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By Ben Eisen
Canada’s equalization program is heading for its comprehensive mandatory review by March 2029, and Finance Canada is already making preparations. Officials should not treat the review as a routine exercise. Big changes should be on the table. But if Ottawa wants the next round of equalization reform to be meaningful, it first needs to fix one rule that requires equalization to continue growing no matter what other changes are made.
The rule in question is known as the “fixed growth rate” requirement. In 2009, the Harper government changed the formula so the overall size of the equalization envelope would keep growing roughly in line with nominal GDP. The original rationale was valid. Equalization costs had been rising quickly, and Ottawa wanted a safeguard against unsustainable growth. However, since 2018/19 this rule has not acted as a safeguard but rather it has pushed costs up.
The reason for this is that when natural resource prices fell in the mid-2010s and the fiscal gap between richer and poorer provinces narrowed, the requirement of continuous growth meant equalization payments couldn’t shrink to reflect the smaller gap.
The direct costs of this design flaw have been substantial in recent years. A rule intended to constrain the cost of the program instead forced Ottawa to spend an extra $10.5 billion since 2018/19. However, the indirect costs are greater still. Specifically, as long as this rule remains in its current form, many promising ideas for reform are essentially moot because they cannot reduce the overall cost of the program.
The best examples surround the treatment of natural resources, which is a frequent flashpoint in equalization debates. For years, Alberta premiers along with other analysts and policymakers have argued natural resource revenues should be excluded entirely from the formula. There are valid reasons for this view (particularly in the case of non-renewable resources) and this reform would generally have the effect of shrinking the fiscal capacity gap between “have” and “have-not” provinces. However, the fixed growth rate rule means that even if the federal government acceded to Alberta’s request, payments wouldn’t actually shrink due to the requirement for continuous growth.
In a related issue, Alberta Premier Danielle Smith recently argued that the equalization formula incentivizes hydro-rich provinces such as Quebec to maintain below-market electricity rates because much of the foregone resource revenue is offset by increased equalization grants. She’s right, but from the perspective of taxpayers in Alberta it is an academic matter. If Quebec were to bring electricity prices closer into line with other provinces the equalization envelope would be divided differently but it wouldn’t be allowed to get any smaller.
A recent study published by the Fraser Institute reviews many other examples that could be used to illustrate the same point. Under the current fixed-growth rule, many otherwise valid reforms would do nothing to reduce the overall cost of equalization.
As we approach a comprehensive review of equalization, we could spend years considering regional concerns and grievances about the formula but the effort would be in many respects futile given that none of the changes could touch the overall size of the program. The fix is straightforward: replace the fixed growth rate requirement with a true cap that acts only as a ceiling, preventing unsustainable growth while allowing payments to fluctuate underneath that cap in response to changing economic circumstances. If Ottawa is serious about modernizing equalization, that’s where it must begin.
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