Ottawa can promote national unity with two key reforms
One of the most important responsibilities of any prime minister is to promote harmony between the provinces and minimize friction between regions. Indeed, improving these relations would be a worthy New Year’s resolution for Justin Trudeau.
At the top of the list, the Trudeau government could reform Canada’s system of fiscal federalism including the equalization program, which sends money to lower-income provinces to help them pay for public services. At the same time, Ottawa could make the federal stabilization program, which essentially provides insurance to help protect provinces from large negative revenue shocks, more rational and fair.
Let’s start with equalization. To improve the program, the Trudeau’s government could change the equalization formula so it more accurately accounts for changes in the relative economic strength of the provinces in recent years. The problem is that over the past several years, even as higher-income provinces such as Alberta have struggled and the economic gap between provinces has shrunk, equalization payments have continued to increase year after year.
This is due to a counterintuitive quirk within the equalization formula, which requires the overall equalization envelope to grow every year whether or not the gap between richer and poorer provinces grows or shrinks. Ottawa could change this rule so the equalization envelope shrinks if that gap shrinks, as the program’s internal logic clearly suggests it should.
Now let’s turn to the Fiscal Stabilization Program, meant as an insurance-type program that kicks in when a province suffers a substantial year-over-year revenue loss. The problem here is a design flaw that puts a completely arbitrary limit on payments. These limits produced an ad hoc response in 2020 from the federal government, which “indexed” the payment cap to adjust for changes in the size of the Canadian economy since the cap was first introduced way back in 1987.
This change immediately increased the scale of payments but didn’t change the fundamentally arbitrary nature of the cap. As a result, even the province that benefitted the most from the change (Alberta) was unhappy with the change. Premier Jason Kenney called it a “slap in the face” to Alberta.
This episode demonstrates the need for program reform based on clearly articulated policy principles and objectives to replace the current system of an arbitrary cap and ad hoc on-the-fly adjustments. Getting the stabilization program right isn’t easy. It’s hard to get payments big enough to help provinces when they face a large fiscal shock without creating incentives for provinces with volatile revenue sources to spend freely during boom periods when they know they’ll receive stabilization payments to offset losses during busts. There are, however, numerous options for reform to try to address these programs based on clearly defined principles and goals. Simply picking a cap out of thin air and making adjustments on the fly during recessions, which is the current status quo, is not the right way to make policy.
Maintaining harmony in Confederation is never easy. Improving relations between the provinces and the federal government—and among provinces—is a worthy New Year’s resolution. The Trudeau government could do this by reforming Canada’s equalization and stabilization programs.
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