Annex 8: Improving Predictability and Stability

The Panel’s mandate specifically calls for recommendations on how to improve the predictability and stability of the Equalization program.

The Panel discussed these issues with federal and provincial governments, as well as academics. We heard two recurring concerns, particularly from provinces. First, the formula-based system in place before the October 2004 New Framework was not very predictable. It was difficult to predict in advance if, and to what extent, Equalization would go up or down within a year or from one year to the next. Second, Equalization payments were volatile, often changing significantly within a year, as well as from one year to the next.

In examining these issues, the Panel’s work focused on two aspects of the Equalization program: the complex estimation and payment system, and the lack of any smoothing (averaging) mechanism to reduce year-over-year volatility in entitlements. This annex provides details on the Panel’s consideration of these issues.

The estimation and payment system

The current Equalization formula uses a complex estimation and payment system that makes entitlements volatile and difficult to predict.

The process begins in April, the beginning of a fiscal year. The federal government starts making semi-monthly payments to the provinces based on its first official estimate for Equalization entitlements for that fiscal year. These payments are then revised throughout the fiscal year. The second official estimate is calculated in October and the third official estimate in February. These estimates incorporate the latest available data (e.g., provincial revenues, sales and population).

By the end of the fiscal year, a province will have received a full year’s entitlement based on the latest available data—but the process is far from over. The entitlement for that fiscal year is revised using new data every October and February resulting in fourth, fifth, sixth, and seventh estimates and a final (eighth) calculation (3 and a half years after the first estimate). With each new estimate, the federal government makes additional payments if the data show that entitlements should have been higher, and likewise, recovers overpayments from provinces if the data show that entitlements should have been lower. Figure 1 provides additional detail on how this process works.

Since it takes almost four years to finalize the entitlements for a given fiscal year, when new estimates are released, payments are revised for up to four fiscal years at the same time. For example, in October 2003, six months after most provinces had released their annual budgets, provinces were informed of:

• Revised entitlements and a payment schedule for 2003–04 based on the second estimate
• Additional payments or recoveries for 2002–03 entitlements based on the fourth estimate
• Additional payments or recoveries for 2001–02 entitlements based on the sixth estimate
• Additional payments or recoveries for 2000–01 entitlements based on the final (eighth) calculation.

Figure 1 – Estimates, Payments And Recoveries under the Current Equalization Program

While in some years new data did not result in huge swings in entitlements, in other years the provinces (and the federal government) could be hit with a perfect storm. New data (i.e., economic, demographic, or revised data) could result in entitlements for all four years being significantly revised upward or downward.

Understandably, some provinces expressed concern that this estimation and payments system makes their budgetary planning very difficult because entitlements are both volatile and unpredictable. For example, if a province, on the eve of its budget, is informed that it owes substantial amounts due to large Equalization over-payments from three years ago, it is put in a difficult fiscal position that adds uncertainty to fiscal planning.

Given the potential for large recoveries due to revised estimates, provisions were adopted in the late 1970s to recover large overpayments over a number of years, rather than immediately after the release of a new estimate. This cash-flow relief was helpful when provinces used cash accounting. But provinces have now largely adopted full or modified accrual accounting, and the change in entitlements (not the cash payments) matters in determining their budgetary balance.

The Panel’s assessment of the estimation and payment system

The Panel recognizes that the principle behind the eight-estimate system is to allow current year entitlements to be based on the most recent data (the first estimate); subsequent estimates are revised using more accurate data. However, in the view of the Panel, this approach does not provide an appropriate balance between using the most up-to-date data (which should reflect current economic conditions), and having a system that is sufficiently predictable and stable for government budget planning. This instability is particularly problematic when Equalization makes up a large share of a province’s overall revenues.

The Panel believes that the current approach for determining Equalization entitlements and payments should be replaced with a one estimate, one entitlement, one payment approach. That is, provinces should be given their entitlements for a fiscal year based on one estimate, and payments should be made based on this estimate, with no subsequent adjustments or revisions. This means that once entitlements are announced for a year, provinces could undertake financial planning with confidence, knowing that their entitlements will not be revised.

This approach would also be much simpler, more transparent, and would enhance accountability to Canadians. In periodic disagreements over Equalization, Canadians have had to contend with contradictory statements from federal and provincial governments about whether a particular province’s payments had gone up or down. Under the Panel’s recommended system, the single annual estimate would make Equalization payments to each receiving province clear and definitive.

The challenge in designing this kind of system is to use data for the one estimate that are as current as possible, but also sufficiently reliable to support large and important federal Equalization payments. In the Panel’s view, the data used for the first three estimates are not sufficiently reliable, and are simply too preliminary to accurately reflect current economic conditions. The use of these data results in significant revisions to entitlements. Data used for the last five estimates, on the other hand, are much more reliable and provide more accurate estimates of final Equalization entitlements.

Figure 2 shows how far each estimate diverges from the final Equalization calculations over a 10-year period.

Figure 2 – Convergence of Official Estimates on Final Calculation, Total Yield of All Provinces (1992–93 to 2002–03)

Given the inaccuracy of the preliminary data that are available for arriving at the first three estimates, and the volatility this creates, the Panel is convinced that these estimates should not be used. Instead, it recommends that the one estimate, one entitlement, one payment approach use lagged data that are much more accurate and stable.

The use of lagged data means that Equalization entitlements would be based on economic events that occurred in the past. The Panel is convinced that this slight loss in responsiveness is outweighed by the increase in stability and predictability that would be gained by using a reliable single estimate that is not subject to subsequent revisions. This slight loss in responsiveness should also be put in context; the first three estimates of the eight-estimate system were themselves not very responsive to current economic conditions. Those data were simply too preliminary to give an accurate picture of current year fiscal capacity.

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