The Economics of Amalgamation

Small municipalities in Nova Scotia are asking tough existential questions. Earlier this year three towns voted to dissolve within a five week window: Springhill, Bridgetown, and Hantsport. Hantsport’s decision came as surprise, given their relatively healthy municipal finances, but as one supporter of the motion put it, the decision to amalgamate represented a “forward-looking” and “strategic” choice for the councilors. The trends foreseen by Hantsport come down to basic economics. In particular, two interrelated economic concepts stand out to explain why so many of Nova Scotia’s small towns are facing increasing cost pressures.

Economies of Scale

The kind of services provided by municipalities are all subject to economies of scale to varying degrees: as the scale of service grows, average or per capita costs fall until reaching a sweet spot, beyond which more scale creates rising average costs. Economies of scale are key to understanding the differing levels of market concentration by industry, and is similarly applicable to analyzing the size and concentration of political units.

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A simple way to demonstrate economies of scale in municipalities is to look at how per capita costs of basic services differ depending on scale. For example, providing a town in Nova Scotia with police and fire services, along with other administrative and counsel expenditures, costs on average $683 per capita annually. Scaling these same services up to the county level reduces the per-capita costs of every category, and cuts the annual total nearly in half to $350 per capita. Costs begin to rise again for CBRM and HRM, but never reach the highs of the town average.

These trends align with the academic literature on the subject. Most studies of Canadian municipalities find that economies of scale are mmaximized for police and fire services between a population of 20 and 50 thousand. Out-migration is, therefore, especially damaging to towns below this population range.

The Cost Disease

The cost disease is a concept that was first observed in connection to the arts. The economist William Baumol noted that musical performers were becoming more and more expensive to hire, despite little to no improvement in their productivity. One had to pay more in order to entice the musically skilled away from high productivity growth sectors of the time, such as manufacturing.

The cost disease is a defining feature of our times, as creeping changes in relative cost, and in particular rising costs of labour, force old practices and structures to break down. For instance, having home servants was once commonplace, but today is associated with luxury. For a similar reason, it’s often cheaper to buy a new home appliance than to call in a technician. In schools, teacher salaries continue to rise without matching productivity growth, too, leading to the infeasibility of the small school model and driving organizational consolidation.

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Residential Tax Burden = Total residential tax revenue ÷ Total dwelling units

The cost disease leads to similar consolidation pressures for municipalities. Nova Scotia’s municipal districts tend to have the fastest growing residential tax burdens for two reasons. First, relative to towns, they have smaller tax burdens to begin with, so a given increase implies a faster growth rate. In absolute terms, towns have the largest tax burdens by a long shot. Second, municipal districts have more mandatory expenditures, such as the education contribution, that they have little control over.

There are no short cuts to fighting the cost disease. The options can be grouped into two types: we can either accept much higher proportions of GDP going to cost diseased areas or we can find ways to adapt to changing cost structures by restructuring organizations, boosting labour productivity and finding labour-saving technologies.

Samuel Hammond is an AIMS on Campus Student Fellow who is pursuing a graduate degree in economics at Carleton University. The views expressed are the opinion of the author and not necessarily that of the Atlantic Institute for Market Studies

Shifting responsibility: Equalization and government spending

Canada’s equalization program, through which the federal government mandates the richer provinces to subsidize their poorer equals, is central to Canadian federalism. Whether the provinces receive or contribute to the scheme determines their “have” or  “have not” status, and political battles over transfers seldom end peacefully.

Although it is understandable that the beneficiary provinces defend the equalization program, taking a closer look reveals the current scheme reduces fiscal accountability in recipient provinces, which compared to the contributing provinces, have a generally bloated public sector (in addition to other perks, such as lower tuition averages and higher teacher-student ratios).

Equalization ensures that poorer provinces are able to provide quality public services to their residents by assessing each province’s ability to pay for a basket of services and using this information to determine whether they will receive from, or contribute to, the program.

An oddity of the scheme is that overlap exists between equalization recipients and net contributors. In 2012, for example, Ontario received roughly $3 billion in transfer payments, while its taxpayers paid over $6 billion toward the program. Even recipients “contribute” to their own transfers: last year, Quebec paid nearly $3 billion toward equalization and took in over $7 billion. In fact, because Ontario receives equalization payments, most of the funds transferred by the program come from its recipients.

The incentive structure of Canada’s equalization program discourages accountability, since the provinces can treat the money they receive from equalization as though it came from thin air, despite the fact that their residents contributed to the scheme via taxation. Furthermore, the provinces are not limited in spending this money and, in some cases such as Nova Scotia’s, use the funds to pay the interest on provincial debt.

The effect is that public sector spending increases in recipient provinces, who justify their spending habits on the premise that “someone else is covering the cost.” Consequently, recipient provinces spend more per capita than the “creditor” provinces. For instance, the net beneficiaries of equalization–Atlantic Canada, Quebec, and Manitoba–there are, on average, more registered nurses, regulated childcare spaces, and residential care beds per resident, as well as lower tuition rates at post-secondary institutions.

Studies published by both the Fraser Institute and the Frontier Centre for Public Policy demonstrate the relationship between equalization and public sector outcomes. In Super-sized Fiscal Federalism, for instance, Mark Milke shows how the recipient provinces outperform the creditor provinces on thirteen of nineteen indicators of public goods provision, whereas the net contributors provided more services in only three categories.  One of these areas, for example, is the number of physicians per capita: in 2011, four of the six provinces receiving payments had more doctors proportional to their populations than Alberta, the biggest giver.

Therefore, although equalization is intended to ensure comparable public services across provincial borders, it actually results in significantly better-funded services in poorer provinces with lower costs.

This inverse relationship between public expenditures and provincial wealth seem to be the result of equalization and its effect on provincial spending incentives. Although the idea of providing comparable levels of public services is noble, Canada’s experience illustrates how equalization transfers preclude accountability. In essence, the recipient provinces have weaker incentives to take responsibility for their spending and, instead, encourage public sector growth that may very well be unsustainable should payments cease.

Michael Sullivan is a 2013-2014 Atlantic Institute for Market Studies’ Student Fellow. The views expressed are the opinion of the author and not necessarily the Institute

Understanding the Laffer Curve

Despite differing opinions about the size of government, revenue for the most necessary programs has to be generated one way or the other. This is usually done through the taxation of income, savings, and property. When more tax revenues are called for, one option is to increase tax rates, which almost seems intuitive. Almost.

Using said logic is akin to trying to press “pause” on the economy, making a change, and then pressing “play” without anyone noticing. In addition, it requires the assumption that these modifications will produce only intended consequences, without having indirect effects on other aspects of the economy. It is more realistic, however, to acknowledge the fact that economic conditions change each day. Not to mention that individuals are constantly deciding how many hours to work, where to purchase property, what investments to secure, etc. and they can alter these decisions an infinite amount of times. In other words, the average person adapts their behavior to different incentives. In the case of taxes, any change to the tax code or the rate of taxation will likely change consumer behavior.

The Laffer Curve is a representation of the relationship between taxation and revenue. It is drawn below:

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The basic idea is that tax receipts will be zero if the tax rate is 0 per cent (for obvious reasons), and they will be zero at a tax rate of 100 per cent, since no one would work if their entire wage is taken. As tax rates rise from 0 per cent, revenues start increasing. However, there comes a point (as rates keep rising) that people decide to not work–or to move away, close their business, or evade taxes–and tax revenues, therefore, begin declining. This is an important concept for policymakers to understand, since misinterpreting the relationship between revenue and taxation could lead to a scenario in which higher rates of taxation generate lower revenues.

Since the 1960s, for instance, the United States federal government has claimed, on average, 18 per cent of the economy, despite wild fluctuations in the rate of taxation since 1960. In fact, the top marginal tax rate in 1963 was 90 per cent, whereas the current rate is 35 per cent. Nevertheless, federal revenue has remained constant at around 18 per cent, begging the question of whether the rate of taxation influences the amount of revenue. Changes to other taxes, including corporate and capital gains taxes, have had no apparent effect either.

Jean Chretien, arguably the most fiscally responsible prime minister in recent Canadian history, may have also sensed this relationship. Chretien’s administration balanced budgets impressively in the early nineties, opting to raise taxes only minimally, as some marginal income tax rates were already as high as 55 per cent. Forcing them higher could have caused more damage, for the reasons above. Thomas Mulcair, the current leader of the opposition, seems to agree and said recently that marginal tax rates above 50 per cent amount to blatant confiscation. In Atlantic Canada, some cities, such as Saint John, have had serious discussions in city council meetings about having a toll or “commuter tax” to enter the city, apparently unaware of the potential disastrous consequences that derive from the Laffer Curve.

Importantly, though, the Laffer Curve’s tipping point remains unpredictable in most cases. Some academic studies estimate that the rate leading to maximum revenues is between 40 and 70 per cent, depending on the good, service, investment, etc. to which the tax applies. In France, for instance, the top marginal income tax rate is 75 per cent and, in response, many athletes, businesspersons, and entrepreneurs have left. Anecdotes abound, including Facebook founder Eduardo Saverin’s relocation to Singapore to avoid capital gains taxes, or suggestions from Danielle Smith, the leader of Alberta’s Wild Rose Party, that high oil and gas royalties in the province discourage growth (wherein evidence suggests lower fees may have brought in larger revenue through increased growth).

Even if a tax rate is below the “tipping point,” an important point remains. Here, cutting the rate will pay for itself partially though economic growth (but not entirely). For example, Greg Mankiw, an economist at Harvard University, found while capital gains tax rate cuts are not revenue-neutral, they only result in about 50 per cent of the “anticipated” revenue reduction, due to increased growth.

There is one certainty, though: as globalization and the capacity for mobilization intensify, the tipping point is likely to become much lower and policymakers from all ends of the economic and political spectrum could benefit from yielding to these developments. This taxation tightrope can provide revenues for important government programs, while at the same time appealing to economic freedom and helping individuals make ends meet.

Mike Craig is a 2013-2014 Atlantic Institute for Market Studies’ Student Fellow. The views expressed are the opinion of the author and not necessarily the Institute