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Annex 6
Renewing Equalization and Territorial Formula Financing

Introduction

When some regions of a country are not as prosperous as others, they find it more difficult to deliver public services unless they impose much higher taxes than other regions. An equalization program is an approach used in various federal countries including Canada, Australia, Germany and Switzerland to deal with this situation.

Conceptually, an equalization program identifies a reference region (or regions) as a standard, and the fiscal capacities of less prosperous regions are raised to that fiscal capacity. This means that the gap in the amount of revenue a less prosperous region can raise from its revenue base, compared to the standard, is fully filled by transfers from the federal government.

In this way, an equalization program acts as a form of insurance for regional governments. As a region’s own-source revenues increase, its need for this insurance declines.

The Canadian Equalization Program

Since its inception in 1957, the Canadian equalization program has played an important role in defining the Canadian federation. Not all provinces in the federation are equally prosperous. The federal government makes equalization payments to less prosperous provinces to allow them to provide their residents with public services that are reasonably comparable to those in other provinces, at reasonably comparable levels of taxation. Provinces that receive these unconditional funds use them to help pay for the programs for which they have primary responsibility, including health care, education and social programs.

The principle and purpose of the equalization program have been entrenched in the Constitution of Canada since 1982:

Newfoundland and Labrador, Nova Scotia, Prince Edward Island, New Brunswick, Quebec, Manitoba and Saskatchewan have been consistent recipients of equalization payments. In recent years British Columbia has also qualified for payments. Over the period 1999–2000 to 2003–04, the equalization program transferred an average $10 billion a year to these provinces. Total equalization entitlements since 1980–81 are shown in the following chart.

How Equalization Payments Are Calculated

Equalization payments are determined by a formula that is established in legislation. The formula measures each province’s ability to raise revenues and compares this to a standard amount related to the ability of reference provinces to raise revenues.

The standard is equal to the average per capita revenue-raising ability of the five "middle-income" provinces—Ontario, Quebec, British Columbia, Manitoba and Saskatchewan. It does not include provinces with the lowest or highest fiscal capacity. The revenue-raising capacity of each province is measured by its ability to raise revenues in each of 33 revenue sources, including personal income tax, corporate income tax, sales taxes, property taxes, fuel taxes, alcoholic beverage taxes, tobacco taxes, motor vehicle taxes, payroll taxes and revenues from natural resources.

For fiscal year 2004–05, the equalization standard is estimated to be $6,126 per capita, as shown in the following chart. Equalization payments are made to the provinces with revenue-raising capacity below the standard to bring their total fiscal capacity, including equalization payments, fully up to the standard. It is the nature of the program that when a province’s ability to raise revenues increases, its equalization entitlement will decline accordingly.

Equalization entitlements are based on the relative fiscal capacities of provinces. Since the beginning of the 1980s, disparities in fiscal capacities among provinces have tended to gradually converge, with the gap between receiving and standard provinces steadily narrowing.

However, in the shorter term, changing economic and fiscal circumstances in Canada’s regions can lead to volatility in payments from one year to the next. For example, when the Ontario economy is growing rapidly relative to other provinces, as it was in the late 1990s, the standard increases and equalization entitlements increase. Similarly, when the Ontario economy is growing more slowly than the rest of the country, as occurred in 2002 and 2003, the gaps between the standard and the less prosperous provinces tend to narrow and equalization entitlements decline. It is worth noting that fluctuations in the Ontario economy have similar impacts on the federal tax bases from which transfer payments are funded.

An equalization program needs to contend with this challenge of volatility. The floor provision in the Canadian equalization program limits the amount by which an individual province’s payments can decline from one year to the next. On the other hand, large upward movements in equalization payments can imply a significant financial burden on the federal government. For this reason, the equalization program also had a provision that limited the amount that overall equalization payments could grow over time. With the improvement in the Government of Canada’s fiscal position, the equalization ceiling was eliminated from 2002–03 onward as part of the 2003 First Ministers’ Accord on Health Care Renewal.

Table A6.1
Equalization Entitlements¹

Equalization Estimate Updates

When equalization payments are initially made to provinces, they are based on estimates. The estimates are updated every six months until a final calculation is made—30 months after the end of the fiscal year to which the payments relate. The updates often result in adjustments to payments to reflect under- or over-estimates with respect to all fiscal years that have not yet been finalized. Naturally, given that equalization fills a "gap" in fiscal capacity, changes in payments to a particular province depend not only on its own economic performance, but also on the performance of the provinces in the standard. For example, since Ontario’s fiscal capacity makes up about 50 per cent of the standard, equalization payments are quite sensitive to the performance of the Ontario economy.

Natural variations in the relative economic circumstances between regions tend to be magnified by the estimates process. As the underlying economies changed, revisions to the data underlying the calculations have resulted in changes in estimated equalization payments as large as 30 per cent from one year to the next.

Given these fluctuations, a challenge arises in budget planning for equalization-receiving provinces. To deal with this, the Government of Canada has extended the repayment period for certain overpayments identified in 2003–04 to five years. These repayments will commence in 2005–06. Such an approach, while helpful, does not deal with the underlying causes of the challenge, which is the large variation in payments related to data revisions. This budget takes steps to reduce this variability.

The 2004 Equalization Renewal

The equalization program is reviewed and renewed every five years to ensure the integrity of the formula upon which payments are based. Maintaining the integrity of the program requires periodic revisions to reflect the evolution in provincial taxation practices and the use of the most up-to-date data. Equalization renewal is thus about making appropriate, fair and accurate changes, not about cuts or enrichment to the program. For example, the equalization program was excluded from Program Review reductions in 1995. Equalization was last renewed in 1999 for the period 1999–2000 to 2003–04.

Legislation accompanying this budget will propose to renew the equalization program for five years—from 2004–05 to 2008–09. Receiving provinces are expected to receive more than $50 billion in payments over this period. As part of this renewal, the budget proposes that a number of issues be dealt with to maintain the integrity of the program and improve its operation. These modifications would provide more stable and predictable equalization payments and more accurate measurements of fiscal capacity in tax bases to deal with the challenge referred to above.

Improving Accuracy: Changes to Tax Bases

A key objective of each five-year renewal is to update the equalization formula to reflect current taxation practices of provinces and to incorporate new or better data used in the measurement of provinces’ ability to raise revenues. To this end, improvements to a number of tax bases are being proposed, including:

• The property tax base: The property tax base will be changed to reflect the use of real market value in the residential property sector. Special consideration will be made for British Columbia, where property values are significantly higher than in other provinces, reflecting to some extent nominal rather than real differences in the quantity and quality of properties. The property tax change is a fundamental redesign of the second-largest base in the program, which will have significant distributional impacts across provinces, and needs to be tested and studied. For this reason, only 50 per cent of the proposed residential property tax base will be used for the next five years. The next renewal will aim for full implementation of this new methodology to the residential sector of the base and extension of the methodology to the commercial/industrial and farm sectors.

• The personal income tax base: The new approach will take into account the adoption by all provinces in the Tax Collection Agreements of "tax on income" in 2001. The new base will model each province’s tax system and will have the added benefit of automatically adapting to changes in provincial tax regimes.

• Other bases: Changes will also be made to: 1) the Hospital and Medical Insurance Premiums base, to reflect changes made to health care premiums in the 2002 Alberta and B.C. budgets and incorporate Quebec’s Health Services Fund; 2) the Water Power Rentals base, to include hydroelectric production on the Columbia River in the United States owned by British Columbia; 3) the Mineral Resources base, to remove certain minerals not generally taxed by provinces and to adjust the definition of fiscal capacity; 4) and the Commercial Motor Vehicle Licences base, to adopt available data on the number of commercial vehicles that are registered in each province and adjust fiscal capacity with respect to farm vehicles.

More Stable and Predictable Payments

A key element of this renewal is making payments more stable and predictable. The budget proposes that payments be based on a three-year moving average. The moving average process will smooth out payments, dampen the effects of data revisions and reduce the number of times payments are revised. Entitlements for each fiscal year will be based on the average of entitlements, as currently defined, for the three years preceding the fiscal year. The ability of the moving average process to smooth out equalization payments is readily apparent in the following chart, which shows what payments would have been over the last 15 years had the moving average been in effect.

As shown in the chart, the moving average process will reduce the effects on equalization payments of data revisions, such as revisions to population data following a new census and revisions to income tax data. Instead of year-over-year changes in equalization payments of up to about 30 per cent under the existing system over the last 15 years, fluctuations would have been limited to about 10 per cent under the moving average.

For example, revisions to income tax and other data incorporated into the February 2004 equalization estimates reduced equalization payments by $2.2 billion in 2003–04. If the moving average had been in place in 2003–04, the decline in payments would have only been $263 million in 2003–04 and the remaining negative adjustment of $1.9 billion would have been spread over the next three years.

To make the introduction of the new approach as smooth and seamless as possible, the new system will be gradually phased in. The introduction of the moving average process will also operate as a natural way to phase in the tax base changes. The new system, including tax base changes, will thus be phased in over the period 2004–05 to 2006–07 and will be fully in place by 2007–08, as shown in the table below. During the transition period between 2004–05 and 2006–07, a declining portion of payments will continue to be made based on the existing structure.

When the moving average is fully implemented, payments to provinces would be delayed by two years on average when compared to the system currently in place. To compensate provinces for this delay, the budget proposes that payments be increased by an adjustment factor. While an 8.5-per-cent adjustment factor would have been approximately cost neutral for the federal government and the provinces, a higher adjustment factor would ensure that most provinces derive a net benefit from the proposal. Accordingly, a 10-per-cent adjustment factor is being proposed, which will provide provinces with an additional $460 million over the next five years.

In addition, provinces with significant volatility in their natural resource revenues, such as Saskatchewan, will be allowed to bring certain amounts of their equalization payments forward in time in order to better manage in-year changes in those revenues.

To advance the benefits from the renewal package, the federal government will augment equalization payments by $150 million for 2004–05 and $25 million in 2005–06. These amounts will be distributed across receiving provinces on an equal per capita basis.

Finally, there have been large fluctuations in equalization payments over the past five years. Given the transition period to the more stable regime, the Government of Canada proposes to make repayable payments to provinces whose equalization payments at the end of 2004–05 are less than the average of payments the province received between 1999–2000 and 2002–03.

Offshore Accords

In the 1980s administrative arrangements were signed to allow Nova Scotia and Newfoundland to manage and tax offshore resources as if they were under provincial jurisdiction. Currently there are two accords in place: the Canada–Newfoundland Atlantic Accord (1985) and the Canada–Nova Scotia Offshore Petroleum Resources Accord (1982 and 1986).

These accords contain time-limited measures that offset the impact on equalization payments of resource development (in general, as a province’s ability to generate own-source revenues increases, its equalization payments decline). The offset provisions take the form of special payments to these provinces. For Nova Scotia, these payments relate to the impact of not including a portion of offshore revenues in the equalization program. For Newfoundland, the payments relate to the size of year-over-year declines in total equalization payments.

In addition to the accords, offshore revenue bases also meet the eligibility criteria of a provision in the equalization program, the so-called "generic solution," which augments the equalization payments of provinces that have more than 70 per cent of any base.

When the generic solution was introduced, an election (or choice) mechanism was introduced for Nova Scotia and Newfoundland in the relationships between their Accords and the equalization program. At the end of each year, these provinces must elect which treatment option they prefer—their accord offset provision or the generic solution.

Nova Scotia: The equalization offset provision of the Canada-Nova Scotia Offshore Petroleum Resources Accord will be reset to start in 2000–01. This change recognizes that Nova Scotia did not receive the expected benefits of this provision when it was originally triggered, as the flow of revenues from offshore oil and gas turned out to be lower than originally expected. The new date will coincide with the start of production from Sable Island.

Newfoundland and Labrador: The deadline for Newfoundland and Labrador to choose either the generic solution of the equalization program or the benefits of the Canada-Newfoundland Atlantic Accord will be extended from December 31 of the fiscal year for which payments are made to the month prior to the final determination of equalization for that fiscal year, to ensure that the province has access to complete information to make the best choice.

Financial Impact of Equalization Renewal

Once legislated, the improvements to the tax bases will provide an estimated $265 million in additional annual funding to provinces. The 10-per-cent adjustment factor will add $150 million to the annual ongoing costs of the program. In total, the tax base changes, 10-per-cent adjustment factor and additional transitional funding for 2004–05 and 2005–06 mean that an estimated additional $1.5 billion will be transferred to equalization-receiving provinces over the next five years (see Table A6.3). The economic realities in each province relative to the standard will determine the actual impact of these changes over the course of the renewal period.

Priorities for Next Equalization Renewal

Work will begin in the near future on the review of the program leading to the next renewal in 2009. The Government of Canada is committing to a full examination of all natural resource revenue bases, including the Crown Lease base and criteria for application of the generic solution. Priority will also be given to the continued examination of the property tax base.

Renewal of Territorial Formula Financing

Territorial Formula Financing (TFF) is the principal federal transfer to the three territories. Similar to equalization, TFF takes into account the revenue-raising capacity of the territories. However, in order to ensure that the territorial governments have the capacity to provide public services comparable to those of the provinces, including health, it is also necessary to take into account the higher costs and unique circumstances in the North.

TFF payments are unconditional grants and are governed by agreements with the territories which are updated every five years on the same cycle as equalization renewal.

The federal government is putting in place new five-year TFF arrangements with the territorial governments for the period April 1, 2004 to March 31, 2009, which will commit additional resources to assist territories to invest in key priorities and respond to the unique challenges in the North.

Following up on the Prime Minister’s February 2003 commitment to review the overall funding requirements of the territories, the federal government and the territories undertook an extensive assessment.

Under TFF, territorial expenditure bases will be increased, providing an additional $150 million over five years to allow each territory to target its priorities. To address the key priority of health, the health transition funding provided following the 2003 First Ministers’ Meeting will be made ongoing in 2006–07 with an annual benefit of $20 million. Finally, effective 2004–05 the TFF ceiling will be removed.

In 2004–05 the federal government will transfer approximately $1.8 billion to the three territorial governments under the new TFF arrangements. Over the next five years, these transfers are projected to total more than $10 billion to ensure territorial governments have the resources to provide northern Canadians with health and other public services.

To further support the territorial priorities, $90 million over five years will be provided to support a northern strategy to ensure that economic development opportunities are developed in partnership with northern Canadians.

As a result of these investments, the federal government will provide an additional $300 million over five years in support of territorial investments in priority areas, including health and economic development (see Table A6.3).

How Territorial Formula Financing Works

• TFF is determined through a formula based on a gap-filling principle, which takes into account the difference between the expenditure needs and revenue means of the territorial governments, and pays the difference in a cash payment.

• Territorial expenditure needs are represented by the formula’s Gross Expenditure Base (GEB), which is indexed to move in line with growth in provincial spending so as to reflect expenditure pressures facing governments in other parts of the country. It is also adjusted for territorial population growth relative to that of Canada as a whole.

• Revenue-raising ability is measured by estimating the revenue a territory would have at its disposal if it exercised a tax effort similar to that in other parts of the country, adjusted to recognize the special circumstances in the North.

Table A6.2
TFF Entitlements¹

Table A6.3
Fiscal Impact of Equalization and TFF Renewals

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