Equalization 101

Equalization: Then and Now

For the purposes of this report, it’s important to look at how the Equalization program worked before and after major changes were made in 2004.

Before 2004, Equalization payments were driven by a complex but consistent formula. The formula determined both the overall amount the Equalization program would pay out to receiving provinces and the amount each province would receive.

Figure 1 – How Equalization has Worked
Per Capita Fiscal Capacity and Equalization Entitlements for 2003–04

Source: Finance Canada

The formula measured the per capita fiscal capacity of provinces using the Representative Tax System (RTS). The RTS measures the amount of money provinces could raise from 33 different tax bases if they taxed those bases at national average tax rates. A province’s fiscal capacity on each of the 33 bases was then summed up and compared to a five-province average standard. If the formula determined that a province’s overall fiscal capacity across all of the tax bases combined was below the standard, that province received an Equalization grant to bring it up to the common standard.

With the formula still in place, Equalization payments had started to decline from their highest peak of $10.9 billion in 2000–01 to an expected level of $8.9 billion in 2004–05. This was due to the combined impact of a slow-down in Ontario’s economy and tax reductions in several provinces.

At the same time, the financial position of the federal government had improved dramatically and resulted not only in balanced budgets but also unanticipated surpluses. A number of federal transfer programs had been reduced by a substantial amount in the mid 1990s and provincial pressures were mounting to increase Equalization as well as other transfers, particularly in the case of health care.

The New Framework, introduced in October 2004, fundamentally changed how Equalization works.

In response, a New Framework for both Equalization and TFF was announced at a First Ministers’ Meeting in October 2004. Under the New Framework:

• The formula is no longer used to determine the overall amount of funding to be allocated for Equalization and TFF. Instead, a fixed pool of funds was set in legislation.
• The pool of funds to be available for Equalization was set at a minimum of $10 billion for 2004–05, effectively stopping the decline in Equalization payments.
• Each province was guaranteed that its Equalization entitlements would not be lower than the amount announced for 2004–05 and included in the 2004 federal budget.
• A guaranteed growth rate of 3.5 percent per year was set in legislation, ensuring that the overall pool of funds available for Equalization would continue to increase over 10 years.
• Fixed shares for receiving provinces were set out in advance for the first two years of the New Framework, replacing the normal operation of the Equalization formula with a negotiated allocation.
• The allocation in the New Framework was legislated on an interim basis pending the outcomes of the Panel’s work and the development of a new allocation method.
• On November 8, 2005, the federal government announced that the same approach would be extended to determine Equalization entitlements
  for 2006–07.

There are some important implications of this New Framework.

The interim allocation does not have a common standard to which all provinces are compared and raised. Instead, the standard varies for individual provinces depending on their former shares (over the last three years) of total Equalization funding, regardless of changes in their relative fiscal capacity. As a result, some receiving provinces receive more and others less than they would have if the previous Equalization formula had been applied.

• As Figure 2 shows, in 2005–06, with the exception of Québec, the
  per capita fiscal capacities of the receiving provinces were higher under the New Framework than they would have been under the former
  five-province standard.

Figure 2 – Fiscal Capacity and Equalization under the New Framework (2005–06)

Source: Finance Canada

• The New Framework results in Newfoundland and Labrador having a higher fiscal capacity after Equalization than Ontario (even without the Offshore Accords being taken into account).
• Because the total Equalization pool is fixed in advance, changes in one province’s fiscal capacity, up or down, will have a direct impact on the amounts other provinces receive.
• The New Framework guarantees a known and growing amount of funds for Equalization. In this way, it improves stability and predictability,
  particularly for the federal government. On the other hand, the shares each province receives under the New Framework are not necessarily any more stable or predictable than they were in the past.

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