Equalization’s Good Intentions Not Enough

Commentary, Equalization, Frontier Centre

With a budget looming, our provincial government is scrambling to find the cash to pay for all the goods and services it delivers. A haemorrhaging health budget and the recent pause in the North American economy have made life complicated for Finance Minister Greg Selinger. An easy answer, the hope for more outside transfer payments, may not be realistic, especially in the long term.

On a cool, rainy day in Montreal last October, several think tanks held a one-day conference on Canada’s equalization program. A variety of academics and leading policy wonks tried to answer the question: Is equalization a welfare trap or helping hand?

It is a thorny issue. The federal equalization program has noble intentions, to allow provinces with lesser tax bases to provide reasonably comparable public services at reasonably comparable levels of taxation. “Have” provinces like Alberta and Ontario -B.C. became a “have not” province under its former NDP government (1999) – pay an annual $10 billion subsidy to poorer provinces. In 2001, equalization accounted for a third of Newfoundland’s total budget and roughly a quarter of the remaining Maritime provinces, followed by Manitoba (19%), Quebec (7.5%), and Saskatchewan (2.6%).

The conference did not arrive at any clear-cut answers to the welfare trap question. The general sentiment agreed that the program had flaws, but that it should be fixed so that there would be fewer damaging side effects.

One of several papers presented (all available at www.fcpp.org) showed that equalization payments create incentives for recipient governments to set higher tax rates and spend more than others on consumption-related programs. With less pressure to live within their means, University of Alberta Professor Bev Dahlby predicted that they will focus less on income-producing policies. In other words, equalization diverts them from the basics of good public policy like competitive taxation and a friendly regulatory environment. Certainly his thesis rings true in Manitoba, where the top marginal income tax rate is an astonishing 75% higher than fast-growing Alberta’s (see Westward Ho charticle).

Two Quebec academics suggested that the subsidies allow have-not provinces to avoid needed adjustments to the new competitive economic environment. A comparison of the wealthy, low unemployment New England economy with the moribund Maritimes region of Canada, or the dynamic Minnesota economy with congenitally “stable” Manitoba, makes this proposition look reasonable. Equalization doesn’t help its beneficiaries – it ultimately makes them poorer.

Others defended equalization. A representative of Prince Edward Island’s government argued in favour of enriching and expanding it. A broad cross-section of interest groups who tend to rely on public sector funding have argued this for many years.

James Buchanan, the 1986 Nobel prize winner in economics who is regarded as one of the original advocates of equalization-type programs 50 years ago, provided an outsider’s perspective. Buchanan argued that equalization is defensible in theory but that such efforts are too easily captured by politics. In an interview later (see Buchanan), he agreed with the proposition that the program risked wasting resources by allowing inordinate room “to expand the size of the public sector in receiving provinces, for example, by propping up inefficient and ineffective policy delivery models”.

Buchanan’s original proposal for equalization meant transfers to individuals, not governments. “From an ideal economic point-of-view” he said, “you would definitely have to give it to individuals. My scheme at that time [1948] applied to differential rates of income tax in different provinces. Once you transfer from government to government, you have another source of major inefficiency.”

The Nobel laureate observed that government-to-government transfers create benefits within the bureaucracy that would be vigorously defended. He was right. Any critique of equalization today evokes a strong reaction from mainstream academia, members of the political class, and public sector spending coalitions.

But several indicators in this province demonstrate the downside of government-to-government subsidies. Do they go into better service or just more inputs in old delivery models? There is evidence for the latter. Sluggish government monopolies dominate the health (see health spending) and education industries, and various commercial sectors. Manitoba spends above the Canadian average for health care, for instance, but the money buys below average outcomes. The civil service is significantly larger and paid higher than national norms (see size of public sector ).
Taxes of several kinds, on property, income, and capital, are plainly uncompetitive, so the tax base has little room to grow. It’s much the same story in the Maritimes.

Over the longer term, this situation is a recipe for steady decline. The population ages and consumes services paid for by equalization, while the entrepreneurs and young people move to places like Alberta with lower taxes. The tax base grows slowly, if at all, and the population becomes more dependent as the local ability to pay for services shrinks.

We need to be bolder. Instead of equalization, why don’t the feds transfer tax room to the provinces? What about letting individual provinces opt off of the subsidy track with a one-time payout to extinguish their debts and create an endowment fund?

In his next budget, Greg Selinger will likely not focus on the basics of creating a dynamic Manitoba economy because there are weak incentives to do so. He will eschew substantially lowering taxes, adopting innovative delivery models, ending business subsidies, and exiting areas where governments have limited skills and competence. Rather, he will pray for more transfers from Ottawa.

Maybe that will happen. But the issue of creating a self-sustaining economy will return next year. It’s time to start seeking intelligent alternatives to our system of inter-governmental equalization.