Fairness for Newfoundland & Labrador

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It Starts with Equalization

Dr. Jack M. Mintz | October 4, 2019

Canada’s first Prime Minister, John A. MacDonald, famously described the act of Confederation as “herding cats” – cats that were, even in 1867, very different one from the other. Some provinces are resource-rich, others resource-poor; some have large populations, some small; some are landlocked, others are coastal. Balancing the interests of all – and ensuring that despite economic disparities, all share in the wealth that is Canada – has been a defining challenge for federal governments ever since.

A current solution to MacDonald’s conundrum is Canada’s equalization program. It is designed to help poorer provinces provide a level of public services comparable to other provinces in Canada, at comparable levels of taxation.   Ottawa makes the payments from its Treasury to those provinces with fiscal capacity below a “national standard”.   It measures equalization by taking broad levels of taxes raised in each province and measuring that on a per capita basis against the national “standard”, based on national averages of tax rates and bases. The payment is equal to the province’s population multiplied by the difference between the province’s per capita tax capacity and the national standard.

The equalization formula applies to personal income, consumption, business income, property and miscellaneous taxes, but only 50% of natural resource revenues are included. Those provinces with a higher tax per capita than the national average do not receive equalization payments.

The 2019-20 equalization programs costs the federal government $19.8 billion of which two-thirds is paid to Quebec due to its population size. In 2019-20, Quebec ($13.1 billion), Manitoba ($2.3 billion), New Brunswick ($2.0 billion), Nova Scotia ($2.0 billion) and Prince Edward Island ($0.4 billion) are receiving equalization payments.  As of this year, Ontario no longer receives equalization payments.  British Columbia, Alberta, Saskatchewan and Newfoundland & Labrador (NL) also do not receive equalization payments. The outlier in this last group is NL. Newfoundlanders have a lower per capita income than the Canadian average, making it the only low-income province not to receive any equalization help.   Even Ontario, one of the richer provinces, still received equalization payments in 2017-18 even though its payment is now phased out.

Equalization is intended to equalize tax capacity, not personal incomes (which could also be viewed as a measure of tax capacity). Yet, the fact that one province with relatively low income is in the same position as rich provinces like Alberta and British Columbia, is disturbing since Newfoundland & Labrador is not a have province.

In addition, circumstances are not improving for Newfoundland & Labrador. By several measures, it is potentially approaching insolvency. It has a current unemployment rate of 12.2%. Its population has grown little in the past decade and is the only province expected to lose population by 2050 (roughly 5%) according to Statistics Canada. Its average annual GDP growth in the past 5 years has –0.5%, the only province with negative growth.

Given its circumstances, the province should be receiving more help from Ottawa. So why isn’t this happening?Why is equalization so unfair to a poorer province? The reason is that the equalization formula is not being applied in a consistent way, due to various rules – rules that are arcane and opaque, and should be changed.

1. Ad hoc treatment of Natural Resource Revenue

As mentioned, the equalization formula requires NL to include 50 % of the roughly $1 billion the province receives annually from royalties in off shore oil in its revenues. This effectively claws back a large proportion of the revenue that NL gets from offshore royalties, and is a major reason that NL does not receive equalization.

Natural resource revenues have been a major issue over the years in terms of their inclusion in the equalization formula. On one hand, all of natural resources should be subject to equalization if one were to equalize tax capacities fully. However, this would make the program very expensive for the federal government since most provinces would be paid equalization given Alberta’s wealth. As a compromise, only 50% of natural resource revenues are included for equalization – but this is not rooted in sound principle.

On the other hand, it must be remembered resource revenues are not non-renewable – once resource deposits are sold, the province cannot renew the asset. Some economists have argued that natural resources should not be included in equalization at all for this reason, a position that has been criticized as unfair to those provinces with few non-renewable resources.

A better argument, perhaps, is that resources revenues should not be included for equalization if they are being used to fund investments (including development) or to pay down debt (the return on investments would be equalized). This would have given more incentive to provinces like NL to save rather than spend their non-renewable resource dollars.

There are other issues are involved. One of the unintended consequences of the equalization formula is that it effectively taxes growth. Recipient provinces that develop their economy and generate more revenues lose equalization payments if they receive more natural resource revenues and other taxes associated with development projects. The clawback is at 50 cents on the dollar for non-renewable resource revenues and a 100% for other taxes generated by resource projects since they are fully equalized.

Another fly in the ointment is the definition of natural resource revenues itself. Not all resource revenues are taxed equally. This has given some recipient provinces, such as Quebec, a significant advantage. The reason? Most Crown Corporation profits are included in business taxes and therefore subject to full equalization. On the other hand, hydroelectric profits are included in natural resource revenues of which only 50% is equalized (Ontario’s Hydro One was shifted to the business tax category since it is involved in electric transmission, not generation, but most provincial power companies are integrated and remain in the natural resource revenue category). This enables provinces like Quebec and Manitoba to receive much greater amounts of equalization than they should.

2. The formula is not sensitive to changing circumstances

In some cases, like Ontario, a province had received equalization in recent years when it was not entitled to it. In other cases, a province should receive equalization but the formula is slow to react to changing circumstances. This results from the payments being based on a moving average of the three years of equalization payments due to the province. While this reduces instability of payments, it also reduces the sensitivity of payments to secular downtrends.

This will prevent the formula providing NL any additional revenue into the near future. The continuing claw back of oil revenue will subdue any future benefit NL will get, as conditions for it worsen under the 50% inclusion of oil royalties in the formula.

3. Two provinces can kill the smaller provinces due to the federal cap on payments

The third problem that exists with the equalization formula is that if either income levels in Ontario or Quebec fall below the national average, they take away most of the equalization pot at the expense of any of the poorer provinces.

To illustrate this, suppose the national average tax base is $25,000, and the national average tax raised in Canada is 20%. If a province has a tax base of $20,000 it is assumed to collect $4,000 per person using the 20 % average national tax rate (not the average tax rate of the province in question, but the federal national tax rate). The lower fiscal capacity of the province in our example is $5,000 minus $4,000, so it drops below the national standard by $1000. The equalization formula takes that difference and multiples it by the population of the province.

If that province was Quebec, the formula would give Quebec the population, 8.4 million times $1,000 or $8.4 billion.

If the Province in the above example was Ontario it would get 14.3 million population times $1,000 or $14.3 billion.

If the Province were NL, the province would get 525,000 times $1,000 or $525 million.

However, Ottawa takes steps to protect its coffers from increasing demands. Federal equalization payments are capped, in that they cannot grow by more than the previous three-year moving average GDP growth rate. Thus, higher equalization payments for one province can result in less equalization paid to other provinces.

This again gives the larger provinces much greater weight, at the expenses of smaller ones. If either Ontario or Quebec suddenly suffers a decline in taxes collected, their deficiency absorbs a large share of the equalization pot.

4. The Ageing Population Syndrome

Provinces with ageing and declining populations have the most to lose under the current equalization formula – and none is ageing or declining more rapidly than that of Newfoundland and Labrador.

By 2050, Statistics Canada projects the province’s population to fall by 60,000 to 75,000 people. Its median age could be almost 55 years. This means that even if there is a deficiency in tax per capita, NL equalization is going to decline and the smaller population will receive less and less.

Not only does the equalization formula penalize an ageing province, the Canada Health Transfer does as well, because it is not age-corrected. Statistics provided by the NL government show that per capita health costs rise by fifty per cent for every five years a person lives. Thus, a 70-year person takes 50% more in per capita health costs than a 65-year old. A 75-year old will need 50 per cent higher health spending than a 70 year old. Given NL’s rapidly ageing population, health and long-term will sky rocket, imposing a large tax burden on NL’s working population.

5. Other Special Expenditure Needs

The last reason that equalization is unfair for NL is that it does not consider the cost of delivering services such as health, education, and infrastructure, including the ageing problem mentioned above. Although not unusual for many Canadian provinces, NL has a huge landmass with a low-density population, which raises the cost of providing services on the island.

Conclusion

How can a province with double digit unemployment, a shrinking population and GDP, and below average per capita personal income be considered a “have” province?  And why would Ottawa approve the same equalization formula for five more years, when it is clear these trends will not reverse themselves – and lead NL to the precipice of insolvency?

The reality is that Newfoundland and Labrador are running out of time. If the province does go over the edge, the impact on the rest of Canada will be enormous. Bailing out NL would be extremely costly – as would the consequences of not doing so. All provinces would face downgraded credit ratings, increased borrowing costs, and higher taxes as a result.

The Fathers of Confederation would not be amused. Canada has compassionate, moral, and financial reasons to provide new assistance to Newfoundland & Labrador. Ottawa needs to act now, before it’s too late.

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