COVID — not Alberta’s referendum — should motivate changes to the equalization program

Trevor Tombe

Economic and fiscal disruptions from the pandemic may soon reveal an unintended quirk in Canada’s equalization program: falling resource revenues in Saskatchewan or Newfoundland and Labrador may cause Ontario to become a recipient province. The case for changes to equalization is growing stronger. It would be unfortunate if Alberta’s referendum distracted from that.

In a referendum last week, 61.7 per cent of Albertans who voted supported removing the principle of equalization from Canada’s constitution. 

While the vote had little to do with equalization, as even many proponents will concede, it may nonetheless have important implications for the program — and not for the better. Rather than motivating reform, the increased polarization and politicization of the program that the referendum created may very well prevent otherwise sensible changes from going forward.

This would be unfortunate, especially at such a crucial time for the program.

The pandemic has created or exacerbated several challenges to equalization that Canada should probably address — one of which may need attention within the next few weeks. 

Each year in December, the federal government releases its calculations of what each province will receive the following year. This time, it is particularly important because data from 2020-21 — when COVID disrupted provincial finances and economies dramatically — will enter the formula for the first time.

It’s hard to predict what will happen, but one possibility is that Ontario might become a recipient province once again, despite not qualifying under the main formula.

Using the new Finances of the Nation online equalization simulator, I’ll illustrate how and why Ontario might receive a payment and explain why a change in the system may be worth considering.

A fixed pool of equalization dollars

Currently, the total size of the equalization program is fixed. Its level was predetermined in 2009 and had grown with nominal GDP growth ever since. This year, it amounts to $20.9 billion. Based on current growth projections, next year it will be $21.7 billion and the year after that, $23.1 billion. 

The primary effect of this is to make the program larger than it otherwise would be. Under the previous 2007 formula, payments would rise or fall with inequality across provinces. As provinces become more similar in their fiscal capacity, less is required to bring lower-income regions up to the national average level. 

This matters now potentially more than ever because COVID has lowered regional inequality substantially. This observation is not new, and was first explored by Ben Eisen and Milagros Palacios. This “great convergence,” as they aptly call it, sees Alberta falling below British Columbia and Ontario in terms of provincial government fiscal capacity. While the economic and fiscal situation facing Alberta has improved somewhat since their report was released, the convergence in provincial fiscal capacity appears likely.

That the program is potentially “too large” is one concern, made frequently by others — including the main proponent of Alberta’s referendum. That’s a fair enough position, but enlarging the program is like increasing the standard to which recipient provinces are raised. It’s not necessarily a technical problem in need of reform.

But a second issue that, to my knowledge, has not been raised elsewhere, is that the fixed pool of payments also creates a strange discontinuity in the determination of payments. This is a quirk that has not occurred before and can happen only in certain situations, but thanks to COVID, it may be on the horizon.

A strange quirk in the formula

The COVID-19 pandemic hit all provinces hard. But it hit the oil-producing provinces even harder because global oil prices declined significantly, so it turns out that both Newfoundland and Labrador and Saskatchewan appear on track to qualify for payments next year. 

Once that happens — once either province receives a single dollar from the program — then Ontario qualifies for significant sums. 

To appreciate this, I’ll start with the data for the current 2021-22 payments. If Newfoundland and Labrador resource revenues drop to $900 million, very little happens. You can verify this in the Finances of the Nation equalization simulator. But if its resource revenues drop to $800 million, then suddenly, on top of Newfoundland and Labrador qualifying for payments, Ontario receives $256 million in equalization despite no change in that province’s underlying fiscal situation!

It turns out, the critical threshold is $855.897 million in resource revenues for Newfoundland and Labrador this year. If it receives $855.896 million instead, then Ontario receives $284.5 million in equalization! This kind of kink in the formula should raise more than a few eyebrows, but may be difficult to understand. To help, I illustrate this discontinuity below.

What’s happening here? Adjustment payments that are distributed anytime there are “left over” dollars are distributed to all recipient provinces or any non-recipient that needs them to not fall behind a recipient

Ontario receives a payment because if it didn’t, then Newfoundland and Labrador, which does, would be “better off” than Ontario in terms of its overall fiscal capacity. (This is a loose but intuitive way to describe the technical details.) 

This discontinuity matters for other provinces too. With Ontario receiving some dollars, there are fewer available for others. Notice Quebec in the above illustration sees a sharp drop in its payment the moment that Newfoundland and Labrador crosses the threshold!

Reforms needed?

Discontinuities of this kind are less than ideal. A $1 change in resource revenues in one province can lead to hundreds of millions in gains for another province and hundreds of millions in losses for a third. 

This is, of course, merely one potential scenario, which may not come to pass. But declining resource revenues in oil-producing regions, combined with potentially lower non-resource fiscal capacity in those provinces, suggests to me we’re more likely to see this happen than not. Indeed, the default projection we build into the simulator suggests that eight out of 10 provinces will receive payments next year — including Ontario, and only because of this quirk — with only British Columbia and Alberta not receiving any.

So while calls for reform are currently loudest in Alberta, it would be unfortunate for this to dominate the conversation over the coming weeks and months.

After all, no explicitly stated case was made by the government during the referendum for how equalization is “unfair” to Alberta. Equalization was instead symbolic of the government’s other grievances, from carbon taxes to pipelines.

But the pandemic has shaken the foundation of many public policies and in many cases widened cracks that were already beginning to form. Gradual and thoughtful ongoing adjustment to policy when economic, fiscal and social circumstances change is necessary and valuable. This is as true for equalization as for any other policy. 

Reforms may indeed be worth considering, especially in the short term. But it’s COVID — not Alberta’s referendum — that should motivate those changes.

Image Credit: Luis Valiente, Pixabay.

About Trevor Tombe

Trevor Tombe is a professor of economics at the University of Calgary, research fellow at The School of Public Policy, and co-director of Finances of the Nation.