Fiscal Federalism and Equalization Policy in Canada
Daniel Béland , André Lecours , Gregory P. Marchildon , Haizhen Mou and M. Rose Olfert
University of Toronto Press, 2017, pp. 114
Reviewed by F.L. Ted Morton
I’ve been saying and writing negative things about the Federal Equalization Program for over three decades. And for three decades, various economists have criticized my criticisms and asserted that I failed to understand the economic benefits of equalization. So, this Christmas, as I navigated my way through several weeks in Florida with the in-laws, I decided to remedy my economic ignorance and read the most recent book on this subject – Fiscal Federalism and Equalization Policy in Canada. Authored by a team of two economists and two political scientists, surely this book would cure me of my ignorance-based criticisms of equalization.
Well, it didn’t work. Indeed, it had the opposite effect. This book confirmed my worst suspicions about the Equalization Program. Politics, not economics, have driven the development of Equalization from the start. More specifically, federal political parties – mainly the Liberals – have habitually used Equalization to secure their electoral base in Quebec and/or to mute the siren call of the Separatists with this offer: why leave Canada and give up the generous transfers from the ROC? Of course, what begins as bribery, over time, becomes a form of blackmail, as the recipients learn how to play the game. But I digress.
Evolution of Equalization
The authors provide a short but insightful history of the evolution of Equalization policy. What strikes the reader is that at each stage it is politics – and usually Quebec politics – not economics, that drove changes.
The authors emphasize that the adoption of the Equalization program in 1957 should be understood as a logical replacement to the “tax rental agreements” between Ottawa and the provinces that had been adopted during the Second World War. But they are equally clear that the immediate catalyst was the “staunch defense of provincial autonomy” by then-Quebec Premier Maurice Duplessis.
“The creation in 1957 of the Federal equalization program can be understood in part as an attempt to break the recent fiscal and institutional isolation of Quebec within the Canadian federal system.”
In 1962 there were two important changes to the formula for calculating fiscal capacity. The original formula included just three types of provincial tax revenues – income taxes, corporate taxes and succession duties. During the 1960s, the number of “revenue sources” was expanded to 16 and now included 50 percent of non-renewable resource revenues (NRRR) such as oil and gas royalties. Since NRRR are not taxes that can be collected year after year – like almost all the other “revenue sources” – you would expect an explanation as to why they were added. There is none.
The second change was to move to a 10-province formula rather than the original 2-province formula (Ontario and British Columbia). The net effect of these changes was to increase the size of the Equalization pool to be divided amongst the “have-not” provinces by almost 50 percent. But for Alberta, BC and Saskatchewan over the next 40 years, this change proved to be a double negative. It pushed Alberta and BC, and later Saskatchewan, out of the “have-not”, receiving group of provinces, and simultaneously increased the size of the Equalization pool paid out to the remaining recipient provinces.
The “energy resource problem” (the authors’ term) became more acute during the 1970s. Soaring oil prices following the 1973 Arab-Israel war, the OPEC embargo, and then the 1979 Iranian Revolution rapidly transformed Alberta into the richest province in Canada on a per capita basis. Initially, the Trudeau Liberals seized this opportunity to expand the quantity of Equalization transfers by “introducing a seemingly arbitrary distinction in the equalization formula between ‘basic revenues’ and ‘additional revenues’ (from oil and gas).”
But by the end of the decade, with energy prices decreasing and federal deficits ballooning, Ottawa was now keen to control the costs of Equalization by making the “pie” smaller. They achieved this in 1982, by adopting what is now known as the 5-province standard, which excluded the richest (Alberta) and the four poorest provinces (PEI, NFLD, NS, NB).
The most interesting thing about the authors’ coverage of this period is the two events that they don’t discuss: the 1976 election of a Separatist government in Quebec and Trudeau’s 1980 National Energy Program (NEP). The latter merits only two references, neither more than a few sentences long. Considering that the NEP was arguably the single greatest interprovincial revenue transfer program in the history of Canada, this omission strikes an Alberta reader as more than a little strange. One of the widely recognized policy objectives of the NEP was to capture a larger share of energy revenues for the Federal government, and use these funds to expand the scope and reach of Federal social programs. Less publicized but still recognized was its political objective: to expand the scope and reach of the Liberal Party’s support in Central and Eastern Canada.
Nor is there any discussion of the human and financial exodus from Quebec that resulted from the election of Rene Levesque’s separatist government in 1976. The PQ’s anti-English language policies (Bill 101) are estimated to have pushed out 99,000 Anglophones by the end of the decade, as well as 263 head offices. In just over a decade, Montreal went from being the “business capital” of Canada to a financial wasteland. For these self-inflicted economic wounds, Quebec was rewarded with increased Equalization payments, which soared from $240 million/year in 1970 to over $3 billion by the early 1980s. These may have helped defeat the Separatists in the 1980 Quebec secession referendum, but the price was high.
What is the connection to the NEP? In theory, the NEP’s capture of what had been provincial revenues was supposed to help the Trudeau government pay for the expansion of equalization payments. In practice, this never happened. In response to the confiscatory policies of the NEP, foreign energy investment stampeded out of Western Canada, and then the price of oil collapsed. The result was one of Pierre Trudeau’s most lasting legacies: a doubling of Canadians’ per capita federal debt.
Equalization politics heated up again in the early 2000s. After the Federal Liberal government of Jean Chretien began to post consecutive budget surpluses, equalization cheques began to shrink, especially for Quebec. Quebec’s preferred solution was simple: grow the “pie” so we will get a larger “slice.” This was to be done by increasing the size of the equalization pool by dropping the 5-province formula and bringing Alberta – and its surging oil and gas revenues – back into the formula. The new Liberal Prime Minister who took over in 2003, Paul Martin, was particularly vulnerable to this pressure, because the Liberals were suffering escalating political damage as details of the Quebec “sponsorship scandal” became public. Martin initially responded with a quick side-deal for Newfoundland (the exclusion of NRRR from its fiscal capacity), but that did nothing for Quebec, which also wanted more Federal dollars for its healthcare system. As the authors note, “It became clear that Quebec would not accept a health care deal without an increase in equalization payments.”
Staggering out of the 2004 election with a just a minority government, Martin soon announced a major change to Equalization: a “fixed pool of at least $10 billion dollars”, meaning that total equalization payments would not be reduced regardless of what the formula might indicate. Despite two more side deals with Newfoundland and Nova Scotia (again excluding NRRR from their fiscal capacity), Martin and Liberals still lost the 2006 Federal election, and their Quebec Caucus dropped from 21 to 13 MPs.
In February, 2006 the newly elected Harper Conservatives faced the same Equalization demands that had helped to sink the Liberals. Anticipating that his minority government would not last for long, Harper adopted most of the reforms recommended by a task force created by Martin prior to the election. These included abandoning the 5-province formula and returning to the ten-province average and 50 percent of NRRR. These changes were not welcomed by resource-rich provinces, but once again electoral prospects in Quebec carried the day:
“From a political standpoint, implementing the recommendations meant more money for Quebec, a province the Conservatives were courting at the time in an effort to secure a majority government as the next federal election.”
The details of the Harper reforms – and the fact that they would boost equalization payments to Quebec – were announced only a week before Quebec’s 2007 provincial election.
“This [timing] move was widely perceived as a way to help a federalist party (the Quebec Liberal Party) in its struggle with the PQ and to boost support for the Conservative Party in anticipation of the next federal election.”
And it worked. Jean Charest led the Liberals to a majority government and picked up 16 additional seats. In the 2008 Federal election, Harper held on to his 10 MPs from Quebec and formed a second minority government.
But the Harper equalization reforms barely survived the end of the decade. The 2008 Recession plunged Federal government budgets into deficits and turned Ontario into a have-not province for the first time ever. This threatened to send the costs of the Equalization program sky-rocketing at the very time the Harper government could least afford it.
Buoyed by his first majority Conservative government following the 2011 election, Harper moved unilaterally to minimize increases in Equalization payments by imposing a new cap on transfers to have-not provinces and limiting the annual growth of the Equalization pool to growth in gross domestic product (GDP). Most resource-rich provinces opposed the changes – Newfoundland paid for full-page ads in the Globe and Mail denouncing Harper for breaking his promises; Saskatchewan premier Lorne Calvert threatened to sue Ottawa. But Quebec was quiet. Thanks to the Harper reforms, a province with less than a quarter of the Canadian population was now (for the first time) receiving over half of all Equalization payments – a fact curiously not mentioned by the authors.
How are we to understand this seemingly ad hoc evolution of 50-years of Equalization policy? One of the keys, the authors tell us, is what they call “executive discretion”. While in theory Equalization is the policy responsibility of the Department of Finance, the practice is quite different:
“[E]xecutive discretion has remained the defining principle for governing equalization in Canada. As a result, equalization is never far away from partisan politics. Federal parties can therefore make competing promises about the program before or after they form the government. These promises are typically informed by political and electoral considerations, and they elicit similar thinking on the part of provincial politicians who see something to gain by engaging their federal counterparts on equalization.”
Translation: The uninterrupted expansion of equalization payments has been driven in part by political bribery and in part by political blackmail, pausing only occasionally when Ottawa finds itself short of funds.
Renewable and Non-Renewable Resource Revenues
One of the mysteries of Equalization for me has been why oil and gas revenues were added to the formula for calculating provincial fiscal capacity, but hydro-electricity revenues never were. The sale of a barrel of oil is a one-off event, never to be repeated. The sale of a megawatt of hydro is repeated hour after hour, day after day, year after year, as long as the rivers keep flowing and the turbines keep turning. This makes hydro closely analogous to provincial tax bases in a way that oil and gas royalties clearly are not.
The authors acknowledge this anomaly:
“These provinces have argued that revenues from ojl and gas are fundamentally different from all other revenues because oil and gas are non-renewable, that is, not part of an endless revenue stream.”
They also note that including oil and gas royalties expands the size of the Equalization pie – and thus the size of each “have not” province’s “slice” – a trend generally opposed by the “have” provinces.
Unfortunately, their analysis stops here. The authors provide no normative justification or explanation as to why oil and gas royalties should or should not be included. The historical review presents it as simply about the size of the “pie” and each have-not province’s “slice” of the pie. NRRR were added (1962), deleted (1982), and finally halved (2007) to produce a political result that the Prime Minister of the day thought his party needed to win the next election and/or manage a budgetary surplus or shortfall.
The authors are more forthcoming about the treatment of hydro revenues:
“Adding to the frustration of oil- and gas-producing provinces in relation to equalization is that many of the monetary benefits hydroelectricity in Quebec and Manitoba generates for the provinces’ own residents are not factored into the equalization system.”
It gets worse. The authors note that it “is widely reported [that] Quebec artificially lowers it formal fiscal capacity ‘by allowing provincially-owned Hydro-Quebec to charge consumers, especially large industrial ones, a price far below the market value’.”
Surely, I anticipated, the authors would at least propose some possible solutions to such an unfair double-standard. But no. With a quick reference to the “symbolic value” of Quebec Hydro to Quebec’s “Quiet Revolution”, the discussion quickly ends with a warning that, “addressing the issue of hydro revenues in the equalization formula would almost certainly mean a confrontation with Quebec.” God forbid!
The issue surfaces again 40 pages later, with the simple observation that:
“The distinction between revenues from renewable (hydro) and non-renewable (oil) natural resources will likely be open to debate from time to time.”
But the authors are clear that this debate is political not theoretical.
“Although economic efficiency arguments may underlie the design of the equalization payments program and the empirical investigation of its effects and effectiveness, expediency is likely to continue to be the driver of the program.” (Emphasis added)
Other Federal Transfer Programs
Equalization is only one of three Federal transfer programs to the provinces. In terms of dollars $17 billion annually – it is smaller than the Canada Health Transfer (CHT) – $34 billion – but larger than the Canada Social Transfer (CST) – $13 billion. (All figures for 2015-16) Interestingly, these three transfer programs, when combined, are “the single largest expenditure program by the government of Canada” at $64 billion.
In their earlier forms, both the CST and the CHT had some element of redistribution from wealthier to poorer provinces. But the Harper government eliminated these by reforming both programs to per capita funding formulas in 2007 and 2014, respectively. The authors note that the new per capita funding “left less well-off provinces with fewer fiscal resources”, but resulted in a “windfall” for Alberta – a term curiously not used anywhere else in the book, despite many “windfalls” for other provinces following changes in the Equalization formula. (104)
However, both the CHT and CST still have a de facto redistributionist effect, because the funds used to pay for these programs come from “uniform federal tax efforts”, meaning that provinces with more high-income individuals and corporations – such as Alberta, BC, and Saskatchewan – “are contributing more than they receive”. While the authors acknowledge that “even equal per capita transfers (such as the CHT and CST) are still redistributing revenue across provinces”, they do not provide any dollar amounts.
The same is true of the Federal payment programs to individuals – Old Age Security (OAS) $46 billion/year; and Employment Insurance (EI) – $18 billion/year. These programs are different from the three other transfer programs, since their payments go to individuals not to provincial governments. But the redistributionist effect is still present. For OAS, more Federal tax dollars are sent to provinces that have a disproportionately greater number of elderly, people (Quebec and all of Atlantic Canada) than to provinces with younger populations.
Prior to Alberta’s 2015-16 recession, EI has had an even larger redistributionist impact. All working Canadians make the same EI payments. But more EI cheques are sent to provinces with higher unemployment rates than provinces with lower unemployment (typically Alberta, BC, and Saskatchewan). This transfer effect has been magnified by Ottawa’s adoption of more generous EI rules for “seasonal unemployment”, which is mostly a euphemism for the Atlantic fisheries. To qualify for full EI benefits, workers in these industries need only about half as many weeks of employment to qualify for full EI benefits as compared to workers in the rest of Canada. The effect is to pay Canadians to stay in regions where there is chronic high unemployment, rather than migrating to areas where there are jobs going unfilled.
Understanding the transfer effects of these other federal programs explains how it is that between 2007 and 2015, Alberta’s net contribution to the Federal government was $221 billion, or an average of over $24 billion a year. There has been some confusion how Alberta’s net annual contribution to Ottawa could be over $200 billion, if the entire value of the Equalization program is only $17 billion a year. The answer is explained by the indirect transfer effect of other federal programs like CST, CHT, EI, OAS and the Canada Pension Plan.
The authors argue that the Equalization program is best understood when it is understood as part of the larger “Federal transfer system”; that is, in the same context as the CHT and CST. Drawing on this perspective, they conclude that the Harper reforms to the CHT and CST have disadvantaged the have-not provinces. To remedy this, they propose that either equalization payments should be increased or the CHT should be amended to include a “needs-based allocation formula.”; i.e., reverse the 2014 Harper reforms and send more money.
I agree with their call to frame our thinking about Equalization to include the CHT and CST, but would go further and expand it to include OAS, EI and CPP as well. This broader and more accurate context explains how it is that Albertans have on average been sending $24 billion dollars more a year to Ottawa than they get back. It also explains why Albertans are not likely to be persuaded by authors’ call to expand Equalization payments.
Benefits of Equalization
Out of 114 pages, only four are used to explain the benefits of federal equalization payments, and even these are prefaced with the warning to the reader that while “strong in theory … empirical evidence remains mixed”. The primary benefit of Equalization is said to be that it pre-empts – or at least discourages – Canadians from moving from poorer provinces to richer provinces just to collect better/more public services at cheaper prices. This negative choice is known as “fiscally induced migration”, and it is bad because it lowers our national productivity. This negative kind of interprovincial migration is contrasted with a beneficial form in which Canadians move from one province to another to get a better job or the same job at a higher salary. This is called “value of the marginal product” (VMP) – a measure of “labour efficiency” and results in “labour market equilibrium”, which is good both for the receiving province and the sending province, and so for all of Canada.
This argument ignores the empirical difficulty (impossibility?) of knowing whether Canadians move from one province to another for bigger private-sector paycheques or more public-sector services. As the authors themselves observe:
“Where migration occurs in the direction of greater fiscal capacity [of the province], this migration might happen because greater fiscal capacity is correlated with better economic opportunities [for individuals].”
More practically, there is the risk that once equalization (and other forms of transfer) payments pour into a poorer, “have-not” province, they may be used to induce residents to remain there – under- or unemployed, but kept afloat by generous EI, welfare, health, child-care, post-secondary education and housing benefits. The authors call this risk the “welfare trap” and observe that it is negative because, “Regions with higher labour productivity may then experience labour shortages, a labour is instead attracted to places with lower costing public services.” While the authors are clear that this would be undesirable (“inefficient”) from an economics perspective, they are silent about its political value to Quebec politicians who may use it to discourage “out-migration” to other provinces. (See next section, below.)
The other argument made for Equalization payments is “horizontal equity”. This concept holds “that otherwise identical persons should be treated equally in terms of the tax price of public services regardless of where they reside”. Accordingly, it would be unacceptable for residents in a wealthy province to have more or better social services “per tax dollar” than residents in a poorer province. Theoretically, in a world of “perfect mobility”, residents of the poorer provinces would simply move to the wealthier provinces, and the “problem” would be solved. But since in the real world, moving from one province to another has all sorts of costs, monetary and non-monetary, that discourage Canadians from leaving their home province, equalization payments are needed to level the playing field. This is “horizontal equity”.
But wait, go back and read the previous two paragraphs. Wasn’t moving to collect bigger/better publicly paid social services precisely the problem of “fiscally induced migration” that equalization transfers were supposed to remedy? And isn’t paying people stay in under-performing provincial economies – “the welfare trap” – precisely the unintended (and problematic) risk of equalization identified above?
Finally, there is the problem of policy jurisdiction. Virtually all of these social services fall under the exclusive jurisdiction of the provinces and cannot be dictated or “equalized” by Ottawa. That why the Equalization program currently gives each “have-not” province a blank cheque with the intent (i.e. the hope) that the funds will be used for topping up “under-funded” benefit programs. But there is no guarantee, because there cannot be. These are all provincial matters.
The authors acknowledge that equalization payments may have unintended and even perverse consequences – the “fly-paper effect”, the “welfare trap” or no effect at all. And they devote another 18 pages to describing the empirical economic research that has been done to test for these problems. I invite the reader to enjoy these pages first hand. But for current purposes, a quotation from the last page will suffice:
“[I]nspite of decades of information about equalization payments and the economic performances of the provinces, it is not clear that fiscally induced migration occurs or, if it does, whether it is serious enough to warrant intervention. … The question of horizontal equity is equally difficult to answer. … Concerns that equalization payments might have a flypaper effect or the potential for creating a welfare trap requires vigilance and further empirical research.”
Bottom line: Three decades of economic analysis can neither prove nor disprove the alleged benefits or unintended harms of the Equalization program. This hardly surprised me. Decisions to expand, narrow or otherwise amend the equalization formula have been driven by the short-term political objectives and budgetary constraints of the governments of the day. Economic analysis has been largely ex post facto and ad hoc.
While it is not without value, the academic debate among Canadian economists risks obscuring the real politik that has driven Equalization from the start. At the end of the day, it has almost always been about trying to win the next election in Quebec and make the Separatist option less attractive. Or, as the authors state it more diplomatically:
“Historically, virtually all of the changes to the equalization program have been in response to practical budgetary considerations or for political reasons.”
While the authors discuss the various and competing economic incentives for inter-provincial migration, they only once connect it specifically to Quebec. They assert that “outmigration” – losing population to wealthier provinces – was not an issue for Quebec “since it would have been inherently difficult for its French-speaking majority, many of whom are unilingual, to migrate to an English-speaking labour market”.
In fact, historically this has not been true. Between 1840 and 1930, over 900,000 French Canadians – a hundred thousand every decade – left Quebec to work in the booming textile industry in Massachusetts, Rhode Island and Connecticut. By 1900, after Montreal and Quebec City, the third and fourth largest populations of Francophones in North America were the Massachusetts factory towns of Lowell and Fall River. (My first teaching position after finishing graduate school was at Assumption College in Worcester, Massachusetts, founded in 1904 by affluent Francophone families and a unilingual French-speaking institution until the 1950s.) In the absence of this economic exodus, the Francophone population of Quebec is estimated to have been 4 to 5 million greater than it is today.
Mitigating the risk of out-migration has been a priority for Quebec Francophone elites for over a century. Perceiving this as a threat to Quebec’s economic and political future in Canada, Quebec elites – initially the Catholic Church, later provincial governments – have sought policies to stem this economic exodus. Alexandre Taschereau, Quebec’s Liberal premier from 1920 to 1936, actively promoted industrialization of Quebec’s economy, declaring that he would “rather import capital than export French Canadians”.
Suffice it to say that this has not been the strategy of recent PQ and even Liberal governments in Quebec. While they have sought the same goal, they have pursued it through very different policies – creating the most generous social safety network and benefits system in Canada – much of it funded with Equalization transfers from Ottawa. Whatever its economic demerits as a “welfare trap”, politically this strategy has worked for Quebec.
Rewarding Fiscal Failure
As noted above, during the 1970s the Equalization program appears to have had the perverse effect of rewarding Separatist language policies that undermined Quebec’s economy. The more Anglophones and head offices Bill 101 drove out of the province, the bigger Quebec’s equalization cheques became. There seems to be a troubling parallel in some other provinces. The election of high tax/high benefits/high regulation governments seems to coincide with poorer economic outcomes, which in turn qualifies the province for equalization payments.
Ontario was a “have-province” – indeed, the foundation of the entire Equalization program – until 2008. It has been a “have-not”/recipient province ever since – a period that coincides with four consecutive Liberal governments. Under almost four uninterrupted decades of Social Credit governments, British Columbia moved from “have-not” to “have” status in 1962, and remained there until 1999 – the eighth year of the “lost decade” of NDP governments (1991-2001). With the return of a Liberal government in 2001 (which governed until just last year), BC again became a “have province” in 2007. Saskatchewan was a “have-not” under almost four decades of NDP governments (1971-2007), but entered the “have” category in 2008, the year after reformer Brad Wall led his “pro-free enterprise” Saskatchewan Party to power.
These examples suggest a prima facie case that the Equalization policy rewards the political mismanagement of a province’s economy – clearly an undesirable trend. The relationship is clearly more complex than this, with many other variables that would have to be accounted for. But this does not mean that there might not be a causal connection. Whether these patterns are a coincidence or something more systematic, I will leave to our economists to figure out.
If the authors are guilty of unduly minimizing Quebec’s role in recent equalization politics in chapter 2, they get full credit for laying all the cards on the table in the final and concluding chapter:
“The federal equalization program not only contributes to making Canada a more egalitarian society but also may foster unity in the country by mitigating the feelings of resentment and alienation that could be fed by large territorial economic disparities.”
In case concepts like national unity and the politics of resentment are too abstract for some readers, the authors then get specific:
“Equalization has most likely helped federalists in Quebec make the case against independence. … The economic arguments in favour of Quebec remaining part of Canada have often featured reference, sometimes explicit and other times implicit, to the equalization program as important to the financing of the province’s social programs.”
I suppose that none of this should really surprise us. For Canadian baby-boomers, the “Quebec issue” has been explicit or implicit in almost every federal election and policy dispute since we reached voting age. From supply management (dairy, eggs and chickens) to Meech/Charlottetown (“the Quebec round”) to aerospace (Bombardier) and now climate change, there is always a fourth dimension to our federal politics.
As my cynical views on this matter are already well known and thus discounted in many circles, I will conclude with a recent (November 2017) observation by Professor Donald Savoie in Canada’s “national newspaper,” the Toronto Globe and Mail. The immediate context of his remarks was the cancellation of the Energy East pipeline. But the import of his observations is much broader:
“Politics, not market conditions, killed the Energy East pipeline. … Atlantic Canadians have learned that when Ottawa speaks about national unity, it speaks, in reality, to Quebec’s place in the federation and that “national unity” are code words for the economic interests of Ontario and Quebec.
For those who may not know him, Professor Savoie is a former president of the Canadian Political Science Association, the author of forty-five books, an officer of the Order of Canada, a Fellow of the Royal Society of Canada, and currently the Canada Research Chair in Public Administration and Governance at the University of Moncton. Those who take exception with his blunt assessment of Quebec’s undue influence cannot just write him off as “another Alberta redneck”. Professor Savoie knows of what he speaks. So, it’s worth listening to his concluding remarks:
“We need to rethink Canada’s institutional arrangements so that we have a two-way mirror that reflects the economic interests of Western and Atlantic Canada, not just Quebec and Ontario. … The Atlantic region does not have the political or economic clout to do something about extending the national unity debate beyond Quebec’s interest. The same does not apply, however, for Western Canada, and policy-makers in Ottawa should take note before it is too late.”
But it is worth asking: Too late for what?