Key Issues for the Review of Equalization and Territorial Formula Financing

6. Issues for the Panel

Evolution of Adequacy

The New Framework means that, from now on, it is the funding growth of Equalization and TFF which will define the extent to which revenue and fiscal need disparities of provinces and territories are equalized. Prior to the New Framework, the revenue and fiscal need standards calculated under Equalization and TFF determined how much the federal government had to spend overall in order to compensate for disparities. The programs' ability to reduce fiscal disparities and support the provision of comparable public services at comparable rates of taxation will depend on how actual disparities grow relative to the overall funding tracks.

The federal government has set out a mid-term review point in 2009-10 to assess whether the growth tracks are still reflective of revenue and fiscal need disparity trends. The Panel is asked to advise on evidence-based indicators of fiscal disparity trends among provinces, as well as costs of public services in the North, to guide that mid-term review.

Multiple Equalization Standards

The temporary freezing of shares in the New Frameworkmeans multiple Equalization standards. This is not new in the program's history. While the broad intent of the program has historically been to raise eligible provinces to a single common standard of fiscal capacity, there have been occasional deviations from a uniform standard. Arguably, Equalization has never been fully comprehensive in scope, nor fully accurate in its measurements so that, effectively, some receiving provinces end up, after Equalization, with more or less revenue capacity than others (contrary to the general intent of the program). Occasionally, multiple standards emerge by design - for instance when a floor provision protects individual provinces against large declines in Equalization.

Some see the New Framework, coupled with the Offshore Agreements described above, as having effectively entrenched multiple standards into the Equalization program. One may ask whether these multiple standards are an expression of deliberate design by the government, or an accident of circumstances. It is timely, therefore, to reflect about whether multiple standards of Equalization are reasonable and sustainable over the long term.

Revenue Coverage

Equalization, throughout its history, has dealt with issues of revenue coverage: what range of revenues should be included to give a fair and complete measure of revenue capacity? The debate raised many concerns: federal affordability, fairness of treatment of all governments, sound incentives, etc.

There were many discussions over the 2000-2005 period with respect to the treatment of offshore resources in Nova Scotia, Newfoundland and Labrador. More recently, the Government of Canada and the NWT have been involved in negotiations concerning the devolution of land and resources to the territory and how this arrangement would affect TFF. This interest is not surprising, given that natural resources are an important source of fiscal disparities among provinces and territories.

Whether to include natural resource revenues in whole or in part in these programs boils down to two issues about the extent to which:

• Revenues from natural resources are inherently different from other revenues such as income taxes or sales taxes;
• Equalization or TFF grants may create particular disincentives for governments to develop and exploit natural resources.

Any decision to exclude (totally or partially) a revenue source from Equalization or TFF raises issues concerning the "reasonably comparable" treatment of all provincial-territorial governments. Equalization or TFF then would arguably understate the revenue capacity of governments well endowed in that revenue source, causing them to be treated more favourably than other grant-receiving governments. Imagine two receiving provinces with identical total revenue-raising capacity, one with natural resources, the other without. Excluding a portion of natural resource revenues from calculations would yield a higher grant to the resource-rich government, despite identical overall revenue-raising capacity.

At the same time, Equalization or TFF reductions can effectively leave a government with no net financial benefit from exploiting its natural resources. This is the so-called "tax-back" or "claw-back" problem, where an additional dollar of royalty revenue is offset by an equal (or even larger) reduction in Equalization or TFF payments. The "claw-back" issue is not unique to natural resource revenues, but is often more visible with these because of how the formulas measure natural resource revenue capacity. Moreover, resource-rich jurisdictions argue that Equalization and TFF fail to take into account the very substantial up-front infrastructure investments required in order for natural resources to be exploited, thus overstating their true revenue capacity.

There is also much debate about whether user fees charged by provinces should be equalized. One view is that the sale of goods and services by governments should not be equalized except when they give rise to a net profit: user fees do not represent fiscal capacity for a government (except the portion of profits over and above costs, for example in liquor sales). Moreover, they are different from compulsory taxation, since they can often be avoided by not purchasing the services in question. Another view is that they should be included not only because they do generate substantial "profit" for governments, but also because they pay for essential public services provided by local governments (e.g. garbage collection, water).

Similarly, some view property taxes as not so much a tax, as a form of user fee and property values as simply a way to allocate these user fees among residents of a municipality.

None of these issues is new. For instance, the Equalization program, throughout its history, has used many different approaches to equalizing provincial natural resource revenues. After first excluding all natural resource revenues, Equalization then included 50% of these in 1962 and 100% in 1967. Subsequently, the OPEC oil price shocks led to a reduction of coverage of oil and gas revenues. In 1982, the program returned to comprehensive coverage of all natural resource revenues, but excluded Alberta and its very large energy revenues from the standard to which provinces were to be raised. More recently, in the mid-90s, it was decided to include, for Equalization purposes, only 70% of provincial revenue from offshore oil and gas, and certain other regionally concentrated natural resources (potash and asbestos). At the same time, Equalization continued to take into account all onshore oil and gas revenues.

TFF has grappled with similar issues, as when territories argued that the Formula should provide them with an economic development incentive (EDI) by excluding a portion of their revenues from the TFF formula. Since 1995, 20% of eligible revenues are excluded from the formula. And the territories have also argued that increased natural resource revenues should not be fully offset by reductions in TFF grants.

Expenditure Need

TFF grants take into account the different expenditure needs of each territory. but do so in a very approximate way (see page 5 and Annex B). The TFF relies on a "snapshot" of territorial spending in 1982, which has been escalated by population growth and the growth of provincial-local spending since then. It is not obvious that the result is an accurate depiction of today's needs. Arguably, the measure used - a snapshot of relative needs as they stood 22 years ago - fails to track any changes that might have occurred since 1982 in relative needs, whether among territories, or between territories and the rest of Canada. The Panel is being asked to examine whether this approach should be updated, improved or even replaced.

Equalization, on the other hand, assumes that all provinces should have no less than the per capita fiscal capacity available to the five "middle-rich" provinces. In effect, Equalization assumes that the size of a province's total population is an adequate indicator of its expenditure need. Some have argued that Equalization ought to measure expenditure needs among provinces. For instance, Equalization could measure differences in proportions of elderly, aboriginal Canadians, the percentage of school-age population or the proportion of rural residents, on the grounds that these populations are more expensive to serve. Measuring expenditure need is done in the Australian system of Equalization. The approach used in Australia would require sector-by-sector investigations of the program requirements of each province (health, education, social services, transportation, justice, etc) as well as the costs of providing those services.

Key issues are whether comprehensive measurements of expenditure need would materially change the measurement of fiscal disparities, and whether they might distort provincial spending decisions and make the Equalization program far more complex.

Measuring Revenue Capacity

a) Under the RTS system

The Representative Tax System (RTS) approach to measuring revenue capacity has been in place, in one form or another, since the creation of Equalization in 1957. It has been improved and updated continually and most observers would agree that it measures well the fiscal capacity arising from some of the largest provincial revenue sources: income, corporate, sales, capital and payroll taxes, which account for about 60% of revenues eligible for Equalization. However, measuring fiscal capacity from some other revenues has proven more challenging. The basic issue is whether the RTS, which is designed to capture what provinces actually tax may not in some cases miss out on what is the essential underlying source of fiscal capacity.

Natural resources (both renewable and non-renewable) are a case in point. They generate incomes well in excess of production costs and normal profit margins -- what economists call ‘‘economic rents". The difficulty in measuring fiscal capacity from, say, a barrel of oil, is that some oil deposits are costlier to exploit, and generate lower rents than others. This is reflected in provinces' practice of taxing oil at different rates, depending on its quality and costs of extraction. For instance, a barrel of light oil is taxed higher than a barrel of tertiary recovery oil. The RTS recognizes that different barrels of oil may give rise to quite different fiscal capacities. It acknowledges that a tax that appears to be levied on oil production volumes is in fact trying to get at the essential underlying source of fiscal capacity: economic rent.

There have been particular difficulties about measuring correctly the rents from Saskatchewan oil and gas on Crown leases. The search for accuracy in measuring natural resource rents has led to ever-finer distinctions between types of oil: light oil, heavy oil, tertiary recovery oil, offshore oil, tar sands oil, etc. Today, 14 out of the 33 revenue sources measured by Equalization refer to different types of oil and other natural resources. The more categories are created, the greater the complexity and the risks of perverse incentive effects.

There have been extensive debates about the nature of the property tax (is it an income tax, a wealth tax, a user charge or a consumption tax?) and how to measure the revenue capacity generated by property wealth. Some have argued that revenue capacity from the property tax should be measured as if it were an income tax, others that it should be derived from market values or property (akin to a wealth tax). Even those who agree it is in the nature of a tax rather than a user fee have different views about the appropriate basis for measuring the fiscal capacity from the property tax.

These different approaches yield very different allocations of property tax revenue capacity among provinces. In 2004, a new approach to measuring property tax capacity, a simpler version of the so-called "stratified market value approach", was introduced. It has been set aside under the New Framework. The fact that property taxes are the second largest revenue source under Equalization (accounting for some $40 billion of provincial revenue) makes it important to find a solution that ensures "reasonably comparable" treatment of all jurisdictions.

For territories, own-source revenue capacity is still measured today on the basis of a 1992-93 "snapshot" of territorial tax systems. This measure is then reduced to an equivalent of 85% of the provincial tax effort at the time, and then escalated to reflect provincial- local changes in tax levels since 1992-93. Finally, since 1995, 20% of own-source revenues are excluded from the formula. There are many reasons to doubt the accuracy of the picture it yields today, and the complexity of these calculations has become an issue.

b) Under Aggregated or "macro" Measures

The steadily increasing complexity of Equalization (and TFF) is one reason that has led academic and government experts to ask whether one might replace the current disaggregated approach to measuring revenue disparities (e.g. the 33 revenue sources tracked by Equalization) with a "macro" approach, relying on one or two macro-economic indicators (for instance, Provincial Gross Domestic Product, or other income measures). If a "macro" approach proved in practice to be much simpler than current approaches, it would have many advantages: it might avoid the perverse incentive effects of excessive "claw-backs" of natural resources, thus reducing pressures to exclude these from Equalization. It might render unnecessary difficult debates about the appropriate way of measuring fiscal capacity from property taxes. It could also improve transparency and accountability. Similar questions could be asked about TFF.

On the other hand, aggregated approaches pose many questions: would they still measure revenue-raising capacity, or something else? A dollar of oil and gas revenue and a dollar of service sales give rise to widely different revenue raising capacities: would the national income expenditure accounts be able to make such distinctions? Would this aggregated approach lead to inevitable pressures to ever disaggregate the income categories, thus returning us to the same level of complexity we are trying to get away from?

The Panel would be interested to hear views on whether it might be possible to use mixed approaches, combining RTS measures with a small number of aggregated measures (e.g. a rent-based measure for natural resources, a GDP-based macro formula for other miscellaneous revenues), and the criteria for deciding to replace RTS measures with more aggregated ones.

Stability-Predictability

Throughout Equalization's history, the federal government had to address concerns about stability and predictability of payments. It introduced floor provisions to prevent excessive drops in payments to individual provinces - these generally benefited provinces whose revenues are more volatile (e.g. resource-rich ones). It also introduced, at times, global ceilings to protect the federal government against undue increases in the costs of the program. Finally, it has provisions to defer recoveries of over-payments, which exceed defined thresholds.

Recent years featured many instances of instability and unpredictability in Equalization payments: several significant data revisions by Statistics Canada and Revenue Canada required that the government effect very substantial changes to payments already made to, or expected by, provinces. Provincial governments argue that large recoveries of federal payments caused major challenges for their fiscal planning.

The new ten-year funding track removes one major cause of instability and unpredictability by setting out long-term funding levels for Equalization and TFF. Yet, what ultimately matters to provincial and territorial treasurers is not the Canada-wide totals, but the amounts they individually get. These amounts may still fluctuate from year to year, depending on the new allocation formula for 2006-07 onward and how payments may be smoothed over time. In 2004, Parliament enacted a smoothing provision for Equalization payments (a three-year moving average), which was suspended under the New Framework.

Against this backdrop, the Panel is asked to advise on whether and how to make Equalization-TFF payments more stable and predictable. And it should take into account the fact that, under fixed funding tracks, stabilizing payments to individual governments will affect other recipients of Equalization or TFF (as will the entry or exit of eligible governments from the Equalization program).

Transparency and Accountability

Equalization and TFF alone account for some $13 billion (and growing) of annual federal program spending. Canadians are entitled to understand the principles underlying these important national programs, so that they can hold the government accountable for their management and performance.

However, the ever-increasing complexity of the two programs, the recent series of one-off adjustments in response to anomalies or data revisions, along with the recent Offshore Agreements have raised questions about whether Equalization and TFF reflect the transparent application of sound principles valid across the country. In turn, there is interest in how to increase transparency, so that Canadians can better understand why and how decisions are being made.

The Panel is to provide advice on whether Canada should create a permanent, independent body to provide ongoing advice to the government on the allocation of Equalization and TFF funds and to conduct periodic reviews of provincial disparities and the costs of providing services in the North.
In considering this issue, it should look at how an independent agency (or other mechanisms) could make a useful contribution as one or more of the following:

• a mechanism for arriving at recommendations on allocation (and on the principles to guide the determination of future funding levels) that could serve as the basis for subsequent discussion among concerned governments and decisions by the Government of Canada;
• a vehicle for public reporting and accountability for decisions taken;
• a vehicle for research and/or policy development on Equalization and TFF.

Last Updated: 2012-02-04		Important Notices