Ontario’s announcement that it will adopt a cap and trade policy to reduce greenhouse gas emissions has re-ignited the environmental federalism debate in Canada. Environmental federalism is especially concerned with which level of government is best-suited to tackle environmental problems: should it be local (provincial) governments, who are presumably best-suited for tailoring policies to local circumstances, or should it be the federal government, who can ensure a level playing field for business operating in multiple jurisdictions?

The conventional wisdom is that the scale of governance should be chosen to match the scale of the environmental problem. For pollutants whose effects are predominantly local, local governments are well-suited to addressing the problem. For pollutants that spill across borders, a higher level of government is required, since local governments typically don’t care about citizens of other states as much as their own. Wallace Oates, an economist who has studied environmental federalism perhaps more than any other, sums up the orthodoxy as follows: ”œwhere environmental quality is a pure public good for the nation as a whole, it seems clear that central determination of environmental standards is in order.”

This orthodoxy was turned on its head this week by Canada’s EcoFiscal Commission. In a well-researched report, the group of economists suggests that local circumstances are important in greenhouse gas policy, such that a provincially led climate policy in Canada can be an effective way to tackle the climate change problem. BC’s Christy Clark, who recently told the feds not to muscle in on what has – through federal inaction – become provincial territory, clearly agrees.

Yet the dilemma for advocates of a provincially led approach to climate policy is the very issue that prompted Wallace Oates to advocate for a federally-led approach: sub-national states in the federation lack complete incentives to implement pollution policies, since much of the negative effect of pollution is external to the state. How to convince Saksatchewan’s Brad Wall, for example, that his province should adopt stringent greenhouse gas reduction policies? As goes the conventional wisdom, the costs of those policies will be borne by his province, while the benefits will accrue mostly outside of the province.

Yet the structure of the federation makes this cost benefit calculus more complicated than it seems. One of the effects of a new policy adopted by a sub-national state in a federation is to affect the federal tax base. For example, higher provincial taxes on corporate income likely reduce the corporate income tax base. Because the federal government also collects corporate income tax, when a province increases its corporate income tax, federal revenue collected from that province falls. Unless the federal government responds by differentiating its tax rates by province (which it doesn’t in Canada), or by reducing transfers to that province (which it doesn’t*) this reduction in federal tax payments by a province is a windfall to the province that implemented the tax. This effect has been referred to as a vertical fiscal externality, because sub-national governments typically ignore the effect of their policies on the federal tax base.

Vertical fiscal externalities could be important for climate policy in a federation. When a province imposes a market-based climate policy like Ontario’s newly announced cap and trade system, it likely shrinks the tax base in the province (again, higher tax rates – and a cap-and-trade policy functions like a tax – typically correspond to smaller tax bases). One of the benefits to the implementing province is that it pays less federal tax as a result – the slack in the federal budget is picked up by other members of the federation.

In a recent paper, I show with some colleagues that the magnitude of these vertical fiscal externalities can be important for climate policy. In fact, given existing federal and provincial taxes in Canada, a policy like Ontario’s cap and trade policy is likely to generate net benefits to Ontario, as a result of Ontario paying less in federal taxes (i.e., the benefit to Ontario of paying less federal taxes is bigger than the costs Ontario will incur from reducing emissions). Rather than falling on Ontario, the costs of Ontario’s policy will instead be borne by the other provinces in the federation. A similar fiscal externality occurred when Quebec shut down its Gentilly-2 electric generating station. Since this closure reduced dividends to the Quebec government, it affected equalization payments: the PBO showed that shutting the facility down would reduce Ontario’s equalization payment by almost 40% (or about $90 per Ontarian), while increasing Quebec’s.

This turns the conventional environmental federalism logic on its head. If provinces understand the effect of their policies on their federal tax payments, then this could provide sufficient incentive for them to undertake climate policies without federal leadership, while retaining their ability to tailor policies to local circumstances. Of course, this isn’t a full remedy for the lack of federal action on climate change, but a fuller understanding of who is paying for provincial environmental policies should prompt more vigorous provincial climate policies. At the very least, provinces – like Ontario – that adopt climate policies can feel some smugness that despite refusing to implement its own stringent climate policies, Brad Wall’s Saskatchewan will end up paying part of the bill for the policies adopted by others.

* Equalization payments are calculated according to ”œfiscal capacity,” which effectively corresponds to the size of the tax base. The new provincial tax reduces the tax base of the province, which qualifies it for larger equalization payments.