Wading through the Equalization Swamp Armed Only With 1105 Words

This post was inspired by my wife, a non-economist (thankfully) who asked me the other day for my opinion on the endless equalization debate. My answer was simple: follow the politics.

As every insider knows, the excommunication of Bill Casey, an MP from Nova Scotia, is only the tip of the iceberg of discontent over the Conservative government’s proposed equalization formula. Clearly, a substantial portion of the relevant caucuses believes that the Conservatives have failed to deliver on a campaign promise although so far, only one member has shown the courage of that conviction.

But my wife’s question did prompt me to ask myself what I knew or thought I knew about equalization. Not as much as I would have hoped. Some reading ensued. What follows is my admittedly truncated attempt to wade through the swamp, the thickets, the morass , the 33 variables (soon to be 5), the Accords and dis-accords, the haves and have-nots, and the promises and betrayals. In 1105 words. Starting now.

Before even beginning to understand the equalization discussion, it is important to understand two things (for a good, short but relatively comprehensive primer, check out the Senate Finance Committee’s recent study):

First, equalization is a constitutionally-entrenched income redistribution program designed to help provinces provide comparable levels of government services at comparable levels of taxation, not an economic growth/develop program. I think it helps to think of it as a kind of means-tested guaranteed annual income for provinces. This is an extremely important though often overlooked point to which I will return to in a moment.

The second point relates directly to the first : the income redistribution under equalization works by taking money through the normal functioning of the tax system by passing tax revenue largely from higher-income individuals/households and redistributing it according to a formula to have-not provinces who then, presumably, spend it on programs that mostly help lower income individuals. At least some portion of these individuals live in the have-not provinces.

It is therefore not correct to say, as Ralph Klein (rip) implied back when, that his province was footing the bill for those slackers out east, although clearly his province has a disproportionate share of high-income individuals. This point also helps us understand why Sask. premier Lorne Calvert’s proposed lawsuit is more political artifice than serious legal challenge : the proposed formula doesn’t in any way infringe on the province’s control over its natural resources, contrary to Calvert’s statements (although his legal argument about fairness may hold more water).

Now, with respect to the current debate, there are only three relevant questions in my mind:

Question 1 : Did Stephen Harper and the Conservatives break their promise? Yes. The Conservative Party’s Election Platform, Stand Up for Canada (p.22), clearly promises to exclude resource revenue through some sort of mechanism, direct or indirect, from any new equalization formula. The proposed new formula by contrast explicitly includes half of resource revenue and imposes a cap on total payments to avoid providing fiscal capacity to have-not provinces in excess of have provinces, as discussed next. It is also clearly less generous than the same formula with zero resource revenue inclusion, as the folks at the Atlantic Provinces Economic Council point out in their recent study.

Question 2: Is Harper’s proposal equalization formula good policy? Yes. The formula incorporates most of the important and quite sensible recommendations contained in the O’Brien report and, I might add, in other studies. These include adoption of:

1. A 10-province standard (instead of 5);
2. A simplified measure of fiscal capacity : under the old (pre-Martin) formula, Finance looked at 33 provincial revenue sources; this has been slashed to 5 : personal income taxes, sales taxes, business income taxes, property taxes and 50% of natural resource revenue.
3. A cap on per capita payments to ensure that a have-not province cannot receive more in fiscal capacity than a have province;
4. A smoothing mechanism on annual payments to avoid retroactive increases or decreases — payments will be made using a weighted 3-year moving average
5. A new method of calculating residential property taxes based on actual taxing practices.

Could the equalization formula be better? Sure. It could for example try to account for the cost of delivering services (per capita funding does a rather lousy job of this, especially for largely rural provinces like NL, NS, NB, and SK), as is done in some other jurisdictions (see O’Brien study), but you have to start somewhere and the current iteration is pretty good.

Question 3 : Did Harper do the right thing politically? Yes & No. Yes, because an intelligent formula-based approach should in theory help diffuse political tensions in the long run between the provinces and the federal government; no, because Harper et al came up short on three counts: (i) they did a lousy job of making the case for their proposed formula; (ii) they have consistently denied that the Conservatives broke a promise when it’s quite clear they did; and (iii) they failed to appreciate that the three provinces have a legitimate concern related to economic growth, although as I discuss next, this concern has very little to do with equalization in any direct sense.

The three provinces in question are, I submit, rightly fully concerned about their economic place in Canada. They are classic have-not provinces that have experienced some serious and deeply worrying declines in their population (especially NL + SK but less so NS).

It is extremely important, however, to understand that their economic challenges are rooted in an important rural versus urban distinction : it’s not people from St. John’s, Halifax, or Regina who leave the province. It’s people from Dildo, Debert, and Dahoe that decamp for (largely) economic reasons.

Here lies, I believe, an important clue to a way out of the current political and economic impasse. The best way to help address economic growth and wealth in these three have-not provinces is by targeting assistance at their rural areas outside of the equalization formula. How do you do that? Work with what you already have in place. Namely, I would suggest three policies to address the have-not provinces’ legitimate economic concerns:

1. Beef up Community Futures funding through the Atlantic Canada Opportunities Agency (ACOA) and Western Economic Development (WD): even ACOA’s arch-nemesis, the Atlantic Institute for Market Studies (AIMS), admits that the Community Futures programs works and works well (Charles Cirtwell, acting AIMS president, says : “If I had to pick one program to keep, of all the ACOA programs, it would likely be the Community Futures Program delivered through the Atlantic Community Business Development Corporations”);

2. Beef up cluster-type investment and rural university/college funding, again through ACOA and WD: AIMS, Fraser Institute and others of the ilk don’t like these kinds of interventionist approaches but rural communities do. Why? Because they work (PEF blog posts on Nordic Countries passim). And ACOA and WD have gotten better at making sure they don’t lose money on these kinds of endeavours.

3. Add an economic mandate, with a strong rural focus, to the Canada Pension Plan Investment Board (CPPIB): Québec’s Caisse de Dépot et de Placement, which manages the QPP, has a mandate to earn the best return it can for its members while contributing to the growth of the Québec economy. While watered down from its earlier more vigorous nationalist economic mandate, this would be at least a good place to start for the CPPIB. The beauty of this proposal is that back in the pre-stock-market-always-goes-up days, the CPP used to invest 100% of its surplus funds in provincial government bonds, a policy that provided a clear benefit to borrowing provinces, especially those that we think of as have-not provinces.

Enough said. 1105 words. Three questions. Three recommendations. Zero chance of implementation. Infinite hope 🙂