Capping Equalization

The Equalization changes are probably the most fiscally significant cuts in yesterday’s unstimulating Economic Statement. In 2009-10, the program is projected to pay out $14.2 billion instead of $16 billion. In 2010-11, it will pay $14.5 billion instead of $20 billion. This $5.5 billion difference exceeds the $3.5 billion in total projected savings from spending austerity, asset sales, the wage freeze and mortgage purchases that year.

But the Equalization changes may attract little attention not only because they are esoteric, but also because of how yesterday’s Statement accounts for them. Table 2.1 rolls the Equalization changes (announced earlier this month) into the overall fiscal impact of economic changes.

Hence the change in baseline expenditures, which would normally be positive in an economic downturn (e.g. as EI claims increase), is instead negative. Rather than one line showing an increase in baseline spending and another line showing significant cuts to Equalization, there is a single line showing a modest decrease in baseline spending.

The Equalization formula unveiled in Budget 2007 included only half of natural resource revenues. To limit the amount of Equalization that resource-rich provinces might receive, the federal government capped Equalization receipts at “the fiscal capacity of the lowest non-receiving province.”

In practice, this meant that provinces with lower personal incomes but more natural resources (per capita) than Ontario could not be “equalized” up to a fiscal capacity above Ontario. With Ontario now receiving Equalization, this cap would rise to the fiscal capacity of the next non-receiving province, increasing the Equalization entitlements of resource-rich provinces.

The new cap will be “the average post-Equalization fiscal capacity of the Equalization-receiving provinces.” At first glance, this rule seems superfluous. Equalization brings all have-not provinces up to the same standard of fiscal capacity, so they should all have the same “post-Equalization fiscal capacity.”

But provinces also have resource revenues, which are only partly included in Equalization. The crucial feature of the new cap is that it includes all resource revenues in determining fiscal capacity. It serves the same purpose as the previous “Ontario cap”: to limit the Equalization entitlements of resource-rich provinces. The “fairness” argument for such a cap conflicts with the “fairness” argument for excluding half of resource revenue, but this debate is not new.

The larger departure from past practice is that, after the formula and cap on particular provinces are applied, the whole program will be capped according to GDP growth. This ubiquitous cap will mean a given reduction in transfers for every Equalization-receiving province.

While an equal-per-capita reduction in Equalization leaves all receiving provinces at approximately the same reduced fiscal capacity, it could eliminate most of the transfers to provinces that qualify for modest per-capita amounts (e.g. Ontario). While the Ontario government’s previous complaints about Equalization have mostly been unfounded, I think that it could legitimately object to the program being capped the moment it qualifies for assistance.

It’s easy to understand why the federal government wants to limit Equalization costs, but there is no apparent justification for this second cap. If interprovincial disparities are growing faster than GDP, then total Equalization payments should grow faster than GDP. The only saving grace is that the federal government will measure GDP growth as a three-year average, so Equalization will not be throttled back as quickly as the economy declines.

Since Equalization automatically targets the less affluent provinces (now including Ontario), sharply higher Equalization payments would be sensible amid an economic downturn. While there is no guarantee that provincial governments would use the money for stimulative purposes, it would help to prevent provincial cutbacks that could undermine potential federal stimulus. (As Paul Krugman notes, the New Deal’s stimulative effect was undercut by austerity from state and local governments.)

Limiting Equalization averts a federal deficit only at the expense of provincial budget balances. Since borrowing costs are higher for provincial governments than for the federal government, the consequence will be higher interest costs for Canadian taxpayers.

UPDATE (Jan. 24): Excellent commentary from the Halifax Chronicle Herald:

Premier Jean Charest is attacking [Harper] because the federal government has put a cap on the growth of equalization payments.

The National Post asked Mr. Harper about that cap.

“We’re just following the recommendations of the O’Brien commission, which said it’s got to be a sustainable program,” he replied. “We brought in some revisions to the formula, which will simply mean the expanded formula we already brought in grows in line with the economy, rather than spikes up and down with oil prices.”

That sounds reasonable, except that the O’Brien commission did not call for a cap on equalization linked to the growth of the economy, which the Tories are imposing, but suggested the government publish a discussion paper if it unilaterally changed the program. The Finance Department has not published such a paper.

UPDATE (Jan. 30): More from The Herald:

With Ontario now collecting modest equalization, the new ceiling for payments would have been British Columbia’s capacity. Mr. Flaherty clearly thought this too generous, so the clawback trigger has been lowered. It’s now the average capacity of the receiving provinces, after counting both equalization and all resource revenues (half of which are excluded when determining who gets equalization).

Muddled? Erin Weir, a young Saskatchewan economist and former NDP candidate, summarizes the impact of Cap 2 in a perceptive online column for the Progressive Economics Forum: It limits the equalization entitlements of resource-rich provinces with below-average personal incomes. So it’s no wonder Newfoundland Premier Danny Williams feels targeted again. Sometimes paranoids do have enemies.

The two caps will save Ottawa $5.3 billion this year and next. Arguably, a large chunk of the budget’s $12-billion infrastructure program is perversely rerouted from equalization.