To start with, the fact that the Ontario government is proposing regional variation in general tax rates within its own province is quite an interesting development. Over the years, Ontario’s rebellious northern subjects have often thought that regional differences in tax policy might be an option worth pursuing when it comes to northern Ontario economic development. The answer from Queen’s Park has inevitably been that Ontario is one big happy province and everyone shares in the costs and the benefits of government taxation and spending. This shift in the provincial stance towards regional tax differences opens the door to future requests for things like special tax zones for income and corporate taxation. Perhaps Kathleen Wynne will now be more accommodating of such requests from northern Ontario politicans than Jim Flaherty was with respect to her request.
As for the federal response to Ontario, well the fact is that nothing is ever set in stone when it comes to tax legislation and agreements. Agreements can be changed. Part of what is going on is invariably political and one can expect some attempts at sticking it to the other side when it comes to relations between a Federal Conservative government and a provincial Liberal one. The Ontario government can raise the provincial HST rate to fund the GTHA transit plan but it will face a political cost from voters outside of Toronto for doing so. Ottawa shutting the door on a regional sales tax for the Toronto region forces the Ontario government into a broader-tax provincial increase and the associated political costs. On the other hand, if Ontario implements a province wide HST tax increase, it can blame Ottawa.
However, the most interesting aspect of regional tax variation as a policy opens the door to reforms in federal-provincial fiscal relations. The current equalization system transfers money to regions. While this approach is found in James Buchanan’s 1950 article “Federalism and Fiscal Equity”, it was not his preferred solution to fiscal equity. James Buchanan provided a rationale for equity based not on regions but individuals. In the absence of corrective actions, regional differences in fiscal capacity would lead to the unequal fiscal treatment of equals. People earning similar incomes would have different net fiscal benefits if they lived in a high income or low income region because of differences in fiscal capacity to provide public services. This would lead to migration that was not based on economic and productivity differences and hence was inefficient.
Therefore, there was a need to equalize the per capita difference in taxes and public benefits - what Buchanan termed the "fiscal residuum". Buchanan’s preferred solution was to have the central authority use geographically discriminatory tax rates thereby transferring the benefits of the equalization policy directly to individuals. Rather than grants to lower income regions to equalize fiscal benefits, simply lower the tax rates on individuals living there. Needless to say, the political consequences of having lower federal income tax rates in say New Brunwick and higher ones in Alberta are a reason such an approach has not been embraced. However, varying the HST rate within Ontario is an example of a geographically discriminatory tax rate policy and sets the stage for future discussion and use of such an approach. This can be a much more interesting and more important issue than just finding a way to fund transit.