Policy Forum: Carbon Taxes and Fiscal Federalism in Canada—A New Wrinkle to an Old Problem

Abstract

The federal government intends to increase its minimum carbon tax from $40 per tonne of carbon emissions to $170 per tonne by 2030. The carbon tax increase will have uneven and potentially large impacts on provincial emissions and carbon tax revenue, but little is known about how decisions to recycle these revenues will affect equalization payments to provinces. This article compares baseline equalization payments with simulated payments under various revenue-recycling scenarios given a $170 minimum carbon tax. The simulations demonstrate that recycling carbon tax revenues with offsetting reductions in provincial personal or business income taxes, for example, lowers overall disparities in provincial governments' revenue-raising abilities and reduces the size of the equalization program needed to address these disparities. The article draws attention to an already controversial design feature of the program, the fixed-growth rule. The simulations show that the fixed-growth rule limits the impact of higher carbon tax revenues on equalization, by adjusting payments to ensure that the overall size of the program grows roughly in line with the economy. As a result, any potential savings in aggregate equalization payments from revenue recycling are not realized. The distribution of payments is also affected by the fixed-growth rule. Overequalization often results, with Quebec and sometimes Ontario as the main beneficiaries.