Getting us out of the welfare trap
The stated goal of Canada’s equalization program is to ensure that Canadians, regardless of their province of residence, have access to public services that are reasonably comparable, at reasonably comparable levels of taxation. This year, the program will distribute over $15-billion to the relatively poorer provinces (typically known as “have-not” provinces in equalization-speak).
In any income redistribution program, there is a risk of creating a “welfare trap” that discourages recipient individuals or communities from building their economic fortunes. Does Canada’s equalization program suffer from this defect? Are the incentives embedded in the equalization formula sufficient to support the development of receiving provinces — and, specifically, the development of their resource sector?
The calculation of the amounts paid to provinces by Ottawa rests on the concept of fiscal capacity. When a government collects tax, it typically sets a rate that is applied to what is called a tax base. For example, the total sales of taxed products during a year represent the tax base to which a sales tax rate is applied. Under the equalization program, the pooled tax bases associated with five major tax categories constitute the “fiscal capacity” for each province. These five are: Individual income taxes, corporate income taxes, consumption taxes, property taxes and natural resource revenues.
Whether the applied tax rate for a given province is high or low makes no difference in the calculation of equalization; only the fiscal capacity, as described in the paragraph above, counts. Since one percentage point of individual income tax generates less revenue per resident in Quebec than it does in Alberta, the portion of Quebec’s fiscal capacity associated with individual income tax is lower than its Alberta counterpart. But the fact that Quebec’s income tax rates are much higher than Alberta’s income tax rates is not taken into consideration.
The fiscal capacity of each province is compared with the average fiscal capacity of the 10 provinces. Those that are situated below the average are entitled to an equalization transfer, which is paid by the federal government out of its own tax revenues. However, total equalization transfers cannot shrink, nor can they grow faster than the economy as a whole.
In the case of natural resources, there is an important difference: In this category only, fiscal capacity is measured according to the revenues actually collected by the government. Unlike with the other four tax-base categories, there is no tax base independent of the rate. Therefore, what a government receives in forest royalties, mining royalties or profits earned by its electricity-producing public corporations, among others, form the resource portion of the fiscal capacity of that province. Since a higher fiscal capacity has the effect of reducing the equalization payments that a have-not province gets, the decisions of the government to authorize the exploitation of natural resources, or to determine royalty rates, will have a direct impact on the amounts received.
Do governments actually take this equalization arithmetic into account when they make resource-related decisions? A controversy surrounding electricity rates in Quebec suggests that they do.
The electricity rates paid by Quebec consumers are lower than the North American market price. According to some, the government has not addressed this issue yet, because it knows that a substantial rate hike would lead to an increase in revenue, which means an increase in the resource portion of the tax base used for the equalization formula, which means a reduction (known as a “clawback”) in equalization payments.
The Quebec government maintains that the calculation of equalization payments does not factor into its decisions. Yet when the equalization formula was modified in 2007, the question of natural resources ended up being central to the debate. The federal government’s decision was to include only half of the revenues drawn from natural resources in calculating equalization payments. The clawback of equalization entitlements accompanying revenue increases drawn from natural resources is therefore smaller (50 cents on the dollar, instead of 100) than for the other categories of fiscal capacity. This was an implicit acknowledgement of the necessity of encouraging the provinces to further develop their natural resources.
This implicit recognition also took the form of specific agreements with two Atlantic provinces. Both Newfoundland and Labrador and Nova Scotia signed agreements through which the federal government committed to compensate them for the reduction in equalization transfers stemming from the exploitation of offshore oilfields. In both cases, the provinces can temporarily enrich themselves by exploiting this oil without being penalized by any clawback in equalization payments.
To ensure that a receiving province does not get equalization payments that are much more generous than what others receive, simply because of the particular way natural resources are treated, the equalization formula also provides for a second calculation that establishes a “fiscal capacity ceiling.” This figure is obtained by assessing the average fiscal capacities of the receiving (i.e. “have not”) provinces only — but this time, factoring in both 100% of natural resource revenues, and the equalization entitlements that already have been determined. Receiving provinces whose fiscal capacities surpass this ceiling have their equalization entitlements reduced to the corresponding level. Quebec, in particular, has reached this ceiling.
The exploitation of natural resources in Quebec could help the province get out of “have not” status in the coming years. And the formula used to calculate equalization should be adjusted to encourage that. One possible concrete solution would be not to have any clawback for revenue from new natural resource projects for a number of years (and also excluding this new revenue from the calculation of the fiscal capacity ceiling). Revenue from new development projects therefore would temporarily not reduce equalization transfers. After the exemption period, the new revenue would then be considered at 50%, as in the current formula.
Within this new framework, an additional adjustment would be to replace the current calculation of fiscal capacity based on 50% of royalties with a different calculation based on 50% of corporate profits from the exploitation of natural resources. This way, the royalty rate would no longer influence fiscal capacity, just as tax rates have no impact in the other categories. Equalization transfers would then be more neutral in terms of a province’s fiscal policy choices.
One way or another, a mechanism encouraging more development of natural resources seems like a promising avenue that could appeal to all sides.
Youri Chassin is an Economist at the Montreal Economic Institute. The views reflected in this op-ed are his own.