Fiscal Federalism and Equalization Policy in Canada Political and Economic Dimensions 9781442635418 2017

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Equalization in Comparative and Historical Perspective

Introduction

Comparative and historical perspectives are important in the study of public policy because policies are the product of long-term economic and political processes that can vary greatly from country to country.1 Reviewing historical processes within a comparative framework helps to explain key differences between countries. In the case of equalization policy in Canada, such an approach can shed light on the structure of the program as it developed in the post–World War II era.

This chapter explores the emergence and development of equalization policy in Canada from an historical and comparative perspective. After showing how the Canadian experience differs from that in other federal countries, the chapter explains why, in the context of the decline of the tax rental agreements that were first signed between Ottawa and the provinces during World War II, Canada came to adopt a federal equalization program in 1957.

One of the central objectives of this chapter is to locate equalization within the broader political and fiscal context of federalism, in Canada and in other federal systems. We discuss, for example, the status of Québec within the Canadian federal system and the potential relationship between equalization and national unity. Another key aspect of the chapter concerns the choice of the governance model adopted for equalization policy in 1957, in contrast to the model developed in Australia during the early and mid-1930s. This “Australian model,” which features an arm’s-length expert commission in charge of determining equalization payments, was explicitly rejected in Canada in 1957, as was the idea that expenditure needs should be considered alongside fiscal capacity to calculate equalization payments, in contrast, expenditure needs were part of the calculation in Australia. To better explain the choices made about the nascent equalization program in Canada, we provide, toward the end of the chapter, a comparison between it and Australia’s equalization policy.

From fiscal federalism to equalization policy

In Canada, equalization policy is a key component of modern fiscal federalism, that is, of how federal fiscal resources are redistributed among different levels of government. The basis of fiscal federalism is the “redistribution of revenue” between central and constituent unit governments (Watts 2008, 95). In most federal systems, as Ronald Watts (2008) notes, the central government is allocated substantial taxation powers as a way to mitigate fiscal competition among constituent units and to draw on “the administrative advantages of centralizing certain kinds of revenue levying and tax collection” (95). As a result, all federations witness a fiscal gap “between the revenues and expenditures of central governments and constituent units, and every central government transfers funds to the constituent units. Through such transfers, central governments exercise their spending power to achieve various goals, including national standards and objectives” (Atkinson et al. 2013, 10).² The centralization of taxation powers is never absolute, however, as constituent units must have the capacity to generate some own-source revenues in order for their constitutional powers to translate to the policy level.

The constitutional division of taxation powers between the central and constituent unit governments varies greatly across federal systems. Looking at central government revenues as a percentage of total government revenues before intergovernmental transfers provides a perspective on fiscal centralization in federal systems (see Table 1.1).

Table 1.1 Federal government tax revenues as a percentage of total government revenues in six OECD federal countries, 2013

Source: OECD.
Australia	80.8
Mexico	80.1
Belgium	57.1
Canada	41.6
United States	41.2
Switzerland	35.2

This indicator suggests that Canada is, from a fiscal perspective, is a most fiscally-decentralized federation, with less than half of total government revenues originating at the federal level. Other centralization indicators suggest a similar conclusion. For example, provincial governments have very few restrictions on their own-source revenues, and their borrowing autonomy is unconstrained. Provincial governments have access to major tax revenue sources such as income tax and sales tax. Also, Canadian provinces are not highly reliant on federal transfers in comparison with constituent units in other federal systems (see Table 1.2).³

Table 1.2 Intergovernmental transfers as a percentage of constituent unit total revenue in five OECD federal countries, 2014

Source: OECD.
Mexico	70 (2013)
Belgium	64.5
Switzerland	25.1
United States	18.9
Canada	18.8

Another indicator of the levels of fiscal centralization of federations is the conditionality of transfers. In Canada, the two main vertical transfers, the Canada Health Transfer (CHT) and the Canada Social Transfer (CST), come with conditions that are not overly constraining. To receive the CST, provinces cannot impose a minimum residency requirement for residents to receive social assistance. As for the CHT, the federal government has the right to reduce transfers to specific provinces by a discretionary amount if it judges that such provinces do not respect the five criteria (portability, accessibility, universality, comprehensiveness, and public administration) or if they allow user fees or extra billing as specified in the 1984 Canada Health Act. Nevertheless, overall, one can say that Canadian provinces enjoy strong fiscal autonomy and that, as a consequence, they can pursue their own policy objectives within their areas of jurisdiction (Atkinson et al. 2013).

While Canadian provinces have one of the highest degrees of policy autonomy compared to constituent units of other federations, the federal government is preeminent in several policy fields (criminal justice, international relations, currency, defence, and citizenship). Provinces play a significant, though shared, role in many other crucial fields (social policy, transportation, agriculture, language, culture, financial regulation, and the environment). In yet other key policy fields (education, health care, employment relations, civil law, natural resources, and policing), provinces have the dominant policy-making position.

These remarks about the high level of fiscal decentralization and provincial autonomy should not obscure the fact that political and policy debates in Canada feature two types of fiscal gap. The first is a vertical fiscal gap, which typically refers to the claim “that the federal government’s tax sources are much greater than its expenditure responsibilities whereas, in the provinces, precisely the opposite is the case” (Atkinson et al. 2013, 62). Another term used in academic and political discourse to describe the vertical fiscal gap is fiscal imbalance, which typically refers to the claim that, given the fiscal gap and limited federal transfers, provincial total revenues do not increase rapidly enough to keep pace with growing policy expenditures. Politically, the claim that Canada is characterized by a vertical fiscal imbalance has been used by provincial leaders to seek greater fiscal transfers from Ottawa. This is particularly the case in Québec, a province that has long articulated a strong discourse denouncing vertical fiscal imbalance in Canada (Commission on Fiscal Imbalance 2002; Lecours and Béland 2010).

A vigorous debate over the issue of fiscal imbalance emerged in the mid-1990s, when deficit elimination became a major priority of the federal government formed by the Liberal Party of Canada (LPC) after the 1993 elections. A crucial tool for reaching a balanced budget was a change in fiscal transfers to the provinces. In the 1960s and most of the 1970s, these transfers took the form of shared-cost programs: the federal government and the provinces would split costs for health care, higher education, and social assistance. In 1977, transfers for health care and higher education were changed to a block grant formula: the commitment of the federal government for helping to finance those fields was detached from provincial spending. However, the Canada Assistance Program (CAP), which ever since 1966 had transferred money to provinces to reimburse them for about half the costs incurred for social assistance and welfare, was left intact. With CAP, the federal government did not have full control over how much it was required to transfer to the provinces. In 1996, the federal government ended CAP as it consolidated its major vertical transfers into the Canada Health and Social Transfer (CHST), an omnibus block grant based on a formula independent of actual provincial spending on health care, education, and social assistance.

The Québec government, then formed by the Parti Québécois (PQ), criticized the changes harshly, as did other provinces. In the aftermath of the 1995 referendum on Québec sovereignty, the PQ denounced the federal government for balancing its budget “on the back of Quebeckers.” It argued that the needy and the sick in the province were cared for by a Québec government that did not have the necessary resources to provide the best services possible, while the federal government’s financial resources exceeded the needs associated with its constitutional responsibilities. The PQ labelled this situation “fiscal imbalance,” and Québec’s other political parties agreed. The Québec government created a commission (the Commission on Fiscal Imbalance) to study this problem and find a solution. In part to suggest the commission reflected a partisan consensus about the issue, the PQ named a former Liberal minister, Yves Séguin, as chair. In 2003, the Québec Liberal Party (QLP) formed the government in Québec and kept up the pressure on the Liberal Party of Canada to address the issue of fiscal imbalance. The QLP did not have to work hard to convince most other provincial governments that there was indeed a fiscal imbalance in the Canadian federation. Sensitive to the electoral implications of denying the notion of fiscal imbalance, all federal opposition parties acknowledged fiscal imbalance and promised to address it, if and when they took power.

The Conservative government formed after the 2006 elections produced a budget that gave considerable importance to the theme of fiscal imbalance. The new government argued for a different approach to federalism, labelled “open federalism,” one that respected provincial jurisdictions and therefore refrained from creating new national programs. Although this approach followed none of the key recommendations of Québec’s Commission on Fiscal Imbalance, which advocated most importantly for giving provinces a greater share of the “fiscal space” (primarily the sales tax) so they could augment their fiscal resources without raising income tax, the federal government declared that fiscal imbalance had been adequately addressed.4 Québec and most of the other provinces did not accept this verdict; yet fiscal imbalance as a burning political issue disappeared from the federal policy agenda, perhaps in part because existing federal surpluses rapidly disappeared during the early Harper years.

The second type of fiscal gap featured in Canadian political and policy debates is horizontal, referring to “the differential capacities of the provinces to raise revenues” (Atkinson et al. 2013, 62). This form of fiscal gap points to enduring fiscal inequalities between constituent units, which reflect broader economic and territorial disparities. In Canada, alongside other factors such as patterns of industrialization, main reasons for these disparities include the provincial ownership and uneven geographic distribution of natural resources. Most provinces have natural resources of some type: oil, gas, hydro-electricity, forestry, fisheries, and minerals. Not only are these resources unevenly spread out across the country but their value is also quite uneven: oil, especially when world prices are high, provides very important revenues. These revenues (whether they come from oil or other natural resources) go directly to the provincial government on whose territory the resources lie. The constitutional basis for the provincial ownership of natural resources is article 109 of the 1867 British North America Act: “All Lands, Mines, Minerals, and Royalties belonging to the several Provinces of Canada, Nova Scotia, and New Brunswick at the Union, and all Sums then due or payable for such Lands, Mines, Minerals, or Royalties, shall belong to the several Provinces of Ontario, Quebec, Nova Scotia, and New Brunswick.” After the Trudeau government embarked on an oil price regulation policy in the early 1980s (more on the National Energy Program in the next chapter), provincial governments insisted that there be a “resource amendment” included in the 1982 constitutional reform. As a result, article 92 A states that “In each province, the legislature may exclusively make laws in relation to (a) exploration for non-renewable natural resources in the province; (b) development, conservation and management of non-renewable natural resources and forestry resources in the province; and (c) development, conservation and management of sites and facilities in the province for the generation and production of electrical energy.” This amendment to the constitutional division of powers enhanced the legislative powers of the provinces (Moull 1987, 413).

The fact that provincial governments receive revenues stemming from resource exploitation taking place on their territory greatly impacts each province’s fiscal capacity. Fiscal capacity refers to the ability of provinces “to raise revenue from their own sources” (Barro 2002, 1). In Canada, as in other federations, fiscal revenues raised by each constituent unit vary across jurisdictions and fluctuate over time. From a normative and a public policy standpoint, these differences are problematic because they can compromise the ability of poorer constituent units to deliver services of comparable quality to those delivered by their wealthier counterparts, without imposing an undue fiscal burden on their residents.

From a public policy standpoint, important discrepancies in provincial fiscal capacities could lead to out-migration from poorer provinces, so wealthier provinces would experience net in-migration. Arguably, the traditionally poorer provinces of the federation (Newfoundland, Prince Edward Island, New Brunswick, Nova Scotia, Manitoba, and Saskatchewan) could have lost even more population than they have lost had no equalization program been created (in all likelihood, Québec would not have suffered a similar fate since it would have been inherently difficult for its French-speaking majority, many of whom are unilingual, to migrate to an English-speaking labour market). The public policy problem of the economic development of poorer provinces would have been compounded by this loss in population. In turn, the institutional basis of the Canadian federation could have been destabilized insofar as important provincial population losses and gains would have called into question the delicate balance of provincial representation in the House of Commons.

From a normative perspective, important differences in the fiscal capacity of provinces challenge the meaning of Canadian citizenship, solidarity, and even nationhood. The development of the welfare state in Canada compensated for socio-economic inequalities (between individuals or social classes), but in the context of federalism, because provinces have an important role to play in social and education policy, there are limits on the capacity of the federal government to provide substance to the idea of Canadian social citizenship. Differences in means among provincial governments to offer social protection to their residents can present a serious challenge to the very notion of solidarity and, sometimes, of nationhood. Indeed, chronic and unmitigated territorial discrepancies may provide material for politicians to generate, build, or sustain feelings of resentment toward and alienation from the central state. In turn, those sentiments can compromise nationhood or exacerbate already existing phenomena of distinct “national” belongings associated with regions or provinces.

The primary goal of equalization programs in federations is therefore to reduce the horizontal fiscal gap among constituent units, so they have a similar capacity to provide roughly comparable public services at a similar rate of taxation. Equalization programs typically do not have strings attached so as to preserve the autonomy of these constituent units, which in turn can help keep centralization at bay. In other words, equalization programs seek to achieve horizontal fiscal redistribution while enhancing or at least preserving the political autonomy of constituent units (Théret 1999).

Most advanced industrialized federations operate standalone equalization programs. One significant exception is the United States.⁵ From 1972 to 1986, the federal government ran a “revenue sharing” program that featured equalization components but focused primarily on addressing the vertical fiscal imbalance between the federal government and both states and municipalities (Wallin 1998). The absence of a standalone equalization program in the United States is the product of three distinct factors: the lack of a direct threat to national unity after 1865, a limited emphasis on equal access to services associated with the notion of social citizenship, and the nature of American political institutions, particularly the power of the second chamber (the United States Senate), which would make the adoption of an equalization program unlikely even if some constituencies within the country supported the idea (Béland and Lecours 2014a).

Equalization programs can take many different forms. Designing and reforming such a program involves making choices about at least six different features. The first choice is the source of financing for the program. In Canada, equalization is financed from the general revenues of the federal government. Other federations have made different choices. For instance, in Australia, equalization payments to the six states and two territories come from the Goods and Services Tax (GST) the Commonwealth government has levied since 2000. Similarly, in Germany, part of the value-added tax (VAT) is allocated to the 16 states (Länder). In Brazil, equalization to states and municipalities comes from the sharing of revenues “from three main federal taxes: personal income taxes, corporate income taxes, and the elective VAT” (Watts 2008, 111). These examples illustrate the diversity of equalization financing across federal countries.

The second choice to be made concerns the degree of equalization to be achieved. In Canada, the operative words are “reasonably comparable,” in relation to levels of public services, as per article 36(2) of the 1982 Constitution Act. In contrast, in Australia, the Commonwealth Grants Commission (CGC) has suggested that “State governments should receive funding from the Commonwealth such that, if each made the same effort to raise revenue from its own sources and operated at the same level of efficiency, each would have the capacity to provide services at the same standard” (CGC 2008, 27, emphasis added). In Germany, a 1999 judgement by the Federal Constitutional Court following a challenge of the federal equalization law by some of the “donor” Länder stated that the purpose of equalization in that country was to “diminish but not level” territorial disparities (Hueglin and Fenna 2015, 191).

The third choice is the structure of the transfers. In Canada, as in most other federal countries, equalization payments are made by the federal government. In Germany, however, they take the form of “direct horizontal transfers from the rich to the poor Länder,” although the federal government provides “a final topping up through vertical supplementary transfers” (Hueglin and Fenna 2015, 190). Interestingly, in Canadian political and media discourse, equalization is sometimes depicted as if the program entailed a direct flow of money from wealthier to poorer provinces, even though this has never been the case in reality (Lecours and Béland 2010). Moving toward such a system in Canada could prove extremely controversial, especially in resource-rich provinces such as Alberta.

The fourth choice involved in the design or reform of an equalization program is whether to equalize strictly on fiscal capacity or to also consider needs, that is, the cost of providing public services for specific constituent units of a federation. Indeed, constituent units with the same fiscal capacity may face greater costs in providing the exact same public service because of particular challenges. Sometimes, the challenges can be related to demography. For example, offering long-term care to the elderly in a province with a higher percentage of older people would be especially expensive. At other times, it can be linked to geography. For example, delivering public services to people living in remote areas typically generates higher costs than delivering them to people living in a geographical area with a highly concentrated population. There is often some tension between those who prefer a strictly equalizing fiscal capacity—a simpler approach—and those who feel that a needs-based approach is more equitable even if more complex.

The fifth choice concerns the governance structure for equalization. The primary issue here is who will have decision-making power over the equalization formula used to calculate payments. In other words, what public authority decides which constituent units receive equalization money and how much. The broad parameters of equalization, for example if needs are considered as well as fiscal capacity, can also be influenced by the source of authority behind the program. In Canada, the federal government is the only formal decision maker for the program. Provinces are often consulted, but there is no obligation on the part of the federal government to consider their position, if there are consultations at all. In Australia, an arm’s-length commission, the CGC, makes an annual recommendation for the “relativities” to be paid to the states. These “relativities” determine the share of the GST that goes to each state, inclusive of an equalization component. The Commonwealth government is under no obligation to follow the recommendation of the CGC, but the arm’s-length agency has a reputation for technocratic expertise and neutrality that gives great credibility to its recommendation.

The sixth choice to make when designing or reforming an equalization program is determining its formal legal foundation. Canada constitutionalized the commitment of the federal government to make equalization payments. Germany also constitutionalized equalization. Article 107 (2) of the Basic Law of the Federal Republic of Germany speaks of the “reasonable equalisation of the disparate financial capacities of the Länder.” In Australia, by contrast, equalization is not constitutionalized.

We will now focus on the historical development of the equalization program in Canada. In telling this story, we highlight the context in which some of the choices related to the design of equalization programs were made.

The historical development of equalization policy in Canada

Rowell-Sirois, the Québec question, and the birth of equalization

Although equalization only emerged as a stand-alone federal program in Canada in 1957, horizontal fiscal redistribution existed long before that (Courchene 1984, 65; Stevenson 2007, 3). In fact, provincial financial redistribution is as old as the 1867 British North America (BNA) Act. As economist Tom Courchene (1984) reminds us, the BNA Act featured statutory federal subsidies to the provinces that “contained an element of equalization in that they were per capita grants up to a maximum population” (65). Yet, importantly, the idea of a formal equalization program only moved into the federal policy arena in the late 1930s. At the time, the Great Depression and, more specifically, the fiscal crisis it created called into question existing federal-provincial arrangements. This was because “the mismatch between taxation powers and constitutional responsibilities had by the 1930s clearly reached unacceptable proportions” (Milne 1998, 181).

Set up in 1937 and reporting in 1940, the Rowell-Sirois Commission (Royal Commission on Dominion-Provincial Relations), tasked to assess provincial-federal relations in a changing economic context, spent much time studying the issue of horizontal fiscal redistribution, both in Canada and abroad. Its report formulated a coherent but controversial solution to the growing mismatch between taxation powers and constitutional responsibilities in Canada (Royal Commission on Dominion-Provincial Relations 1940, vol. 2). The Rowell-Sirois Report adopted a more centralizing perspective as it advocated the creation of purely federal social programs, such as unemployment insurance, as well as a sweeping concentration of fiscal powers in the hands of the federal government (for a critical discussion of the report’s perceived centralizing bias, see Ferguson and Wardhaugh 2003). On the one hand, the Rowell-Sirois Commission recommended a permanent centralization of personal and income taxes as well as succession duties, a situation that would have increased the fiscal power of the federal government. On the other hand, to reduce fiscal inequalities among provinces, the commission also suggested the creation of National Adjustment Grants tasked with transferring money to the provinces on the basis of fiscal needs (Courchene 1984, 65). For the commission, these grants would have the double advantage of preserving provincial autonomy and fostering national unity by making sure the inhabitants of poorer provinces did not feel they had been left behind (Royal Commission on Dominion-Provincial Relations 1940, 2: 79).

The Rowell-Sirois Report proposed an equalization system for Canada that made two specific recommendations with respect to design (Béland and Lecours 2011). First, while taking into consideration the provinces’ fiscal capacity, the proposed system would also evaluate their particular expenditure needs. Thus, in contrast to the system eventually adopted in 1957 and much like the Australian model, “the adjustment grants would have had both a revenue and an expenditure component” (Brown 1996, 13). Second, a financial commission similar to Australia’s Commonwealth Grants Commission would advise Ottawa on the allocation of the National Adjustment Grants (Royal Commission on Dominion-Provincial Relations 1940, 2: 86).

In its chapter on the proposed National Adjustment Grants, the Rowell-Sirois Report did not refer to the Australian model. Yet, there is evidence that the inspiration for the proposed scheme came from that country. For instance, the commissioners consulted directly with Australian scholar and civil servant Lyndhurst Falkiner Giblin, who had played a major role in setting up his country’s Commonwealth Grants Commission back in 1933 (Bird 1986, 141). Five years later, in August 1938, Giblin himself appeared before the Rowell-Sirois Commission (Royal Commission on Dominion-Provincial Relations 1940, 2: 216).

Despite the fact that the equalization system created in 1957 would profoundly differ from the approach formulated more than 15 years earlier by the Rowell-Sirois Commission, the commission’s report offered a clear and lasting rationale for the adoption of a federal equalization program in Canada: “each level of government in our federation should have the requisite financial means and financial security to carry out its constitutional responsibilities” (Milne 1998, 181, emphasis in the original).

In the 1950s, the decline of the tax rental agreements between Ottawa and the provinces provided the immediate stimulus for the modern equalization policy in Canada (Courchene 1984, 27–35). Established in 1941 to finance the war effort, these centralizing yet temporary agreements stipulated that “the provinces agreed to vacate the income tax and estate tax fields in return for ‘rental’ payments” from the federal government (Sheikh and Carreau 2000, 14). Importantly, such agreements “took into account differences in fiscal capacity through per capita payments (implicit equalization) and provided minimum base grants to poorer provinces” (Marchildon 2005, 422). Soon after the end of World War II, a series of developments in Québec, then controlled by the conservative nationalist and autonomist Union Nationale government of Maurice Duplessis, gradually weakened the tax rental system adopted during the war. For instance, though “Quebec signed the 1941 rental agreement, it refused to be party to the others (1946, 1952 and 1957). … In 1947, Quebec introduced its own corporate income tax” (Madore 1997, 3). More important, in 1954, the Duplessis government decided to reimpose the Québec income tax. As David Milne (1998) states, this decision, and the publication in 1956 of Québec’s autonomist Tremblay Report, made it clear that “any trade off of equalization for federal occupation of the central tax sources … was impossible” (190). In the wake of Québec’s decision on its income tax, moreover, “providing equalization payments, regardless of whether or not a particular province rented its tax fields to the national government, would be a way of ending the isolation of Quebec” (Bryden 2009, 81). Thus, the creation in 1957 of the federal equalization program can be understood in part as an attempt to break the recent fiscal and institutional isolation of Québec within the Canadian federal system (Pickersgill 1975, 309). In Canada, equalization played a role in accommodating sub-state nationalism in the politically contentious context of a divided, multinational state (Béland and Lecours 2014b).

As created, the 1957 equalization program did share some features with the model outlined in the 1940 Rowell-Sirois Report. For instance, as Courchene (1984) wrote, “the fact that equalization payments are transferred unconditionally to the recipient provinces probably owes a great deal to the Rowell-Sirois Commission’s emphasis on fiscal autonomy” (39). Yet Courchene (1984) also reminds us that it would be a mistake to think that the new program was simply “a natural outgrowth of the Commission’s arguments for National Adjustments Grants” (38). In fact, the 1957 program differed from the National Adjustment Grants advocated in the 1940 Rowell-Sirois Report in at least two major ways. First, Ottawa rejected their needs-based approach and, instead, created a program focused exclusively on the assessment of the provinces’ fiscal capacity. Thus, starting in 1957, “Provinces would receive a grant if the revenue they could generate from three taxes at a given tax rate was less than what the two richest provinces of the day could generate at those same rates” (Marchildon 2005, 422). Second, instead of setting up an arm’s-length expert body similar to Australia’s Commonwealth Grants Commission, the federal government managed the equalization system and determined the entitlements for provinces falling below the average fiscal capacity (MacNevin 2004, 188). To account for these two choices, we need to go back to the criticisms formulated by the provinces against the Rowell-Sirois approach to equalization while at the same time understanding these grievances in the context of the enduring idea of provincial autonomy (Béland and Lecours 2011).

For the Rowell-Sirois Commission, the creation of a federal equalization program, combined with permanent fiscal centralization, represented a solution to both the horizontal and vertical fiscal gaps present in the 1930s. Yet, in the name of provincial autonomy, some provinces opposed the commission’s report and the permanent fiscal centralization it advocated. For example, at a 1941 dominion-provincial conference, Ontario, heavily supported by Québec, led the opposition against the commission’s recommendations (Bryden 2009, 77). Because of the opposition of Canada’s most populous and powerful provinces, the conference “turned out to be a fiasco” and the Rowell-Sirois recommendations on equalization and permanent fiscal centralization were not implemented (Betcherman 2002, 329).

After the war, Québec and the Union Nationale government of Premier Maurice Duplessis were the strongest advocates for provincial autonomy. The Duplessis government constantly attacked perceived federal intrusions into provincial matters. For instance, when Ottawa adopted a national family allowance scheme in 1944, Premier Duplessis denounced it as a direct attack against both provincial autonomy and French-Canadian families.⁶ As indicated previously, in the name of provincial autonomy, the Duplessis government became the first province to exit the tax rental system created during the war (Courchene 1984). This move contributed to the need for Ottawa to implement an equalization program that would reduce the isolation of Québec by maintaining some form of territorial redistribution outside the tax rental system without threatening the provincial autonomy Duplessis defended so aggressively (Béland and Lecours 2014b; Bryden 2009). Because Duplessis would have depicted Ottawa assessing expenditure needs as an intrusion into provincial matters, the idea of a needs-based equalization formula was rejected, a casualty of the growing intergovernmental tensions between Québec and the federal government (Pickersgill 1975, 106).

Ontario also played a key role in discussions leading up to the adoption of the federal equalization program in 1957. Ontario was the wealthiest province in the country at the time, and its government recognized that, in the context of its fiscal negotiations with Ottawa that emphasized strengthening provincial taxation rights, backing the idea of a new equalization program would help generate the support Ontario needed from poorer provinces, such as New Brunswick, for more provincial autonomy in the realm of taxation (Bryden 2009). Like Québec, Ontario had long supported the idea of provincial autonomy. To this end, Ontario worked closely with Québec to oppose federal proposals they both considered to be overly centralizing (Cameron and Simeon 1997, 163).

After 1945, although Ontario and Québec officials frequently disagreed on basic policy choices, their bold defence of provincial autonomy transformed them into “strange bedfellows” in the context of key political fights with Ottawa (Bryden 2000, 385). For instance, in the context of the 1945–46 Dominion-Provincial Reconstruction Conference, Ontario Premier George Drew worked closely with Premier Duplessis to oppose federal plans to further centralize Canada’s fiscal arrangements. The alliance between the two largest provinces of the country, known as the “Drew-Duplessis axis,” challenged centralization in the name of provincial autonomy (Bryden 2000, 386). In light of this post-1945 rejection of fiscal centralism and the promotion of provincial autonomy by these two politically powerful provinces, it is hardly surprising that the equalization program adopted in 1957 differed so much from the one formulated in the widely criticized Rowell-Sirois Report (Brown 1996, 23). Indeed, the model proposed in the 1940 Rowell-Sirois Report would have been perceived by these two provinces as an intolerable federal intrusion in provincial matters. As Milne (1998) states,

The decision to proceed with a system of revenue equalization based in a representative tax-system approach rather than one addressed to expenditure needs also owed a good deal to the growing political power of provincialism in Quebec and elsewhere. In this climate, the adoption of the Australian model of equalization was clearly regarded as so intrusive as to be unworkable. (191)⁷

The staunch defence of provincial autonomy by the most powerful premiers in the country may help account for Ottawa’s 1957 decision to have the federal government, rather than an arm’s-length body, assess the fiscal capacity of the provinces, as well as for the decision to reject an evaluation of expenditure needs. In the end, the approach adopted in 1957 received general support from the provinces. Provinces did not challenge the source of financing (it was always assumed the program would be run by the federal government and financed from its general revenues) or the structure of transfers (a direct province-to-province transfer was unthinkable in the context of the provincial defence of autonomy). Provinces also never pushed for the creation of an Australian-style, arm’s-length commission or for the inclusion of service needs in the equalization formula (Béland and Lecours 2014b). In the absence of any comprehensive constitutional talks at that time, there was no serious suggestion that equalization be enshrined in the Canadian Constitution, nor was there any principled statement about the desired comprehensiveness of equalization.

The evolution of equalization

From its creation in 1957 to the early 2000s, the equalization program witnessed many incremental changes that were primarily technical and did not alter the basic structure of equalization policy in Canada.⁸ Such changes to the equalization formula (see text box) typically took place every five years, when the time came to review the program.

The Equalization Formula

Primary variations in the equalization formula over time are due to changes in three factors. The first is the “standard” that is used as a reference point in determining the target per capita revenues. The second relates to the categories of revenues that are included in the calculation. The third consideration is whether actual revenues or representative revenues (based on average tax rates) are used in the assessment of revenues. Once these decisions are made, the formula that determines province p’s equalization entitlement is some version of this:

standard per capita fiscal capacity — province p’s fiscal capacity = entitlement of p.

Practical considerations have often been the overriding determinant of the choices that dictate how the standard is defined, the revenue types that are included and excluded, and the use of actual versus representative revenues. These practical considerations usually relate to what is manageable from the federal government’s point of view given its budget constraints.

One key area of change to the program concerned the type of tax revenues included in the federal equalization formula. Originally, the formula only considered three provincial sources of revenue: income taxes, corporate taxes, and succession duties. In 1957, these were the only well-documented taxes present in all of the 10 provinces, which is why the federal government limited the formula to these three taxes. In 1967, the formula had grown to include no fewer than 16 provincial revenue sources. In addition to the three original revenue sources, the extended list included sales tax, motor fuel tax, alcoholic beverage revenues, forestry revenues, and oil royalties (Perry 1997, 128). Over time, the number of provincial revenue sources used in the equalization formula further increased, reaching 27 by the late 1970s (MacNevin 2004, 193) and 33 in the 1980s. This staggering multiplication of the tax sources taken into consideration by the equalization formula increased its complexity over time.9

Of course, increasing the number of tax sources used in the formula had consequences for the provinces, and, in the first decades of equalization, the federal government typically met with them to hear their position on a proposal for change and attempted to address their concerns. For example, the provinces used a meeting of the Federal-Provincial Tax Structure Committee to present their views on the 1966–67 proposed reform that added a dozen new taxes to the formula. Several provinces opposed the reform, including Saskatchewan, because it would see its equalization payments drop. Prince Edward Island objected because it did not want the expansion of the program to come at the expense of grants designed to support the Atlantic provinces. In the end, the federal government established a transition period and “stabilization provisions” for Saskatchewan and similar protection commitments for the Atlantic provinces (Perry 1997, 128).

An enduring source of policy change over time for the equalization program is the number of provinces used to determine an equalization standard. For instance, in 1962, a decision was made that “equalization would now be based on the average per capita revenue of all ten provinces rather than on the average for the two most revenue-rich provinces” (Perry 1997, 120). As this change disadvantaged the four Atlantic provinces; Ottawa raised the special adjustment grants that had been created for them half a decade earlier (Perry 1997, 120). The new 10-province standard survived until 1982, when the federal government adopted a five-province standard, which was designed to exclude both the richest (Alberta) and the four poorest provinces (New Brunswick, Newfoundland, Nova Scotia, and Prince Edward Island) from the calculation of average fiscal capacity. The logic underlying this change was to control the cost of the program for the federal budget by excluding Alberta’s large oil revenues from the determination of the equalization standard.

The adoption in 1982 of a five-province standard points to the growing role over time of revenues from non-renewable resources such as oil and natural gas in Canadian equalization policy. In 1962, the federal government started to take into account 50 per cent of provincial natural resource revenues in its assessment of provincial fiscal capacity. Even if Alberta would receive equalization payments for several more years under a special guarantee provision, this federal decision altered the status of Alberta from a receiving to a non-receiving province, a status that it has retained ever since (Courchene 1984, 42–43; Lecours and Béland 2010).

Rapid increases in oil revenues after the 1973 energy crisis created a strong fiscal challenge to the federal equalization system (Perry 1997). To address the impact of high energy prices and tax revenues on equalization, the federal government adopted emergency measures (MacNevin 2004, 193). For instance, the 1974 budget introduced a seemingly arbitrary distinction in the equalization formula between “basic revenues” and “additional revenues” (from oil and gas) as a result of the rapid and unexpected price increases stemming directly from the 1973 energy crisis (Perry 1997, 134–35). In the late 1970s, growing resource revenues meant that Ontario, the most populous province by far, would qualify for equalization payments, something the federal government as well as the provinces, including Ontario, found intolerable (Perry 1997, 140). To avoid this scenario, the new federal law excluded “from equalization payments any province with per capita personal income that was regularly above the national average” (Perry 1997, 140). In the end, Ontario did not receive federal equalization payments, and, in 1982, the adoption of the five-province standard became a more permanent solution to the energy resource problem (Lecours and Béland 2010).

The early 1980s witnessed a period of intense constitutional negotiation. Prime Minister Pierre Trudeau was determined to patriate the Canadian Constitution from the United Kingdom and to place in the Constitution a Charter of Rights and Freedoms. In the context of such an agenda for constitutional change, many other items crept onto the agenda, including equalization. Once the window was opened, there seemed to be a general consensus to go ahead and constitutionalize the principle of equalization payments. Indeed, the negotiations leading to the 1982 Constitution Act were very acrimonious about the Charter, among other things, but not about equalization. In the end, article 36(2) of the Constitution Act states that “Parliament and the government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation.”

This article provides a statement of principle about the aim and scope of equalization: comparable levels of public services are the objective, not the same levels. This policy was consistent with the political discourse in the country about what the equalization program should achieve. For example, in a 1966 statement, then Finance Minister Mitchell Sharp used the term “adequate” when characterizing the level of public services that should be attained in each province. The constitutionalization of equalization also provides some protection for provinces against a federal government that might wish to terminate the program. However, this protection may not be as strong as it appears, in part because what is constitutionalized is the federal government’s commitment to the principle of making equalization payments. As a consequence, there is really nothing about the specific workings of equalization that could be enforceable in court (Kellock and LeRoy 2007, 27–29).

At the same time, because equalization payments are completely unconditional, a province is in fact not obliged to provide public services comparable to those available in other provinces, despite the spirit of article 36 (2). Hence, what equalization does is simply offer less well-off provinces a more realistic possibility of being able to offer such comparable services than if they did not receive equalization payments.

In the late 1980s, provinces sought to take advantage of another round of broad constitutional negotiations launched by Progressive Conservative Prime Minister Brian Mulroney to tighten the language of the equalization article. After the failure of the Meech Lake Accord that sought to gain the signature of Québec’s government to the amended Canadian Constitution (Québec had not signed the 1982 Constitution Act), another attempt was made at a constitutional agreement that would not only satisfy Québec’s demands but also address the concerns of other provinces and of Indigenous peoples. In this context, provinces saw an opportunity to strengthen the standing of equalization in the Constitution. They successfully proposed to insert the following clause in the Charlottetown Accord: “Parliament and the Government of Canada are committed to making equalization payments so that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation” (emphasis added). With this phrasing, the federal government would be committed not merely to the principle of equalization but to making payments to the provinces. The Charlottetown Accord also stipulated that the “Constitution should commit the federal government to meaningful consultation with the provinces before introducing legislation relating to equalization payments.” Because the accord was never implemented (it failed to gain majority support in all provinces and in the country as a whole in an October 1992 referendum), the only constitutional specification of equalization remains article 36 of the 1982 Constitution Act.

In the early to mid-1990s, large budget deficits meant that fiscal austerity dominated the policy agenda. The Liberal government of Jean Chrétien enacted cuts to both federal social programs and transfers to the provinces in an attempt to balance the federal budget. For example, announced as part of the austerity-laden and controversial 1995 federal budget, the Canada Health and Social Transfer deeply and suddenly cut federal transfers for health care, social assistance, and postsecondary education (Banting 2005; Bashevkin 2000). In that period, fiscal austerity impacted the federal equalization program through the imposition of a cap on total equalization payments “to a rate of growth no higher than that of the gross national product” (Perry 1997, 162). In stark contrast to federal social transfers, however, equalization never faced direct, explicit, and politically controversial cutbacks. As David Milne (1998) states, “no other fiscal program has … been so insulated from the savage series of federal restraint measures in the 1990s” (193). A possible explanation for that is that ad hoc adjustments, for example the equalization cap and the shift to the five-province standard in 1982, helped limit the overall fiscal weight of the program over time. In fact, as “a share of total federal revenue, [equalization fell] from a high of almost 7.8 per cent in 1984 to a low of roughly 5.6 per cent in 2001” (Marchildon 2005, 422). Another potential explanation for the absence of direct cuts to equalization payments is that they would have affected only less well-off provinces, but cuts to health and social transfers affected all the provinces, thus potentially reducing political costs for Ottawa.

Direct cuts in equalization payments therefore proved unnecessary during the austerity of the mid-to late 1990s, as the relative fiscal weight of the program had declined. Even during this period, although economists and policy experts such as Dan Usher (1995) criticized the federal equalization program and called for bold change, the political consensus surrounding equalization remained strong within the federal political arena. With the partial exception of the Reform Party, which called for a more targeted federal program (Milne 1998, 199), all the federal parties supported equalization, possibly in part because of the electoral weight of receiving provinces (Lecours and Béland 2010).

Explaining fundamental equalization choices: A comparative perspective with Australia

The creation of a stand-alone equalization program in 1957 represented a milestone for Canadian political development, not only because it established mechanisms to reduce the consequences of territorial disparities but also because it embedded equalization in broader notions of Canadian citizenship, solidarity, and nationhood. Provinces that are typically equalization recipients consider equalization payments a “right” of Canadian citizenship and an expression of Canadian solidarity and of Canadian national unity. Although conflict around equalization erupts from time to time (as will be seen in the next chapter), even traditionally non-recipient provinces view equalization largely as a positive contributor to the Canadian political community (Alberta being a partial exception).

If we are to gain greater insight into the development of equalization in Canada, it is useful to have a comparative perspective. For this, we turn to Australia, another federation frequently compared to Canada (Béland and Lecours 2011; Coleman and Skogstad 1995; Hodgins et al. 1989; Obinger, Leibfried, and Castles 2005). Beyond the key historical and institutional similarities between these two Commonwealth countries, similarities stemming in part from their colonial past, it is appropriate to turn to Australia because it created the first system of equalization in the 1930s. Also, as we discussed previously, the Australian model served as a reference point for Canadian policy specialists in the late 1930s and early 1940s when the idea of instituting an equalization system made its way into federal policy debates.

First of all, there are some parallels between the birth of equalization programs in Canada and Australia. The story of the development of equalization in Australia validates some of the points already made about the impulse behind the establishment of the Canadian equalization program in 1957. Australia, like Canada, is a large federation with a stand-alone equalization system created partly to mitigate territorial conflict. The creation of the CGC in 1933, which formalized Australia’s equalization system, was prompted in part by a secessionist movement in Western Australia, whose grievances were primarily of an economic nature. Western Australia even held a referendum in which a majority voted for independence. Although Australia is now widely considered to be a territorially homogenous country (Fenna 2007), it was not always, and secessionism in Western Australia provided an incentive for creating an equalization system in that country just as national unity concerns linked to Québec favoured the creation of Canadian equalization.

When the time came to design and implement an equalization system in 1957, Canadian decision makers made some different policy choices than their Australian counterparts. Most important, Canada chose to base its equalization formula strictly on fiscal capacity (the revenue side) rather than also considering needs (the cost side). Furthermore, Canada favoured federal executive discretion in the management of the program rather than using an arm’s-length agency.

Why did Canadian federal and provincial officials not favour incorporating a needs component into the equalization formula? To answer this question requires a broad understanding of federalism in Canada and Australia. Australian federalism has had a clear centralizing trajectory (Fenna 2007). The Commonwealth government is incontestably the most important government in the eyes of Australians, and its strong presence in a multiplicity of policy fields is not only tolerated but desired. In Canada, the historical trajectory of federalism is quite different. Created as a centralized federation, the evolution has been toward a gradual empowerment of the provinces, which have defined political communities with strong identities. Hence, Canadian provinces strongly value their autonomy, are usually ready to defend it, and can count on their residents for support.

The consequence of these differences in the federal dynamics of Canada and Australia for the design of equalization systems is that, in Australia, the assessment of expenditure needs was widely accepted as legitimate, whereas, in Canada, it was considered an outright intrusion into provincial affairs. In fact, in Canada, in the rare instances when this option was raised, provincial autonomy moved to the forefront of the debate and became a direct obstacle to its adoption (Leslie 1988, 28; McLarty 1997, 207). Knowing that introducing needs assessment would be perceived as an intrusive move by at least some provinces (given the on-site scrutiny that is implied), federal officials have seldom been keen to promote this controversial policy option (Béland and Lecours 2011).

The decision not to create an arm’s-length body similar to Australia’s Commonwealth Grants Commission to manage equalization in Canada also can be linked to the distinct natures of Australian and Canadian federalism. The strength of Canadian provinces has meant that they see themselves as equal partners with the federal government in the management of the federation; they have therefore been loath to endorse a governance structure in which an arm’s-length agency would potentially limit the agency of provinces in shaping decision making on equalization. Of course, provincial governments play no formal role in the management of equalization, and the federal government does not even have a formal obligation to consult them, even on important decisions. However, the existence of dense networks of intergovernmental relations means that provinces can potentially reach, and indeed exercise, some leverage on the federal government when it comes to equalization.

Conclusion

Both change and continuity have characterized equalization in Canada since its creation in 1957. The governing structure of the program based on federal executive discretion and its basic logic of using fiscal capacity to determine payments to provinces have remained unchanged. This being said, many changes have been made to the program over the years, whether these are related to the number of provinces used to determine the equalization standard or to how non-renewable natural resource revenues are factored into the formula. In some instances, reforms (or reform proposals) generated heated political debate. Indeed, there is an inherent potential for the politicization of equalization within Canadian federalism, which means that the program can become the subject of intergovernmental conflict. We develop this idea further in the next chapter as we focus more clearly on the politics of equalization in Canada.

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Footnotes

1 The first and the last main sections of this chapter draw directly on Béland and Lecours (2016). Return to text.

2 For a discussion of the concept of spending power in comparative perspective, see Watts (1999). Return to text.

3 OECD data for Australia under this category are currently unavailable. Return to text.

4 However, the Harper government enacted a two-point reduction in the federal GST (Goods and Services Tax), which gave provinces more room to raise their own PST (Provincial Sales Tax). Return to text.

5 In comparative policy and social science research, it has long been common to compare Canada to the United States (Leman 1977; Lipset 1990; Maioni 1998; Zuberi 2006). This comparison is particularly the case in the field of federalism studies, where it is both common and fruitful (Boushey and Luedtke 2006; Simeon 1995; Théret 1999; Watts 1987). That said, the absence of an equalization program in the United States obviously reduces the value of the comparative perspective with regard to the management of the horizontal fiscal gap. Return to text.

6 At first, the program penalized large families, which were overrepresented in Québec’s Catholic society (Marshall 1994). Return to text.

7 For a similar perspective, see Leslie (1988, 28). Return to text.

8 The following historical discussion draws on Lecours and Béland (2010). Return to text.

9 Interestingly, in 1967, when a major increase in the number of revenue sources used in the equalization formula took place, the federal government borrowed the “representative tax system” (RTS)—now used to calculate provincial fiscal capacity—from a foreign expert panel, namely the US Advisory Commission on Intergovernmental Relations, which had put forward this model five years earlier (Bird and Slack 1990, 916). Return to text.