Federal government wants to renew flawed equalization formula

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Appeared in the Financial Post, May 17, 2023
Federal government wants to renew flawed equalization formula

Recently in Parliament, the Trudeau government tabled a motion, which if passed, would implement parts of the 2023 federal budget. On its face, it was a rather routine bureaucratic maneuver. But buried on page 194 of the 415-page motion lies the renewal of the current formula for Canada’s equalization program. While the move hasn’t yet received much attention, it represents a major policy decision with far-reaching implications, considering the problems with the formula, Albertans voting to demand a change in equalization, and ongoing concerns from several provinces.

In case you haven’t thought much about it since high school, here’s a quick refresher. Equalization is a system of payments from the federal government to certain “recipient” provinces to help equalize their ability to deliver comparable levels of services at comparable levels of taxation. Equalization has been in place in some form since 1957, and in recent years, the formula has been renewed in five-year intervals. In 2018, the Trudeau government renewed the existing formula with few changes—again, despite concerns from provinces over a lack of consultation. Now, the government wants to do the same again.

But in fact, the program’s current formula should be reformed, not simply renewed, because some aspects of the program are working in the opposite way they were intended. For example, equalization payments are calculated based on the “fiscal capacity” of provinces—basically, their ability to raise revenue. In theory, when disparities in fiscal capacity shrink—that is, when the gap between poorer and richer provinces grows smaller—equalization payments should also shrink.

But this isn’t happening. Differences in fiscal capacity between provinces have been getting smaller in recent years yet equalization payments to recipient provinces continue to grow. Why? Because the program’s “fixed growth rule,” which was implemented by the Harper government in 2009, requires payments to grow at a rate connected to growth in the overall economy. As a result, this rule, which ironically was designed to limit increases in equalization costs, is causing payments to recipient provinces to increase, even as the gap between richer and poorer provinces is shrinking.

Not surprisingly, representatives in some provincial governments, which do not receive equalization payments, don’t think this is fair and have been vocal in their criticism, with proposals ranging from completely eliminating the program to substantial reforms. Clearly, any renewal of the current formula by the federal government would likely be highly divisive.

Perhaps less obviously, equalization reform should be of interest to long-term recipient provinces as well. Due in part to the fixed growth rule, equalization as a share of provincial revenue has been on the rise in most recipient provinces. For example, in New Brunswick equalization represented 23 per cent of total provincial revenue in 2020/21 (the most recent fiscal year of available data), a figure that has been on the rise for several years. With more than one in five provincial revenue dollars coming from this single federal program, provinces such as New Brunswick depend on the program. While escalating equalization payments may provide a short-term revenue boost, they leave these provinces highly vulnerable to future program changes, an issue that could also be addressed in reforms.

Escalating equalization costs, rules working the opposite way they were intended, and the potential for more division and acrimony—these are just a few of the many problems with Canada’s current equalization program. Another five-year renewal of this program, as currently proposed by the federal government, would be a missed opportunity for reform.

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