Why Provinces Need Fiscal Constitutions

Commentary, Frontier Centre, Public Sector, Uncategorized

The scare that Ontario voters gave the Liberal Party during the federal election has largely been attributed to anger with that province’s Premier, Dalton McGuinty, who broke his 2003 election promise not to raise taxes. Not only did his inaugural budget feature major hikes in health premiums, but the new Premier confirmed his government would be jettisoning Ontario’s Taxpayer Protection and Balanced Budget Act, which required voter approval for such increases. No surprise, his government now languishes at about 35% in opinion polls.

The decision to turf that law will come back to haunt Mr. McGuinty. Properly designed, such legislation can serve as a fiscal constitution that delivers superior long-term policy and better services paid for by expanded growth. It inoculates politicians from the danger of fiscal whims.

Politicians operate obsessively in the short term, thanks to the phenomenon known as “concentrated benefits versus diffused costs”: Organized groups that stand to gain substantial benefits from expanded government programs constantly lobby them to spend. On the other hand, individual taxpayers, who pay only a few dollars more because costs are spread among millions, will not waste valuable time opposing the change. Over time, this dynamic drives government spending past the point considered optimal for economic growth, higher living standards and revenue generation, somewhere near 30% of GDP.

Politicians and Canadians are bombarded by well-funded interest groups on the “need” to spend billions more on monopoly programs and a myriad of imposts and subsidies. The easy way out is to cater to them by spending and taxing incessantly. This explains the bias in Canadian public policy toward “resource reform” – pouring more money into healthcare, daycare, cities, etc. The same lobbies that push those solutions – public-sector unions are the most prominent – have nothing to gain from “structural reform” – rethinking how the same or better outcomes might be achieved using other methods.

A properly designed fiscal constitution that deals with the concentrated-benefit-diffused-cost problem effectively gives the politicians a practical way to say, “My hands are tied on the spending front,” and at the same time prioritize spending and explore more creative models. These laws also stimulate economic growth because investors like stability and avoid places where tax increases and wasteful spending are routine policy. High-tax locales stagnate relative to places where governments show restraint.

The McGuinty flip-flop highlights the fragile foundation of taxpayer protection in Canada. A simple majority vote in the legislature can terminate or drastically water down Ontario’s law. To their credit, Manitoba’s New Democratic government has retained its Balanced Budget, Debt Repayment and Taxpayer Accountability Act, the first in Canada and the model for Ontario’s. The Doer government doesn’t like the law but, despite the occasional diddle, kept it in place to solidify its record of fiscal accountability.

A second issue relates to the abysmal financial information that allows politicians to promise the moon and then renege by claiming the “books are in chaos.” Provinces need to adopt the equivalent of New Zealand’s Fiscal Responsibility Act, which mandates rigorous transparency in government accounting. Because it requires a high level of disclosure, based on accrual accounting, it means open budgeting and no post-election surprises á la Ontario.

To be effective, taxpayer protection must limit not just tax increases, but spending increases as well. This prevents the instability caused when temporary surpluses are built into base spending, an illusion which dictates future cutbacks or tax increases. To be effective, taxpayer protection must control spending as well as taxes. This prevents the instability caused when temporary surpluses, as in Ontario, are built into base spending, an illusion which dictates future cutbacks or tax increases. The legislation also needs to be entrenched so it can not be cavalierly tossed aside. The simplest approach is to ratify the legislation through referendum. Rejecting a popular mandate is a different matter than repudiating the decisions of a now-defeated legislature.

In 1992, Colorado passed a law popularly referred to as TABOR, or the Taxpayer’s Bill of Rights. A study of the law’s effects, A Decade of TABOR (available at fcpp.org), details the effects of the law on state politicians and the state economy. It should be required reading for those who fail to understand the benefits of such constraints.

Embedded in Colorado’s constitution, TABOR’s stated goal is to “reasonably restrain most the growth of government.” It overcomes the concentrated-benefits-diffused-costs dynamic by linking spending increases to a simple formula based on population and growth. Tax increases must be approved by voters. It applies to all state government entities, including cities and school boards.

Politicians cannot spend more than they did the year before – except to accommodate natural expansion – unless the public says so. If state revenues are greater than predicted, officials have to ask the public’s permission to keep the extra cash. TABOR mandates contingency funds to meet public emergencies, but obligates the state to replenish them in the next calendar year.

The law was originally imposed by means of a citizen referendum and passed on its third try, despite fierce opposition by the political class and powerful public spending lobbies. The initiative process, a feature in many U.S. states and not alien to Canada, is often derided as a complicated tool. But in the case of TABOR, it has conferred enormous benefits. Between 1997 and 2001, TABOR’s rebate mechanism returned US$800 per capita in surplus revenues to taxpayers, a total of US$3.25 billion.

Critics who pooh-poohed the law said they would have to put “going out of business” signs up at the Colorado border. Quite the opposite happened. The stability and predictability of the tax climate prompted strong economic growth. Private-sector jobs increased at nearly double the rate of government jobs. Instead of starving government, these consequences allowed it to spend more in tandem, at a per capita growth rate of 72% over the decade. When other state governments faced recession and collapsed revenues in 2000, Colorado largely sailed through.

Spending controls keep politicians out of trouble. If they want more money, they have to make the case to the people and hone their powers of persuasion. Dalton McGuinty will have to learn this lesson the hard way.

An edit of this article originally appeared in the National Post, July 6, 2004.