How to fix equalization to encourage growth
by Jack M. Mintz

Equalization encourages small provinces to keep taxes too high. Dropping natural resource revenues could make things worse. Here’s a better plan.

The surprising heated summer debate over the little understood equalization program has taken a rather nasty turn. Ontario Premier Mike Harris argues that natural resource revenues should be subject to equalization. Newfoundland and Nova Scotia, on the other hand, point out that the equalization program, which claws back 85% of new resource revenues, unfairly discourages the development of the resource industry and robs them of a revenue-generating asset.

Some of the press has vilified Mr. Harris and supported the Atlantic premiers in their quest for a better deal. Mr. Harris’s comparison of equalization-recipient provinces to people on welfare did not exactly help clarify the principles for design of the equalization program. But he does have a point. The solution, though, is not to try a Band-Aid resource revenue fix. What we need is a broader reform that reduces distortions in the system and encourages provincial growth through tax cuts.

The intent of equalization is to provide support for provinces with insufficient fiscal capacity so that they may have sufficient revenues to support a minimum level of public services. If a poor province receives new sources of revenue, why not include all sources in determining fiscal capacity, and therefore reduce federal support that would be less needed?

As pointed out by several commentators, resource royalties are not the same as other revenues. Unlike income taxes, for example, resource royalties are derived from the sale of assets on Crown lands. In principle, if resources are sold and invested in financial assets (or used to reduce government debt as done in Alberta recently), there is an exchange of one asset for another. However, there is no case for ignoring altogether the contribution of resource revenues to a province’s fiscal capacity. If the province spends the resource revenues on public programs (including infrastructure), then, effectively, the province has added to its fiscal capacity. Take an extreme example: If Alberta put all of its resource royalties into a fund that generated enough income to pay for education, health, infrastructure and other public services, wouldn’t it have sufficient fiscal capacity without receiving an equalization payment from the federal government?

But Mike Harris, the tax fighter, probably recognizes that there is something wrong with a program that can discourage provinces from developing their economies. If a provincial economy grows, the province can lose equalization payments, which are based on the difference between their own tax base and a standard national per capita tax base. The tax on new revenues can be close to 100% due to the loss in equalization payments.

In principle, one should think of the equalization program as having a similar impact on taxpayers who receive an income-tested refundable child tax benefit, GST tax credit and old-age guaranteed income supplement. When a person works harder and earns more income, income-tested benefits are reduced, increasing the tax rate on new income. The equalization program is similar in impact: Poor provinces face a high tax penalty in lost equalization revenues when they grow their economies and receive more revenues.

But just dropping natural resource revenues from equalization could make matters worse rather than better in terms of developing the economy. Under the existing equalization program, the smaller provinces lose substantial equalization payments if they get new corporate and personal taxes. Michael Smart, a University of Toronto economics professor, made this point in an important paper several years ago. The problem with the equalization program is that it especially encourages smaller provinces to keep their tax rates too high.

This can be seen in the latest round of corporate rate reductions. Three large provinces — Alberta, Ontario and Quebec (and British Columbia will likely follow suit) — will have corporate income tax rates below 10% by 2005. So far, none of the small equalization-recipient provinces are planning to reduce their corporate income tax rates, which are above 16%, even though they will lose significant revenues as corporate income is shifted to low-tax provinces. Why aren’t these provinces responding? Quite simple. Equalization revenues will make up losses in corporate taxes due to income shifting, dollar for dollar. From a development perspective, it would be good for equalization-recipient provinces to cut business taxes to encourage more investment and job creation. However, given the complexities of the formula, a province that cuts taxes to spur growth also loses equalization payments.

Actually, Quebec reduced corporate income tax rates in the early 1980s, knowing full well it would benefit from increased corporate income tax revenues shifted to la Belle Province. In principle, Quebec would lose some equalization payments, but, being a large province, the impact of growth policies in Quebec would result in a smaller clawback of new revenues through reduced equalization payments.

The implicit equalization penalty on growth therefore affects not only development of the resource industry. Equalization payments are reduced if a poor province grows more. Therefore, instead of using a Band-Aid solution of dropping resource revenues from equalization, we should seek a more general approach to reduce the impact of the equalization system on decisions of recipient provinces.

Here is one suggestion: A province receives equalization payments based on the difference in its fiscal capacity compared to a national standard. Instead of basing the formula solely on the differences in fiscal capacities, the equalization payment could be based on two parts. The first would take into account on a 75% basis (instead of the current rate of 100%) the difference between a province’s fiscal capacity and the national average. The second would be a 25% incentive payment for provinces that grow their fiscal capacity beyond some minimum level (determined as some percentage below the national average).

Under this plan, provinces would face a much smaller equalization clawback in growing their economy — each dollar in additional tax revenues would result in a loss of 50% on each dollar of revenue due to growth raised, rather than a possible 100% under the existing regime. The advantage of this general formula is that it applies to all revenue sources and would not distort provincial priorities by favouring only one type of industry.

The inclusion of resource revenues in the equalization formula is a difficult issue, given the nature of the revenue received. But, the aim should be to develop a general approach to reduce the penalty that the equalization system imposes on growth, as opposed to some ad hoc adjustment that might create distortions and unfairness for the provinces.

Jack Mintz is president and CEO, C. D. Howe Institute, and Arthur Andersen Professor of Taxation at the J. L. Rotman School of Management, University of Toronto.