Putting Equalization back on track

Striking a balance on the treatment of resource revenues

No issue in the entire Equalization program is more contentious than how to deal with resource revenues. Through its consultations, the Panel heard strongly held and diametrically opposing views from both provinces and academics. Some argue that 100 percent of resource revenues should be included in Equalization while others say resource revenues should be excluded completely.

No issue in the entire Equalization program is more contentious than how to deal with resource revenues.

The issue is more than just one of principle. Natural resource revenues are a very significant source of disparities in fiscal capacity among the provinces. There are also very different impacts on provinces depending on whether, and to what extent, natural resources are included in the Equalization formula.

In general terms, receiving provinces with significant natural resources but lower than average revenues from other tax bases (e.g., Saskatchewan and British Columbia) receive substantially higher benefits if resource revenues are excluded from Equalization or included only on a limited basis. Receiving

The starting point for the Panel’s recommendations is ownership. Under Canada’s Constitution, provinces own their natural resources. As owners, they should receive a net fiscal benefit from those resources. The workings of the Equalization program should not compromise this fundamental principle.

It’s clearly a Canadian conundrum.

The Panel has reviewed the various ideas and options and attempted to strike the right balance with the following package of recommendations.

Additional information on the treatment of resource revenues in Equalization is included in Annex 7.

The starting point for the Panel’s recommendations is ownership. Under Canada’s Constitution, provinces own their natural resources. As owners, they should receive a net fiscal benefit from those resources. The workings of the Equalization program should not compromise this fundamental principle.

Several provinces voiced concerns about having their resource revenues clawed back as a result of Equalization. In the Panel’s view, it’s not completely accurate to talk about provinces facing a claw-back if they receive less Equalization than they otherwise would have if they see substantial increases in resource revenues. That’s precisely how Equalization is intended to work. On the other hand, provinces that see increases in their resource revenues almost completely offset by decreases in Equalization payments can argue, and rightly so, that the result is they’re no better off in the end than if they had no resource revenues at all.

The Panel believes that provinces should receive benefits from the development of their natural resources. Nothing in the Equalization program should provide a disincentive for maximizing the potential of resource developments. At the same time, Equalization is not and should not be considered a permanent entitlement. Provinces with natural resources are in a good position to develop their economies and reduce, if not completely eliminate, their need for Equalization. This should be pursued as a stronger objective than retaining their eligibility for Equalization.

The Panel heard strong arguments for and against including resource revenues in the Equalization formula. The arguments generally fall into three categories:

“The current program fails to acknowledge the ownership of natural resources rests with individual provinces under the Constitution. Saskatchewan’s rights of ownership extend to the financial rewards for those resources, to be used for the benefit of its citizens. Equalization transfers most of those benefits to other parts of Canada and to the federal government.” - Government of Saskatchewan22

• Include 100 percent of resource revenues

Several provinces and experts suggest that all provincial resource revenues should be included in the Equalization formula since these revenues are a major source of income for the provinces and a cause of significant fiscal disparities across the country. Resource revenues are an important component of a province’s fiscal capacity. They help provinces pay for the costs of providing public services. And, as we’re seeing now with high prices for oil and gas, they result in stronger economies for provinces lucky enough to have natural resources within their boundaries. They are also a significant source of fiscal disparities among provinces.

• Exclude resource revenues entirely

Starting from the principle of provincial ownership, some have recommended that resource revenues be completely excluded from the Equalization formula. In many cases, the arguments relate primarily to the exclusion of non-renewable resource revenues on the basis that these resources are capital assets which can only be used once. They are not a permanent source of revenues for provinces.

• Include a portion of resource revenues

This middle position reflects the view that both extremes are untenable in the Canadian context. A portion of resource revenues should be included because of the fact that resource revenues do contribute substantially to a province’s fiscal capacity. On the other hand, because resources are owned by provinces and there are other factors to consider, less than the full amount of resource revenues should be included.

“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 Attorney General, Alberta23

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 that this solution is appropriate for a number of reasons.

First and foremost is the fact that, constitutionally, provinces own natural resources within their boundaries. As owners, the provinces determine when and under what conditions a particular natural resource will be developed. This is very different from other sources of revenues that are owned privately and simply taxed by a provincial government.

Second, provinces that benefit from natural resources face considerable uncertainty due to large swings in prices (for oil and gas in particular), wide variations in costs of production, uncertainty over the potential volume of production, and significant changes in profitability. On top of that, there are public costs involved in providing the necessary infrastructure to develop natural resources as well as in monitoring and regulating environmental impacts. Provinces with resource revenues reap not only the benefits but also must pay the costs for development, regulation, and management of their natural resource sectors.

Third, based on the principle of policy neutrality, the Equalization program should not provide incentives or disincentives for provinces to develop natural resources or adjust their royalty programs. If receiving provinces with resource revenues are allowed to “keep” more of those revenues without seeing them offset by corresponding reductions in Equalization, there is a greater likelihood that they will fully develop their resources and tax them appropriately.

“A portion of resource revenues—greater than zero but significantly less than 100%—must be included in Equalization. There is no magic figure...” - Royal Commission on the Economic Union and Development Prospects for Canada25

The Panel does not, however, 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. However, receiving provinces without resource revenues would see a substantial drop in the overall size of the Equalization program and the amount they receive. Economics aside, this doesn’t meet the fairness test for all Canadians.

We also do not accept the argument advanced by those who favour full exclusion that there is a fundamental difference between renewable and non-renewable resource revenues. In fact, there is good evidence to suggest that “non-renewable” energy sources such as oil and gas are, in fact, more durable and long-lasting than some resources that have been considered “renewable”, particularly Canada’s fishing stock and lumber resources.

The Panel’s conclusion is that some, but not all, resource revenues should be included in the Equalization formula. The question then becomes: what proportion of resource revenues should be included?

In the absence of what the Royal Commission (1985) terms a “magic figure”, the Panel has used economic and Constitutional arguments combined with best judgements to propose what we believe is a balanced solution.

Our 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.

Looking at the literature, arguments are made for an inclusion rate that is somewhere between 20 percent at the low end and 70 percent at the high end. Several academics suggest that the lower end, in the 20 to 30 percent range, should be the target. Support for a lower inclusion rate dates back to a 1982 Economic Council of Canada report.²⁴ Others suggest that 30 percent of resource revenues should be excluded (roughly the rate of federal taxes), while the remaining 70 percent would be subject to Equalization. The 70 percent inclusion rate is also favoured by some because it mirrors the generic solution already in place in cases where the vast majority of a particular tax base is included in one province.

The Panel has considered all these arguments and, most importantly, assessed the impact of various scenarios on all receiving provinces. Our 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.

If a portion of resource revenues should be included in Equalization, how should those resource revenues be measured?

The RTS approach is used for all the major tax bases included in the Equalization formula, and for the most part, it works well, particularly if the Panel’s recommendations for simplifying the approach are adopted. But in the case of resource revenues, it has become increasingly complex with 14 separate tax bases. Suggestions are that the current approach likely will become even more complex in future in order to capture the dynamics of a changing industry and taxation environment. There are also serious measurement problems with the RTS approach when it is applied to resource revenues.

There are serious measurement problems with the RTS approach when it is applied to resource revenues.

The Panel considered a number of different alternatives for replacing the current RTS approach, including the use of actual revenues, introducing an aggregate resource GDP tax base, or developing a new measure of economic rent.

Keeping in mind that the Equalization program is intended to reflect what provinces actually do, a good case can be made for replacing an overly complex and somewhat inaccurate RTS approach with actual revenues. Under this approach, instead of estimating what provinces could or might raise through royalties using elaborate but inaccurate calculations, Equalization would be based on the revenues provinces actually receive.

A second option, creating a resource GDP tax base, would aggregate the value of production in all resource sectors in a province to create a new tax base. Initial work done for the Panel suggests that there may be merit in pursuing this option in the longer term, but considerable work and analysis would be required.

A third option is to develop a new measure of economic rent. Economic rent is the difference between the selling price of a good or service and the cost of producing it, including a normal return on the investment involved. In the case of resources like oil and gas, there’s a difference between the price of oil and gas set on international markets and the cost of producing it. Because provinces own the resources, they are also in a position to capture some of that gap, the economic rent, through royalties paid by companies developing the resources and by the sale of Crown leases.

“... provinces are rational and intelligent revenue maximizers. This means that the actual revenues collected should serve as the tax base for purposes of the formula.” - Thomas Courchene26

The challenge becomes how to develop a measure that accurately reflects the potential economic rent a province could receive from the exploitation of natural resources. The Panel believes that an economic rent measure would be exceedingly complex and based on many hypothetical assumptions.

Based on these assessments, the Panel believes that the use of actual revenues is preferable to the current RTS approach or to a new measure of economic rent.

One potential downside to the use of actual revenues in the formula is the possible incentive for provinces to manipulate their royalty rates in order to maximize how much they could receive under Equalization. A 50 percent inclusion rate, combined with a number of smoothing mechanisms outlined in subsequent recommendations, will help to minimize this possibility.

An issue that has arisen with respect to oil and gas revenues is whether all revenue received should be counted for Equalization purposes, or whether revenue dedicated to savings vehicles such as Heritage Funds should be excluded on the grounds that it is not being used to provide public services. The Panel considered this issue and concluded that it is difficult to sustain these distinctions in a market environment where provinces are able to borrow on capital markets. Not counting resource revenues that are “saved” could provide incentives for provinces to save resource revenue and borrow against this asset to fund current expenditures. For this reason, the Panel recommends that all oil and gas revenue received by provinces should count as resource revenues for the purposes of Equalization.

The Panel sees no reason to distinguish between different types of resource revenues. Therefore, the treatment of all resource revenues should be the same whether those revenues arise from oil and gas, onshore or offshore resources, forestry, potash, other minerals, or hydroelectricity.

The measurement of fiscal capacity related to hydroelectricity deserves special mention. In most cases, provinces with substantial hydroelectricity resources have chosen to develop and distribute those resources through Crown corporations. For the most part, provinces have also chosen to provide electricity to their residents at low prices rather than charge full prices. Instead of capturing economic rent and generating government revenues, they give their residents the direct benefit of lower-priced electricity.

Under the current RTS approach, a portion of provincial revenues from hydroelectricity is counted in one tax base (the water rentals base), while a portion of the profits of Crown corporations paid to provincial governments is considered in the same way as profits of private corporations. Some have suggested that this approach underestimates the revenue-generating capacity of provinces in cases where they charge less than the full economic value of the electricity.

The Panel considered a number of options for the treatment of hydroelectricity in the Equalization formula. Consistent with its position that all resource revenues should be treated in the same way, the current water power rentals base should be folded into a single resource revenue base and measured by actual revenues. In addition, the Panel recommends that the remittances from Crown corporations involved in resource extraction and development, including hydroelectricity Crown corporations, should be included as part of a province’s resource revenues and not as business income.

Consistent with the Panel’s principles, Equalization should provide equity among provinces. However, it should not result in less wealthy provinces having a greater fiscal capacity than provinces that do not receive Equalization.

Consistent with the Panel’s principles, Equalization should provide equity among provinces. However, it should not result in less wealthy provinces having a greater fiscal capacity than provinces that do not receive Equalization.

The Panel’s recommendations for including 50 percent of resource revenues in the Equalization formula will benefit receiving provinces with resource revenues. However, in some scenarios, a receiving province like British Columbia, Newfoundland and Labrador, or Saskatchewan could end up with a higher fiscal capacity after Equalization than a non-receiving province like Ontario. That runs counter to a fundamental principle of equity that should underlie any changes to the Equalization program.

Consequently, the Panel recommends that a fiscal capacity cap be implemented. To determine a province’s post-Equalization fiscal capacity and whether or not it is entitled to Equalization, the Panel’s view is that 100 percent of a province’s resource revenues should be included in calculating a province’s fiscal capacity for the purposes of the cap. If a province’s resulting fiscal capacity is higher than that of the lowest non-receiving province, then its entitlement to Equalization would be capped. While some might suggest that less than 100 percent of resource revenues should be included in the cap for a variety of reasons, in the absence of reliable and comparable information, the Panel’s view is that including 100 percent of resource revenues in determining a province’s fiscal capacity for purposes of calculating the cap is appropriate.

The Panel understands that implementation of its recommended cap is complicated by the existence of separate Offshore Accords for Newfoundland and Labrador and Nova Scotia. In the case of Nova Scotia, its fiscal capacity continues to be lower than the lowest non-receiving province, so the cap does not apply. But in the case of Newfoundland and Labrador, the combination of resource developments in the province along with the Panel’s proposed revisions to the Equalization formula mean that Newfoundland and Labrador’s fiscal capacity (including own-source revenues, payments from Offshore Accords and Equalization) is expected to be higher than the lowest non-receiving province.

In the Panel’s view, this contradicts a fundamental principle. It is not within the Panel’s mandate to suggest that the Offshore Accords should be changed. However, we believe that the principle should be upheld. If Newfoundland and Labrador’s fiscal capacity after Equalization is higher than the lowest non-receiving province, the cap should apply regardless of the Offshore Accords and the province should not receive Equalization payments that put them above the cap. The Panel understands that, under their 2005 Accord, Newfoundland and Labrador is protected from losses in Equalization payments. It’s up to the federal government to determine how this should be resolved. In the Panel’s view, the principles of Equalization should not be compromised nor should the Equalization program be adjusted to accommodate the Offshore Accords.

Further details on how this fiscal capacity cap is calculated are contained in Annex 10.

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