Equalization 101: Defining one of Canada’s continual sources of tension

Equalization is a complicated and contentious topic that is often debated but seldomly understood in its entirety. This makes the program the subject of a significant amount of commentary from many sources, which has diluted the amount of unbiased information available for the public.

In this month’s Dive Deeper, we dig into the bare-bones workings of the federal program, outlining its intended purpose, and calculation considerations. As Calgary’s podium of record, presenting unbiased information to our business community is essential to our role.

What is equalization?

First introduced in 1957 then modified in 1967, the Equalization program is one of the three major financial transfers made by the federal government to support provinces. Taken in conjunction with the Canada Health Transfer and Canada Social Transfer, Equalization payments were designed to reduce the differences between our ten provinces in revenue-generating capacity.

Simply put, the payments were adopted to create a level playing field between Canada’s diverse provinces, each of whom have a different tax base and different natural resource endowments they can leverage to support provincial programs. At a high level, the goal of the program is to provide Canadian citizens with similar levels of government services regardless of which province they choose to call home. Where the program gets complicated is how it calculates the amount to transfer and which provinces are eligible to receive payments.

Each December, the federal government outlines the major transfers planned for every province and territory. Details on recent transfer payments made by the federal government to the provinces can be found here.

What is is not

It is crucial to note that Equalization payments are not made between provinces. “Have” provinces do not directly transfer anything to the “have not” provinces. All monetary transfers are made by the federal government only and distributed from the pool of funds that are collected from the federal taxes levied. Equalization payments also do not affect funds collected by provincial governments, all taxes levied by provinces remain within their borders.

How is it calculated?

A formula-based approach to Equalization was reintroduced in 2007 when the federal government moved away from fixed-sum payments introduced in 2004. The last structural change to the formula came in 2009 when federal government changed the formula to cap the total amount of Equalization payments made.

The base formula calculates a province’s ability to raise revenues it can source on its own and compares each province’s fiscal capacity to the rest of the provinces across the country. Fiscal capacities for all provincial governments are calculated based on five categories:

1. Personal income taxes
2. Business income taxes
3. Consumption taxes
4. Property taxes
5. Natural resource revenues

Due to the wide range of natural resources available across the country, only the first four categories are used to determine the amount of per capita revenue each province could generate if all provinces had identical tax rates. Due to the aforementioned diversity in natural resources across provinces, actual resource revenues from each province are used to measure fiscal capacity to ensure the formula accounts only for the resources available in each province.

Based on the five categories above, the formula then compares the capacity for each province to that of the ten-province average. If a province’s capacity falls below the national average it is categorized as a ‘have-not province’ and receives payments from the federal government through the Equalization program. If a province is above this national average, it is a ‘have-province’ and does not receive Equalization payments. Without Equalization payments, it would be next to impossible for smaller provinces like Prince Edward Island to raise enough funds to provide similar levels of services that can be found on Ontario.

University of Calgary Economist, Trevor Tombe, provided a detailed look at how this process played out in the 2018-2019 fiscal year here.

Added layers

However, that is not the end to the Equalization formula. Since 2007, there have been four separate considerations added to the formula that increase to the complexity of how the payments are measured and paid to provinces that receive them.

These four additions are:

Changes to Natural Resource Revenue Calculation – Prior to 2007, 100 per cent of all natural resource revenues were used in the Equalization calculations, with Alberta and the Atlantic provinces’ resources kept out of the calculations for Equalization payments. Since 2007, Alberta’s natural resources have been included in calculating the standard, however any provinces that have eligible natural resource revenues now apply 50 per cent or zero per cent of their natural resource revenues to the formula. Whichever one of the two options lead to more Equalization payments for the province is used to calculate the payment.

Gross Domestic Product (GDP) Growth Consideration – Another addition was made to the formula in 2009 to ensure the long-term sustainability of providing funding to provinces by working both as a floor and a ceiling. Compensation for GDP growth was added to the formula to ensure that payments grew in tandem with the growth in the Canadian economy and buffered any fiscal disparities between provinces. This ‘fixed growth rate’ rule protects the federal government from runaway program costs while concurrently growing payments at the same rate as the Canadian economy.

Fiscal Capacity Gap – Introduced as a measure to ensure fairness, the Fiscal Capacity Gap creates a cap on an Equalization-receiving province’s overall fiscal capacity. Originally introduced in 2007, the Cap was used as a marker to limit eligible per capita payments made to a province to ensure it was not unjustly rewarded for having a low capacity. The first iteration of the Cap used the poorest Equalization-receiving province as a benchmark. This was adjusted in 2009, the formula now uses the average fiscal capacity of all Equalization-receiving provinces, lowering the relative cost of the program for the federal government.

Moving Average on Actual Payments – Also added in 2007, Equalization payments are now transferred to provinces based on a weighted three-year moving average, lagged by two years. This means that payments made for the 2019-20 fiscal year is the sum of 50 per cent of its payments for 2017-2018, 25 per cent of its payment for 2016-2017, and 25 per cent of its payment for 2015-2016. This method is meant to smooth out the payments received by the province in order to reduce fluctuations and ensure consistency in long term planning.

Why Alberta is a 'have' province

Although the adjustment for Natural Resource Revenues has helped Alberta, our ‘fiscal capacity’ remains largely untapped. Our relatively high income and spending compared to other provinces, inherently increases our provincial sales tax base harming our province’s position in the overall calculations, making our fiscal capacity higher than the national threshold.

Moving forward

With so many moving parts Equalization frequently becomes a misunderstood and miscommunicated program. The ever-evolving, federally funded program was put in place to ensure that Canadians from coast to coast will receive a minimum standard of programs and services from their government, regardless of which province they choose to call home. Equalization has seen falling support over the last two decades, however, a majority of Canadians are still in support for less prosperous provinces receiving payments.

Equalization has become an essential part of Canada’s funding and governance structure. No matter whether you support or decry Equalization, it is essential that we have a good understanding of the program we have today.