November/December 2001
The Taxpayer Magazine

Good Intentions are not enough

by Brian Lee Crowley

After 44 years and $180-billion dollars in equalization spending (not adjusted for inflation) the Atlantic provinces are only barely more able to meet the needs of their citizens with their own revenue sources than they were when equalization was introduced in 1957. On average, about 40% of provincial budgets in the four Atlantic provinces comes from federal transfers, most in the form of equalization. As the accompanying charts show, the other equalization-receiving provinces are less dependent, but still receive very significant amounts of revenue under the program – in the case of Quebec, nearly $4-billion which, because of its large population, only represents 7.5% of the province’s revenues.

Apologists for the regime say it was never equalization’s purpose to “close the disparity gap” with the rest of the country, but simply to compensate for its existence. But what we have discovered after nearly half a century is that incentives matter, and the incentives attached to equalization can penalize the poorer provinces for developing their economy and encourage them to settle for permanent reliance on federal transfers.

Equalization: Who Gets What
Province Contribution to Federal Revenues $ Million Equalization ($ Million) Per-Person Equalization Equalization as % of Provincial Revenues Transfers as % of Provincial Revenues
Newfoundland $2,256 $1,163 $2,159 32.6% 44.1%
PEI 557 262 1,886 27.5% 40.5%
Nova Scotia 4,011 1,315 1,397 24.5% 37.0%
New Brunswick 3,271 1,152 1,523 23.9% 36.9%
Quebec 37,794 3,834 520 7.5% 16.1%
Ontario 75,003 – – 0.0% 9.7%
Manitoba 5,774 1,265 1,102 18.7% 31.3%
Saskatchewan 5,527 178 174 2.6% 12.9%
Alberta 21,179 – – 0.0% 7.1%
BC 21,881 – – 0.0% 11.6%
Sub-Total (Provinces) $177,254 $9,169
Nunavut 190 327 10,651   91.3%
Northwest Territories 396 593 14,086   69.2%
Yukon 159 572 20,650   66.6%
Grand Total $178,000 $10,661

Source: Public Accounts 2001, Volume 1, Table 3.8

How does equalization work?

The equalization program is intended to solve a potential problem within federalism. The tax base is not equally distributed across the country, so that means that people living in less developed provinces are less able to finance public services, such as education or health or welfare. In order to avoid what Canadians might consider unacceptable disparities in important services to some citizens merely because they live in poorer jurisdictions, equalization was invented. The program was placed in the Constitution in 1982 (virtually the only spending program to have been constitutionalized), where its stated intention is to allow provinces to provide “reasonably comparable” public services at “reasonably comparable” levels of taxation.

The formula measures the per capita fiscal capacity (i.e. ability to raise tax revenues) of each province on the basis of each of 33 different revenue sources. It then takes the difference between that fiscal capacity and the capacity as measured by the average of five provinces (Alberta and the four Atlantic provinces are excluded for reasons too complicated to explain here).

Ottawa sums these differences to come up with a per capita entitlement for each province. Provinces whose total measured fiscal capacity (the pluses and minuses across the 33 different tax bases) is above the five-province standard receive nothing, and provinces below the standard receive a per capita payment.

In 2000/2001, these calculations produced a maximum payment of $2,159 per person in Newfoundland and a low of $174 per person in Saskatchewan. Equalization makes up a fifth to a quarter of provincial revenues in Atlantic Canada, while three provinces (British Columbia, Alberta and Ontario) receive no equalization payments at all.

What’s wrong with equalization?

I would like to suggest that there are at least two practical effects of equalization that we should be concerned with.

The first such effect I want to mention has to do with the impact equalization has on the behaviour of less-developed provinces, particularly with respect to promoting economic growth. After all, the alternative to dependence on equalization is to grow your own tax base so that provincial taxpayers can pay the cost of the public services they choose to have their government provide. Equalization actually works against this goal. The mechanism is similar to the welfare trap for individuals. As the province builds its own tax base and earns more revenue, Ottawa withdraws equalization payments, in some cases dollar for dollar, leaving the province no better off for its efforts.

The result is that the provinces have little reason to try to maximize their long-term tax revenue and economic development from, say, their natural resources. Most of the tax benefit would be scooped up by wealthy Ottawa. Instead, they try to extort superficial benefits out of the industry, such as lots of short-term and often relatively low-skilled jobs. They build outdated gravity-based structures for oil extraction, or require companies to make vague promises of massive exploration and development spending in exchange for drilling rights, or hold out for the construction of redundant processing capacity, as in the case of Voisey’s Bay. They could sell more of the resource up front, to retire some of their huge debt and reduce their crushing interest payments, but after Ottawa’s huge take, it hardly seems a good move. If they privatize important assets, such as Crown Corporations, Ottawa takes the lion’s share of that as well, making it hard for equalization-receiving provinces to clean up their balance sheets and return to fiscal health.

The other practical effect of equalization that I want to touch on is the distortion of democratic accountability that it introduces. Equalisation subsidises provincial spending, and any economist will tell you that if you subsidise something you will get more of it. The reason that you get more of it is that if people don’t have to pay the full cost of what they’re consuming, they will demand more of it than they would if they had to pay the full shot.

The reason that is important in this context is that it introduces an incentive for provincial governments to promise more spending than local taxpayers would support, and local electorates demand more public services than they are willing to pay for, secure in the knowledge that a large chunk of that spending will be drawn from taxpayers elsewhere in the country. But that means that the electorate that is demanding the spending is not paying the whole shot, and the politicians who are promising the spending are not answerable to all those who are paying.

This helps to create a political culture in which spending is encouraged, and self-reliance and economic growth are discouraged. The ideal, from a democratic accountability point of view, is that those voters who are demanding spending be the ones who bear the cost, and the politicians who promise new spending are answerable to all those whose taxes contribute to the new spending. Equalisation short circuits this accountability loop.

You might want to ask yourself whether Nova Scotia could sustain so many publicly financed universities, or Newfoundland could keep the best ratio of teachers to students in the country, or Manitoba could continue to be the biggest per capita spender on health care, if local taxpayers had had to foot all the bill.

Federal transfers (the ability to shift costs to non-resident taxpayers) plus deficit financing (the ability to shift costs to taxpayers unborn or too young to vote), meant that we evaded democratic accountability for our decisions and landed ourselves in quite a mess. These were our choices and no one else’s, but it is fair to ask if we would have made the same choices if the incentives we faced were not so badly skewed, including by equalization.

What’s to be done?

Here are two suggestions of things that might be done to equalization to remove its perverse incentives, reduce the cost, reward provinces for developing their economies, and moving equalization-receiving provinces along the path of self-reliance and away from dependence.

1. Take natural resources out of the formula. Accommodating volatile natural resource revenues has always been a huge challenge for the equalization formula. Newfoundland is projected to be producing around 40% of Canada’s conventional oil within a few years, while a natural gas pipeline, possibly the first of several, already connects Nova Scotia with New England. It appears that offshore and onshore petroleum resources may be discovered in or around virtually every province in the region.

The development of natural resources, primarily oil and gas but also other minerals, such as the Voisey’s Bay nickel deposit, creates the conditions in which economic growth in the region could well outstrip that of the rest of the country. Taking natural resources out of the formula would put the Atlantic provinces in exactly the same position Alberta was in the early days of equalization. Alberta was an equalization recipient, but natural resources were not included in the formula. Within a few years, Alberta had leveraged its resources into a prosperity that allowed it to escape dependence. Ottawa will still get is “clawback” under equalization, but only when natural resource-led growth has fed through to things like higher corporate and personal income taxes, sales taxes, real estate values and so on.

2. Swap equalization payments for a debt reduction plan. The lion’s share of federal equalization payments to provinces go straight back out the door in the form of interest payments on provincial debt. Ottawa could take over part or all of the provincial debt of equalization receiving provinces, in exchange for corresponding but permanent reductions in equalization payments and firm rules to prevent the accumulation of new debt. The strengthening of provincial balance sheets and reduction in the depth of dependency on federal transfers would give the provinces much better incentives to develop their own economy, and a firm yet reasonable time frame in which to act. Ottawa can service this debt more cheaply than the provinces, resulting in a mutually beneficial deal.

The Per Capita Costs and Benefits of Federal Transfers
Province The Winners The per capita dollar amount of what these provinces receive in federal transfers and spending over what they pay in taxes The Losers The per capita dollar Amount of what these Provinces pay in federal Taxes over what they Receive in federal Spending and transfers*
Newfoundland $4,801
Prince Edward Island $4,501
Nova Scotia $3,016
New Brunswick $3,682
Quebec $495
Ontario   ($1,064)
Manitoba $1,757
Saskatchewan $511
Alberta   ($1,291)
British Columbia   ($7)
Nunavut $9,770
Northwest Territories $10,284
Yukon $19,869

Source: Public Accounts 2001, Volume 1, Table 3.8 *This chart subtracts what each province contributes to the federal kitty from total federal transfers (CHTS, EI, CPP and Equalization) to arrive at a net, per person total.

Conclusion

While there is some justification for equalization in a federal state, the case for it is not overwhelming. In any case, it would certainly appear that our program has a number of perverse incentives within it that actually help to trap less well-off provinces in a state of dependency and underdevelopment. Those incentives get worse the greater the degree of dependence.

Whether the changes will take the form I have suggested, or some other direction is irrelevant. What is clear is that days of the old transfer mentality are numbered. The changes can’t come fast enough for the less well-off regions of the country, whose potential has been frustrated for so many years by programs, like equalization, whose effects reach far beyond the good intentions of their authors.

Brian Lee Crowley is President of the Atlantic Institute for Market Studies, a Halifax based social and economic policy think tank. E-mail: brianleecrowley@aims.ca