A Short History of Equalization, Part 2

As discussed in Part 1, the equalization program was significantly overhauled in 2007. This was largely because it had become, in the minds of many critics, an overly-complex mishmash of special deals and formulae that benefited some more than others and pleased no one. From 1982 to 2004, in general terms, the program used a complex but consistent formula of an equalization standard that was based on the average of the fiscal capacities of five provinces (British Columbia, Saskatchewan, Manitoba, Ontario and Quebec), using 33 different tax bases (including 100% of natural resource revenue). In 2004, the Fixed Framework was adopted, which replaced that formula with a fixed pool of funds that was set in legislation (at a minimum of $10 billion for 2004–05), which would grow by 3.5% each year. As well, each province was guaranteed that its equalization entitlements would not be lower than the amount announced for 2004–05.

However, many provinces believed the 5-province standard didn’t provide for a realistic national benchmark since not included in that calculation was Alberta and its oil-rich economy. There was growing demand for a return to the 10-province standard that had been used before 1982.

Also, the 2005 Atlantic Accords signed by Nova Scotia and Newfoundland and Labrador, which essentially protected their equalization entitlements from clawback due to rising revenue from their offshore oil and gas industries upset other resource-rich provinces such as Saskatchewan. Neither the federal government nor the provinces were satisfied with the equalization program. The federal government gave the provinces a year to try to reach some sort of consensus on how the program should be improved, but despite many first ministers meetings held throughout 2006, the provinces were unable to achieve any sort of agreement, leaving the federal government free to modify the program, which it did in 2007.

Budget 2007 (tabled in the House of Commons on 19 March 2007) included a new equalization program that was principle-based and formula-driven. Following on the recommendations of the Expert Panel on Equalization in Achieving a National Purpose: Putting Equalization Back on Track, commonly known as the O’Brien Report, the new program includes the re-establishment of a ten-province standard, simplified measures of capacity through a reduction in the number of equalization bases in the formula from 33 to 5, and a more predictable and stable payment system. Equalization payments are also constrained by a fiscal cap so that the total fiscal capacity of a receiving province cannot rise higher than that of the lowest non-receiving province.

Complicating matters somewhat was that the new program included special provisions for Newfoundland and Labrador and Nova Scotia, the two provinces covered by the equalization offset programs under the Atlantic Accords, which compensate for reductions in equalization payments associated with oil and gas revenues. Both provinces were given the option of remaining under the previous Fixed Framework, with an opportunity to permanently opt into the new Equalization program at a future date. However, if either province opted to switch to the new equalization formula, that choice was to be permanent.

What follows is an overview of the major changes to the program.

1. The Equalization Standard

The equalization standard is the level to which equalization payments raise the fiscal capacity of receiving provinces. From 1982 to 2004, the standard was based on the average of the fiscal capacities of five provinces: Ontario, British Columbia, Quebec, Saskatchewan and Manitoba. Alberta’s oil-rich economy and the poorer Atlantic Canada provinces were not included in the calculation.

The equalization standard in the new program reflects the recommendation in Achieving a National Purpose: Putting Equalization Back on Track (the O’Brien report) and is based on the fiscal capacity of all 10 provinces. The overall program cost will be determined by the application of a complex formula, which is detailed in the Budget Implementation Act. Annual volatility associated with a 10-province standard will be addressed through the use of a weighted three-year moving average calculation for payments.

2. Natural Resources Revenue

The treatment of natural resources has long been one of the most contentious issues in the equalization program. This is due in part to the uneven distribution of natural resource wealth across provinces. Debate about natural resources has focused on two key issues—the appropriate inclusion rate and how to measure fiscal capacity. Under the system used from 1982 to 2004, 100% of resource revenue was included. However, provincial resource royalty regimes are quite specific to each province and industry, given the varying amount of economic rent different natural resources will generate. This made it a challenge to use the Representative Tax System (RTS) approach that is used for other tax bases, which simulates how much revenue a province could raise if it levied the national average tax rate using a typical tax system. Often, when average tax rates were applied to these bases, without taking into account differences in the economic rent generated by a given dollar or volume of production, the result is a measure of capacity that is very different from what the provinces can actually collect.

The new program adopted the O’Brien report’s recommendation to exclude 50% of provincial natural resource revenues, and provides provinces with the benefit of full exclusion without reducing payments to any province. The use of actual revenues also permits an important program simplification, as the 14 separate bases used previously can be consolidated into a single natural resource revenue base.

3. The Fiscal Capacity Cap

The new program includes a fiscal capacity cap, as recommended by the O’Brien report, to ensure that equalization payments do not raise a province’s total fiscal capacity above that of any non-receiving province. The definition of total fiscal capacity for the purpose of the cap will include fiscal capacity for non-resource revenue sources, 100% of natural resource revenues and equalization offset payments made pursuant to the Offshore Accords with Newfoundland and Labrador and Nova Scotia.

4. Simplified Measurement of Fiscal Capacity

The measurement of provincial fiscal capacity is simplified based on the recommendation of the O’Brien report. Instead of 33 tax bases, provincial fiscal capacity will be measured using 5 tax bases — personal income tax, business income tax, consumption tax, property tax and natural resource revenues.

5. The Commitment to Exclude Non-Renewable Resource Revenue

The new program allows provinces to receive the greater of their equalization payments under the new formula using 50% resource exclusion and the amounts they would receive under the same formula with full exclusion of natural resource revenues.

6. Nova Scotia and Newfoundland and Labrador

Newfoundland and Labrador and Nova Scotia were given the option of opting into the new program, or remaining with the Fixed Framework and the Atlantic Accord. If they opted for the new program, they forfeited the benefits of the Atlantic Accord. However, even if they opted to remain in the old system, the Atlantic Accord was still compromised because the fiscal cap introduced in the new program applies to all provinces, including Newfoundland and Labrador and Nova Scotia even if they aren’t part of the new system (section S.3.4. of the Budget Implementation Act).

Summary

Provincial equalization payments are now calculated using a 10-province standard based on 5 tax bases. A province receives the greater amount using 50% resource exclusion or full exclusion. A fiscal capacity cap ensures that equalization payments will not raise a province’s total fiscal capacity above that of the lowest non-receiving province. Nova Scotia and Newfoundland and Labrador were given the option of remaining with the old Fixed Framework system and retaining most of the benefits of the Atlantic Accords, or opting into the new system and losing the Atlantic Accords. Nova Scotia opted for the new system. Newfoundland and Labrador no longer receives equalization payments.

The new equalization program, while addressing some of the issues and problems that had arisen over the years, also introduced a new round of issues and complaints, which will be discussed in a future post.

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