Analysing Vertical Fiscal Imbalance in a Framework of Fiscal Sustainability

* This paper reflects the views of the authors and no responsibility for them should be attributed to the Department of Finance. The authors would like to thank François Delorme for his comments and suggestions. The authors would also like to thank Brian Murphy for his assistance with SPSD/M. Any and all errors are the responsibility of the authors. 1Abstract Recent studies on vertical fiscal imbalance (VFI) in Canada subscribe to a definition of VFI that is based on the mismatch in structural budget balances between the federal and provincial/territorial levels of government. In this framework, projected budget balances illustrate the path of VFI. Using a measure of fiscal sustainability developed in Auerbach (1997), this paper constructs an indicator of VFI that is based on the amount of fiscal room available, subject to a government’s intertemporal budget constraint, given underlying fiscal projections. VFI exists in this framework if one level of government has fiscal room available to reduce taxes or increase program spending-- and satisfy its intertemporal constraint-- while the other level of government must increase taxes or reduce spending in order to satisfy its intertemporal budget constraint. Fiscal projection