Practical solutions for equalization’s real problems

In our last blog post we identified several problems with Canada’s equalization program, including negative incentives for pro-economic growth policy, particularly surrounding taxation and natural resource development in “have-not” provinces. The ad hoc rule that payments must rise every year even if the economic gap between rich and poorer provinces is shrinking is another serious problem.

We now turn to discuss possible solutions to these problems, which happily exist.

For instance, in an essay published in the 2007 series Beyond Equalization: Examining Fiscal Transfers in a Broader Context,  Fred McMahon and Jason Clemens proposed the current system could be reformed by determining each province’s equalization entitlement using macroeconomic measures of overall economic performance rather than using an approach based on estimates of tax revenues from various sources if rates were set at the national average. In essence, this means that variables such as Gross Domestic Product (GDP) per capita or personal income per capita would be used to estimate a province’s fiscal capacity rather than tax variables. Similar reforms have also been proposed by economists Trevor Tombe and Dan Usher.

This reform would not produce transformational changes in the scale of provincial entitlements, but using a macro approach provides simplicity and eliminates arguments over which taxes should be included in the equalization formula and which ones shouldn’t. Provincial governments have limited direct control over macro variables, which makes it exceedingly difficult to “game” the system in an effort to maximize transfers. The mechanism also improves transparency of the program and is easy to communicate, which would allow citizens the opportunity to better understand how the program operates. Confusing situations such as have prevailed in some recent years where per-capita incomes were higher in Ontario than in British Columbia, but Ontario received (very small per-capita) payments while B.C. did not due to quirks in the formula could thus be avoided.

Other potential solutions involve replacing the fixed growth rate rule with a pure ceiling on equalization payments that fixes the maximum amount of equalization payments at a set share of GDP (to achieve the federal government’s goal of cost stability and fiscal sustainability), while allowing the aggregate payment envelope to shrink as the gap between richer and poorer provinces gets smaller, which has been happening in recent years. By eliminating “overpayments" that stem from the ad hoc rule, the flexible ceiling could also effectively diminish regional tensions surrounding payment increases when non-recipient provincial economies falter.

More broadly, steps could be taken to try to take regional politics out of the decision-making process to the extent possible. Creating an independent arms-length agency like Australia did to administer the new system would help depoliticize the equalization program by removing executive discretion. Daniel Béland and André Lecours note that Australia uses an expert independent commission to both recommend the level of equalization payments and prevent the exacerbation of regional conflicts and alienation.

A similar approach in Canada may promote an equalization environment that is transparently designed to advance rational policy objectives without ad hoc decision-making that can sometimes benefit one region more than others.  Thus, such a process could help calm down regional tensions. McMahon and Clemens note that such a panel could also be employed to consider other changes to the formula, including design specifics surrounding their proposal to use macroeconomic variables to set entitlement levels rather than tax variables.  

We have not sought to provide a comprehensive catalog of possible reforms to equalization. Indeed, we have left some especially thorny issues (such as the treatment of natural resource revenues) untouched. Instead, our goal here has been to illustrate that if we move beyond angry hand-waving and regional acrimony there are responsible policy options that can help make the program work better for Canadians. 

Ultimately, no set of reforms will solve all of the problems related to the equalization program. A 2013 essay series examined federal transfer programs in Canada, Australia, Switzerland and Germany—all of which have formal mechanisms designed to equalize revenues among sub-national jurisdictions. The report concluded that all four “experience incentive problems with respect to their fiscal transfer programs.” These case studies suggest that some level of incentive problems is inherent to the very project of equalization-type programs or, at the very least, that no perfect solution to such problems has yet been found.

That said, there are clear examples from our past that show how evidenced-based discussion of program reforms can lead to improvements. For example, several of the reforms proposed by McMahon and Clemens in the “Beyond Equalization” series have in fact since been implemented. These include relying on a ten-province standard to set entitlements, relying on a multi-year fiscal capacity average to enhance predictability, and capping aggregate payment growth to protect the sustainability of federal finances.  

The equalization program has many problems and can never be made perfect. History shows us, however, that it can be improved. To achieve this objective it’s important to identify actual problems and practical policy solutions rather than simply pointing fingers and making vague calls for program renovation without specifics.