What's at stake in the battle with the provinces

Understanding equalization.
Federal Finance Minister Jim Flaherty and Governor of the Bank of Canada Mark Carney (left) prepare for a meeting of federal and provincial finance ministers on Nov. 3, 2008. ((Canadian Press/Frank Gunn))

Equalization began in 1957 as a noble gesture to help share the wealth within the Canadian family and ever since, Ottawa and the provinces have been squabbling over it at almost predictable 10-year intervals.

  • The mid-1970s, the Pierre Trudeau years, saw the first of the bitter battles over Alberta's burgeoning oil wealth and culminated in the decision to shield provincial resource revenues from the already complex equalization calculations.
  • The mid-1980s, the Brian Mulroney years, witnessed the protracted court battles over offshore resources and resulted in the creation of the Atlantic accords, first with Nova Scotia and then with Newfoundland and Labrador, and the decision that equalization payments for these two provinces would not be affected or "clawed back" as their oil wealth came on stream.
  • The mid-1990s, the Jean Chrétien period, saw Ottawa retrenching under its own fiscal burden. Equalization, a federal program, became patched together like an improvised quilt, with its almost incomprehensible generic formulas and side deals to withstand the strains.

Now, it's Stephen Harper's turn. In the name of resolving the so-called fiscal imbalance among the provinces, the Harper government introduced a new equalization formula in the March 2007 budget. It was to run concurrent with the old one and, indeed, three other variations, giving the provinces the right to cherry-pick which package worked best for them.

Solution found? The Conservatives thought so. "It's certainly the end of the bickering," Finance Minster Jim Flaherty said on budget night as he shovelled out a massive amount of new money to the provinces, equalization being just one part of it. That, alas, was not to be.

First, Newfoundland Premier Danny Williams and then Nova Scotia's new premier, Rodney MacDonald, both Conservatives, accused Harper in the strongest terms of bullying their provinces over equalization and breaking the tenets of the Atlantic accords.

Nova Scotia eventually came around, though the final details are still to be ironed out. Newfoundland spectacularly did not. But now it is Ontario's turn to grumble and Flaherty is back at the federal-provincial negotiating table trying to put a new cap on equalization in these more turbulent times. 

After paying into the plan for over half a century, Ontario now finds itself a so-called have-not province, the result of its once-mighty manufacturing sector being buffeted into recession by the global downturn in 2008. Beginning in the spring of 2009, for the 2009-10 fiscal year, Ontario will receive equalization payments for the first time in its history, to the tune of $347 million. 

But that amount is still a far cry from what it would have received under the old pre-Harper system and should expect to get even under the revamped one announced in the March 2007 budget. 

According to an analysis by TD Economics, at this rate Ontario's share of the equalization pie would expand to $1.3 billion in 2011-12 under the new rules brought in by the Harper government in 2007.

Couple that with the fact that equalization payments jumped 16 per cent  in 2008-09, you can see why Ottawa is talking about clamping down further on equalization payments, just in time for another once in a decade battle.

What is equalization?

Simply put, equalization is one of five federal programs through which Ottawa transfers money to the provinces and territories, in this case to try to ensure that every province has roughly the same capacity to pay for basic public services such as health and education.

In the case of the smallest province, PEI, for example, equalization payments amount to just over $2,200 a resident and represent close to 25 per cent of that province's total revenues.

In its heyday, equalization was worth as much as one per cent of GDP, which in 2006-07 would have been something in excess of $14 billion. Instead, it was just over $11 billion that year. It rose to $13.6 billion in 2007-08, part of $51 billion that Ottawa sent the provinces as part of five large federal transfer programs.

In 2008-09, four provinces — Alberta, B.C., Saskatchewan and Ontario — are considered wealthy enough not to require equalization. All, except for Ontario, have received it in the past.

To calculate the amounts due, Ottawa analyzes up to 30 different taxes and royalties in each province and territory to try to determine a national standard.

The most recent changes, introduced in the March 2007 budget, flow from the recommendations of a so-called Expert Panel that attempted to strike a balance between competing claims.

The provinces, for example, had wanted something called the 10-province standard (as opposed to that of the five middle-income provinces, which had been the standard since 1982).

Basing the calculations on 10 provinces would bring Alberta, with its huge provincial revenues, into the mix and so ensure a higher fiscal capacity, or a bigger pot for Ottawa to fill. The tradeoff, from the federal perspective, was to include 50 per cent of provincial resource revenues into the calculation. (Before now they had been excluded so Alberta's massive energy royalties would not skew the mix and so provinces like Saskatchewan, with energy royalties but a low tax base, could be included.)

This is the tradeoff, of course, that has caused the problems with the Atlantic accord provinces. The Harper plan also includes something called a fiscal capacity cap to ensure that other have-not provinces don't get boosted to a level above Ontario.

The dispute over the Atlantic accords

There are two issues at play here. One is the interpretation of the terms of the two Atlantic accords. The other is how big a slice of pie any one province can take from equalization.

To smooth the way for his reforms, Harper offered two basic choices to the provinces, choices that really only affect those, N.S. and N.L., that are also bound by their respective offshore agreements.

These two provinces have the option of staying with the old equalization formula, the one that's been cobbled together over the years, and thereby shielding virtually the full amount of their offshore revenues from any kind of clawback, at least until the accords end in 2012.

Or, they can opt for the enriched equalization plan that Ottawa is now offering, but the calculation for this plan includes 50 per cent of a receiving province's wealth from natural resources, including those offshore, which the two premiers see as a violation of their respective accords.

By Ottawa's calculation, the enriched plan is worth more for both provinces, at least for the foreseeable term. Under it, for example, equalization payments for 2007-08, would jump from $477 million to $733 million in the case of Newfoundland and Labrador, and from $1.3 billion to $1.53 billion for Nova Scotia.

But there's a catch. The provinces can jump into the new plan at any time. But once they're in, they only have a year to test drive it if they want to go back to the old one.

So far, Newfoundland has elected to stick with the old equalization regime. Nova Scotia opted for the new version, but eventually struck a deal with Ottawa to have an independent panel evaluate the different schemes.

The Nova Scotia argument

Nova Scotia's position is that it shouldn't have to choose between two competing equalization schemes. A 2005 addendum to its offshore accord says revenue offsets are to be based on the equalization formula "as it exists at the time." The province, therefore, should be able to choose from whichever formula suits it best, while still being able to protects its offshore revenue, as per the Atlantic accord.

Premier MacDonald put it this way in an interview with the National Post: "Suppose you are an employee in a company and you achieve a bonus from your boss. Two years later, the company is doing better so the boss gives everyone a raise.

"But he gives you a choice between your old salary with the bonus you got two years ago or the raise. But the catch is that if you take the raise you have to pay back the bonus you got. Is that fair?"

Good question. One thing to consider: The new enriched formula wouldn't claw back the entire bonus, just that portion representing 50 per cent of offshore royalties. And it may still represent a better long-term deal.

But this could still be a huge gamble in Nova Scotia's case in particular. It took $830 million in future payments upfront in 2005 when it signed an extension to its accord, and has already spent the money paying down debt. If some of this money is to be clawed back, the province's ability to manoeuvre in the future will undoubtedly be compromised.