Federal Transfer Programs and the Need for Reform of Equalization

by Honourable John Crosbie, P.C., O.C., Q.C.

Of all the federal fiscal transfer programs equalization is easily the most confusing and complex. The Atlantic Institute for Market Studies (AIMS) has again done a great public service by sponsoring two studies of the Equalization Program, one by Roland T. Martin, former Deputy Minister of Finance for Newfoundland in the 1970’s, University teacher, and private sector executive on “Equalization: Milestone or Millstone?” and the other by Kenneth J. Boessenkool of Alberta who has published extensively on public policy issues entitled “Taking off the Shackles: Equalization and the Development of Non-Renewable Resources in Atlantic Canada”.

Canada is a federal nation that has taken a leadership role in generous federal-provincial sharing programs but, after 44 years of the equalization program, and the transfer of almost $180 billion (in current dollars) to the seven equalization-receiving provinces, the fiscal gaps for those provinces are still very significant. In 1999, Atlantic Canada had 7.8% of the nation’s population, 6.9% of its employment, but only 4.8% of its real gross domestic product (GDP). Today equalization payments to each of the four Atlantic Provinces represent on average more than 25% of the total revenues these provinces collect and, in the case of Newfoundland, equal 50% of revenue from its own sources. The studies suggest that rather than assisting provinces to attain higher percentages of spending from their own resources, equalization may be contributing to the reverse outcome: a poorer quality economy, and a higher dependency on the resources of other Canadians.

In 1957-58 when the federal equalization program began, Newfoundland received $11.8 million, P.E.I. $3.1 million, N.S. $17.2 million and N.B. $8.6 million. All other provinces that year received equalization payments except Ontario. In 1999-2000 Newfoundland received $1,050.5 million, P.E.I. $240.6 million, N.S. $1,260.2 million and N.B. $1,152.0 million. Ontario, Alberta and British Columbia did not receive equalization as they did not meet the requirements.

No one can say that equalization is not a generous program – the question is whether the present program is as effective and beneficial to the receiving provinces as it should be? The Constitution Act of Canada, 1982, Section 36(2) states the main principles are to make “equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable public services at reasonably comparable levels of taxation”.

The problem is that these principles might result in subsidizing some provinces just to tread water at a comparable level of services rather than getting incentive to close the gaps through their own efforts and result in existing provincial and federal government taxation policies having the long term impact of increasing, not decreasing, taxation levels in receiving provinces.

Martin concludes that equalization must be restructured and reinvented. He suggests the redesign of equalization should become part of a national economic strategy with a special goal of accelerating economic growth in the poorer provinces.

The fact is that some provinces can collect higher per capita tax revenues from their citizens and corporations because their economies are stronger and more diversified and their tax payers are wealthier. As a result the tax sources of those stronger provinces are usually larger than the economically poorer provinces. To level the public services and taxation playing fields, the federal government unconditionally transfers funds directly from its treasury to those provinces that have fiscal capacity deficiencies in comparison to a “standardized” or average Canadian province.

Without this system there would be no sharing among the provinces to enable equal access to needed services by all Canadians none of whom should be disadvantaged simply because they live in economically poorer provinces.

There have been numerous changes in the calculating of equalization payments in 44 years. First, the standard to which the weaker provinces are now raised, is not the cross-country average nor the level of the two strongest provinces, both used earlier. The standard now is the 5-province standard or a weighted average of British Columbia, Saskatchewan, Manitoba, Ontario and Quebec. The Atlantic Provinces as a group and Alberta were dropped eliminating the volatility of the high natural resources revenues of Alberta and the low fiscal capacities of Atlantic Canada.

A further change is that each province’s revenue raising or fiscal capacity is now measured by examining 33 actual or potential revenue sources. The calculation is based on determining each provinces per capita fiscal capacity for each of these potential tax bases. This is not determined by how much each province actually collects from each base but from what it could collect if it imposed an “average tax effort” on that tax source. To implement these principles and to calculate the entitlements of each province under the 33 tax bases involves a tremendous number of data sources and continuous technical interpretations.

One of the most important adjustment mechanisms of the equalization formula is the built-in tax-back or claw-back. If a province has an increase in revenues from a particular tax source, for example, the personal income tax (PIT), its per capita yield on that tax base also increases so there is an offset decrease in its equalization entitlement because the per capita fiscal deficiency with respect to that tax source has gone down. This claw-back or tax-back feature caused the most problems when natural resources revenues emerged as a major financial factor in provincial revenues. Boessenkool argues that three criteria should guide the treatment of natural resources within equalization. First, that it protect Ottawa’s bottom line from shifts in the prices of oil and gas, second, that it minimize the tax-back of equalization entitlements province’s face when revenues from natural resources increase and finally, that it ensure that the portion of natural resource revenue that should be equalized is very small, if not zero.

Boessenkool points out that the 5-province standard effectively protects the federal government from rapid escalation in equalization costs due to resource revenues primarily because Alberta is excluded from that standard. Ottawa has also capped the total cost of the program at $10 billion annually.

Early in this century, the Government at Ottawa transferred to Alberta and the other prairie provinces ownership of the natural resources within those provinces. However, in the 1970’s the Government at Ottawa headed by Mr. Trudeau and represented by then Energy Minister Jean Chretien opposed any suggestion that offshore resources of oil and gas should be owned by the provinces off whose shores the resources lay (i.e. Newfoundland and Nova Scotia) and won before the Supreme Court of Canada. It was the P.C. Government led by Prime Minister Mulroney that entered into accords in the 1980’s with Newfoundland and Nova Scotia providing for the joint administration and ownership of the offshore resources which gave those provinces the right to collect revenue by way of taxes and royalties from the offshore oil and gas resources.

……..to be continued