Annex 8: Improving Predictability and Stability

Lack of a smoothing mechanism

In addition to multiple estimates for a given year’s Equalization entitlements, the Equalization formula used prior to 2004–05 contained no smoothing mechanism to address year-over-year volatility.¹ The effects of the business cycle, sudden data revisions, or fluctuations in commodity prices were reflected in payments as soon as they showed up in the statistical data entering the formula. As a result, payments were responsive to the latest data, but this responsiveness came at a cost—entitlements could change significantly year-over-year, and often these changes could not be predicted.

The Panel noted that other Equalization programs, such as in Australia, use moving averages to smooth fluctuations and reduce instability in year-over-year entitlements. Smoothing mechanisms (where entitlements are based on the average of fiscal capacity over a number of years) delay the program’s response to deteriorating or improving fiscal circumstances. However, they also provide greater predictability and stability because entitlements are adjusted gradually with changes in economic circumstances and new data. This allows for better fiscal planning by receiving provincial governments.

The precise choice of the moving average is ultimately a balancing of objectives. A long moving average, such as one based on average fiscal capacity over the past 10 years, would provide significant stability and predictability over time, but would leave the system very unresponsive to changes in economic circumstances. A short moving average would result in greater responsiveness to new data, but also more volatility.

The Panel’s assessment

Based on discussions and research, the Panel recommends that a single estimate, single entitlement, and single payment approach, combined with the use of a three-year moving average, would create a system that is more predictable and stable, while still maintaining an appropriate degree of responsiveness.

A single estimate, single entitlement, single payment system would radically simplify the payment system and remove the unpredictability and instability caused by the eight-estimate system. The simplicity of this approach would also significantly increase transparency, making it clear how much Equalization a province would be entitled to receive each year.

The single estimate should be based on a three-year moving average, lagged two years. For instance, for 2007–08 entitlements, payments should be made based on a single estimate using data from 2005–06, 2004–05 and 2003–04, weighted at 50, 25 and 25 percent, respectively. The recommended weighting gives the most weight to the most recent year in the three-year moving average in order to maintain responsiveness. The lag in the data, together with the three-year weighted moving average, would make payments more predictable and more stable by dampening fluctuations in annual payments by approximately 25 percent.

The Panel suggests that the federal government consult with the provinces to determine the most desirable time to announce entitlements for a year. Under the proposed system, the federal government could announce 2007–08 entitlements in the fall of 2006 based on the data available at that time. This would give provinces certainty as they prepare their upcoming budgets. Alternatively, the federal government could wait until somewhat better data are available in early 2007.

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