Equalization: Help that Hurts

Commentary, Equalization, Ken Boessenkool (historic), Uncategorized

The federal equalization program — which distributes dollars to poorer provinces based on their ability to raise revenues — is rather simple in theory and noble in intent. According to the Canadian Constitution, equalization exists to “ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation.” In practice, however, equalization is exceedingly complex and some of the incentives it creates are far from noble. In short, equalization appears to be help that hurts.

For at least 30 years, we policy wonks have built economic models showing equalization creates incentives for less-developed provinces to raise their taxes. By manipulating their own tax rates, in theory poorer provinces can affect the size of their equalization payment, and get partially compensated for the debilitating effects of those higher taxes.

But until now, no one has actually checked the evidence to see whether this prediction about equalization’s perverse incentives is actually borne out by the facts. Well, the verdict is in: There is strong evidence that equalization does, in fact, encourage poorer provinces to overtax their population. Start with the evidence about tax rates. The burden of personal income taxes in poorer provinces is, on average, one-third higher than in richer provinces (British Columbia, Alberta and Ontario). Capital taxes in poorer provinces are more than two times higher than in the rich provinces; sales taxes are half-again as high; and fuel taxes are one-tenth to three-fifths higher. Even if you take low-tax Alberta out of the calculation, and compare taxes in the equalization-receiving provinces only with those in Ontario and British Columbia, the conclusion still holds.

Now the wonks not only predicted that taxes would be higher in recipient provinces; they also foresaw two other effects of equalization on taxes. First, they predicted that the bigger the province, the stronger the incentives would be — i.e. these incentives should be stronger for Quebec (the largest recipient) than for the Atlantic Provinces. Second, they predicted there would be a perverse incentive to levy higher tax rates on weaker tax bases (those tax bases most likely to shrink under the burden of heavy taxation) and lower tax rates on stronger tax bases (those more resistant to the effects of heavy taxes).

The evidence supports both predictions — tax rates in Quebec are generally higher than tax rates in Manitoba and Saskatchewan, which are in turn higher than in the Atlantic provinces. To take but one example, average personal income tax rates as measured by Ottawa’s equalization calculations, are more than 43% higher than the national average in Quebec, 18% higher in Manitoba and Saskatchewan and 16% higher in the Atlantic provinces. Recipient provinces also show evidence of levying higher tax rates on relatively weak tax bases, and lower tax rates on relatively stronger tax bases.

These findings are striking, for they confirm not only that the constitutional imperative to ensure “comparable tax rates” is not working, but that the predictions of the theorists about equalization’s perverse incentives are precisely mirrored in the real world. In short, equalization rewards recipient provinces for imposing high and damaging tax rates. For far too long, proponents of equalization have dismissed such concerns about perverse incentive effects as ivory tower analysts having too much fun with economic models. They were only partly right (we do have fun with our models). It will now be much more difficult to play down these incentive effects in the face of this empirical support.

Of particular interest is the fact that the highest tax rates in recipient provinces tend to be on personal income and, to a slightly lesser extent, taxes on consumption. In other words, the perverse effects seem to be showing themselves most strongly via taxes on people.

These higher tax rates that are a result of equalization’s perverse incentives threaten to derail a prosperous future for Canada’s poorer provinces. At a time when human capital is one of the most important keys to growth in an increasingly globalized and technologically dependent world, these incentives ought to worry all Canadians who are concerned with the future of our more economically dependent regions. These regions have faced enough challenges in the past, and in the present, without the noble intentioned equalization program creating further perverse results.

Moreover, Canada’s wealthier provinces have clearly chosen a low-tax model as the basis for their future growth, and are in competition to lower tax rates. That means that the provinces most in need of growth, the equalization recipients, are now being rewarded for keeping their tax rates too high, as the wealthier provinces drop their taxes to make themselves a magnet for investment and jobs. Such a policy is almost guaranteed to keep the poorer provinces poor and to make dependence on transfers a permanent feature of Canada’s policy landscape.

This opens up a new challenge, namely, how might equalization be reformed to reduce these perverse incentives. That work must now proceed if Canadians who live in recipient provinces are to be relieved from the excess tax burdens that equalization’s incentives appear to be producing. All Canadians have a stake in ensuring that we stop providing help that hurts.