Why Ottawa needs to upend equalization

The federal equalization program has become a flashpoint in the separatism debate in Alberta, a shorthand for the sense that the province is somehow being fleeced by the rest of the country.

Much of the criticism of equalization – which is intended to ensure roughly comparable services across the country at roughly comparable taxation levels – is only loosely founded on the facts. Despite intimations to the contrary, Alberta, the province, pays exactly $0 into the equalization fund (unlike in other federations, where subnational jurisdictions do actually cut a cheque). Albertans, by paying the same tax rates as everyone else, do contribute an outsize amount to federal coffers, and by extension, the federal funds spent on equalization.

But the abundance of misinformation does not mean that the equalization program is beyond criticism. Far from it. It’s been nearly two decades since the federal government did anything more than tinker with the structure of the program.

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The next deadline for renewing the 70-year-old program is in less than three years. That’s enough of a runway to allow the federal government to fundamentally redraw the equalization program with the triple goals of making it fairer, reducing its cost and eliminating unintended incentives for provinces not to aggressively pursue economic growth.

It is Ottawa’s choice to make, since there is no legal requirement to secure the consent of the provinces. (Politics is a different consideration.) The Constitution does create an obligation for some sort of equalization program, but the wording is broad. The federal government has all the latitude it needs, should it want to act.

The more-than-equal equalization formula

The most obvious reform is to stop the bizarre practice of paying out hundreds of millions of dollars each year (sometimes billions) that aren’t justified by the need to bring have-not provinces up to the average fiscal capacity – including by giving funds to have provinces such as Ontario.

Take a look at this first chart below. As you might expect, Quebec, Manitoba and the Atlantic provinces are all recipients; they are have-not provinces, meaning that their per capita fiscal capacity (measuring a broad range of taxes and other revenue sources) falls below the average for the provinces.

But so is Ontario, which got $406-million in the current fiscal year even though its fiscal capacity is above the national average. So why does it receive payments under equalization?

The answer is to be found in the surge in oil prices around 2008. As crude prices rocketed up, Alberta’s fiscal capacity ballooned. In turn, that would both inflate the national average fiscal capacity, and increase the gap between that average and the fiscal capacities of the have-not provinces. The result would have been a massive increase in the cost of the program.

So the Conservative government of the day decided to cap the increase in the cost of equalization by tying it to the rolling three-year average growth in gross domestic product. At the time, that functioned as a ceiling, with the equalization program growing more slowly.

But today, that ceiling has become a floor. Even after billions of dollars have been distributed to the have-not provinces to bring them to the national average fiscal capacity, there are still funds remaining, which are distributed as “adjustment payments,” as this second graph shows. For the current fiscal year, there was $739-million in such payments, with more than half going to Ontario.

If the $739-million were distributed solely to the have-not provinces, some would end up with a per capita fiscal capacity higher than Ontario’s. The rules of the equalization program bar that, so Ontario receives enough of the adjustment-payment pool to prevent any leapfrogging.

That result is the policy equivalent of a concrete life-preserver. It might be made entirely to specifications, but the result is ridiculous.

So, any reform of the equalization program should start by making the economic-growth rule a ceiling, only. Any funds that would be adjustment payments should simply not be spent. That would have saved $739-million in the current fiscal year, but the potential savings have been much higher in other years: $2.3-billion in fiscal 2023-24, for instance.

This third graphic shows what the equalization program payouts would look like if the fixed-growth rule no longer put a floor under payments.

Such a change would eliminate one of the more bizarre distortions of the equalization program, and move it closer to its intended purpose. But there would be only modest economies. For more substantial savings, the federal government would need to look at broader reforms.

An electric question

One of the most intriguing possibilities – and undoubtedly, one of the most politically explosive – would be to change how the equalization formula deals with revenues and profits from the sale of electricity.

Right now, electricity revenues are included in the natural resources category, with only actual rather than potential revenues counted. If a province opts to keep electricity prices low, it is not penalized under the equalization formula.

But that is a policy choice, one that deliberately and artificially deflates a province’s fiscal capacity. The current structure of the equalization system creates a disincentive for any province that might think of charging market rates: the Fraser Institute has estimated that a province would see 70 cents in equalization payments clawed back for every dollar it took in from higher electricity prices.

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Ottawa does not need to cajole the provinces to raise their electricity rates. It can simply calculate the provinces’ fiscal capacities as if that were the case, thereby removing any fiscal incentive for artificially low rates. Already, the equalization formula does this for taxation – Alberta’s fiscal capacity is calculated as if it had a provincial sales tax, even though it very much does not.

If the federal government were to similarly read in higher electricity prices for Quebec, Manitoba and British Columbia, it would have saved $3.4-billion in the current fiscal year (without the fixed-growth rule), according to the equalization simulator on the Finances of the Nation website. Along with eliminating adjustment payments, that would trim $4.1-billion from the program.

Those are substantial savings that could be redeployed to other spending, or better yet, used to reduce personal income tax rates, or to simply trim the deficit. But there are other reforms that could push those savings higher.

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The question of incentives

One big problem with equalization is that it mutes the incentive for provinces to increase their revenues through economic growth. Without the cushion of equalization payments, New Brunswick might not be quite so quick to dismiss development of natural gas reserves through a ban on fracking.

A possible solution is to set the bar for equalization slightly lower, perhaps levelling up the provinces to 95 per cent of the average national fiscal capacity rather than 100 per cent. That change, without the fixed-growth floor, would reduce the cost of equalization to $20.3-billion this year, freeing up $6.9-billion.

There could be even bigger savings if Ottawa were to use a 95-per-cent rate and change how equalization deals with electricity revenues. As this last graphic shows, the cost of the program would fall by $10.5-billion.

Quebec would still be the largest recipient, but its payments would decline by nearly $8-billion, or more than half.

Another tricky question is that of accounting for the differing costs of providing services. Wages and other costs are typically lower in have-not provinces. If price differences were taken into account, their equalization payments would fall (although Ontario would morph into a have-not province). There’s also the consideration of geography: Newfoundland, for instance, faces higher costs because of the distance between small, scattered communities.

And then there is the demographic factor. Provinces with older populations will, all things being equal, be hit with higher health care costs. Ottawa should take those factors into consideration as part of a reevaluation of equalization.

Not all of the savings discussed above are politically achievable. Changing the treatment of electricity revenue, for instance, is bound to be controversial in Quebec. University of Calgary economics professor Trevor Tombe has suggested a more nuanced approach that would change how the equalization formula treats natural resources revenue. Rather than have a separate category for natural resource revenue, his analysis looks at treating it as corporate income. Prof. Tombe estimates that the clawback rate for Quebec would decline to less than 9 per cent from 69 per cent. That would reduce the incentive to sell electricity at artificially low rates.

A major reduction in equalization transfers would also generate political pushback in every have-not province. One way to make that reduction more politically palatable would be to recycle savings back into transfers on a per capita basis to the provinces, at least for the short term.

But those transfers need not be unconditional. To the contrary, they could be a prybar for economic reform. Every penny paid out from equalization savings should be contingent on a recipient province eliminating any interprovincial trade barriers. The resulting boom in economic growth would be the best equalization program possible.

The Sunday Editorial