Should equalization really grow forever?

The relative economic strength of Canada’s provinces has shifted in recent years, as former powerhouses have struggled while former laggards have improved. Canada’s equalization program, in present form, is not equipped to respond fairly to these developments.

Consider this fact—in the past two fiscal years, Quebec has collected more revenue from natural resources than Alberta. This reality, which may be stunning to some, is symbolic of a broader trend where provinces that receive equalization payments have generally seen their ability to generate revenue improve more than provinces that do not receive payments.

Indeed, we’ve seen dramatically divergent trajectories in “fiscal capacity” between have and have-not provinces. Fiscal capacity refers to each province’s ability to raise revenue through provincial taxes. It’s linked to overall economic performance and is the metric used to determine who gets equalization payments and how much.

Over the past two years, the fiscal capacity (including all natural resource revenues) of the four provinces that do not receive equalization (British Columbia, Alberta, Saskatchewan, and Newfoundland and Labrador) has collectively shrunk by 3.5 per cent. By comparison, the six “have-not” provinces have seen their fiscal capacity rise collectively by 8.1 per cent.

In short, the gap between richer and poorer provinces has been shrinking.

One might think that if this trend continues, equalization payments would also start to shrink. But they won’t, due to a relatively new policy that requires equalization payments to grow in line with national GDP—even if the gap between richer and poorer provinces continues to become smaller.

How did this counter-intuitive policy come to exist? The rule pegging the growth rate of the overall equalization envelope to GDP growth was introduced 2009 in an effort to slow the growth in equalization program costs, which were in danger of skyrocketing due to high energy resource prices and Ontario’s transition to a have-not province.

Given the speed at which equalization costs were rising and the state of federal finances at the time (there was a large deficit in 2009), there were good reasons for Ottawa to constrain program costs by putting a “ceiling” on the rate of equalization’s growth.

However, the mechanism used to create this ceiling—pegging the rate of equalization growth to national GDP growth—is now on the cusp of creating a perverse outcome. As the rule is currently interpreted by the federal government, it can actually force equalization payments to become larger than they would be in its absence if the gap between richer and poorer provinces shrinks sufficiently. In fact, we project this development will occur as soon as next fiscal year.

In short, a rule designed to constrain costs will soon act as a cost driver.

This raises important questions about fairness. Taxpayers in provinces struggling economically, but with fiscal capacity still too high to receive equalization payments, will be disadvantaged by a rule that artificially drives up equalization payments beyond what they would be in its absence.

Importantly, there’s historical precedent for allowing equalization payments to shrink when fiscal capacity gaps narrow (this happened in the early 2000s). The rule requiring equalization to grow every year is of recent vintage.

Unfortunately, equalization remains a touchstone of regional tension. A rule requiring payments to grow—even if provinces such as Alberta and Saskatchewan, that contribute and receive no payments, continue to struggle—can only exacerbate regional friction.

The Trudeau government can avoid this outcome by reforming the rule that requires payments to grow even if the economic gap between rich and poor provinces shrinks.