Tuesday, October 31, 2000
The Globe and Mail

The impossible game
Politicians woo votes by trying to fit the provinces into a federal payments puzzle. The scheme hammers both out of shape. It’s a welfare trap

By Brian Lee Crowley

When politicians as different as Stockwell Day and Brian Tobin agree that a fundamental building block of modern Canada must change, something profound is beginning to stir in the body politic. Not a moment too soon.

The fundamental building block of Canada that is in question is equalization. The mere mention of that word makes every Canadian with a life glassy-eyed. That’s a pity, because by definition, it leaves equalization, a huge $10-billion federal program, the province of incomprehensible policy wonks and bureaucrats.

Yet equalization has far-reaching impacts on the poorer parts of the country, effects that have become so obvious that Mr. Day and Mr. Tobin have both proposed equalization reform. Mr. Tobin made it his battle cry on his return to Ottawa. Mr. Day upstaged the former premier by actually announcing in St. John’s a sketchy plan to make equalization friendlier to Newfoundland’s interests. Mr. Tobin’s concrete proposals have to be divined from various public statements.

Equalization, despite its arcane language of “fiscal capacity” and “five-province standards” actually tries to do something very simple. Because some provinces are richer than others, they have a greater ability to pay for the services that are their responsibility under the Constitution.

That means, all other things being equal, places like Ontario and Alberta could pay for much better schools and health care than provinces like Newfoundland and New Brunswick. Yet the people who live in each of these provinces are Canadians, and entitled to some reasonably comparable levels of service in these matters without having to bankrupt themselves through ruinous levels of provincial taxation to achieve it.

Enter equalization. While it does not make provincial revenues “equal” per capita across the country, it does transfer vast sums of money to the less well-off provinces. The average Atlantic province gets roughly 40 per cent of its revenue from Ottawa, not from provincial taxpayers, the bulk of it in the form of equalization.

In Quebec and Manitoba, the share of the provincial budget represented by equalization is smaller, and Saskatchewan is so close to the national average in many ways that some years it receives equalization, and in others it does not, depending on economic conditions.

So, the intentions behind equalization are good. But neither mice nor men can afford to be satisfied with the nobility of their intentions.

Equalization’s effects reach far beyond the intentions of those who designed and administer it. And what Stockwell Day and Brian Tobin are competing to do is to fix one of those unintended consequences.

Equalization works for provinces a bit like the welfare trap does for low-income people. As you move off welfare and into work, not only are your cash benefits withdrawn, but so are many other non-cash benefits, such as prescription drugs. On top of that, employment income is taxed. The result is that people at the lowest income levels are often materially better off on welfare than if they work. This traps people in dependence.

Equalization can have analogous effects on provinces.

Equalization “tops up” provincial revenue to something close to a national average. Thus, when new money flows into the coffers of a province receiving equalization payments, the federal government, logically, reduces those payments. The “clawback” rate can vary from about 70 to 90 per cent. Therein lies the rub that galls both Stockwell Day and Brian Tobin.

Voisey’s Bay, the huge nickel deposit in Labrador, is a classic example of the perverse incentives of equalization at work. Then-premier Tobin would not give Inco the go-ahead to develop that mine without getting a guarantee that a smelter would be built to employ large numbers of Newfoundlanders. Why not? Because the equalization clawback meant that virtually all of the tax revenues that the mine would generate would flow to Ottawa, not to the province that owns the resource.

The only way that the province could get value for its citizens from a resource that they owned was to try and force Inco to provide lots of jobs. But Inco has tons of spare smelting capacity elsewhere in the country, and it faces low-cost competition in the world nickel market. The result was an impasse in which the poorest province in the land would not agree to a mine development that would have employed a great many people (with or without the smelter), and would have resulted in a direct investment of many hundreds of millions of dollars. Everybody lost.

That’s why Mr. Day is proposing to reduce the clawback on equalization for big natural-resource projects in Newfoundland, at least in the short run. Mr. Tobin appears to want to take a slightly different tack, and have the federal government lock in equalization payments at a fixed level for five years at a time, rather than to adjust them repeatedly over the course of the year as economic conditions shift.

But these are only quick fixes for part of what’s wrong with equalization. As Tom Courchene of Queens University, and others have shown over the years, equalization has lots of other perverse effects. In effect, it mutes the effects of destructive yet popular policies, such as too-high minimum wages, in recipient provinces. It allows provinces to spend money that they do not have to raise through taxation on their own voters, raising serious questions of democratic accountability. And voters in these provinces have incentives to support wasteful politicized spending, knowing that someone else will foot a major part of the bill.

In other words, equalization can be an obstacle to provinces adopting policies that would allow them to escape dependence on federal transfers.

This is the opposite of what makes most sense: the maximum incentive for provinces to grow their own economy and make equalization unnecessary. Like welfare, it should be there for those who truly need it, but it should never be an end in itself, an obstacle to self-reliance.

At last we’re discovering that equalization loves economies in decline, but sits awkwardly with prosperity. Yet offshore oil and gas may well be about to thrust prosperity on both Newfoundland and Nova Scotia. Mr. Day and Mr. Tobin are performing a huge service for the poorer parts of the country by putting equalization at the forefront of political debate. But their proposals fall well short of the fundamental rethink that equalization, and the provinces that depend on it, desperately need.

Brian Lee Crowley is president of the Atlantic Institute for Market Studies, a public-policy think tank based in Halifax.