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By Ben Eisen
A rule designed to control the cost of Canada’s equalization program has instead forced the federal government to spend an extra $10.5 billion over the past seven years. Fixing it should be one of the easier decisions for the Carney government. A straightforward reform can make the program more responsive to changes in the relative economic strength of provinces and could save billions in the years ahead.
The problem dates back to a change made to the equalization formula in 2009. To simplify slightly, equalization is a cash transfer from the federal government to economically-weaker provinces that have more difficulty raising revenue to help pay for public services. Before 2009, the total size of the program fluctuated solely based on changes in the relative economic strength of the provinces. The Harper government changed that by tying growth in the overall equalization envelope roughly to nominal GDP growth.
The purpose of the new rule was to slow the rapid growth in equalization costs. At the time, the program had been getting more expensive due in part to high natural resource prices, and there was concern that costs could rise further as Ontario became a “have-not” province.
There were and remain valid reasons to limit the growth of equalization. Cost containment is an entirely legitimate policy rationale. However, the mechanism chosen to control costs—a fixed growth rate for payments—eventually backfired and created a perverse outcome. When natural resource prices fell in the mid-2010s and the gap between richer and poorer provinces shrank, the fixed growth rule caused program costs to keep growing at the same rate instead of slowing down as they otherwise would have. In other words, a policy reform meant to act as a cap on payments ended up functioning as a floor that propped them up.
The added spending has been substantial. The 2009 rule change has increased rather than reduced equalization costs every year since 2018/19. In total, the requirement for continuous growth has caused an extra $10.5 billion in equalization payments. In three different years, adjustments caused by this rule accounted for more than 10 per cent of the total equalization envelope.
There’s little compelling rationale for this additional federal spending. The main defense offered for the floor is that it provides budgeting certainty for recipient provinces. But this argument is weak. Have-not provinces (that receive equalization money) budget individually, not collectively, so guaranteeing growth in the size of the overall equalization envelope is a clumsy way to provide stability for individual recipients.
There’s a simple fix. The federal government can amend the formula by replacing the requirement that equalization grow at a fixed rate with an explicit cap that prevents unsustainable growth but allows total payments to fluctuate below it as economic circumstances warrant. This would allow the overall cost of equalization to shrink if the gap between “have” and “have-not” provinces narrows significantly, which is consistent with the program’s underlying logic and common sense.
Federal finances are deteriorating and the Carney government must cut costs. Some options for doing so will involve difficult tradeoffs, but this is low-hanging fruit. Removing the floor propping up equalization payments should be an easy call.
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