Ottawa should make equalization more fair and shrink payments

The Alberta government is moving forward with a referendum, scheduled to take place in October, that will ask Albertans if the equalization program should be scrapped from the Constitution. Before answering that question, it’s important to understand the basics.

The purpose of equalization is to ensure Canadians across the country have access to “reasonably comparable levels of public services at reasonably comparable levels of taxation.” A province’s relative ability to raise own-source revenue is referred to as its “fiscal capacity.”

Simply put, the federal government transfers money to the governments of relatively low-income provinces that are less able to generate revenue than higher-income provinces. Provinces that raise a relatively high amount of revenue (due in part to higher personal income) do not receive equalization payments while provinces that only generate a relatively low amount of revenue do.

In recent years, however, the gap between “richer” provinces such as Alberta and “poorer” provinces has shrunk dramatically due in part to “fiscal capacity” declines in oil-intensive provinces including Alberta and Newfoundland and Labrador, which have seen revenues collapse in recent years.

Consider this. In 2007 Alberta’s per-person fiscal capacity was 88 per cent higher than Ontario, the largest province that generally mirrors the national average on many economic measures. By 2018/19, we estimate that gap had fallen to 23.7 per cent (and almost certainly continued to shrink during COVID). Similarly, the gap between Alberta and equalization-receiving provinces in the Maritimes, Quebec and Manitoba also collapsed.

This brings us to the problem. Since the gap between richer and poorer provinces has been shrinking, the basic logic of the program suggests equalization payments should fall. Indeed, the 2007 “O’Brien Report” recommended that the size of the equalization envelope, not just its distribution, should be determined by a formula that allowed payments to grow and shrink along with changes in relative fiscal capacity rather than being determined by a fixed envelope.

Instead, however, in 2009 the federal government changed the equalization rules by creating the “Fixed Growth Rate” rule which required the program to grow roughly in line with nominal economic growth, regardless of whether the gap between richer and poorer provinces shrinks or grows. As a result, no matter how much the gap between rich and poor shrinks, equalization continues to grow.

The cost of this peculiar rule has been substantial in recent years and is set to grow dramatically in years ahead. University of Calgary economist Trevor Tombe suggested that the fixed growth rate rule could add nearly $5 billion per year to the overall cost of equalization by 2025.

Albertans will likely vote on equalization in October. Whatever the referendum’s outcome, federal policymakers should make the program more fair and transparent to help achieve its objectives at the lowest possible cost. One straightforward way to help make equalization a more rational program would be to eliminate the Fixed Growth Rate rule and thus meaningfully reduce program costs in the future.