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Reforming Equalization: Balancing Efficiency, Entitlement and Ownership†

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Reforming Equalization: Balancing Efficiency, Entitlement and Ownership† Volume 7 • Issue 22 • September 2014 REFORMING EQUALIZATION: BALANCING EFFICIENCY, ENTITLEMENT AND OWNERSHIP† Bev Dahlby Distinguished Fellow, The School of Public Policy and Professor, Department of Economics, University of Calgary SUMMARY In this paper, we provide an overview of the equalization grant system in Canada and the issues that have been raised concerning the reform of the fiscal transfer system. Any reforms to the equalization grant system have to balance three concerns — “efficiency” effects that arise through federal financing of transfers, and the incentive effects on provincial fiscal policies, “entitlement” to reasonably comparable public services at reasonably comparable levels of taxation, and “ownership” of resources and independence of fiscal policies by provincial governments. Five proposals for reform of the equalization system are discussed. With regard to the inclusion rate for resource revenues in equalization formula, we argue that the rate should be reduced from 50 per cent to 25 per cent and that ceiling on total equalization payments should be eliminated. We argue against the proposal to exempt from the calculation of equalization entitlements that are deposited in provincial sovereign wealth funds because this would not reduce total equalization entitlements in present value terms, it would be complex to implement if it extended to all forms of savings by provinces (such as debt reduction), and it would not alter the resource rich provinces’ incentives to save more of their resource revenues. We argue against a proposal to reduce CHT and CST to provinces with above average fiscal capacities because this would reduce their incentive to develop and tax their resources, and it would be counter to the purpose of these block grants, which is to reduce the vertical fiscal imbalance between the federal and the provincial governments. We review the Gusen (2012a) proto-type model for incorporating variations in costs and needs in the computation of the equalization entitlements and argue that this procedure seems feasible and merits further analysis. † I would like to thank Mel McMillan, David Sewell, and an anonymous referee for their comments on a draft of this paper. They are not responsible for any of the errors, omissions or opinions expressed in this paper. www.policyschool.ca INTRODUCTION First recommended by the Rowell-Sirois Commission in 1940, federal equalization payments to reduce the differences in revenue-generating capacity among the provinces were introduced by the Liberal government of Louis St. Laurent in 1957. Ottawa’s commitment to providing equalization was later incorporated into the Constitution as part of the patriation process initiated by Pierre Trudeau. The wording used to enshrine this commitment, however, is ambiguous, providing little guidance in designing or evaluating a specific equalization program. According to Section 36(2) of the Constitution Act, 1982: Parliament and the Government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation. What are reasonably comparable “levels” of taxation? How are the “levels” of taxation to be interpreted? How much variation in public services is consistent with “reasonably comparable levels” of services ― 10 per cent, 20 per cent or 50 per cent variations? What services should be compared across provinces ― services to individuals, services to business or both? Should variations in the cost of providing public services across provinces affect equalization entitlements? Should provincial capital expenditures be treated differently than provincial expenditures on current services? All of these issues concerning permissible variations in the standard of service, the applicable range of public services and the measurement of services are complex and open to a range of interpretations. The constitutional obligation to provide equalization grants is deliberately vague because the issues regarding the appropriate level of equalization are complex and do not admit to simple solutions. Furthermore, the objective of equalization may conflict with other objectives or constraints in the Constitution. Any reforms to the equalization grant system would have to balance concerns about: • “efficiency” effects that arise through federal financing of transfers, the incentive effects on provincial fiscal policies and regulations and the consequent re-allocation of labour and capital within the economy; • “entitlement” to reasonably comparable public services at reasonably comparable levels of taxation; and • “ownership” of resources and independence of fiscal policies by provincial governments. Achieving a fine balance of these goals is not easy. Inevitably, there will be differences in the emphasis that commentators and government officials place on each. A frank and open discussion of the objectives, constraints and trade-offs is necessary to understand the competing points of view on how the equalization system should be structured or reformed. This paper provides an overview of the equalization grant system in Canada as well as the issues that have been raised concerning its reform. In the next section of this paper, we summarize some of the main points from the theoretical frameworks that have been developed to evaluate equalization transfers. In the following section of this paper, we provide a statistical overview of the current equalization program, including measures of fiscal capacity and disparities in 1 provincial tax rates and expenditures. A subsequent section of this paper is devoted to examining the prominent reform proposals put forward over the years by commentators and provincial governments. The paper concludes with a list of recommendations on how the equalization system can best be reformed. FRAMEWORKS FOR EVALUATING EQUALIZATION TRANSFERS It is important to have analytical frameworks or models that provide a rationale for equalization grants when evaluating the system. The economics literature on intergovernmental grants is vast and here we will only present a brief summary of the aspects that are most relevant to the reform of the Canadian fiscal transfer system.1 For our purposes, we will parse the theoretical literature into models of (a) labour mobility and net fiscal benefits, (b) horizontal and vertical fiscal imbalances in the marginal cost of public funds and (c) regional shocks and fiscal insurance. In the final part of this section, we will examine a model used by Dahlby to evaluate the trade-off between efficiency and fiscal equity.2 Labour Mobility and Net Fiscal Benefits In their seminal article, “Efficiency And Equalization Payments In A Federal System Of Government: A Synthesis And Extension Of Recent Results,” Boadway and Flatters provide the rationale for equalization transfers in a federation based on the inefficient regional allocation of labour that can arise from a household’s decision of where to live and work. Only the key aspects of this framework, which has been extended over the years by Boadway and his co-authors and extensively reviewed elsewhere by Boadway and Tremblay, will be outlined here.3 The basic assumption of the model is that production is based on a Ricardian technology with diminishing marginal product of labour owing to a fixed input, such as land or mineral resources. Labour is mobile between provinces and will be allocated up to the point where the after-tax wage rates and benefit from provincially provided public services are equalized across provinces. The equilibrium allocation of labour with costless mobility can be inefficient because individual workers do not take into account the fiscal externalities they impose, or provide, to existing residents when they move from one province to another. These fiscal externalities arise because if the provinces provide pure public goods, the migrant does not add to the cost of providing the public good in that province, but helps to finance it through the provincial taxes that he pays. This externality is diminished to the extent that the public services are impure public goods and in the limit it disappears if the provinces provide quasi- private goods. This latter case seems to be the most relevant in the Canadian context because most provincial government spending is on health care, education and social assistance payments, which can be considered publicly provided private goods. The other source of fiscal 1 For a comprehensive review of the literature on intergovernmental grants, see Robin Boadway and Anwar Shah, ed., Intergovernmental Fiscal Transfers (Washington, D.C.: The World Bank, 2007). 2 Bev Dahlby, “Notes on the Trade-Off between Efficiency and Fiscal Equity in a Federation with Imperfect Labour Mobility and Economic Rents” (Unpublished, School of Public Policy, University of Calgary, 2014). 3 Robin W. Boadway and Jean-Francois Tremblay, “Reassessment of the Tiebout Model,” Journal of Public Economics 96 (2012): 1063-1078; Robin W. Boadway, “The Theory and Practice of Equalization,” CESifo Economic Studies 50 (2004): 211–254 2 externality arises from provincial variations in the net fiscal benefits that workers can derive in different provinces because of differences in the source-based tax revenues — economic rents from provincial ownership or taxes on natural resources and source-based taxes on capital — and differences in average incomes that
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