*The cruel hand of equalization

Equalization, Ken Boessenkool (historic), Uncategorized, Worth A Look

After 44 years and $180-billion dollars in equalization spending (not adjusted for inflation) the Atlantic provinces are only barely more able to meet the needs of their citizens with their own revenue sources than they were when equalization was introduced in 1957. On average, about 40% of provincial budgets in the four Atlantic provinces comes from federal transfers, most in the form of equalization.

Apologists for the regime say it was never equalization’s purpose to “close the disparity gap” with the rest of the country, but simply to compensate for its existence. But what we have discovered after nearly half a century is that incentives matter, and the incentives attached to equalization can penalize the poorer provinces for developing their economy and encourage them to settle for permanent reliance on federal transfers. “Sharing” has its virtues, but surely the prime object behind our fiscal arrangements should not be to maintain poorer provinces in a state of splendid dependence, but rather to build their capacity to pay their own way. The greatest victory of fiscal federalism could and should be the elimination of the need for equalization payments.

The time has never been better for the Atlantic provinces to lessen their dependence on federal transfers and to become masters of their own fate. Energy prices are high, shortages are emerging in Canada’s major U.S. markets, and the Prime Minister has responded favourably to U.S. requests to speed up the development of new energy supplies. The picture is positive for the newly emerging offshore oil and gas industry in Atlantic Canada. Within a few years, Newfoundland is projected to be producing around 40% of Canada’s conventional oil, while a natural gas pipeline, possibly the first of several, already connects Nova Scotia with New England. It appears that offshore and onshore petroleum resources may be discovered in or around virtually every province in the region.

The development of natural resources, primarily oil and gas but also other minerals, such as the Voisey’s Bay nickel deposit, creates the conditions in which economic growth in the region could well outstrip that of the rest of the country.

Unfortunately, with equalization, the potential for growth, and realizing that potential, are two different things.

Unlike Alberta, the Atlantic provinces see little reward from developing nonrenewable natural resources. The reason is that the equalization program can strip more than 90% of any new provincial revenue from such development. Thus, the perverse incentives of the program shackle economic policy in the Atlantic provinces.

Consider this: Ottawa lets Newfoundland and Nova Scotia keep 30% of revenue from offshore petroleum resources. The result is that the provinces have little reason to try to maximize their long-term tax revenue and economic development from the offshore, most of which would be scooped up by wealthy Ottawa. Instead, they try to extort superficial benefits out of the industry, such as lots of short-term and often relatively low-skilled jobs. They build outdated gravity-based structures for oil extraction, or require companies to make vague promises of massive exploration and development spending in exchange for drilling rights. They could sell more of the resource up front, to retire some of their huge debt and reduce their crushing interest payments, but after Ottawa’s huge take, it hardly seems a good move.

An attractive way to fix a major part of the problem would be to remove all nonrenewable resource revenue from the equalization formula. The reasons for doing so are at least three. First and most important, this change would eliminate the clawback on nonrenewable resource revenue. Second, including this revenue within equalization makes little economic sense. It is not annual income; it is the transfer of a stock of wealth from one form to another, generating no increase in wealth. Further, the economic activity that follows the exploitation of natural resources is a sure-fire way to drive up other prices, such as wages and housing prices, which are already captured in the equalization formula. Removing nonrenewable natural resources from equalization would end this double counting.

This change would provide the Atlantic provinces with the incentive to rely on natural resources development as a centrepiece of their economic strategy in place of pleading for larger transfers from equalization. Gone would be the days when an Atlantic province might forfeit a nickel mine, or forgo sound long-term development of offshore oil and gas deposits because of the perverse incentives of the equalization program.

Removing nonrenewable natural resources from the equalization formula would require the Atlantic provinces to accept small decreases in their equalization entitlements — smaller than the recent increases in equalization payments and nothing that a modest transition mechanism could not fix — but leave the region much stronger in the long run.

Taking off the shackles would make Atlantic Canadians the big winners as provincial policy in the region shifted away from dependence on Ottawa toward greater self-reliance. Indeed, the inter-regional economic gap would shrink, and all Canadians would benefit.