Canada has a different legal structure compared to the United States. Canada is one of the most decentralized countries in the world where provinces are actually responsible for most major social expenditures as a whole. The Canadian provinces receive large, unconditional transfers from the federal government whereby some provinces receive transfers from the federal government that are more important sources of revenue than their own local taxes. This does set the stage for resentment between provinces, which is rather different from the United States model where the states are separate, individual, sovereign entities.
When we then look at the next tier lower, Canadian municipalities are effectively only agents of provincial governments, and in the United States, they too are stand alone entities. Therefore, in Canada, we have a hierarchical budget and debt constraints that combine to restrict the revenues of municipalities. Consequently, the province impacts the direct expenditures and controls access to capital markets for municipalities. If a local government gets into financial trouble, then the province comes to the rescue in various ways and can even change the municipal territorial boundaries, which is sort of similar to merging banks when in trouble. The province can even take over functions and has the authority to take over control of a municipality’s finances.
Municipalities cannot, therefore, actually go bankrupt in Canada since they are implicitly guaranteed by the province. This also means that in Canadian municipalities, the normal interest rate spreads or disparities are based upon various credit ratings and are not really a big factor at the municipal level, but rather at the provincial level. In Canada, local borrowing requires prior provincial approval and is severely limited. Therefore, the credit rating tends to be that of the province. Such debt constraints are a product of the implicit provincial responsibility for bailing out any municipal default, which is a legacy of the Great Depression, since in Canada, that event caused a tidal wave of local defaults amounting to about 10% of all Canadian municipal debt.
Canada has continued to expand the size of provincial transfers to municipalities as a percent of GDP, which has reached nearly the 50% level. This tends to introduce a different risk whereby if the province gets in trouble, it will directly impact all municipalities within its domain. So during the Great Depression it was one municipality against another, today in a sovereign debt crisis everyone risks going down with the ship.
In Canada, provinces have freedom to choose their own tax bases and rates. In practice, the majority of provincial income taxes are collected by the federal government under tax collection agreements. The underlying terms dictate that the same base is taxed for the federal income tax. Therefore, the Canadian federal government collects corporation income taxes and personal income taxes for several provinces under these arrangements. Therefore, in the United States, there tends to be tax competition among states where some states do not have income taxes at all, but the Canadian federal and provincial governments essentially tax the same basis. The Canadian federal government collects more from its taxes than its direct spending. The excess taxation is transferred through two large, unconditional transfer programs to the provinces.
Therefore, the risks in a sovereign debt crisis are actually higher in Canada than the United States. The Canadian structure means it is one for all and all for one, whereas in the United States there will be a disparity between states as some will survive better than others. A Detroit bankruptcy is not possible in Canada, whereas in the United States everyone stands alone and a collapse of one does not take down the whole. So a collapse in Illinois will not take down North Carolina.
