February 5, 2012
Equalization’s Other Half
Expenditure Need: Equalization’s Other Half is the first paper in a Mowat Centre series exploring options for reforming the Canadian transfer system.
This paper updates and expands on Peter Gusen’s previous work on expenditure need. It argues that the current approach to Equalization turns a blind eye to the differences in expenditures that provinces must make to provide comparable levels of public services.
The paper shows that incorporating these differences can make Equalization fairer and less costly. It also highlights Ontario’s unique position—the province has both higher than average expenditure needs and lower than average revenue raising capacity. The paper demonstrates that adopting an expenditure need based approach to equalization would come closer to fulfilling the federal government’s Constitutional obligation to ensure that provinces have the fiscal capacity to provide their residents with comparable levels of services at comparable levels of taxation.
Canada’s Equalization program distributes payments to provincial governments with below average capacity to raise their own revenues. It makes no allowance for differences in what provinces have to spend. This paper explores the consequences of recognizing gaps in expenditure need as well as revenue-raising potential. It suggests that doing so may make Equalization fairer to provinces and bring it more in line with its constitutionally mandated purpose.
Expenditure need is not new. It features in other countries’ equalization systems, notably Australia’s. It shows up in programs provinces use to set transfer payments for municipalities, school boards, and hospitals. It has been discussed in the Canadian Equalization context, though never adopted.
Many reasons have been advanced for rejecting expenditure need: too complicated, too many value judgements, too much federal interference with provincial decisions, too costly, too much trouble for too little difference in outcomes. This paper assesses these critiques and generally finds them wanting.
The greatest impediment to building expenditure need into Canadian Equalization may have been that, as long as it has remained a theoretical concept, the objections put forward by opponents have carried the day by default. It is difficult to refute the idea that expenditure need is too complicated, too intrusive, etc., without having a real life, operational, dollars and cents specimen to put to the test. This paper constructs a prototype system, reflecting both revenue potential and expenditure need, and inserts actual data to shed light on how expenditure need would work in practice in a test year, 2008-09. The paper does not claim that this prototype system is ideal, but rather that it provides a basis for evaluating expenditure need critiques and a target to refocus critics’ attention towards making constructive suggestions for improvement.
The paper reports that, while the prototype system would have relatively little impact on overall Equalization support for provinces, it would substantially alter the provincial distribution of payments. For example, Ontario would match Quebec as the province receiving the largest amount, at least in the test year.
The paper acknowledges the practical challenge of introducing any change that has such large and divergent financial consequences for provinces. However, it finds that the disruption is less alarming when expressed in the terms that really matter—its proportional impact on provincial budgets. Nevertheless, getting general approval for an initiative that shifts billions of dollars among provinces is no mean feat. The paper offers some suggested mitigating measures that may help the expenditure need medicine go down.