Putting Equalization back on track

Improving predictability and stability

In practice, there is little certainty around a receiving province’s entitlement for Equalization.

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

Through its consultations, the Panel heard two types of concerns about volatility in Equalization. The first concern is with predictability and the fact that continual adjustments to the data and the resulting “data shocks” months after the year’s payments have been made make it difficult if not impossible to predict what actual Equalization payments will be.

Under the current system, entitlements for Equalization in a given year are re-estimated a number of times over four years until final data are available for the year in question. In practice, this means that there is little certainty around a receiving province’s entitlement for Equalization. Seven different estimates are used, and then a final calculation is made. This can extend the process for up to 30 months after the initial entitlement is determined. Examples of prominent shocks that have taken place in the recent past include: unanticipated economic developments in certain provinces that have an impact on the overall Equalization pool, and revisions in key Statistics Canada data (e.g., changes in population estimates as a result of new Census figures).

The second concern is with stability in Equalization entitlements on a year-over-year basis. While the provinces suggest that the Equalization program should be responsive to changing economic circumstances, that objective needs to be balanced against the impact significant year-over-year changes in Equalization entitlements can have on individual provinces.

To address these concerns, the Panel recommends the following:

The Panel understands the importance of basing Equalization entitlements and payments on accurate and complete data. However, accuracy is being achieved at the cost of considerable uncertainty for provinces.

Provinces would know with certainty what their entitlement and payment would be for the year based on a single estimate of their fiscal capacity.

The combined effect of both these recommendations would be a significant simplification of the payment system and a vast improvement in the stability of Equalization entitlements. In effect, it means that provinces would know with certainty what their entitlement and payment would be for the year based on a single estimate of their fiscal capacity.

Using a three-year moving average will ensure that changes in data are accommodated on a continuing basis. The Panel recommends that data used in the three-year moving average be weighted on a 50–25–25 basis. This gives the highest weight to the most recent year and makes the formula more responsive to changes in provinces’ financial circumstances. The use of two-year lagged data will help improve the accuracy of the data used to determine Equalization entitlements.

In practice, this approach means that, for the year 2007–08 for example, payments would be made based on a moving average of data from 2005–06, 2004–05, and 2003–04, with weights of 50, 25, and 25 percent, respectively.

This approach, combined with the use of a 10-province standard, will also smooth out year-over-year changes in the Equalization program caused by economic changes in specific provinces. For receiving provinces, the use of moving averages means that, if a province experiences a sharp increase in its fiscal capacity, for example, a moving average would prevent the province from experiencing a similarly sharp decline in its entitlement for Equalization. The reverse would also be true; if a province experiences a sharp decline in fiscal capacity, it would take a couple of years before it would see a corresponding increase in Equalization funding.

Additional information on the Panel’s recommendations for improving
predictability and stability is included in Annex 8.

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