McGuinty on Equalization: A Reality Check

For a while, the Ontario Premier was looking quite reasonable in his dispute with the federal government. As Jim Flaherty charged that Ontario’s economic woes reflected a lack of provincial corporate tax cuts, Dalton McGuinty correctly responded that a lower rate of tax on profits would entail a large fiscal cost and provide little assistance to Ontario’s currently unprofitable manufacturing sector.

Unfortunately, the Ontario Premier seems to have changed his tune. His new line is that he would cut corporate taxes if only the federal government would scrap Equalization.

This line seems like a diversion from the debate that should be happening in Ontario about how to use provincial procurement, targeted tax credits, electricity policy, etc. to revitalize the ailing manufacturing sector. The focus on Equalization also distracts attention from federal policies, including trade and monetary policy, that have actually hurt Ontario manufacturing.

In criticizing Equalization, McGuinty speaks of the federal government taking $20 billion out of Ontario’s economy. Since the entire Equalization program costs about $15 billion, this figure deserves some scrutiny.

In 2005, the most recent year for which the relevant Statistics Canada figures are available, the federal government raised about 42% of its revenues in Ontario ($91 billion out of $216 billion). Therefore, the people of Ontario pay about $6 billion into Equalization, which equals about 1% of provincial GDP.

As far as I can tell, $20 billion is approximately the difference between total federal revenues from Ontario ($91 billion) and total federal spending in Ontario ($70 billion). Less than one-third of this difference constitutes Ontario taxpayers’ contribution to Equalization.

The remaining two-thirds mostly reflects the extent to which Ontario was more prosperous than other provinces in 2005. On average, Ontarians paid more federal taxes and qualified for fewer federal benefits than other Canadians.  In 2005, the overall federal surplus and federal spending outside Canada also contributed about $3 billion to the gap between federal revenues and expenditures in Ontario.

I suspect that the deterioration of Ontario’s economy since 2005 has narrowed this gap. But it remains because Ontario is still richer than most of the rest of the country.

Ontario’s per-capita GDP has fallen behind the three oil-rich provinces: Newfoundland, Saskatchewan, and Alberta (with combined populations of 5 million). However, in 2007, Ontario’s per-capita GDP exceeded every other province (with combined populations of 15 million). Continued redistribution from Ontario taxpayers to these other provincial governments hardly seems unreasonable.

Even if the federal government took McGuinty’s advice and eliminated Equalization, it would not automatically increase the Government of Ontario’s fiscal capacity. If Equalization and the federal taxes that finance it disappeared, Ontario after-tax incomes and profits would rise by about $6 billion. Conceivably, the Ontario government could then raise provincial tax rates enough to collect this additional $6 billion. However, this scenario does not support McGuinty’s apparent suggestion that killing Equalization would permit lower provincial tax rates.

UPDATE (May 12): Not surprisingly, the National Post has praised McGuinty’s call to scrap Equalization.