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Equalization and the Incentives for Growth: An Empirical Investigation of the "Tax-Back" Effect

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  • Ann Cavlovic
  • Kathleen Day
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    Abstract

    Questions have been raised as to whether the equalization payments system in Canada is such that a recipient government’s tax and expenditure policies may have a direct effect on the size of its equalization payment. As a result, there has been discussion over the possible links between the equalization program and fiscal decisions made by provincial governments. Specifically, a potential interaction often referred to as the so-called "tax-back" effect has received a great deal of attention, since it points to incentives for inefficient behaviour by provincial governments. Using vector error correction models of the economies of the six equalization-receiving provinces that received equalization payments without interruption during the 1961-1998 period, as well as a generalized impulse response analysis, the paper explores the dynamics of the interactions between flows of equalization payments and other key variable in the economies of recipient provinces. We find that during the 1963-1998 period Canada’s equalization system does not appear to have had an overall negative effect on economic growth. Plusieurs questions ont été soulevées quant à savoir si le système des paiements de péréquation fiscale au Canada est conçu de telle façon que la politique fiscale et la politique des dépenses du gouvernement bénéficiaire peuvent avoir un effet direct sur la subvention de péréquation qui lui sera versée. Par conséquent, les liens possibles entre le programme de péréquation fiscale et les décisions fiscales des gouvernements provinciaux ont suscité beaucoup d’intérêt. Plus particulièrement, mentionnons une des conséquences possibles, soit l’effet de la « récupération fiscale » qui a reçu une attention particulière puisqu’il signale des mesures incitatives pour contrer les comportements inefficaces des gouvernements provinciaux. En utilisant une représentation autorégressive à correction d’erreurs (VECM) des économies des six provinces qui ont été bénéficiaires de péréquations fiscales sans interruption au cours de la période de 1961 à 1998, ainsi qu’une une analyse des sentiers de réponse dynamique, nous examinons dans ce document la dynamique des interactions entre le roulement des paiements de péréquation fiscale et les autres variables clés de l’économie des provinces bénéficiaires. Nous constatons que, durant la période de 1963 à 1998, le système de péréquation fiscale du Canada ne semble pas avoir eu un effet négatif général sur la croissance économique.

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    Paper provided by Department of Finance Canada in its series Working Papers-Department of Finance Canada with number 2003-23.

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    Handle: RePEc:fca:wpfnca:2003-23

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