Putting Equalization back on track

There is no perfect solution for Equalization in Canada. That’s the reality the Panel faced.

Given the dynamics of Canada’s federation and the strong differences among the financial situations and preferences of individual provinces, not to mention the expectations of the federal government, perfection will undoubtedly continue to elude all of us.

The Panel has pursued the goal of developing a sound and effective Equalization program for Canada. To achieve that goal, we reviewed all of the various issues and options in detail, not only in principle, in theory or in concept, but from a thorough technical perspective.

Nonetheless, the Panel has pursued the goal of developing a sound and effective Equalization program for Canada. To achieve that goal, we reviewed all of the various issues and options in detail, not only in principle, in theory or in concept, but from a thorough technical perspective. This level of technical analysis proved to be time consuming but essential. Often we have found ideas that, while promising in principle, have consequences for provinces and for the Equalization program as a whole that are simply not acceptable.

What follows, then, is a balanced package of recommendations designed to put Canada’s Equalization program back on track and to establish a solid and sustainable foundation for the future.

Recommendations

Starting with principles

In developing recommendations for the future of Canada’s Equalization program, the Panel has been guided by a set of principles, some of which have been in place for some time and others which are new.

Consistency with Canada’s Constitution
The design and implementation of the Equalization program should be consistent with and support the national purpose outlined in section 36(2) of Canada’s Constitution.

Fairness
Canada’s Equalization program should provide equitable and consistent treatment for all provinces. The “rules of the game” should be embodied in an Equalization formula that applies equally to all provinces.

Adequacy and responsiveness
The Equalization program should provide sufficient revenues to receiving provinces to allow them to meet the goal of providing reasonably comparable public services at reasonably comparable levels of taxation. The program also should be robust enough to respond to changes in provinces’ financial situations and to preclude the need for separate agreements with individual provinces.

Policy neutrality and sound incentives
The Equalization program should respect the autonomy of provinces in making decisions on behalf of their residents. It should have sound incentives and not cause provinces to make decisions that they would not make if the Equalization program were not in place.

Equity among receiving and non-receiving provinces
While the objective of Equalization is to increase the fiscal capacity of less wealthy provinces, it should not bestow benefits on receiving provinces that put them in a stronger financial position than provinces that do not receive Equalization payments.

Simplicity
Equalization, by its very nature, will remain a complex program. However, expectations for accuracy and comprehensiveness should not be used to add excessive complexity to the program.

Transparency
Steps should be taken to improve awareness and understanding of the program and to clarify how decisions are made and how the program operates.

“At first glance, the move to a fixed pool of equalization funds under the 2004 New Framework appears likely to improve stability. But this view rests on a fundamental misconception: the goal should be stability in receiving provinces’ net revenues and not in Equalization transfers themselves. The goal should therefore be transfers that are highly responsive to changes in a receiving province’s own fiscal capacity, not to extraneous events.” - Michael Smart16

Predictability and stability
Although Equalization should be responsive to changes in provinces’ financial circumstances, it should be designed to avoid unnecessary shocks and to provide reasonable stability and predictability for both the provinces and the federal government.

Affordability
The Equalization program must be affordable and sustainable over time. The federal government is responsible for determining how much it will spend to achieve the goals of the Equalization program.

Accountability
Given that Equalization is a federal program paid for by Canadian taxpayers, the federal government should be accountable for the overall operation of the program and the allocation to individual provinces. Provinces are accountable to their residents in terms of how Equalization funds are used.

Returning to a rules-based, formula-driven approach

If there was one consistent message the Panel heard throughout its consultations, it was the need to return to a rules-based, formula-driven approach. Rightly or wrongly, provinces and many academics perceive that the former rigour of the Equalization program has been replaced by more ad hoc, one-off decisions with individual provinces and on individual issues.

Therefore, the Panel recommends that:

“If the federal government first establishes its financial commitment [to Equalization] and then determines a means of allocating this funding among provinces, we limit the possibilities to determine a fair allocation and create a beggar- thy-neighbour mentality among provinces.” - Government of Saskatchewan17

The Panel understands that the New Framework introduced by the federal government in October 2004 has some distinct advantages, particularly because it provides certainty about how much will be allocated to the Equalization program on an annual basis. However, there are serious concerns with the approach. Provinces argue that it increases stability and predictability for the federal government but not for the receiving provinces. Their shares of the fixed pot could go up or down based on factors completely outside their own province’s control, particularly if there are changes in the economic situation of other receiving provinces.

There also is a sense that the concept of a fixed pool runs counter to the fundamental nature of Equalization—that it is intended to respond to changes in fiscal capacity of the provinces, rather than acting as a fixed entitlement over time. Establishing a fixed pool with a growth track divorces the Equalization program from the actual financial situation in provinces and the overall need for Equalization over time.

The vast majority of provinces and many academics recommend adoption of a 10-province standard. The Panel agrees.

Over the years, a variety of different standards have been used in the Equalization program (see Annex 2 for more information). Some experts and academics suggest that the choice of a standard is ultimately a political choice reflecting Canadians’ values and the extent to which they want to see disparities among provinces addressed through a program like Equalization.

On the other hand, others argue that a 10-province standard is a “natural” standard that reflects the reality of the financial circumstances of all 10 provinces, not just the middle five. The five-province standard, in place before the New Framework, was introduced for a single, but important, purpose—to decrease the federal government’s overall costs for Equalization at a time when Alberta’s fiscal capacity was increasing dramatically because of high oil prices. While it makes sense from a financial perspective, it is not a principle-based approach and it does not adequately capture the reality of the diversity and disparity among the various provinces.

The Panel recommends that a 10-province standard should be adopted.

“The government believes that a national-average standard would more accurately reflect the level of fiscal disparities throughout the country and is more consistent with the intent of the constitutional commitment.” - Honourable Jeannot Volpé Minister of Finance, New Brunswick18

We acknowledge that this may increase the overall costs of the Equalization program. If the costs of a full 10-province standard (combined with other adjustments to the formula recommended by the Panel) exceed what the federal government is prepared to spend on Equalization in any given year, it should explicitly scale back the entitlements to receiving provinces on an equal per capita basis. As outlined later in this report, the federal government should outline the parameters for determining the affordability of the Equalization program as part of a number of steps to improve the transparency and governance of the program.

To date, the way of determining whether or not provinces receive Equalization funding has focused exclusively on determining fiscal capacity. That is to say, do provinces have the capacity to raise enough money through their own sources of funds to provide reasonably comparable
public services?

Assessing expenditure needs would require comparable approaches across the provinces to measure disparities, not only in the volume of services provided but also in a number of factors that affect the costs of delivering services (e.g., composition of the population, health and education status, dispersion of the population, wage rates, etc.).

The Panel examined the approach taken in Australia, for example, where an independent commission systematically gathers comprehensive and detailed information on a whole range of variables related to actual expenditure
programs in the different states. Comprehensive information is tracked over time for each of the states and for the country as a whole. For each program reviewed, national average standards are determined and grants to individual states are based on program expenditure standards as well as fiscal capacity standards.

There is one critical difference, however. Canada is a much more decentralized federation where provinces have jurisdiction over key areas like health and education. Different provinces have different priorities in terms of what services they provide and how they provide them. Provincial governments make political decisions about the menu of public services they will provide to meet the needs of their residents, and they are accountable to their residents for those decisions. It’s a complex and diverse approach, but it reflects the reality of our country and it has served us well.

While some provinces believe the idea of addressing needs has merit, all acknowledge that this would add considerable complexity to what is already a very complicated program.

Moving to a needs-based approach would require common information bases and common ways of measuring standards for programs across 10 very disparate and autonomous provinces. It would also involve a much more prominent role by the federal government in measuring and tracking information on areas that are beyond its jurisdiction. While some provinces believe the idea of addressing needs has merit, all acknowledge that this would add considerable complexity to what is already a very complicated program.

On balance then, the Panel recommends that needs not be assessed as part of the Equalization program. If the Government of Canada feels that there are disparities in particular public services that should be addressed, and the provinces agree, it should do so through targeted programs such as the Canada Health Transfer, the Canada Social Transfer, or national infrastructure programs—but not through Equalization.

Additional information on issues related to expenditure needs is included
in Annex 3.

As if the Equalization program isn’t complicated enough on its own, other federal transfer programs, particularly the Canada Health Transfer and the Canada Social Transfer, also include an equalizing component. These programs provide federal funding to provinces through a combination of per capita cash payments and tax points. The result is that wealthier provinces like Ontario and Alberta receive lower cash payments than other provinces. There is a designated component (called Associated Equalization) that provides payments to provinces to equalize tax points as part of the Canada Health Transfer and the Canada Social Transfer.

“... there is a useful principle that can guide our approach—put as much as possible of the explicit inter-provincial redistribution into one program: Equalization. Canadians will support a transparent formula to help less well-off provinces provide reasonably comparable public services. Building unequal treatment into program after program not only hurts the economy but also fuels inter-regional grievances.” - William Robson19

Furthermore, under these transfers, if a province’s fiscal capacity increases to a point where it is no longer eligible for Equalization, that province actually receives more in per capita cash transfers through the Canada Health Transfer and the Canada Social Transfer to compensate for the fact that it no longer receives Equalization funding for its share of the tax point transfer.

The result is confusing at best and adds yet another layer of complexity to the process. It amounts to “back door” equalization and is an ongoing source of irritation both on technical grounds and in principle. It is beyond the Panel’s mandate to recommend a specific solution; however, the Panel encourages the federal government and the provinces to address this issue so that Equalization is the primary vehicle for equalizing fiscal capacity across provinces.

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