Tuesday, July 31, 2001
The National Post
Remove resource revenues from equalization
by Ken Boessenkool
Equalization was designed to give cash to economically weaker provinces so that they would have total revenues that are comparable to a representative Canadian average. And at that task, the program works remarkably well. In doing so, however, the program also contains economic incentives that can lead recipient provinces to prefer the certainty of transfers from Ottawa over the uncertainties of trying to strengthen their economies and thereby make provincial tax bases stronger.
These incentives are the result of equalization payments that fall when provincial revenues rise. And, in many cases, they fall dollar for dollar. This severely reduces the incentive to follow growth-oriented policies such as reductions in corporate income tax rates that are occurring in nearly all non-equalization recipient provinces.
When an Atlantic province cuts its corporate income tax, the result is less corporate income tax revenue in the short term, which is not compensated by equalization (which uses a national average rate to calculate transfers). But, more importantly, the long-term benefit that comes in the form of a stronger economy is taken away through reductions in equalization (which uses the provincial tax base to calculate transfers). So growth-oriented policies that have long-term payoffs for provinces that do not receive equalization, have little or no payoff for governments in equalization-receiving provinces.
This is a serious problem that requires a well thought-out, broad-based solution. As important as that problem is, however, it does not conflict with the desire to address the problems specific to the treatment of non-renewable resource revenues.
The main reason to think of non-renewable resource revenues separately is that resource revenues fit uneasily with other revenues in the equalization formula.
Unlike other revenues, when a province collects royalties from its non-renewable resources, it is the result of converting an asset from one form to another — from physical to financial. In accounting terms, the transaction would be considered a sale of a capital asset. And when a firm sells a capital asset, the proceeds from the sale do not enter the revenue stream.
The same should be the case with resource royalties. (Admittedly, offshore resources in Atlantic Canada legally belong to Ottawa, not the provinces, but Ottawa gave over de facto ownership by allowing them to collect royalties on these resources.) Non-renewable resource royalties are not properly part of a province’s revenue stream, and therefore have no place in the equalization formula.
In theory, this argument holds regardless of what the province decides to do with the royalties — just as an accountant will not allow the proceeds from the sale of a capital asset to enter income just because an imprudent owner decides to use these proceeds to pay the salaries for his staff, rather than reinvest them. In practice, if a province uses these royalties for current spending, they are depleting their assets for the benefit of current generations at the expense of future generations.
The trouble is, the equalization formula promotes just that kind of imprudence. By including resource royalties as part of provincial fiscal capacity, it encourages provincial governments to use these dollars for current program spending. Only if resource revenues are removed from equalization will provinces have the proper incentives to use this money for capital purposes. This is what Alberta did. In the early 1970s it used some of its resource royalties money to build up the Heritage Fund, and in recent years resource royalties have been used to accelerate debt repayment.
Removing resource revenue from equalization is therefore defensible on its own merits: It acknowledges that royalties are proceeds from the sale of a capital asset, and it removes the perverse incentive to use these proceeds for current spending.
Dealing with the natural resource question should not prevent Ottawa from addressing more fundamental questions, but the two issues need not be set against one another. While one motivation for dealing with the resource question — that of incentives — is the same as for other revenue sources, the fact that resource revenues are fundamentally unlike other revenues in equalization justifies dealing with them separately.
Ken Boessenkool is the Calgary-based author of Taking off the Shackles: Equalization and the Development of Non-renewable Resources in Atlantic Canada, published by the Atlantic Institute for Market Studies. He has recently been named an adjunct research fellow at the C.D. Howe Institute.
