Transformational Equalization

Part One – The Flypaper in the Ointment

By Peter Holle

Last month’s federal budget renewed one of Canada’s most sacred public policy cows, our 10 billion dollar equalization program, as is, for another five years. The opportunity for substantive reform must now wait. This venerable and well-intended program shifts resources from “have” to “have–not” provinces to ensure a reasonably similar level of services across the country. That sounds noble, but several of the country’s bolder think tanks are exploring the program’s downside. The problems lie in its creation of perverse incentives. Equalization locks “have-not” provinces into enormous welfare traps that encourage increased dependency on federal transfers. It perpetuates stagnant and inefficient policy models and promotes tax and regulatory regimes that discourage economic growth.

Saskatchewan’s beleaguered finance minister, Harry Van Mulligen, understands the welfare trap well. As Social Services Minister in the Roy Romanow government, he spearheaded a set of welfare reforms lauded in 1999 by the OECD for helping welfare clients to achieve independence. Welfare reform’s main goal should be to reward the decisions of individuals to work, as opposed to remaining on social assistance, he maintains.

“But what about my province and equalization?” he asks. “Why does it punish Saskatchewan for having a successful oil industry?” It’s a good question. Bizarrely, in 2001the equalization system deducted $885 million from his province’s transfer payments because Saskatchewan’s oil industry generated $668 million. Theoretically, Van Mulligen’s government would have been further ahead, in terms of revenue, if it had shut the whole industry down. The Federal Government should stop punishing Saskatchewan for economic growth in our resource sector”, he says.

The formula for determining transfer amounts includes five provincial standards, 33 tax bases and a set of special transitional formulas. It is so complex that perhaps only 30 government technocrats and academics in Canada understand it at all. One “solution” proffered for the Saskatchewan equalization rip-off is to allow that province the same arrangement enjoyed by fellow “have-nots” Nova Scotia and Newfoundland – namely that the feds will “only” clawback 70% of offshore oil revenues. Ouch.

A 2002 study by the Atlantic Institute for Market Studies (AIMS) demonstrates that recipient provinces can maximize their equalization subsidies by raising taxes on weak tax bases. Personal taxes, on average, are one-third higher in “have not” provinces than in “rich” provinces. Similarly, capital taxes are more than twice as high, while sales taxes are half again as high. Are we surprised that capital, jobs, and growth gravitate towards the “have” provinces of Ontario and Alberta, who then are blessed to share some of the fruits of growth with their subsidized brethren?

Federalized states around the world have installed equalization programs. Invariably, they are too complex to be understood by more than a few government technocrats. Always well intended, they invariably entrench old policies by draining the economic vitality of the most productive regions. Most damagingly, they can inflame regional tensions to the point of fuelling aggressive separatism in some countries.

Consider the following 3 countries.

In Belgium, the Flanders region heavily subsidizes the states of Wallonia and Brussels (see Frontier BackgrounderIn Flander’s Field the Transfers Grow). The Brussels and Walloon governments raise taxes and aggressively regulate the economy with the knowledge that economic misperformance increases Flemish transfers. The separatist, Flanders-based Vlaams Blok Party now campaigns aggressively to take Flanders out of Belgium.

The residents of prosperous Stockholm refer to Sweden’s equalization program as the “Robin Hood tax”, an odd metaphor since the legendary rebel stole from the taxman, not the other way around. The transfer is huge, over $11,500 per Stockholm resident. It is no coincidence that the most impressive reforms to the public sector, including the introduction of competitive markets in healthcare and transportation, have occurred in Stockholm, while the recipient regions coast along with old monopoly models funded by rising equalization (see Frontier BackgrounderSweden’s Equalization Milk Cow).

Equalization also strains the Australian federation. In 2002, Tasmania, the poorest state, received 67% of its revenues from these transfers. Unsurprisingly, the easy outside money allows the state to impose comparatively high taxes and restrictive labour and environmental legislation – all amid an accelerating drain of young people and entrepreneurs, the life-blood of a successful economy (see Frontier BackgrounderThe Tasmanian Devil is in Equalization’s Details).

An articulate 2002 critique of Australia’s equalization system (available at identified problems which resonate eerily on Canada’s own policy landscape. It refers to “game-playing” by bureaucrats in recipient states who seek to redefine activities and tend to increase taxation and spending, both to maximize equalization payments. Significantly, the system creates “a tendency towards a reduced effort on cost-reducing reform.” Colourfully, the study says that these states suffer from the “flypaper effect:” ”Money ’thrown’ at a State government tends to stick, even though the welfare of households would be better served by if the money were passed on to them through lower taxes.“

Let’s apply the “flypaper” effect to Canada, particularly Manitoba. In 2003, it received $1.4 billion in equalization, or 19% of its budget. The money has indeed stuck to its public sector. It has the biggest provincial government in western Canada, 24% of GDP compared to 19% in the equalization loser, Saskatchewan. The extra spending, not coincidentally, is similar to the amount of equalization Manitoba receives. It spends the most per capita in Canada on healthcare, without remarkably better results. If its health spending were brought down to the Canadian average, a reasonable scenario, spending would fall by almost $400 million.

As predicted by the AIMS research, Manitoba has Western Canada’s highest personal and capital taxes on the weakest base. Finally, it has little incentive to price its hydro-electric resource properly to generate its own revenue base. According to Tom Adams, director of Energy Probe, a Toronto think-tank, Manitoba could generate at least $900 million a year extra in revenue if it priced its electricity at market rates.

But why should it? As long as Alberta and Ontario pay the freight for a system that bloats up its public sector, keeps its taxes uncompetitive and removes any reason to price its resources properly, it will continue to coast along in a “have-not” purgatory.

In short, Manitoba is paid to have a big government and not grow or innovate, a rational result of an irrationally complex and distorting system.

Part Two – The Tasmanian Devil is in the Details – Australian Equalization Blues

By Mike Nahan

Tasmania – Australia’s island state – is caught in a classical welfare trap. Its economy is in relative decline. It is losing its best and brightest. Poverty and despondency are increasing. And while it is not quite the Appalachia of Australia, it is on the same path and subject to the same type of jokes.

How could a potentially resource rich states such as Tasmania, in a federal nation which has an extensive system of redistributive grants designed expressly to avoid large divergences in economic and government capacity, be in decline?

The answer lies, in main, with the Australian federal system. In spite of its good intentions, the system has created a perverse set of incentives that lure states into dependency and lock them into decline.

The root of the problem lies with the central [Commonwealth] Government’s domination of taxing powers. Even at the time of federation in 1900, the Australian States were more dependent upon the central government than their North American counterparts. As time went by, the Commonwealth steadily accreted more taxing powers to itself. As a result, the states, on average, now rely on the Commonwealth for 43 per cent of their total revenue, with the smaller state Tasmania dependent on the Commonwealth for 65 per cent of its total revenue.

Australia’s most articulate founding father, Alfred Deakin, warned of this flaw prior to federation when he stated that the Australian Constitution left the states “legally free but financially bound to the chariot wheels of the central government”. But his successors did not listen. While the state leaders have at times complained about the imbalance, in the end they acceded to Commonwealth control. Their rationale was best expressed by a former Premier of Queensland when he stated that “the only good tax is a Commonwealth tax”, meaning that he and his colleagues where happy for the Commonwealth to do their taxing for them.

The imbalance in tax powers naturally led to a large flow of payments from the Commonwealth to the states. The size of programme was augmented by the fact that the Australian Constitution gives the lion’s share of spending responsibilities to the states.

Initially the Commonwealth’s surplus funds were allocated on a one-off basis to struggling states. There was no attempt to equalize income or services across the States and the grants were viewed at least by the Commonwealth as temporary.

Starting in the 1930s, the perennially struggling States, including Tasmania, demanded a more comprehensive and permanent system. They also argued that the system should be put at arms length from the political process and turned over to a dedicated bureaucracy. The Commonwealth and the more prosperous States resisted these demands. However, in the 1930s a successful pro-independence referendum in Western Australia frightened the Commonwealth into acceding to these demands. It established the Commonwealth Grants Commission to devise a methodology and provide advice on the allocation of grants amongst the States. Under the Commission, the scope and purpose of the grants steadily changed from providing temporary respite from hardship to permanent respite from hardship, and from considering the equalization of some services and revenue to the equalization of all revenue and services.

From its inception, the equalization process was criticized for its potential to create a dependency amongst States, as well as the potential for gaming and other unproductive activity.

Despite the Commission efforts to avoid these distortions, they inevitably failed. The task of simulating something as complex and malleable as ‘the standard level of service’ in an independent and objective manner across a large continent nation such as Australia was simply impossible.

The Commission’s process has had a number of central flaws.

First, it gives no consideration to the effect of the state’s own decisions on its economy.

Second, the benchmarks used to determine the acceptable level of services are not based on effectiveness or efficiency, but rather on a common policy. As such the process, at times, not only compensates for inappropriate policies, but perpetuates them.

Thus, as Tasmanian governments lock away larger chunks of the state’s resource base from development, they have not only not been penalized but have received compensation for the loss of revenue earning power. As they impose higher taxes and regulations that create a disincentive for job creation and economic growth, they have suffered no penalty. As Tasmanian governments borrow heavily to fund unproductive jobs in government-owned businesses, they have received additional compensation.

Over the last two decades, as that state’s economy has stagnated, its per capita grants have increased and now stand 87 per cent above the all-state average.

While official reports have tended to blame natural causes, such as the state’s small size and remote location, for the States poor economy, the evidence points clearly to poor policy choices, aided and abetted by the federal equalization system.

The system has sheltered Tasmanians from taking responsibility for their own future and induced them to become dependent on the generosity of their fellow Australians. This has bred a culture of complacency and political resistance to change.

The future is not rosy for Tasmanians. The generosity of their fellow Australians is being strained and change is on the cards. Change will only go in one direction; less welfare and more self reliance.

The question is: after decades of equalization, dependency and with a lagging economy, can Tasmania change and recover? One thing is clear; the adjustment cost will be high.

(Mike Nahan is the executive director of the Institute for Public Affairs, an independent think tank based in Melbourne, Australia, This article is based on a six page Frontier Centre Backgrounder – The Tasmanian Devil is in Equalization’s Details)

Part Three – Making Equalization Transformational – A Better Way to Help the Have-Nots

Equalization began as a simple program in 1957. Despite cumulative expenditures of over $200 billion through 2004, the economies of “have not” provinces have fallen progressively behind. Indeed, these well-intended transfers now encourage proactive stagnation in recipient regions. The evidence indicates it is time for an honest re-evaluation.

Ontario was the only “have” province until 1966, when Alberta’s oil wealth allowed it to graduate from the “have not” ranks. In 1982, equalization was entrenched in the new constitution as a key building block of the Canadian federation. But, as former New Brunswick Premier Frank McKenna astutely observed, equalization is not “transformative,” at least not in a positive direction. The first of this series described its perverse incentives for provinces like Manitoba. The transfers encouraged it to balloon public sector spending, raise taxes and misprice its massive hydroelectric resource. Outrageously high “claw-backs” punish provinces like Saskatchewan, Newfoundland and Nova Scotia for developing their oil resources.

Yet equalization remains the holiest of Canada’s sacred cows. Beneficiary groups hotly condemn suggestions for tackling the program’s welfare trap effects. Perhaps revisiting the policy’s origins may provide a starting point for this needed debate. Was the theory that inspired it sound?

Yes and no. Nobel Laureate James Buchanan, the “father” of equalization theory, originally described it as a bribe to induce residents in low-income areas to stay home, to avoid the swamping of wealthy areas by migration. But the gnomes who devised Canada’s program ignored his preferred method. Buchanan recommended transfers to individuals by means of regionally lowered income taxes, not unconditional transfers to “have-not” governments. He described intergovernmental transfers as an inferior option, their usefulness limited to investment in productivity-enhancing areas like education or transportation.

In 2001, Buchanan repeated his prediction that our style of equalization would tend to expand the government sector in recipient provinces. Witness the so-called “flypaper effect,” as public sector intermediaries captured the transfer’s benefits. It is no coincidence that Canada’s largest governments (as a percent of the economy) invariably occur in “have not” provinces.

Both “have” and “have not” provinces have a stake in substantive reform. Equalization ought to convert poorer provinces into self-sustaining ones, not lock them into dependency or hobble them with high taxes and low-performing services. If equalization instead place the “have-nots” back on a growth track, all parties will benefit. The effort would unravel decades of fiddling and fumbling with obscure formulas and the complex policy distortions they have spawned.

It is unreasonable to expect “have not” politicians to bear the cost of reform. Making equalization a truly transformative policy would require a transition period and appropriate compensation for required adjustments. To avoid rancour, the change would be voluntary for have-not provinces. Saskatchewan, clearly ripped off in the present system with 125% clawbacks on resource revenues, also deserves special consideration.

In that context, four ideas for equalization reform:

Tinkering with the formula – Recent research (see shows that removing resource revenues from the formula would greatly simplify the program while ameliorating the egregious welfare trap effect caused by claw backs. A second fix would make transfers sensitive to the effectiveness of spending in recipient regions, with a simple rule, phased in over five years that recipient provinces cannot spend more than national averages on public services. This would end the perverse situation where “have not” provinces spend more per capita for healthcare and education than payer provinces. It would create an impetus for needed structural reform in these inefficient service sectors.

Regional federal tax reduction – Buchanan’s original theory would entail dramatic income tax reductions in “have not” provinces. Both Paul Martin and Frank McKenna have toyed with the idea of converting ineffective regional development and job creation programs into a 10-year federal tax holiday for the “have nots.” Conversion from the entrenched existing program would be politically difficult as stakeholders fight ferociously to maintain the flow of funds through the public sector. Nor could support by Alberta and Ontario for such a scheme be assumed. Paying to keep fellow provinces on a dole that keeps them uncompetitive is one thing. Paying them to have lower taxes while removing systemic foibles that make them uncompetitive is another. Perhaps they will eschew such cynicism, and insist on help that really helps.

Debt-for-equalization swap – Most equalization goes right back out the door in the form of provincial debt service charges. If Ottawa and the provinces did a debt-for-equalization swap, the provinces could clean up their balance sheets, swapping the end of debt payments for equalization payments. Capitalizing the present $10 billion equalization commitment into a one-time debt swap of $135 billion (7.5% cap rate) would allow, based on present funding distributions, the following provinces to swap the following debt with Ottawa – $52 billion (Quebec), $18.5 billion (Manitoba) and $15.8 billion (Nova Scotia). Ottawa’s equalization commitment and the accompanying distortions would be eliminated. The price? A manageable increase in a steadily falling federal debt with a further saving due to lower debt servicing costs in Ottawa due to its better credit rating. This would have to be accompanied by strict rules that prevented provinces from simply running up their debt again.

The tax swap – If we bundle equalization together with other federal transfer programs, including support for health and other social programs (CHST), the transfer in 2004 totals about $33 billion. The revenue from the GST during the same period is projected at almost $29 billion, or roughly the same amount. Subject to harmonizing the GST with provincial sales taxes, the federal government would simply hand provinces the GST as a substitute for equalization and CHST programs. This would sidestep the unnecessary bureaucratic and political churn that characterize transfers by eliminating the whole complex mess. It would also be the least difficult to sell since all provinces benefit from the swap.

Imagine the day Manitoba had competitive taxes, an innovative, high performing public sector, and priced its hydro resources properly. With a growing population and strong business investment it would become a have province. Replay this story throughout the Maritimes and Quebec. Dramatic equalization reform is the fastest way to get there.