Annex 7: Resource Revenues

What is the appropriate inclusion rate for natural resource revenues?

The Equalization program generally includes all provincial revenues in the formula in order to accurately measure a province’s fiscal capacity. Supporters of this approach argue that failing to fully take into account the fiscal capacity from all revenue sources would result in provinces receiving an incorrect amount of Equalization, thus undermining the principle of providing “reasonably comparable services at reasonably comparable tax rates,” as set out in Section 36(2) of the Constitution. Indeed, the current Equalization formula is considered to be very comprehensive and includes almost all provincial revenues.

While comprehensive revenue coverage is considered important by most supporters of Equalization, many have also argued that this principle needs to be considered within the context of the unique features of natural resource revenues, and that a strong case can be made for excluding some or all natural resource revenues from the Equalization formula.

The Constitutional arguments for excluding resource revenues

The arguments for excluding natural resource revenue stem from the provincial ownership of natural resources as reflected in Section 109 of the Constitution. Proponents of excluding resource revenues argue that an essential element of resource ownership is that a province and its citizens should be able to receive a net benefit from natural resources. However, if resource revenues are fully included in the formula—and Equalization entitlements go down dollar-for-dollar as resource revenues go up—the fiscal benefit of resource ownership is neutralized.

Numerous academic studies have proposed including less than 100 percent of resources stemming from this constitutional argument. In their seminal article of 1975, Gainer and Powrie proposed that about 70 percent of provincial resource revenues should be equalized. They argued that, conceptually, provincial resource revenues should be treated as if they had accrued to the private citizens or corporations of the province (since they are the ultimate owners). The federal government should therefore receive the portion of natural resource rents that it would get if it had levied personal or corporate income tax on this income. Assuming a federal tax rate of 30 percent (the approximate rate at the time the article was written), only 70 percent of the revenues should be subject to Equalization.¹

Other contributors to the debate, such as the Economic Council of Canada, have used the constitutional argument in a similar vein. The Council argued that provincial resource revenues are owned by the citizens of the province. The only portion that should therefore enter into the Equalization formula is the amount that would be raised by the provinces if they levied income tax on the resource revenues distributed back to their residents. Assuming a 20–30 percent provincial income tax rate, only 20-30 percent inclusion of resources revenues would be appropriate.

Other arguments for a lower inclusion rate for natural resources

Proponents of a less-than-full inclusion rate point to two additional considerations. First, provincial ownership means that provinces have significant control over the development of resources, much more so than over other economic sectors.

“A provincial government under the constitution has ‘vastly greater control over the natural resources it owns than it does over the natural resources it doesn’t own. A province can with respect to natural resources it owns: (a) decide whether to develop them, (b) decide by whom, when, and how they’re going to be developed, (c) determine the degree of processing that’s to take place within the province, (d) dispose of them upon conditions that they only be used in a certain way, or in a certain place, or by certain people, (e) determine the price at which they or the products resulting from their processing will be sold.”

- Mervin Leitch, (Former Alberta Attorney General)²

Accordingly, it is argued that the Equalization program should be structured to ensure that incentives are in place to support the development of resources by provinces. The dollar-for-dollar reduction in Equalization (that would result from full inclusion) clearly reduces a government’s incentive to support resource activity.

Second, and closely related to the issue of provincial control, natural resources are more likely than other revenue sources to involve public costs. Natural resource development often requires substantial infrastructure and entails environmental impacts that need to be regulated, monitored, and managed. For instance, resources found in isolated and largely unpopulated areas, such as the Voisey’s Bay nickel deposit in Labrador or hydro-electric installations in northern Québec, require significant provincial infrastructure investments that are essentially dedicated to the extraction of natural resources.

In order for the Equalization program to accurately reflect the net provincial revenues that are left after incurring the costs associated with resource development, and to ensure that provinces have the incentive to invest money to support resource development, it is argued that the inclusion rate of natural resource revenues should be less than 100 percent.

Finally, the Panel also heard arguments to partially or fully exclude non-renewable resources (e.g., mining, oil and gas) from Equalization while continuing to include revenues from renewable resources (e.g., forests and hydro-electricity). The main rationale is that non-renewable resources do not generate an ongoing flow of
revenues; their exploitation is akin to the conversion of an asset in the ground into a financial asset, leaving the province no better off financially in the long term.

The Panel’s view on the appropriate inclusion rate

The Panel assessed the arguments in support of full inclusion of resource revenues put forward by a number of provinces and experts and does not believe this approach is appropriate. The Panel’s view is that full inclusion of natural resource revenues does not recognize that:

• Provincial governments own the resources and should get a net fiscal benefit as owners.
• Provinces have significant control over resource development, and appropriate incentives need to be in place for provinces to support resource development.
• There are public costs involved in providing the infrastructure necessary to develop natural resources.

Moreover, full inclusion does not appear to be sustainable, as evidenced by the special Offshore Accords that essentially reduced the inclusion rate to zero percent for offshore resource revenues for Newfoundland and Labrador and for Nova Scotia.

This being said, the Panel also does not support the view that the ownership argument naturally leads to the conclusion that 100 percent of resource revenues should be excluded from Equalization. That approach would appeal to receiving provinces with natural resource revenues, as it would allow them to receive all the benefits from their own resource developments plus full access to Equalization. Receiving provinces without resource revenues would see a substantial drop in the overall Equalization pool and the amount they receive. Economics and efficiency aside, this does not meet the fairness test for all Canadians.

The Panel weighed the economic and constitutional arguments and considered the distribution impacts of various inclusion rates. The Panel’s best judgement indicates that a 50 percent inclusion rate combines the merits of the various arguments and provides the most reasonable results for all receiving provinces, particularly when this is combined with the entire package of changes proposed by the Panel. In this respect, a 50 percent inclusion rate facilitates the Panel’s recommendation to adopt a 10-province standard by making it more affordable for the federal government. It also recognizes that 43 cents out of each dollar of revenue raised by the federal government comes from taxpayers in Ontario, a province that does not receive Equalization and has no oil and gas revenues.

The Panel’s view on renewable versus non-renewable resources

The Panel also considered the issue of renewable versus non-renewable resources. Although a distinction can be made in theory, in practice it is not that clear-cut. Revenue streams generated by many non-renewable resources extend over many decades, as has been the case in Alberta and Saskatchewan. Moreover, resources thought to be renewable (e.g., forestry or fisheries) can be depleted and may turn out to be more finite than expected.

The Panel was also not persuaded by the argument that revenues from non-renewable resources should be excluded because this was tantamount to a conversion of an asset into a revenue stream. Government revenues of all kinds are derived from different forms of capital (capital assets, human capital [ i.e., personal income tax and consumption taxes ], corporate capital, hydrological potential, forests), all of which are subject to some depreciation, as are resources in the ground. Non-renewable resource revenues can and are used to
provide public services and reduce the level of other forms of taxation.

A province could choose to convert the finite revenue stream from a non-renewable resource into an equivalent permanent income stream through the use of financial market instruments or mechanisms such as heritage funds. Exclusion of revenues set aside in such funds could be justified, as the revenues set aside are not immediately available to fund services. However, it is not clear that even this distinction is meaningful given the interchangeability of revenues, and the possibility that a province could simultaneously borrow and set revenues aside in a fund.

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