Nothing for the Money

Brian Lee Crowley, Commentary, Equalization, Uncategorized

Almost 70 years ago, a Nova Scotian stood before a Toronto audience and gave a remarkable speech. He told that audience what his part of the country — the Maritimes — needed to overcome its underdevelopment.

The biggest obstacle to the region’s development was what he called “the tariff,” or the old National Policy of Canada’s first Prime Minister, Sir John A. Macdonald, a policy we abolished with the free trade agreement with the United States. So what could Ottawa do to help?

First, lower the tariffs. Failing substantial reductions in tariffs, some compensation for the effects of those tariffs (such as reduced freight rates). Finally, and least satisfactory of all, he said, would be the granting of subsidies from the Dominion Treasury. “Subsidies do not increase the general level of the prosperity of the people. They may make the task of government a little easier. They may render the work of balancing the budget a little less difficult, but in the last analysis they do not add to the economic advancement of the people.”

No economist, the speaker still understood in his gut how things worked. His essential argument was that if you removed the barriers to people’s prosperity they would quickly make up any lag compared to wealthier and more developed places. Try instead to compensate for underdevelopment with money and it creates dependence.

Economic theory and real-world experience in places as diverse as Ireland, Japan, the Netherlands, the Asian Tigers, China, India, Slovakia, and elsewhere agree: Lagging economies naturally catch up with advanced ones. Normally a lagging region should close the gap in economic performance with its relevant leading economy by 2% to 3% annually. Yet Atlantic Canada’s economy has converged with that of the rest of Canada at less than half that rate. The reason is massive federal intervention, financed, in large part, with tax dollars from Ontario and Alberta.

How massive has that intervention been? If you took the net transfers into Atlantic Canada (federal spending in the region minus federal taxes collected in the region) between 1971 and 2003 and had invested the money in the TSE/TSX 300 and reinvested all the dividends, that account today would be worth more than $2.2-trillion, enough to pay off the entire national debt of Canada four times over. And what have we got in exchange for this vast opportunity cost? A rate of convergence less than half what we would have expected to achieve if we had done nothing at all.

This failure is not due to Atlantic Canada and other underdeveloped parts of the country not being “normal.” In the postwar era to 1971, Atlantic Canada’s per capita economic growth often outpaced the nation. Only when Ottawa dramatically increased transfers in the early to mid-1970s did the region’s growth falter relative to the rest of Canada. To cite only one example, consider how unemployment in Atlantic Canada behaved before and after the broad liberalization of Unemployment Insurance in 1971. Atlantic Canada unemployment had just converged on the national rate in 1970. Then, bingo, we were clobbered by the insurance reforms (see graph).

Federal programs aimed at accelerating convergence and minimizing economic disparity have encouraged Atlantic Canada to become reliant on Ottawa’s generosity.

This phenomenon becomes particularly instructive when placed in the context of the complaints successive Ontario governments, including Dalton McGuinty’s, have made in the past 15 years or so that Ottawa is taking too much out of the Ontario economy. The trouble is Ontario has been asking the wrong question. The right question is not “Is Ottawa taking too much?”, even though I think the answer is unambiguously “yes”. The far more interesting question is “What is Ontario getting for the money?” Canadians would be far less supportive of massive spending if they know that not only do the transfers fail to achieve objectives of fairness and equity, they impose a burden of taxation on Ontario that is making it uncompetitive with economies across North America.

Ottawa’s good intentions have held back underdeveloped regions across the country, in this case making Ontario uncompetitive while undermining the Maritimes. Two examples demonstrate how bad policies affect behaviour for the worse, creating perverse incentives in vulnerable regions that encourage dependence, policy paralysis, low growth and unemployment.

Engage with me in an experiment. Imagine you are a provincial finance minister in a less-developed province. With your cabinet colleagues, you would like to find some new money to spend on programs — health care, education, roads. There are basically four ways you can find the money.

First, you could actually encourage growth of the provincial economy. You would get more money because the same tax load on a larger pie generates more revenue. Second, you could raise your taxes on existing economic activity. Third, you can get transfers from Ottawa. Fourth, you can borrow. Each of those choices comes with a certain set of rewards and penalties attached to it.

Option 1: Create conditions where the economy will grow. That’s often a difficult thing to do. It might involve taking on the trade unions and liberalizing labour market rules. That will get you thousands of protesters on the steps of the legislature. You might have to cut business taxes, introduce user charges on public services or cut inefficient and unproductive public employment. You might need to reform welfare to encourage people to return to the workforce.

Most of the measures necessary to generate economic growth come with a political cost. And even then the tax revenue from growth may take several years to materialize.

All finance ministers face such obstacles to good policy. But there’s an even greater obstacle in Atlantic Canada. If the economy does grow and new money comes in the door, what does Ottawa do? Under equalization, Ottawa takes about 90 cents or more of that new revenue by deducting it from your equalization payment. You pay the political cost of reform and Ottawa scoops up the cash.

Option 2: Increase taxes. If you raise taxes on existing business activity, you get to keep the money. Raise your tax take by a dollar and you get an entire dollar to spend, whereas if you generate new economic activity you get at best 10 cents on the dollar, and maybe nothing. The perverse incentives multiply. High taxes can drive away investors and destroy economic activity. Ottawa, under equalization, actually rewards such bad policy by compensating you for its ill effects. So not only do you get a whole dollar from raising taxes on your existing economic activity, but if you damage the economy as a result, Ottawa will help you out.

Option 3: Get increased transfers from Ottawa. A dollar in transfers is a whole dollar available for spending. Remember, if you’re trying to grow the economy, it’s only 10 cents dollars at best.

Transfers from Ottawa deliver a bonus because the money is raised on the national tax base. You’re now getting money to spend on programs for people in your province but the vast bulk of the money comes from other parts of the country and from people who do not vote in your provincial elections. It’s a sweet deal for the local voters too, who can vote for new spending knowing they can pass part of the bill on to non-residents.

It’s also a sweet deal for those who work for those provinces. Spending other people’s money makes the provinces less disciplined about spending. Not only do Atlantic Canada governments have more effective revenues per capita than Ontario and spend more per capita than Ontario. The region also has more public servants at the provincial and local government level (68 public employees per 1,000 Ontarians, but 88 per 1,000 Atlantic Canadians) and pays them more compared with local wages than Ontario pays its public employees. Much of the transfers go, not to providing more services, but creating more public sector jobs at higher relative wages than Ontarians provide themselves.

The final option for you, our imaginary finance minister, is debt. Borrowing is not as attractive as it once was, but a borrowed dollar is still an entire dollar to spend compared with the 10 cents dollar from economic growth.

A smart politician, adding all these things up, will react to the incentives. You are going to devote relatively little attention and energy to creating genuine sustainable economic development because it takes a lot of effort, and is politically costly. The results are uncertain and, under equalization, you don’t get much money out of it. The end result is predictable: high taxes, endless battles with Ottawa for more transfers, and high levels of debt.

That’s a quick insight into the political incentives our federal fiscal arrangements have created for less-developed provinces. How about individuals?

Here I want to talk about employment insurance.

Some of you may have noticed an article on the front page of the National Post on May 8 under the headline “PEI plant imports Russian workers: Not enough locals willing to work at seafood facility”. The article noted that the province’s unemployment rate stands at 10.5%. Similarly, CBC News reported on May 9 that “crab processing plants on [Newfoundland’s] Avalon Peninsula are having trouble finding workers, even though there have been hundreds of layoffs at fish plants around the province.”

Anomalous? Think again. This barely scratches the surface of the havoc created by an EI system that pays benefits for most of the year in return for few months’ work. Potential workers don’t look at the wages they would earn in a new year-round job, but rather at the difference between what they might earn in that new job and what they can earn with a short bout of seasonal work supplemented by months of EI. The difference is often pretty small, not least because the seasonal work cycle has already left these workers without job skills and education that might otherwise make them more valuable to employers.

If you have the standard prejudices about Atlantic Canada, your reaction might be that this makes sense because, after all, there are no jobs down there. Au contraire. Virtually every major business organization in the region reports its members have tremendous difficulties finding workers with the skills they need willing to work at prevailing wages. Those same organizations are pressing provincial governments to come up with an aggressive strategy to recruit immigrants to fill these gaps. We’ll soon have 70,000 to 80,000 fewer workers due to retirements and out migration. Even the fishery, as these recent stories show, is starting to feel the effects of a shortage of workers. Two summers ago the Halifax Herald devoted the entire front page of their business section for a week to stories about industry after industry facing crippling labour shortages in the region.

What we have is a desperate mismatch between the skills our workers have and the skills local employers need, plus an EI system that pays people not to work and penalizes people who try to get an education (because students don’t qualify for EI). Federal and provincial studies galore have repeatedly identified the perverse incentives in EI as the biggest obstacle to Atlantic Canada escaping its chronic underdevelopment.

Ontario Premier Dalton McGuinty and all those who pay into the edifice of programs designed to “help” the poorer regions of the country are right to be scandalized about what is going on, but the scandal is not the gap between what Ontarians pay in and what they get out of Ottawa, but rather the tragic destruction and waste wrought on the hapless “beneficiaries” of your money. The only thing I can say is that I implore you to stop doing us these “favours.”

I know you are anxious to discover who the mystery speaker was from whom I quoted at the outset. It was Angus L. Macdonald, the greatest Nova Scotian premier of them all. I still think the message he brought to Toronto 70 years ago was prescient and insightful into human nature and the behaviour of government. He would have felt consternation at how little his advice was heeded here, and disappointment in his own people, of whom he had such high expectations.

Our current approach is failing the poorer parts of the country, damaging Ontario’s ability to compete successfully in a tough and unforgiving world, dragging down productivity nationally and exacerbating regional tensions. After 70 years, Angus L.’s prescription of faith in Maritimers and creating opportunities for them rather than dependence is still the right one.

Help me honour his memory by demanding Ottawa and the provinces put things right so that the next progress report on Angus L’s challenge to Canada can say that not only was he right about what doesn’t work, but also about what does. As he said all those years ago, “[I]t is the difficult and dangerous effort that has always shouted the most compelling challenge to adventurous souls.”

Brian Lee Crowley is president of the Atlantic Institute for Market Studies, a public policy think-tank in Halifax. This is from his address to the Empire Club, Toronto, May 11, 2006. It was published in the National Post on May 13th.