Equalization and fiscal imbalance have moved from the back pages, to front page headlines across the country.

Under Canada’s constitutionally entrenched equalization system, provinces with lower-than-average fiscal capacities receive transfers from the federal government that vary acccording to the amount of their shortfall in fiscal capacity.

Recent recommendations for changes to Canada’s system of equalization amount to little more than tinkering, while calling for transfers of ever-larger amounts of money. Left out of suggestions for reform are considerations of economic efficiency: getting the greatest benefit for the least cost. In AIMS latest paper on Equalization, “Too Many Cooks” argues that the efficient way to achieve the equity goal of equalization is by using a system of provincially differentiated taxes rather than one of provincially differentiated transfers.

Author Robin Neil argues that equalization by way of transfers is inefficient for a number of reasons, but three stand out. First, it entails a fiscal imbalance, which occurs when one government taxes and another government spends the revenue generated by the tax. The inefficiency of such a fiscal imbalance occurs because the government that estimates the benefit from the expenditure is not the same government that estimates the cost of levying the tax.

Second, insofar as the transfer of revenue damages the fiscal capacity of the receiving province – for example, by discouraging the province from developing its tax base in order to keep up the flow equalization payments, or by encouraging it to seek electoral gains from subsidizing jobs in low employment areas – such payments are inefficient because they worsen the situation they were intended to ameliorate.

Third, transfers discourage the internal migration of resources, particularly labour, from economically lagging regions to more productive areas, and frustrate the natural process of adjustment that would bring about convergence in the level of productivity and fiscal capacity in different regions.

While the tax burden on the population would remain unchanged, efficiency gains would arise from the province’s being able to match the costs of the tax with the benefits from expenditures.

To read this paper, click here