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Equalization Program in Canada

The Equalization Program is an important component of Canadian federalism and the notion of equality between provinces regarding the social services they provide. Moreover, the principle of equalization has been a major source of debate in Canadian politics, between the federal and provincial levels of government, as well as between provinces. This article provides an overview of the purpose, operation and history of the Equalization Program, including a summary of key contemporary issues and debates.

Introduction to the Equalization Program

Definition, purpose and history of equalization in Canada

Operation of the Equalization Program

The equalization formula and how the numbers are crunched

Issues and Debates on the Equalization Program

Contemporary issues on the operation and nature of equalization

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Introduction to the Equalization Program

Definition, purpose and history of equalization in Canada

Definition of the Equalization Program

Equalization is the Government of Canada’s program for addressing fiscal disparities between provinces. The territories do not participate in the Equalization Program (finances for the territories are governed under a separate program – the Territorial Formula Financing program). Under the Equalization program, the federal government makes financial transfers to the provinces in support of their spending initiatives. These federal transfers are unconditional block grants, meaning there are no federal conditions on the transfers, allowing the recipient province to spend the money however it chooses.

In this context, Equalization is one of three major federal transfer programs. The others are the Canada Health Transfer and the Canada Social Transfer.

Purpose of the Equalization Program

The purpose of the Equalization Program is to allow provinces to provide comparable levels of social services at comparable levels of taxation. The program’s goal is to ensure citizens in all provinces have access to roughly the same level of social services – such as education and social assistance – without having to pay exorbitant levels of taxation. In understanding this purpose more fully, it is important to note two sorts of fiscal imbalances that can arise in federations such as Canada – vertical and horizontal.

Vertical imbalance is an imbalance between the different levels of government; in the case of Canada, between the federal and provincial levels of government. This sort of imbalance occurs when the responsibilities of one level of government are disproportionately large compared with its share of revenues. Such imbalances can be addressed by a transfer of responsibilities and/or revenues from one level of government to another. In the context of Canada, the Canada Health Transfer and the Canada Social Transfer are meant to address vertical imbalances by transferring funds from the federal government to the provinces.

Horizontal imbalance, by contrast, is a fiscal imbalance within one level of government; in the case of Canada, between the various provincial governments. This sort of imbalance occurs when some provincial governments have much weaker fiscal capacities than others. Traditionally, this has included provinces such as Quebec, Manitoba and those in Atlantic Canada. Because of their smaller populations and/or economies, these provinces tend to have less capacity to support social services than their larger provincial cousins, such as Alberta, British Columbia and Ontario. Equalization is meant to address this horizontal imbalance by providing federal monies to those provinces with lesser financial capacities. The result is greater equality between provinces in terms of their levels of taxation and ability to provide comparable social programs.

Equalization and Tax Rental Agreements

The history of equalization dates back to the 1940s, with the introduction of tax rental agreements between the federal government and 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. In exchange, 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 1962. Thereafter, the federal government entered into a new system of tax collection with the provinces. 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 the Equalization Program in Canada.

Evolution of the Equalization Program

Since 1957, the Equalization Program has undergone a number of significant changes, mainly having to do with the manner in which equalization has been calculated. Originally, Ontario and British Columbia were used as the comparative benchmarks. If a province’s per capita revenue from three sources of revenue (personal income tax, corporate tax and inheritance taxes) were less than these two provinces, then it was entitled to receive equalization from the federal government.

Over time, however, the equalization formula was adjusted. Today, the comparative benchmark is based upon a multi-provincial average, as opposed to simply British Columbia and Ontario. Moreover, the number of different revenue sources included in the calculation has been significantly broadened beyond simply personal income tax, corporate tax and inheritance taxes. For example, provincial revenues from natural resource extraction is now included. However, offshore oil revenue for Nova Scotia and Newfoundland has been excluded at times through individual deals between the federal government and those provinces.

One of the most important changes to the Equalization Program came in 1982, with its inclusion in the Canadian Constitution. Section 36(2) of the Constitution Act, 1982 states that the federal government and the provinces are “committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation” (Department of Justice Canada, Constitution Acts 1867 to 1982). It is important to note, however, that Section 36(2) only provides a commitment to the principle of equalization payments, but does precisely outline how such payments are to be calculated or made.

Operation of the Equalization Program

The equalization formula and how the numbers are crunched

Legislative Framework of the Equalization Program

As the Equalization Program involves federal transfers to the provinces, its framework is set in federally enacted legislation. This legislation is renewed every five years, at which time the federal government and the provinces work together to negotiate any changes to the program. The legislation is then debated upon and passed by the federal Parliament. Within the five-year period, the federal government can modify the program.

Calculation of Equalization Payments

The federal legislation sets out precisely how equalization payments are calculated. The following provides an overview of the equalization formula as of December 2007. It is important to note that this current Equalization Program is the result of significant reforms introduced by the federal Conservative government in its 2007 budget.

The equalization formula involves two key calculations. First, the fiscal capacity of each province must be determined. Provincial fiscal capacity is measured using five tax bases: personal income tax, business income tax, consumption tax, property tax and natural resources. However, 50 per cent of natural resource revenues are excluded in determining each province’s fiscal capacity, as well as the national standard (see below for more on the national standard). The result is a determination of how much revenue per capita (or per person) each province is able to raise. These figures will not be uniform across all provinces, as some have higher fiscal capacities than others.

Second, these per capita revenue figures are then compared with a national standard. Prior to 2007 this national standard was based on the average incomes of the five middle-income provinces: Quebec, Ontario, Manitoba, Saskatchewan and British Columbia. Following the 2007 changes, however, the national standard is now based on the average incomes of all 10 provinces. Whether a province is eligible for equalization, and how much it may receive, is based on its comparison to this national standard. Those provinces that are below the national standard will receive funds to top them up to the average of all 10 provinces. Those provinces that are above the national standard are not eligible for equalization payments.

Certain qualifications have been built into this basic system of calculation. For example, Nova Scotia and Newfoundland and Labrador have been allowed to maintain the benefits the Atlantic Accords, which had been agreed to in 2005. Under these Accords, the federal government had committed to completely protecting the two provinces from any reduction in equalization payments due to increased revenues stemming from the offshore oil industry. Originally, the Conservatives’ new system of equalization had backtracked from this commitment, which had been negotiated by the previous Liberal government. However, after these two Atlantic provinces strongly denounced the plan, the Conservative government agreed to a compromise. Under the agreement, Nova Scotia and Newfoundland and Labrador have the option of continuing under the old equalization system with the full protection of the Atlantic Accords, or adopting the new system, which includes higher levels of federal transfers for those provinces that fall below the national standard.

Comparison of Provincial Equalization Entitlements

In 2007-2008, the federal government transferred $12.9 billion to the provinces through the Equalization Program (Department of Finance, Federal Transfers to Provinces and Territories). The following provides a breakdown of equalization payments by province.

2007-2008 Equalization Payments by Province ($ millions)

British Columbia

0

Quebec

7,160

Alberta

0

Newfoundland/Labrador

477

Saskatchewan

226

Nova Scotia

1,465

Manitoba

1,826

New Brunswick

1,477

Ontario

0

Prince Edward Island

294

(Source: Department of Finance, Federal Transfers to Provinces and Territories)

Traditionally, the key recipients of equalization payments are the Atlantic provinces and Quebec, especially when examining the amounts they receive on a per capita basis. By contrast, Alberta, British Columbia and Ontario generally do not receive equalization payments (although, British Columbia did receive small levels of payment between 1999 and 2006).

Issues and Debates on the Equalization Program

Contemporary issues on the operation and nature of equalization

Determining the Equalization Formula

Since its inception in 1957, there has been a debate on precisely how equalization payments should be calculated. Two issues are central to this debate: calculation of the national standard and calculation of individual provincial fiscal capacities.

A province’s fiscal capacity is measured against a national standard comprising the average taxing capacity of a number of given provinces. Since the first equalization agreement in 1957, the number of provinces making up the national standard has changed several times. In 1957, a province’s fiscal capacity was measured against the average taxing capacity of Ontario and British Columbia, which, at the time, were Canada’s two richest provinces. In the 1960s, the federal government changed the calculation to include all 10 provinces. Including oil-rich Alberta in the calculation created problems in the 1970s when international oil prices skyrocketed. Alberta’s tax revenues raised the average to the point where even Ontario would have received equalization.

In 1982, the federal government removed both Alberta and the poorer provinces from the calculation. The national standard was based on the average taxing capacity of five middle-income provinces – British Columbia, Ontario, Saskatchewan, Manitoba and Quebec. Several provinces argued that the five-province standard unfairly lowers their entitlements, and sought a return to the ten-province standard.

In 2007, the Conservative federal government introduced significant reforms to the Equalization Program to address some of these issues. The new system reverts back to a national standard based on the average fiscal capacities of all 10 provinces (instead of just the five middle-income provinces). In order to deal with problems stemming from including oil-rich Alberta, the new system includes only 50 percent of provincial resource revenues in calculations of the national standard. This qualification is meant to mitigate a rise of the national standard to an inflated level. Nevertheless, the result has been a substantial increase in equalization payments to eligible provinces.

In regard to the calculation of individual provincial fiscal capacities, some experts had argued that the equalization formula was too complicated. Since its inception, the number of items used to determine each province’s fiscal capacity had risen from the three items contained in the original tax rental agreements (corporate income tax, personal income tax and succession duties) to 33. Critics argued this made the program more difficult to understand, and increased the possibility of error.

The new equalization system introduced in 2007 significantly reduced the number of items used to determine a province’s fiscal capacity. Instead of taking into account 33 different types of provincial revenues, the new system is now based on only five types: personal income tax, business income tax, consumption tax, property tax and natural resources.

Equalization Encourages Dependency

Some economists have argued that the Equalization Program contributes to financial and economic dependency, particularly in the case of Atlantic Canada. The basic argument is that no incentive exists for a province to strengthen its economy, since generating more revenue would equal losing out on financial transfers from the federal government. Similarly, if a province has discovered potential sources of revenue, such as natural resources, there is no incentive to develop them, as the new revenue would lower the provinces equalization payments.

In the past, the federal government has attempted to address this issue with special agreements, such as the Atlantic Accords. These agreements provided Nova Scotia and Newfoundland and Labrador with temporary protection from reductions in equalization payments due to increased government revenues from their offshore oil industries (until these industries are fully developed). As such, the motivation to develop new revenue streams is maintained.

It is important to note that such dependency arguments assume that provincial governments are only motivated to develop their economies if it will result in greater government revenues. One may argue, however, that other factors motivate provincial governments in this respect, such as improving the economic conditions and quality of life of their residents. In this context, a government may be motivated to improve its economy even though it may result in decreased equalization payments.

Equalization Unfair to the Richer Provinces

Another important debate regarding the Equalization Program concerns its fairness to richer provinces — in particular, those provinces ineligible to receive payments from the federal government. The basic concern here is that the federal government takes tax dollars it has collected from the richer provinces, and redistributes those monies elsewhere in the country. As such, the equalization system is unfair in the sense that it represents a financial drain on the economies of non-eligible provinces.

Supporters of the Equalization Program, in contrast, draw attention to the fact that all provinces, even the rich ones, receive substantial transfers from the federal government every year (for example, through the Canada Social Transfer and the Canada Health Transfer). Moreover, supporters argue that the Equalization Program is fair in the sense that it is meant to ensure a comparable level of social services at a comparable level of taxation across the country.

At the core of this debate are very different senses of ‘fairness.’ The anti-equalization argument conceives of fairness in terms of proportionality. Those provinces with stronger economies are entitled to the full rewards of their economic success, while those with weaker economies should be satisfied with what they have. The pro-equalization argument, by contrast, views fairness in terms of sameness; all citizens are entitled to the same social services at the same tax rate, regardless of where they live. How one personally views fairness in this context will bear heavily on whether or not they support the very notion of the Equalization Program.

Equalization and the Atlantic Accords

Another important issue regarding equalization has been the 1985 and 2005 Atlantic Accords, which were agreed to by the federal government and the provinces of Newfoundland and Labrador and Nova Scotia. Under these Accords, the federal government agreed to protect these provinces from any loss in equalization payments due to increased provincial revenues stemming from the development of offshore oil industries.

For more information on the Atlantic Accords:

Some critics of the Atlantic Accords have questioned whether such protection should be afforded Newfoundland and Labrador and Nova Scotia. If these provinces are gaining new revenues from the extraction of offshore oil, why should they be entitled to the same levels of equalization payments as before? This criticism can seem particularly strong considering that no other provinces received similar protection regarding their natural resources revenues.

In response, supporters of the Accords have argued that Newfoundland and Labrador and Nova Scotia still require equalization protection in order to continue their financial turnarounds. These provinces have endured an extended period of economic decline, which have contributed to a cycle of government deficits and ballooning debt. Moreover, unlike other oil-rich provinces, such as Alberta, the Atlantic offshore oil industry is still in its infancy, and will not fully reward the provinces for several years to come. As such, supporters of the Accords argue that some temporary equalization protection must be offered to Newfoundland and Labrador and Nova Scotia to ensure their long-term financial stability.

This debate came to a head in 2007, when the new Conservative federal government, helmed by Prime Minister Stephen Harper, unilaterally altered the Equalization Program and the Atlantic Accords. Under the reforms, federal transfers under the Equalization Program were enriched; Newfoundland and Labrador and Nova Scotia, however, would no longer be completely protected from declines in these payments due to increasing provincial oil and gas tax revenues. This change led to a very public conflict between the two provinces and the federal government, and created strong dissent within the federal Conservative Party and its Atlantic caucus.

In an effort to overcome the issue, the Harper government offered two options to Newfoundland and Labrador and Nova Scotia. The provinces could either continue with the old equalization formula and the Atlantic Accords, or they could enter into a new enriched equalization formula that included a cap on the amount of equalization payments if offshore oil and gas revenues reached a certain level. In 2007, both provinces agreed to the new formula – although Newfoundland and Labrador did so only for one year, leaving the door open to change its position in the future.

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