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Friday, April 3, 2020

Quick Comment On The Difference Between Provincial And U.S. State Finances

There has been a lot of interest in state and municipal finance in the United States; a recent publication is by Alexander Williams (link). This article qualitatively outlines the key differences between U.S. state and local finances and that of the Canadian provinces.

As a disclaimer, I am working solely from memory, and want to stay away from specific data. My comments here are based on my experience as working as an analyst in a fixed income portfolio where our mandate was against provincial bond indices.

Tax Situation Sets U.S. Municipal Market Apart

U.S. sub-sovereign debt market appears unique in the developed fixed income markets due to their tax situation. (This market is typically referred to as the "muni market," although it includes states as well as municipalities.) Residents of a state get a tax benefit for owning that debt. (Roughly speaking, the interest is not taxable, but the reader is directed to your local tax professional for the answer.) This means that the bonds normally trade at a lower yield than U.S. Treasury bonds (perhaps not any more in the low interest rate environment).

This makes buying these bonds utterly non-economic for entities that are not directly exposed to U.S. income taxes -- which is almost all global fixed income investors. Some banks can invest in these securities. Also, before the Financial Crisis, some special purpose vehicles were created to buy the bonds and issue short-term paper to locals (i.e., maturity transformation). Those vehicles were not exactly well positioned during the Financial Crisis.

The only instrument that could be traded by us international types were some basis swaps, which I looked at. (Although most aficionados of financial crises have become aware of the extremely important cross-currency basis swap market, other basis swaps exist. A basis swap is a swap where both legs are floating, as opposed to other swaps where one leg is fixed, and the other floats.)

As a result, I never looked at U.S. state and local finance (beyond the basis swaps). My comments here are based on what I saw as a macro tourist.

Canadian Provinces: Big Balance Sheets, Sophisticated Issuers

The Canadian provinces are the front line of the Canadian welfare state. This poses theoretical risks from a Modern Monetary Theory perspective, but has huge practical advantages. An important example is health care, which is a provincial responsibility. The reason why having this at the provincial level is an advantage is that provincial politics is inherently less ideological, and more based on actual performance. Meanwhile, anyone who hangs around with older Canadians (who are the dominant voting bloc) knows that all we do is yammer on about health issues when we are not discussing the weather or sports. The buck stops with the provincial governments, and they are forced to be competent. (A recent poll put the Quebec's handling of the pandemic at 93% favourable, 3% unfavourable.)

This means that provincial governments have a lot of debt. Since provincials have no tax issues, they trade with a positive spread to Government of Canada issues (typically near swap rates). Provincial trading is highly technical positioning for small spread movements most of the time. (Separation referenda is when things get exciting.) This is very similar to other quasi-sovereign markets, like the pfandbriefe market in the euro area. (I spend more time looking at those other quasi-sovereigns than Canadian provinces; other team members were on the province beat.)

Since most provinces can issue big chunky bond deals, they are not exposed to corporate default risk, and they trade at a spread to GCAN's, they are of interest to foreign investors. This means that provincial debt management offices rub shoulders with big bond buyers at trade conferences. This means that they have the capacity to follow sophisticated strategies, such as arbitraging the cross-currency basis swap markets to get cheap funding in foreign currencies.

This explains why provincial governments have foreign currency debt (a fact that was questioned by a user on Twitter). These foreign issues pose zero foreign exchange risk to the provinces, as the debt has been swapped.

(I believe that the City of Montreal had the bright idea of issuing Swiss Franc debt in the late 1970s because the interest rate was optically lower. This did not work out well for long-suffering Montreal taxpayers. This was the horrible example that taught Canadians not to issue unhedged foreign currency debt.)

Macro Differences

The big macro difference between the United States and Canada in this area is that the provinces have the capacity to launch counter-cyclical deficits. They are big issuers, and there is nothing resembling balanced budget amendments. There is the hypothetical risk that there could be a run on the provinces in a crisis. However, the Bank of Canada has launched a provincial bond purchase plan (link to Bank of Canada list of crisis actions). The lender-of-last-resort has extended its reach to the provinces.

It should be noted that this safety net might not always be there, so nobody should conclude that provinces are default risk free. The example to keep in mind was Alberta during the Great Depression. Albertans elected a Social Credit government, where Social Credit was an economic theory that revolved around what can only be described as a Universal Basic Income. This doctrine was too radical for the Federal Government (which had a sociopathic attachment to the Gold Standard), and the Federal Government helped push Alberta into default. (Alberta was a dirt-poor farming province at the time; the oil wealth came later.) Outside of a crisis, there could be a showdown between a province and the Federal government, and the Bank of Canada is a subsidiary of the Federal Government.

This means that Canada does not face the same risk of sub-sovereign austerity policies as the United States. It is entirely possible that provincial governments will retrench and slow the recovery, but this probably would only happen once a recovery is already in motion. As such, there is less need for institutional changes. All that really needs to be done is for the Federal Government to increase transfers to the provinces if provincial debt levels appear worrisome for bond investors.

(Since I had no reason to look at the details of state finances in the United States, I will stay clear of commenting on various proposals to support them.)

Property Taxes

Property taxes are levied exclusively at the municipal level in Canada. Since each municipality is different, generalisations are awkward. However, the property tax system is less pro-cyclical than I believe is the case in the United States.

The way the Canadian system works is that the city decides how much tax it wants to levy, and then sets the tax rate to hit the target. If valuations drop by 10%, the tax rate will correspondingly rise. My understanding is that the tendency in the United States is to keep the tax rate fixed -- which means revenues drop if property valuations tank.

This means that a potential collapse in Canadian house prices (not my prediction, but a possible scenario) does not necessarily mean a lower tax take for municipalities.

(c) Brian Romanchuk 2020

1 comment:

  1. Brian,

    There is also the effect of equalization payments (aka transfer payments). That would lower the risk of any individual province becoming revenue-constrained. I included the second paragraph in the quote because equalization payments are not quite the same as provincial transfers, even though they end up looking like that.

    Equalization payments are based on a formula that calculates the difference between the per capita revenue yield that a particular province would obtain using average tax rates and the national average per capita revenue yield at average tax rates. The current formula considers five major revenue sources (see below). The objective of the program is to ensure that all provinces have access to per capita revenues equal to the potential average of all ten provinces. The formula is based solely on revenues and does not consider the cost of providing services or the expenditure need of the provinces.

    Equalization payments do not involve wealthy provinces making direct payments to poor provinces as the money comes from the federal treasury. As an example, a wealthy citizen in New Brunswick, a so-called "have not" province, pays more tax into the federal system and funds more equalization than a poorer citizen in Alberta that pays less federal tax, a so-called "have" province. However, because of Alberta's greater population and wealth, the citizens of Alberta as a whole are net contributors to equalization, while the government of New Brunswick, therefore the citizens, are net receivers of equalization payments. —
    [end quote]


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