A Short History of Equalization, part 1: 1930-2006

The Rowell-Sirois Commission

In the 1930s, after several provinces had gone bankrupt trying to cope with effects of the Great Depression, the federal government established a Royal Commission on Dominion-Provincial relations (the Rowell-Sirois Commission). In its 1940 report, the Commission concluded that the Constitution did not give the provinces sufficient taxing power to meet their constitutional responsibilities across the social policy areas for which they were responsible (outlined in sections 92 and 93 of the Constitution Act, 1867). The Report of the Rowell-Sirois Commission concluded that while the Depression certainly did make matters worse for the provinces fiscally-speaking, the difficulties the provinces and territories faced were inherently systemic in nature. When they established the Canadian federation, the founding fathers could not have anticipated how costs in these areas would skyrocket. For example, between 1874 and 1937, the costs associated with running education and public welfare systems rose from $4 billion to $360 billion (Royal Commission on Dominion-Provincial Relations, pp. 244-245, in Equalization: Its Contribution to Canada’s Economic and Fiscal Progress, p. 180).

In exploring the notion of making fundamental changes that would better position the provinces and territories vis-à-vis their funding commitments as outlined in the Constitution Act, the Rowell-Sirois report considered and rejected any constitutional changes that would alter the division of powers, or give the provinces greater fiscal capacity. Instead, the Commission recommended centralizing taxation powers with the federal government, and the provision of a guaranteed annual income to the provinces and territories by the federal government.

The Commission’s report included three key recommendations:

  • The federal government take over control of unemployment insurance and old age pensions;
  • The federal government take over the collection of all major taxes, including personal income tax and succession duties (taxes placed on property or assets of an individual following their death, generally paid by the heirs to the estate); and,
  • The federal government should compensate the provinces for the lost tax revenue (and the removal of previous subsidies), by paying annual “National Administration Grants.” These Grants would help provinces “provide adequate services (at the average Canadian standard) without excessive taxation (on the average Canadian basis).” Essentially, these were the foundations of what we now know today as equalization.

Tax Rental Agreements

In 1940, the provinces agreed to a constitutional amendment giving the federal government control of unemployment insurance. The federal government did not, however, adopt the other principal recommendations of the Rowell-Sirois Commission. The fact is that provincial governments refused to give up their taxation powers, even with the promise of extra funding from the federal government. This resulted in a new course of action, with the federal government entering into ‘tax rental agreements’ with the provinces. These agreements meant that each province ‘rented out’ its right to collect taxes to the federal government. Under this arrangement:

  • The federal government took over the collection of personal income taxes, corporate income taxes, and succession duties from participating provinces;
  • The federal government paid annual compensation to the provinces to make up for the income each province lost by not collecting these taxes;
  • The terms of the tax rental agreements were renegotiated every five years; and,
  • Federal compensation was unconditional, meaning that provinces could spend the money as they saw fit.

First implemented during World War II, the tax rental agreement arrangement between the two levels of government ran until 1956. Throughout this period, several provinces remained uncomfortable with the idea of ceding taxation powers to the federal government, even as part of a temporary rental agreement. Ontario did not participate until 1952, when the federal government changed the way payments were calculated, and Quebec never participated in the tax rental agreements.

Initially, the principle of equalization was not found in the tax rental agreements. Indeed, the arrangements were designed solely to compensate a province for lost tax revenues, not to increase the revenue of the provinces to a higher level based on a national norm. In 1957, however, poorer provinces whose per capita tax revenues fell below a national standard found themselves eligible for additional federal compensation. This marked the beginnings of ‘equalization’ and its implementation. In 1967, provinces resumed collecting their own taxes.

The Birth of Equalization

In 1957 the equalization program included only three revenue sources: personal income taxes, corporate income taxes, and succession duties. These revenue sources were equalized to a high standard, namely, the weighted average of the per capita revenue of the two richest provinces (at the time Ontario and British Columbia), based on tax rates determined by the federal government.

In 1962, 50% of natural resource revenues were added to the list of revenues to be equalized; the same year, the standard was changed to the average of the ten provinces. The inclusion of natural resource revenues disqualified Alberta and British Columbia from receiving equalization payments. After the 1963 federal election, the incoming Liberal government changed the formula and returned to the weighted average of the top two provinces. Resource revenues were no longer included. However, 50% of natural resource revenues were deducted from the equalization payments, once again eliminating Alberta and British Columbia as recipient provinces.

The formula for determining equalization payments was overhauled yet again in 1967 when the fiscal arrangements were renewed for another five years. First, there was a major expansion, from four to sixteen, in the number of revenue sources included in the formula. Second, the revenues to be equalized were the actual revenues collected by each province. Third, the standard was changed once again from the average of Ontario and British Columbia to the average of the ten provinces.

Between 1972 and 1981, a number of ad hoc adjustments to the formula were introduced, largely for the purpose of dealing with volatile oil revenues. For example, soaring energy prices from 1973 put enormous pressure on the cost of equalization and placed Ontario as a recipient province from 1977-82. In 1973 and 1974 some ad hoc measures were taken to dampen the impact of energy on equalization.Then in 1977 only 50 per cent of resource revenues were made eligible.  But still Ontario qualified. Ontario’s economy was extremely hard hit by the recession of the early 1980s brought on in good part in the wake of the energy price boom. Ontario was only retroactively excluded from receiving payments through the “personal income override” whereby no province could be eligible if its per capita income exceeded the national average. With increasing oil prices raising equalization payments, this was creating a fiscal problem for the federal government. It was time to rethink the program, and the time for action came in 1982, when the fiscal arrangements were renegotiated.

The revisions to the equalization formula followed the format already employed in 1967. First, the list of revenues to be equalized was substantially expanded to thirty. Through this broad coverage of provincial revenues, the equalization formula was based on a “representative tax system” (RTS). Second, since it was based strictly on relative revenue capacity, the equalization formula implicitly assumed that the per capita provincial and local government expenditures financed by these federal transfers were equal across the country. Third, the standard was further modified by equalizing the per capita yields of the provincial revenues to the average of five provinces: Ontario, British Columbia, Saskatchewan, Quebec, and Manitoba, what became known as the five-province standard. The exclusion of Alberta from the standard eliminated the problem created by the inclusion of natural resources. The Atlantic provinces, which had no oil revenue at that time, were excluded as a counterbalance to the exclusion of Alberta; a wealthy province was offset by a less affluent region with a – at the time – comparable population. This formula, with some adjustments made over time, served as the foundation for equalization payments from 1982 until the 2005-06 fiscal year.

It should be noted that also in 1982, on March 2, the Government of Canada and the Government of Nova Scotia signed the Agreement on Offshore Oil and Gas Resource Management and Revenue Sharing. While the Agreement as such is not part of the equalization program, it is still important to mention it at this point since it would eventually have implications for the equalization program. The Agreement stemmed from the discovery of a large deposit of natural gas, known as the Venture well, near Sable Island offshore of Nova Scotia. The agreement provided that Nova Scotia’s share of the offshore revenues “shall equal 100 per cent, provided in that year the Nova Scotia government’s per capita fiscal capacity, including its share of off­shore revenues, does not exceed 110 per cent of the national average per capita fis­cal capacity plus 2 percentage points for every percentage point by which Nova Scotia’s average annual unemployment rate exceeds the national average annual unemployment rate.” What this meant was simply that the province would keep all the revenue it received from the development of this offshore resource until such time as its economy exceeded the national provincial average.

Most notably, however, in 1982, Canada enshrined the principle of equalization in the Constitution. The commitment to equalization is found in Section 36 (2) of the Constitution Act, 1982, which states:

Parliament and the Government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public service at reasonably comparable levels of taxation.

1982 to present

The Atlantic Accords

As mentioned briefly above, in March 1982, the governments of Canada and Nova Scotia signed the Agreement on Offshore Oil and Gas Resource Management and Revenue Sharing which was drafted to allow Nova Scotia to keep 100% of its revenue from expected offshore natural gas developments following their discovery in 1979. Oil had also been discovered off the coast of Newfoundland in 1979 – the Hibernia field. In 1984, the Supreme Court of Canada declared that the oil and gas resources off the Newfoundland coast belong to the jurisdiction of the federal government. In the wake of the decision, the federal government initiated discussions with Newfoundland and Labrador and Nova Scotia in an effort to develop some guidelines to govern the development of the offshore petroleum industry. Taken together, these guidelines or agreements are loosely referred to as the Atlantic Accords. The purpose of the Accords, as they were developed, was to protect the two provinces from losing any revenues gained from petroleum revenues at the expense of equalization payments, until each of the provinces was sufficiently able to establish its respective offshore petroleum industries.

The reason for this protection was because one of the key issues that arose in the context of factoring revenues from natural resources into the equalization equation. When an equalization-receiving province realized big gains in natural resource revenues, it was then penalized through a reduction of its equalization payments, commonly referred to as equalization clawback. As a province’s revenue from natural resources (or any other source) increased, that province saw a comparable reduction in the amount of equalization it received. The Atlantic Accords provided for time-limited, partial compensation for any reductions in equalization payments to these two provinces as a result of increasing revenues from offshore developments. In effect, the Accords meant that the two provinces would receive separate offsetting payments from the federal government if increasing revenues from offshore developments led to decreases in their equalization payments. However, this was not what occurred, as will be discussed further on.

1992 Charlottetown Accord

Constitutional experts have argued that Section 36 of the Constitution Act, 1982, does not clearly spell out the federal government’s responsibilities regarding equalization; in fact, it has been suggested that the stipulation in the Act would be unlikely to survive a legal challenge.

Interestingly enough the proposed 1992 constitutional amendment (better known as the Charlottetown Accord), would have resulted in an altered Section 36, one that would have clearly committed the federal government to equalization – not only in principle but in practise. Further to this, the Charlottetown Accord committed the federal government to consulting with provincial governments on a meaningful basis before making any alterations to the legislation governing equalization payments. The Charlottetown Accord, however, died after 54 percent of Canadians voted it down in a national referendum that same year.

The Generic Solution

The generic solution, introduced in 1994, has been applied to the provinces of Newfoundland and Labrador (offshore revenues), Nova Scotia (offshore revenues), Quebec (asbestos), and Saskatchewan (potash). Under the generic solution, provinces lose only 70% of a major increase in fiscal capacity resulting from the development of non-renewable natural resources. Previously, for every $1.00 increase in a province’s fiscal capacity, its equalization payments decrease by $1.00. Under the generic solution, in very specific circumstances, for every $1.00 increase in a province’s fiscal capacity, its equalization payments are reduced by only 70 cents. This, of course, completely undermined the intent of the Atlantic Accords.

The Fixed Framework

Before 2004, equalization payments were driven by a complex but consistent formula. The formula determined both the overall amount the equalization program would pay out to receiving provinces and the amount each province would receive.

The formula measured the per capita fiscal capacity of provinces using the Representative Tax System (RTS). The RTS measured the amount of money provinces could raise from 33 different tax bases if they taxed those bases at national average tax rates. A province’s fiscal capacity on each of the 33 bases was then summed up and compared to a five-province average standard. If the formula determined that a province’s overall fiscal capacity across all of the tax bases combined was below the standard, that province received an equalization grant to bring it up to the common standard.

With the formula still in place, equalization payments had started to decline from their highest peak of $10.9 billion in 2000–01 to $8.9 billion in 2004–05. This was due to the combined impact of a slow-down in Ontario’s economy and tax reductions in several provinces. As well, since economic performance data on each province was updated constantly – several times a year, and since Ottawa used population estimates rather than actual population figures when doing its long-range planning, provinces occasionally either received adjustments (more money than previously announced) or had to repay over-payments. This uncertainty sometimes played havoc with a province’s fiscal planning, since money for which  it had budgeted sometimes did not materialise, or it found itself having to repay the federal government for a previous over-payment.

At the same time, the financial position of the federal government had improved dramatically and resulted not only in balanced budgets but also significant surpluses. A number of federal transfer programs had been reduced by a substantial amount in the mid 1990s and the provinces were demanding that Ottawa increase equalization as well as other transfers, particularly in the case of health care.

In response to that pressure, a new framework for both equalization and territorial funding was announced at a First Ministers’ Meeting in October 2004. Called the Fixed Framework, it featured the following elements:

  • The formula was no longer used to determine the overall amount of funding to be allocated for equalization and territorial funding. Instead, a fixed pool of funds was set in legislation.
  • The pool of funds to be available for equalization was set at a minimum of $10 billion for 2004–05, effectively stopping the decline in equalization payments.
  • Each province was guaranteed that its equalization entitlements would not be lower than the amount announced for 2004–05 and included in the 2004 federal budget.
  • A guaranteed growth rate of 3.5 percent per year was set in legislation, ensuring that the overall pool of funds available for equalization would continue to increase over 10 years.
  • Fixed shares for receiving provinces were set out in advance for the first two years of the Fixed Framework, replacing the normal operation of the equalization formula with a negotiated allocation.
  • The allocation in the Fixed Framework was legislated on an interim basis pending the outcomes of the work of a special Panel set up to review the equalization program and the development of a new allocation method.
  • On November 8, 2005, the federal government announced that the same approach would be extended to determine equalization entitlements for 2006–07.

There were some important implications of this new framework.

The interim allocation did not have a common standard to which all provinces were compared and raised. Instead, the standard varied for individual provinces depending on their former shares (over the last three years) of total equalization funding, regardless of changes in their relative fiscal capacity. As a result, some receiving provinces received more and others less than they would have if the previous equalization formula had been applied.

  • For example, in 2005–06, with the exception of Quebec, the per capita fiscal capacities of the receiving provinces were higher under the Fixed Framework than they would have been under the former five-province standard.
  • The Fixed Framework resulted in Newfoundland and Labrador having a higher fiscal capacity after equalization than Ontario (even without the Offshore Accords being taken into account).
  • Because the total equalization pool was fixed in advance, changes in one province’s fiscal capacity, up or down, would have a direct impact on the amounts other provinces received.
  • The Fixed Framework guaranteed a known and growing amount of funds for equalization. In this way, it improved stability and predictability, particularly for the federal government. On the other hand, the shares each province received under the Fixed Framework were not necessarily any more stable or predictable than they were in the past.

The 2005 Atlantic Accords

In February 2005, new Offshore Accords (Arrangement between the Government of Canada and the Government of Newfoundland and Labrador on Offshore Revenues, 2005 and Arrangement between the Government of Canada and the Government of Nova Scotia on Offshore Revenues, 2005) were signed with the two provinces. Those Accords extended protection to 2012 and provided full compensation for any reductions in equalization payments as a result of increased revenues from offshore developments. Generally speaking, in order to qualify for the full offset payments (made outside of the equalization program) and a potential extension to 2020, the two provinces would have to continue to qualify for equalization and continue to have a higher-than-average per capita net debt burden. Both provinces received guaranteed advance payments of a part of the benefits they were expected to receive over the first eight-year term of the 2005 Accords.

The impact of these Accords on the equalization program was controversial. Both Newfoundland and Labrador and Nova Scotia contend that the Accords have nothing to do with equalization and are intended to support economic development and debt reduction in the two provinces. On the other hand, others have argued that these so-called “side deals” have broken the fundamental, underlying nature of the equalization program and opened the door to calls for similar deals with other provinces.

It was against this backdrop that the federal government set out to reorganize the federal equalization program, as will be discussed in Part 2.

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