However, this highly decentralized constitutional model has evolved into a highly centralized model. In contrast, even though the British North American Act 1867 established the Canadian federation with a dominant federal government, Canadian provinces today enjoy much greater fiscal autonomy than they inherited from the constitution. Canadian province2 have access to virtually all major taxes and also enjoy a high degree of autonomy in respect of priorities for public spending, although the debate about the centralizing impact of the federal spending power continues (more on this below). With a low dependence of provincial governments on federal fiscal transfers, federalism in Canada appears to be operating much closer to the theoretical benchmark of a 'market preserving federalism' (Weingast, 1995) than could be said of the Australian case. The fact that evolutionary experience in these two mature federations has been so different, whereas they both share common features of British colonial past, parliamentary democracy and centralization of tax powers during and following the World War II, is indeed intriguing and invites explanation.
A related aim of this paper is to draw possible lessons for other federations. In recent years, there has been increasing interest in fiscal decentralization outside the formally federalized countries, e.g., in the former Soviet Union States and the East European emerging market economies. In the European Union, member countries have also been concerned to ensure that the new EU governance structures (e.g., the EU Commission and the EU Council) do not threaten their own choices in regard to fiscal decentralization. …