Saskatchewan Should Lead Transformational Equalization

Commentary, Equalization, Frontier Centre, Saskatchewan, Uncategorized

A recent flurry of commentary about equalization in Saskatchewan is unsurprising, because the province continues to be the most obvious loser from this antiquated transfer system. Last week the Star-Phoenix endorsed yet another “fix” for this well-intended but damaging policy relic, this one from Professor Tom Courchene. Unfortunately, his prescriptions would add another layer of complexity to a program that most people already find incomprehensible. If you will, it’s more “lipstick on a pig.”

In 2001, Ottawa deducted $885 million from Saskatchewan’s equalization payments after it reported $668 million in oil revenues. In effect the province was paying Ottawa $227 million for having an oil industry. That’s a blunt hint that the formula needs change. It punishes resource development by treating the sale of a capital asset like an income flow. A pertinent analogy might be a business that draws down its cash balance to fund operations, or one the average Joe might understand, a family that sells off its house to pay for groceries. When the asset is gone, the party is over and the cupboard bare.

Equalization is supposed to help recipient provinces, but a substantial body of evidence indicates that unconditional transfers lock the “have nots” in a powerful welfare trap. They fall prey to perverse incentives to maximize subsidies by keeping taxes and spending high. Research by the Atlantic Institute (www.aims.ca) shows that high tax rates on weak tax bases maximize the yield from equalization. High taxes discourage economic growth and investment, and today’s competitive, wide-open economy requires precisely the opposite approach.

Equalization also retards beneficial structural reform of the public sector. Transfers tend to be capitalized into bigger government budgets and higher public payrolls. It’s called the “flypaper effect” – a bias towards keeping money within government programming and operations, even if there would be more economic benefit to sending the money through to citizens by lowering taxes.
Consider the different circumstances in two demographically similar provinces – Manitoba and Saskatchewan. Manitoba’s education and healthcare systems are among Canada’s most expensive, much more than Saskatchewan’s, thanks to generous equalization payments that account for 20% of its provincial budget. A recent Atlantic Institute study, the Flypaper Effect, indicates “that the equalization-receiving provinces have larger than average public service employment, higher than average public sector wages and higher than average levels of debt. Simply arriving at national average levels of these performance indicators would release two provinces, Manitoba and Québec, entirely from reliance on equalization.”

As mentioned, the quirky equalization formula punishes oil revenues by deducting them from payments. But Manitoba and Québec both have vast, renewable hydro-electric resources, which they price far below market value in the domestic market for political reasons. The cheap power encourages what are among the world’s highest per capita rates for consumption of electricity. Manitoba would generate an extra billion dollars in revenue – equivalent to almost two thirds of its equalization boodle – if it recognized the value of that resource. But it does not have to, since equalization subsidizes the slack.

In a 2001 Frontier Centre interview, the intellectual father of equalization, economist James Buchanan, recanted his original theory. It was intended for governments to “bribe” people not to move to economically vibrant areas. Canada made a mistake, he argued, by transferring the subsidies to governments instead of individuals. His original proposal, that taxes simply be reduced in “have not” areas, would have avoided capitalizing transfers into higher government spending.

The challenge is to find safe and reasonable ways for politicians in recipient provinces to move to smarter alternatives, ones that clearly have more benefits than downsides, and to eliminate the program, after a decent adjustment period. A transformational equalization program must help recipient provinces build self-sustaining and prosperous economies in their own right.

The range of possible reforms includes a few that merely tinker with a flawed policy:

  • Simplify the formula by removing resource revenues from it to ameliorate the punishment of clawbacks. You could also recognize the deliberate underpricing of hydro-electricity by deducting the opportunity cost of lost revenues.
  • 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 the national average on public services.
  • If you really wanted to make equalization truly transformational, these structural reforms are the way to go:

  • Redirect equalization towards the original idea proposed by Buchanan, income-tax reductions in “have not” provinces.
  • Most equalization revenue goes right back out the door in the form of provincial debt service charges. With a debt-for-equalization swap, provinces could clean up their balance sheets. This reform would have to be accompanied by strict rules that prevented provinces from simply running up their debt again.
  • 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, values that, prior to the recent run up in transfers, were approximately equivalent.
  • Ultimately a combination of the last two would be the most productive way out of the equalization policy swamp. As presently construed, the program creates a massive welfare-trap. It penalizes non-renewable resource wealth , encourages higher taxes and therefore lower growth, and promote inefficient government spending.

    Next year equalization will be 50 years old. It will be nothing to celebrate. We need to start talking about real alternatives. Why doesn’t Saskatchewan lead the way?

    (Peter Holle is president of the Frontier Centre for Public Policy)