Transforming equalization

Peter Holle
National Post

Friday, April 16, 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 last of a three-part series looks at how equalization can be transformed.

Equalization began as a simple program in 1957. Despite cumulative expenditures of more than $200-billion through 2004, the economies of “have-not” provinces have fallen progressively behind. It is time for an honest re-evaluation.

Perhaps revisiting the policy’s origins may provide a starting point. Nobel Laureate James Buchanan, the “father” of equalization theory, originally described it as a bribe to induce residents in low-income regions to stay home, to avoid swamping wealthy ones with migrants.

But the gnomes who devised Canada’s program ignored his preferred method. Buchanan recommended transfers to individuals through regionally lowered income taxes, not unconditional transfers to “have-not” governments. The value of the inferior option was limited, at best, to investment in such productivity enhancements as education or transportation.

In 2001, Buchanan repeated his prediction that our style of equalization would tend to expand government in recipient provinces. Public sector intermediaries capture the transfer’s benefits, the so-called “flypaper effect.” It explains why “have-not” provinces host the largest governments, as a percentage of their economy.

Both “have” and “have-not” provinces have a stake in substantive reform. Equalization ought to make poorer provinces self-sustaining, not lock them into dependency or hobble them with high taxes and inefficient services. Equalization could instead be structured to place the “have-nots” back on a growth track. The effort would unravel decades of fiddling and fumbling with obscure formulas and the complex policy distortions they produce.

It is unreasonable to expect “have-not” politicians to bear the cost of reform. Making equalization truly transformative would require a transition period and appropriate compensation for adjustments. Saskatchewan, clearly ripped off in the present system with 125% clawbacks on resource revenues, also deserves special consideration.


– Tinkering with the formula: Recent research shows that removing resource revenues from the formula would greatly simplify it while mitigating the egregious welfare-trap effect. A second fix would make transfers sensitive to the effectiveness of spending in recipient regions, with a simple rule that recipient provinces cannot spend more than national averages on public services. This would end the perverse situation where “have-not” provinces spend more per capita for health care and education than donors, and give impetus to structural reform in these low-performing sectors.

– Regional federal tax reduction: Buchanan’s original theory entails dramatic income tax reductions in “have-not” provinces. Both Paul Martin and Frank McKenna have talked about converting regional development and job-creation programs into a 10-year federal tax holiday for “have-nots.” This conversion would generate political heat from stakeholders fighting to maintain the flow of funds through the public sector. But paying fellow provinces to lower taxes while removing systemic foibles that make them uncompetitive is the sort of assistance that might really help.

– Debt-for-equalization swap: Most equalization money goes right back out the door in the form of provincial debt service charges. If Ottawa and the provinces swapped debt for equalization, the provinces could clean up their balance sheets and stop those payments. Based on present distribution and assuming a cap rate of 7.5%, capitalizing the current $10-billion commitment into a one-time debt swap of $135-billion would see Ottawa assume, for example, $52-billion, $18.5-billion and $15.8-billion in ownership of the respective debts of Quebec, Manitoba and Nova Scotia. Future transfers, along with their accompanying distortions, would disappear. The price? A manageable increase in a steadily falling federal debt, with a further saving from lower servicing costs due to Ottawa’s better credit rating. It would have to include strict rules that prevented provinces from simply running up new debt.

– The tax swap: The total bundle of equalization and other federal transfer programs comes to about $33-billion in 2004. Federal GST revenue is projected at almost $29-billion, or roughly the same amount. Subject to harmonizing it with provincial sales taxes, the federal government would simply hand over the GST in place of these transfers. By eliminating the whole complex mess, this would sidestep unnecessary bureaucratic and political churn. It would also be the least difficult to sell, since all provinces benefit from the swap.

Imagine the day Manitoba had competitive taxes, an innovative, high-performing public sector, and priced its hydro resources properly. With a growing population and strong business investment, it would become a “have” province, and the story would be replayed in the Maritimes and Quebec. Dramatic equalization reform is the fastest way to get there.