Pressing Need to Reform Equalization - Fraser Institute

Fraser Forum
8 | Fraser Forum
The Pressing Need
to Reform
Equalization
by Fred McMahon
Canada’s regional programs
are a mess. They make worse
the very problems they are supposed to
solve. And equalization is part of that
mess.
Employment insurance is supposed to
provide a cushion for the unemployed.
Instead, it increases unemployment (see
box). Regional development programs
are meant to spur economic growth.
Instead, they dampen growth. Equalization
is supposed to provide equivalent
services across the country. Instead, it
leaves “have” provinces struggling to
provide services while government
spending becomes a political tool in
poorer provinces.
Along with a number of technical
changes, Beyond Equalization (2007), a
book edited by Jason Clemens and Niels
Veldhuis, to which I contributed a
chapter, recommends two fundamental
reforms to eliminate the problem of
“over-equalization” that creates government
bloat in have-not provinces and
exacerbates other problems with
regional programs.
Before discussing solutions, this article
will look at the overall impact of fiscal
federalism to explain why reform is so
urgently needed. I am from Atlantic
Canada, Nova Scotia to be precise, and
the damage is greatest in the Atlantic
region because the money flow is greatest
there.
Some numbers will provide an idea of
the magnitude of the problem.
Let’s compare Ontario with my home
province of Nova Scotia. Government
spending as a percent of GDP in
Ontario in 2005/06 equalled 35 percent
of the economy. It was 54 percent in
Nova Scotia in the same period. Federal
spending alone equalled about a quarter
of Nova Scotia’s economy compared to
a tenth of the Ontario economy.
You might think this discrepancy in federal
spending in the two provinces is
almost totally due to equalization. Not
so. Federal spending in Ontario is about
$4,500 per person; in Nova Scotia it is
Fred McMahon (fredm@fraserinstitute.ca) is Director of the Centre for
Globalization Studies at The Fraser Institute. He is co-author of the
“Solutions to Equalization,” chapter in the recently-published Fraser
Institute book, Beyond Equalization: Examining Fiscal Transfers in a
Broader Context.

almost $10,000 per person. And when
you subtract equalization, it’s still about
$8,000 per person. In other words,
Ottawa spends nearly twice as much per
person in Nova Scotia as Ontario not
even counting equalization, and more
than twice as much when equalization is
counted.
The damage done
The great burst of spending in Atlantic
Canada took off under Pierre Trudeau
in the early 1970s, a time of minority
government when buying seats in the
region could make the difference between
victory and loss, minority or majority government.
Federal spending has maintained
its political edge ever since.
Ottawa spends
nearly twice as
much per person
in Nova Scotia as
Ontario not
counting
equalization...
Let’s take a look at how these transfers
undermine economic growth, leave
“have” provinces struggling to provide
services, and result in government bloat
in the have-not provinces.
A study sponsored by the government
of Nova Scotia and the Atlantic Canada
Opportunities Agency, which was supposed
to show that Nova Scotia businesses
were competitive, instead found
that the corrosive effects of government
Regional Programs
spending were undermining competitiveness.
[A] significant proportion of the
Nova Scotia firms visited were partially
dependent either directly
upon provincial or other forms of
public purchasing or indirectly
through subcontracting to larger
firms which are in turn reliant
upon government spending for
their survival and profitability....
Public policy appears inadvertently
to have reinforced market failure to
some extent by cushioning profits
via grants, subsidies and preferential
purchasing thereby reducing the incentive
to change.... The heavy reliance
upon Federal transfers has
indirectly promoted a dependency
culture in the province...a culture,
as one owner manager said of “a
whole region being on the dole.”
(O’Farrell, 1990, pp. 24-25. Emphasis
in the original)
Federal transfers to poorer provinces,
including equalization, provide the
money for these provinces to undermine
the competitiveness of provincial
businesses through subsidies and generous
government contracts that leave
businesses dependent on government.
(See McMahon, 2000, chapter 5 for
more details.)
Meanwhile, Ontario struggles to provide
health care (with 2.7 hospital beds
per thousand population, below the
national average of 3.6), while Nova
Scotia boasts four beds per thousand
and New Brunswick leads the pack at
5.3. Even Alberta lags all “have-not”
provinces except PEI (MacKinnon,
2005, citing 2003 numbers).
Solutions
While there are strong arguments to
eliminate equalization, Beyond Equalization
limits itself to recommending
Unemployment in the
Maritimes
Prior to the introduction of highly generous,
regionally extended Unemployment
Insurance in the early 1970s,
every Maritime province had spent at
least one year below the national unemployment
rate and regional and national
unemployment were converging.
Afterwards, unemployment in the region
soared to about 50 percent higher than
the national average. UI became such a
disincentive to work that in some
months more than twice as many people
collected UI as were officially unemployed.
They didn’t count as officially
unemployed because they stopped looking
for work while collecting UI.
With a real unemployment rate of
around 20 percent, both Statistics Canada
and the Atlantic Provinces Economic
Council reported labour
shortages throughout the region after
the creation of regionally extended UI.
Business growth was frustrated because
businesses, small business in particular,
couldn’t compete against the UI system.
(See McMahon, 2000, chapter 5 for a
full discussion of these issues.)
sensible reforms to the program in light
of overall fiscal federalism. Unfortunately,
other studies of equalization
have failed to recommend fundamental
reforms and typically recycle previous
versions of the system.
Respect the constitution
The first task is a reform that goes well
beyond the equalization debate but
would solve many of the perversities in
the equalization system. Ottawa should
remove itself from areas of provincial
jurisdiction, end its fiscal transfers in
March 2007 | 9

these areas, and open an equivalent
amount of tax room for the provinces.
There are many reasons for this reform
outside of the equalization context:
respect for Canada’s constitution,
replacing federal-provincial finger-pointing
with accountability and
transparency by making one level of
government responsible for programs
like health care, allowing provinces to
tailor programs to the unique needs of
their people. (See Clemens, Veldhuis,
and Palacios, 2006; and Harris and
Manning, 2005a and 2005b for a fuller
discussion of the need for these
reforms.)
At a stroke this would end a large part
of the over-equalization problem. As the
Expert Panel on Equalization and Territorial
Financing Formula noted:
As if the Equalization program
isn’t complicated enough on its
own, other federal transfer programs,
particularly the Canada
Health Transfer and the Canada
Social Transfer, also include an
equalizing component. …. The result
is that wealthier provinces like
Ontario and Alberta receive lower
cash payments than other provinces.
(2006, p. 47)
Base equalization on costs
The second key reform is to base equalization
on the cost of providing services.
Here it is important to remember the
actual intent of the equalization program.
The constitution does not require
that provinces receive equal revenues
but rather that they be able to provide
reasonably comparable services at reasonably
comparable levels of taxation.
And here, reality bites. It simply costs
more to provide services, or build hospitals,
in Toronto or Vancouver than in
New Glasgow, Nova Scotia, or
10 | Fraser Forum
Regional Programs
Saskatoon, Saskatchewan. And this
needs to be recognized in equalization
payments.
Unless this is recognized in the equalization
formula, then the intent of the constitution
will be violated in that poorer
provinces, with a lower cost of living,
will always be able to provide better services
than richer provinces at the same
level of expenditure.
Reforming equalization by itself will not
clean up the mess of fiscal federalism
but, by keeping in view the larger picture,
the recommended reforms will
reduce some of the perversities of fiscal
federalism. The two key reforms discussed
here are only part of a broader
package of reforms, many of them technical,
discussed in Beyond Equalization.
References
Clemens, Jason, Niels Veldhuis, and
Milagros Palacios (2006). “Fiscal Balance,
the GST, and Decentralization: An
Opportunity for Reform.” In Veldhuis
and Clemens, eds. Beyond Equalization:
Examining Fiscal Transfers in a Broader
Context. Vancouver: The Fraser Institute.
Clemens, Jason and Niels Veldhuis, eds.
(2007). Beyond Equalization: Examining
Fiscal Transfers in a Broader Context.
Vancouver: The Fraser Institute.
Council of the Federation. (2006). Reconciling
the Irreconcilable. Ottawa. Digital
document available at http://www.councilofthefederation.ca/pdfs/Report_Fiscalim_
Mar3106.pdf.
Expert Panel on Equalization and Territorial
Financing Formula [EPETF] (2006).
Achieving a National Purpose: Putting
Equalization Back on Track (May 2006).
Ottawa: Government of Canada, Department
of Finance. Digital document available
at www.eqtff-pfft.ca/.Harris, Mike
and Preston Manning (2005a). A Canada
Strong and Free. Vancouver: The Fraser
Institute.
Harris, Mike and Preston Manning (2005b).
Caring for Canadians in a Canada Strong
and Free. Vancouver: The Fraser Institute.
MacKinnon, David (2005). Fairness in Confederation—Fiscal
Imbalance: A Roadmap
to Recovery—Phase 2 Report. Toronto:
Ontario Chamber of Commerce.
McMahon, Fred (2000). Retreat from
Growth: Atlantic Canada and the Negative
Sum Economy. Halifax: Atlantic Institute
for Market Studies.
O’Farrell, P.N. (1990). Small Manufacturing
Competitiveness and Performance: An
Analysis of Matched Pairs in Nova Scotia
and New England. In association with
Gardner Pinfold Consultants. Halifax:
The Nova Scotia Department of Industry,
Trade and Technology and the Atlantic
Canada Opportunities Agency.