Equalization buys big government
April 14, 2004
Last month’s federal budget renewed one of Canada’s most sacred policy cows — our $10-billion equalization program — for another five years. The first of a three-part series looks at how equalization locks “have-not” provinces into enormous welfare traps.
Well-intended transfer payments shift resources from “have” to “have-not” provinces to ensure a reasonably similar level of services across the country. While that sounds noble, the downside lies in the program’s creation of perverse incentives. Equalization locks “have-not” provinces into enormous welfare traps that encourage increased dependency on its funding.
Saskatchewan’s beleaguered Finance Minister, Harry Van Mulligen, understands the welfare trap well. As social services minister in the Roy Romanow government, he spearheaded a set of welfare reforms lauded for helping welfare clients achieve independence. Welfare reform’s main goal should be to reward the decisions of individuals to work, he maintains.
“But what about my province and equalization?” he asks. “Why does it punish Saskatchewan for having a successful oil industry?” It’s a good question. Bizarrely, in 2001 the equalization system deducted $885-million from his province’s transfer payments because Saskatchewan’s oil industry generated $668-million. The province would be ahead if it shut the whole industry down. “The federal government should stop punishing Saskatchewan for economic growth in our resource sector,” Van Mulligen says.
The formula for determining transfer amounts is so complex that perhaps only 30 government technocrats and academics in Canada understand it at all. One “solution” proffered for the Saskatchewan equalization rip-off is to duplicate the arrangement for fellow “have-nots” Nova Scotia and Newfoundland — namely that the feds will only claw back 70% of offshore oil revenues. Ouch.
A 2002 study by the Atlantic Institute for Market Studies shows how recipient provinces maximize their subsidies by raising taxes on weak tax bases. On average, in “have-not” provinces personal taxes are one-third higher, capital taxes are more than twice as high and sales are half again as high as in “rich” provinces. Are we surprised that capital, jobs and growth gravitate toward Ontario and Alberta?
The global experience with equalization is just as poor. Invariably too complex to be understood by more than a few, it drains the economic vitality of productive regions while entrenching counterproductive policy choices in poor ones. Most damagingly, equalization inflames aggressive separatism in some countries.
Consider the following three examples:
– In Belgium, Flanders heavily subsidizes the regions of Wallonia and Brussels. Governments in the latter two raise taxes and aggressively regulate the economy with the knowledge that economic misperformance increases Flemish transfers. The separatist Vlaams Blok Party is campaigning to take Flanders out of Belgium.
– The residents of prosperous Stockholm refer to Sweden’s equalization program as the “Robin Hood Tax,” an odd metaphor since the legendary rebel stole from the tax man, not the other way around. The transfer is huge — more than $11,500 per Stockholm resident. Not coincidentally, the most impressive public sector reforms, including the introduction of competitive markets in health care and transportation, have occurred in Stockholm. Recipient regions coast along with old monopoly models funded by their more efficient counterparts.
– Equalization also strains the Australian federation. Tasmania, the poorest state, receives 65% of its revenues from transfers. Not surprisingly, the easy outside money allows the state to impose comparatively high taxes and restrictive labour and environmental legislation — all amid an accelerating drain of young people and entrepreneurs, the lifeblood of a successful economy.
A 2002 critique of Australia’s equalization system identified problems that resonate eerily in Canada. It refers to “game-playing” bureaucrats who redefine activities to maximize equalization payments. The system creates “a tendency toward a reduced effort on cost-reducing reform” — a phenomenon called the “flypaper effect.” “Money ‘thrown’ at a state government tends to stick, even though the welfare of households would be better served if the money were passed on to them through lower taxes.”
Let’s apply the flypaper effect to Canada, particularly Manitoba. In 2003, it received $1.4-billion, or 19% of its budget, through equalization. It has the largest provincial government in Western Canada — 24% of GDP. The extra spending is about the same as the amount it receives in equalization. It spends the most per capita in Canada on health care, without better results. Bringing health spending down to the Canadian average would reduce it by almost $400-million.
Predictably then, Manitoba has Western Canada’s highest personal and capital taxes. It also has little incentive to build its tax base; it sells its hydro-electric resources too cheaply, for example. According to Tom Adams, director of the think-tank Energy Probe, Manitoba could realize at least $900-million a year in extra revenue if it priced its electricity at market rates.
But why should it? As long as Alberta and Ontario pay the freight for a system that bloats its public sector, keeps its taxes uncompetitive and removes any reason to price resources properly, it will continue to coast along in a “have-not” purgatory.
In short, Manitoba is paid to have a big government and not grow or innovate — a rational result of an irrationally complex and distorting system.
Tomorrow: The Tasmanian Devil
Peter Holle is president of the Frontier Centre for Public Policy, a Winnipeg-based think-tank.