GLOBAL ECONOMICS
Patrick Grady
The Expert Panel’s Report on Equalization was Dead on Arrival1
June 10,2006
The Expert Panel was given an impossible job. It was established to provide advice on the allocation of a fixed pool of equalization money among the provinces. This pool, which had been announced in October 2004 following a First Ministers’ Meeting, had been arbitrarily set at $10.9 billion in 2005-06 and was, equally arbitrarily, to be increased 3.5 per cent per year. In November 2005, this pool was boosted to $11.3 billion in 2006-07 by the Minister of Finance. The key feature of the new growing, fixed-pool approach is that it delinked equalization from any measure of provincial fiscal disparities or their growth. Within the fixed-pool framework, the Expert Panel was also asked “to review all aspects of the allocation of Equalization, including the treatment of property tax revenues.”
Last November, largely because of growing dissatisfaction among the provinces over the proposed formula and the implications of the special deals allowing Newfoundland and Nova Scotia to retain 100 per cent of their offshore oil and gas revenues, the Expert Panel requested and was given an extension on the deadline for its final report. At the same time, the Panel’s mandate was implicitly broadened by the Minister of Finance’s acknowledgment of the “complexity and importance of its work” and his announcement that the Panel was being given the “opportunity and time necessary to ensure every relevant consideration is reflected in its final report.”
The problem with the Expert Panel’s report reflects its ambiguous and evolving mandate in combination with the extreme difficulty of hitting a moving target. Its original mandate was too narrow to address the original problems of equalization created by the special offshore oil and gas deals. And its new mandate was too narrow for it to deal with equalization within the broader context of the new issue of “fiscal imbalance” between the federal and provincial governments. This issue, which has been championed by the Premiers of Ontario and Quebec, was taken up by the Conservatives during the election. In the heat of the campaign, Conservative leader Stephen Harper pledged to "fix the fiscal imbalance." This commitment, which was subsequently featured in the speech from the throne, has become an important part of the new minority Conservative Government’s broader strategy to appeal to Quebec voters in order to win some more seats there to help it form a majority.
Incidently, for an effort to fix the “fiscal imbalance” to be considered serious by the provinces, it will probably have to involve the transfer of at least $5 to $10 billion from the Federal Government to the provinces. This is roughly equivalent to 1 to 2 personal income tax points. And if the tax transfer is not net and is accompanied by program transfers, the gross transfer would have to be even larger, say at least $20 billion, to be considered serious by the provinces. It would take an increase of this magnitude for the more elastic additional tax revenues transferred to outgrow the program spending transferred sufficiently to make a serious net contribution to provincial finances and to curtail the inexorable tendency of the federal fiscal dividend to grow over time. It is this tendency and the federal government's proclivity to spend the money on what provinicial government s consider "low priority programs" in their areas of jurisdiction that has given rise to provincial concerns about "fiscal imbalance."
In making its recommendations, the Expert Panel disregarded one of its narrow constraints, namely the Government’s pledge to respect the offshore oil and gas deals with Newfoundland and Nova Scotia. This constraint, which was part of its original mandate from the Liberal Government that established it, had been reiterated by the new Conservative Minister of Finance Jim Flaherty in March.
The Panel’s report was not well-received by Minister Flaherty. And this wasn’t only because of its lack of respect for the offshore accords. At the Federal-Provincial Finance Ministers’ Meeting after the release of the report of the Expert Panel, he and the Ontario Finance Minister Greg Sorbara told reporters that, given the federal government’s limited resources, improving equalization payouts is not a top priority. The implied priority is, of course, fixing the “fiscal imbalance.” Minister Flaherty, having been the Finance Minister in Ontario, understands very well the Ontario Government's concerns about "fiscal Imbalance."
The failure of the Expert Panel to respect the offshore deals and the emergence of the new priority "fiscal imbalance" issue pretty much ensured that most of the report’s main recommendations were dead-on arrival. Even though the Panel’s report provides some interesting recommendations and useful technical analysis, its recommendations will only have a marginal impact on the next round of federal-provincial negotiations over fiscal transfers.
An important exception is the Expert Panel's recommendation that the Equalization Program be based on a set of principles, which, although it should be obvious, is still worth saying given the provocatively unprincipled nature of the recent changes in the formula. An important consequence of this focus on principle and a formula-driven approach to equalization favoured by most practitioners is that the Panel also recommended that the Representative Tax System (RTS) approach for assessing provincial fiscal capacity be "retained." While it could be argued that the verb utilized should have been “restored,” it should also be obvious that a program that is designed to equalize fiscal capacities needs to be based on some sort of a measure of fiscal capacity. It certainly doesn’t make much sense to try to tackle provincial disparities in fiscal capacity through a growing pool of money totally unrelated to disparities in fiscal capacity.
Four of the most important technical recommendations will probably be seriously considered by Finance Ministers or at least finance officials. First, that a new measure for residential property tax based on market value assessment for residential be adopted. Second, that the RTS approach be simplified. Third, that the approach of making prior year adjustments as new, more accurate data become available be dropped in favour of a one estimate, one entitlement, one payment approach. Fourth, that three-year moving averages combined with the use of two-year lagged data should be used to smooth out year-to-year changes. The first two of these sound sensible enough. Indeed, the first recommendation flows out of work already underway by federal and provincial finance officials. However, the third and fourth recommendations have the important drawback of not using the most accurate information to calculate equalization, which could result in inequities and might run into resistance from provincial finance officials more concerned with accuracy and equity than stability of payments .
A major recommendation that has some stand-alone appeal is that a 10-province equalization standard should be adopted. The 5-province standard, which excluded Alberta and the Atlantic provinces, was an ad hoc expedient that was adopted to remove Alberta’s oil and gas resource revenues from the formula while leaving most other provinces resource revenues in from the point of view of calculating their equalization entitlements. Reverting to a 10-province standard would certainly be more consistent with a principled approach to equalization. However, it would also cost a lot of money – $1.8 billion in 2007-08 according to the Panel which is the big factor behind the $1.3 billion overall increase in program costs proposed by the Panel. This is money that could be more productively put to use in resolving the “fiscal imbalance” problem, which is the main reason why this recommendation will probably not find much support in the upcoming negotiations.
The biggest problem in the Expert Panel’s report is its recommendation that 50 per cent of provincial resource revenues should be included in determining the pool of revenues to be equalized. It would be neither fair, nor politic, for the Federal Government to unilaterally back out of the Newfoundland and Nova Scotia offshore oil and gas deals at this point, regardless of how bad and unfair the deals originally might have been. The only real possibility for the Federal Government now to restore the fairness of the Equalization system is to exclude oil and gas revenues for all provinces, which would have its largest impact on Saskatchewan, the province that is currently being treated the most inequitably. It should be noted that this would involve treating oil and gas revenues differently from other resource revenues, which would run counter to one of the recommendations of the Expert Panel. But this is the smallest possible modification to the existing system that would be consistent with equity and would save the big bucks for fixing the "fiscal imbalance."
Moreover, there are three good reasons why the Federal Government should not equalize oil and gas revenues. First, the Federal Government does not have access to oil and gas royalties so that it can’t share with the equalization-receiving provinces what it doesn’t have. Second, equalization of even half of oil and gas revenues is a very costly proposition and the funds required for this additional transfer could be put to much better use in helping to resolve the higher priority problem of “fiscal imbalance.” And, of course, since any transfers of revenues to the provinces to right the “fiscal imbalance” will have to be equalized, the additional money might have to be used for other purposes within the equalization program itself. Third, adding half of oil and gas revenues would have a disproportionately adverse effect on British Columbia, which would hardly be fair given the generous treatment accorded to the other oil-and-gas-producing equalization-receiving provinces.
Another problem with the Expert Panel’s recommendations is its proposal for a cap on equalization to ensure that no equalization-receiving province would end up with greater fiscal capacity than a non-equalization-receiving province. This is a problem with the existing system that has particularly irritated Ontario. But a cap would cause problems of its own. No one can guarantee that oil and gas prices won't increase substantially even from their current elevated levels. If the increases were large enough even with only half of oil and gas revenues included in equalization, Alberta could become the only non-equalization-receiving province. This would mean that the cap could disappear unexpectedly in any given year and the Federal Government could be forced to pay much more in equalization than anticipated and budgetted. This particular source of unpredictability and instability, two characteristics that are considered undesirable in the Panel’s report, could be avoided by excluding oil and gas revenues from equalization. Then the cap could serve its intended purpose without adding unpredictability and instability to the program. And, of course, last but not least, the cap in combination with the proposed 50 per cent inclusion rate for resource revenues invalidates the special offshore deals with Newfoundland and Nova Scotia and would thus constitute a breach of the agreements with these two provinces.
It’s unfortunate that events have passed the Expert Panel by. And it’s not surprising its report got pretty short shrift at Federal-Provincial Finance Ministers’ Meeting at the end of June. Perhaps, if the Panel had tailored its report more to the political constraints and the current political agenda, it would have gotten a better reception. But it’s hard to see exactly how this could have been done. More importantly, it is clear that, if the “fiscal imbalance" issue is going to be ‘fixed,” it will be necessary to simultaneously make significant appropriate accompanying modifications to equalization. Locking in a new equalization regime at this stage in the game would be an error in sequencing that could stand in the way of the best fix for the "fiscal imbalance." Better to leave equalization open for the time being and throw the Expert Panel report as one more input into the “fiscal imbalance” hopper, recognizing that what comes out is unlikely to look anything like the Panel's recommendations.
1. The March 19, 2007 budget, which introduced legislation implementing most of the Expert Panel's recommendations, revealed that the report wasn't really dead. But subsequent events have confirmed that it would have been better if it had been for many of the reasons noted in this article.