Need for Change

The Government of Newfoundland & Labrador is a strong supporter of the principle of equalization. That is, we are strong supporters of the need in a federated country, such as Canada, where all sub-national governments will not have equal fiscal resources, to have some financial mechanism at the national level to ensure all citizens can avail of similar public services and can share in similar opportunities of citizenship.

Whether Canada�s Equalization program has served us well in the past is not the current issue. Newfoundland and Labrador is concerned about whether the present program will serve us well in the future. One strength of the program is that throughout its existence it has been in a continuous state of evolution. That is what this presentation focuses on, our view on some of the directions that evolution should take.

In broad terms, the direction change should take is straightforward. The singular measure of the success of Canada�s Equalization program is to compare the result to the Constitutional commitment it is meant to satisfy. The Constitution commits the Parliament and Government of Canada to make equalization payments to provinces to ensure Canadians have access to reasonably comparable levels of public services at reasonably comparable levels of taxation. If queried about whether the present Equalization program satisfies this commitment for our province, we would have to answer - no.

Under the current Equalization program, we could well be moving for the foreseeable future further away from satisfying this commitment, rather than moving closer to fulfilling it. The most visible evidence of this is in the tax system where some richer provinces appear to be competing with each other to offer ever lower tax rates, tax rates that most, if not all, Equalization recipient provinces will never be able to match while maintaining services. This has unsettling implications for balancing economic growth and providing economic opportunity across the entire country.

We have to ask whether the transfer system is contributing to what may be characterized as a country made up of different classes of provinces. It could be argued that there now is a top tier of a few large wealthy dominant provinces, who can offer attractive tax regimes, superior quality public services and generous investment incentives. This is followed by another tier of a few more who can almost hold their own but are unlikely to make it into the top tier anytime soon. Trailing these is a last group who appear to be more or less relegated to quasi permanent have not status. We must reject any vision of Canada that assumes have not status for some provinces is the natural order of things, and the Government of Canada, by its actions, should make it clear that it rejects this too. Yet, the Equalization program appears to be a large contributor to perpetuating the status quo.

Equalization is a crucially important program for this country because it is designed to provide a hand up to provinces not in the tier of the so called "have" provinces. There are some federal economic development agencies and programs that also are meant to provide a hand up. But the benefits these could provide are diluted by wide geographical coverage and a narrow mandate that does not deal with the full spectrum of development issues like competitive taxation, infrastructure and public services. As well, their activities can be counteracted by economic incentives wealthy provinces can offer on their own account. We also have an income tax system that gives attractive benefits to business regardless of location, like R & D incentives whose benefits flow primarily to wealthier provinces.

While some argue that Equalization, by design, is not intended to address issues of economic opportunity, we believe that Equalization also should not, by design, retract from Equalization recipients most of the fiscal benefits of economic development. These benefits, if retained, would allow recipients to catch up economically and socially to other better off provinces. Rather than provide a real hand up, Equalization could be acting as a vehicle that is maintaining the inequality of the status quo.

Directions for Change

In outlining potential changes to Equalization, we will discuss briefly a number of issues. The first is adequacy, which in our view is the overriding issue for Equalization and federal transfers to provinces in general. We also have concerns about the impact of economic development, and natural resource projects in particular, on Equalization. And finally, there is the issue of expenditure need, a subject that has been highlighted by our province in transfer discussions for some time.

The repeated calls by Premiers and provincial Finance ministers for federal action to:

• remove the ceiling on the program,
• move to a ten province national average standard for Equalization, and,
• institute comprehensive revenue coverage,

are all recommendations that reflect an overriding provincial concern that program adequacy is not what it should, or could, be. Adequacy is recognized as a key criterion against which the effectiveness of the Equalization program can be assessed. From our viewpoint, it is the key criterion. But we see adequacy from two points of view. The one most frequently discussed is the more narrow, albeit very important, focus to ensure that the Equalization program can satisfy the Constitutional commitment. The other is broader in scope, and less talked about, and that is to ensure that transfers are sufficient to provide the opportunity for recipient provinces to rise above have not status and become self sufficient partners in the Canadian federation.

There is an old truism that goes, "a chain is only as strong as its weakest link". To make Canada stronger, and a better country, much more effort and resources should be devoted to making the economically weaker provinces stronger and more robust. In our vision of Canada, the active promotion of growth and prosperity in the economically weaker provinces so they can become equal partners with their more wealthy cousins in Confederation should be an imperative for any federal government. Only with a real, genuine commitment, financial and otherwise, by the federal government can this happen. With the present structure of the fiscal transfer programs in Canada, including Equalization, this level of commitment is not in evidence.

The current level of Equalization gives us little better than a subsistence diet. We are getting maybe just enough fiscal top up so we can still push on, but we are not getting the level of fiscal support that will see us thrive and flourish over the longer term. And the ironic reality we have come face to face with, notably from natural resource developments, is that the more fiscal sustenance we provide for ourselves, the less the federal government will provide, leaving us without much prospect of ever reaching sound economic and fiscal health. It is cold comfort to know, for instance, that when we eventually use up our natural resources trying to raise ourselves up, that the federal government and the Equalization program will step in after the fact to see that we won�t succumb to fiscal malnutrition over the lean years ahead. The irony for the federal government is that if they devote more funding to raising provinces up when the opportunity arises, like it has now with offshore developments in our province, then this would reduce Equalization payouts in the future and, at the same time, create a stronger country.

What do we need? At a minimum, we need an Equalization program that truly satisfies the Constitutional commitment. We need an Equalization program that provides recipient provinces with sufficient funding to have comparable public services at comparable levels of taxation. We know there is an academic type debate over what "reasonably comparable levels of public services and reasonably comparable levels of taxation" really means. Our view comes from having to manage the affairs of a province on a practical basis. To us, it means that the Equalization recipient provinces can offer public services and taxation levels at comparable levels to those provinces that do not receive Equalization. If the recipient provinces can�t do this, then the federal government, through the Equalization program, is creating one class of citizenship for those Canadians who reside in wealthy provinces and another class, or maybe two or three, for those apparently second or third class citizens who live in the rest of the country.

Will the Province of Newfoundland and Labrador be in a position for the foreseeable future to provide its citizens with comparable public services at comparable levels of taxation? Under the present Equalization program, it would appear it will not. We would have to say the Equalization program, in its present form, does not satisfy the criteria of adequacy for our province, as the Constitution defines it. Repeated calls by Premiers and provincial Finance ministers for a national average standard, removal of the ceiling and comprehensive revenue coverage are all calls, at their essence, for the federal government to address the adequacy issue.

We have an Equalization standard setting the level recipients are equalized up to that excludes the province with by far the strongest fiscal capacity and by far the most significant base of petroleum revenues. We have an artificial constraint on the program in the ceiling that can prevent payouts from reaching the level of even the substandard standard. And we have the federal government excluding revenues from the Equalization formula that all recipient provinces view as integral to the proper measure of provincial fiscal capacity and Equalization entitlements. We also have a federal government that is in far better financial health than Equalization recipient provinces that appears more concerned with constraining Equalization by emphasizing what it calls "affordability" over the adequacy of the program to deliver the benefits of citizenship to all Canadians.

We see the federal approach to Equalization reflected in Bill C-18. All provinces are facing great challenges in funding health care, none more than the Equalization recipient provinces. To assist in meeting this challenge, Premiers at the September 2000 First Minister Meeting sought an increase in the federal financial contribution to health care. One element of this was removal of the ceiling on the Equalization program. Premiers thought they got agreement on removal, but, as it turned out, it was a disappointing lifting of the ceiling for one year only.

The challenge of funding health care is not a one year issue. In fact, at the same time, the federal government agreed to a five year commitment for enhanced CHST funding. While this is welcomed, CHST is distributed largely on an equal per capita basis, which dilutes its value for most of the Equalization recipient provinces. For example, a billion dollars in additional CHST nationally means only about $17 million for our province. Adequate Equalization is crucial for us to maintain public services like health care. Yet the federal government chose to treat Equalization in a very tepid manner, keeping the ceiling in place for all but one year. This is part of a pattern of Equalization restraint measures that will see Equalization entitlements continue their trend of decline as both a percentage of federal revenues and GDP.

This brings us to look at a broader view of adequacy. To illustrate this, we will use a brief analogy. We don�t give patients with a headache or a heart attack the same treatment. Yet, this is precisely what the Equalization program does. As long as both patients are breathing, the Equalization program is satisfied with the result, never mind that the one with the heart attack could probably use more intensive treatment to become healthy. What the Equalization program does is raise all provinces with below average capacity to raise sufficient own source revenues to the same standard level of fiscal capacity by supplementing provincial revenues with equalization payments.

It takes no account that some provinces are much closer to average fiscal capacity with their own source revenues than others. Likewise, it doesn�t consider that some provinces have stronger economies because of historical development patterns and natural resource endowments, or economic advantages such as proximity to markets, that allow them to have greater fiscal capacity than some of their fellow provinces. It also ignores that some provinces have fiscal capacity substantially in excess of the average. Whether you lag the pack, are almost a have province or are far ahead of other provinces, Equalization is a one size fits all solution.

If the current system of transfers and federal support for provinces is perpetuated, this will mean have not provinces are unlikely to move beyond the status quo at any foreseeable time. In a properly functioning federation, with an adequate system of fiscal transfers, we would expect to see some convergence over time with underperforming provinces closing the gap with the leaders, or at least with the average. To avoid quoting too many numbers and statistics in this regard, we offer only a few comments on fiscal capacity. Fiscal capacity matters to governments because this measures the ability of a province, relative to other provinces, to generate the revenues necessary to fund the full range of programs and services we deliver, as well as provide capital infrastructure and service provincial debt.

The fiscal capacity of provinces is measured by the federal government as part of the Equalization program. The available series of comparable numbers dates back to the 1972-73 fiscal year and runs to 2000-01, just short of 30 years. The question we pose is - has the federal system of transfers and federal support for economic development closed the fiscal capacity gap between the have and have not provinces over that 30 year period? If we look at the seven Equalization recipient provinces, we see two have seen an increase in their fiscal capacity of about 8 percent, one has seen a decrease of almost 15 percent and the remaining four are pretty well where they were 30 years ago. The three provinces that were the have provinces then are still the have provinces now.

The four Atlantic Provinces each had fiscal capacity more than 25 percent below the all province average in 1972-73. They all still do today. With all the up and downs over the past 30 years, none of the Atlantic Provinces managed to get up to even 80 percent of the average at any time. All spent several years, or more, below two thirds of the average. Newfoundland and Labrador exceeded two thirds only once in those 30 years.

Our conclusion - from the evidence of the past 30 years, federal transfers to provinces and federal economic development programs, taken together, are bringing about little or no convergence in the relative fiscal capacity of Equalization recipient provinces. If federal policy has accomplished anything, it has been to maintain the status quo, a status quo that perpetuates great disparities between provinces and does not give provinces the hand up they need to become full partners in Confederation.

Adequacy in transfers needs to go beyond raising the fiscal capacity of provinces to the same minimum level if things are ever to change. We cannot support a transfer system that could see Newfoundland and Labrador 30 years from now likely in the same relative position as it is in today. Under the present transfer system, our province could pump hundreds of thousands of barrels of oil every day for the next 30 years and see 80 percent of the fiscal benefits go to the federal government, leaving us almost no better off fiscally than we are today. And this may not mean we are left with even 20 percent. The corporate income tax system could see over half the remaining 20 percent allocated to other provinces, reducing our share of the net fiscal take to under 10 percent. Retaining a 10, or even 20, percent share of the fiscal take, will not enable Newfoundland and Labrador to bring about the positive changes needed to become economically and fiscally more self sustaining.

We advocate a system of enhanced transfers that provide the funds needed to allow recipient provinces to have competitive tax regimes, assured quality public services and necessary infrastructure, while also being able to address fiscal challenges like paying down high public debt. The greater the disparity between a province and the national averages, the more assistance a province should receive until that gap starts to close. As the relative position of a province improves, this enhanced assistance would phase down until it phases out as the province approaches national averages. Only this way can we give all provinces the opportunity to become full partners with the rest of the country.

It is unimportant whether these enhanced transfers are delivered through the Equalization system or by some other mechanism. It is the result that is important. A place to start is to allow provinces to keep a greater share of the fiscal benefits of their natural resource developments until the disparity gap is narrowed. Can a have not province ever advance its lot if the total of own source revenues and federal transfers equals more or less the same amount no matter how much new resource development a recipient province is successful in bringing about? In the case of non-renewable resource developments, the potential fiscal benefits are by their nature of limited duration. If the transfer system provides an inadequate level of financial support to begin with, and then retracts the fiscal benefits that should flow to a province from non-renewable resource developments, in particular, what hope does a have not province have to better its lot?

Non-Renewable Resource Revenues

Let us look briefly at the somewhat convoluted treatment of non-renewable resource revenues in the Equalization program. First, the federal government says that the natural resource revenues of Alberta must be excluded from determining the Equalization standard because of federal affordability concerns, and, besides, resource revenues are volatile. This significantly lowers Equalization entitlements for recipient provinces and appreciably reduces the adequacy of the program to satisfy the Constitutional commitment.

Yet, when determining the Equalization entitlement of Newfoundland and Labrador, the federal government insists that our non-renewable resource revenues must be included because to do otherwise would not fully measure fiscal capacity. This action will greatly reduce the fiscal benefits our province derives from resource endowments by transferring billions to the federal government through reduced Equalization payouts over the life of the projects. So the federal government, who can unilaterally set the rules, benefits both ways, excluding Alberta�s resource revenues, which lowers Equalization payouts, while, at the same time, including our resource revenues, which also reduces federal Equalization payouts. In both instances, those actions are at the expense of satisfying the adequacy criterion.

Because federal transfers and supports for have not provinces do not meet the adequacy criterion, Newfoundland and Labrador is forced to seek a greater share of the fiscal benefits from natural resource developments like offshore petroleum. Put aside that we should not have to seek this as we have an agreement with the federal government, the Atlantic Accord, that states the province is to be the principle beneficiary of offshore developments, even though present fiscal arrangements all but guarantees this will not be the case. In the absence of other adequate supports, how can we ever rise above have not status, the most fiscally challenged of the have nots, if we do not receive significant fiscal benefits from the development of our natural resources? Without them it will be a long, hard, difficult and, perhaps, unsuccessful struggle. The federal government may be taking from us the only opportunity we may have in several generations to bring about lasting positive change. We believe this strong moral case to allow Newfoundland and Labrador to take advantage of the offshore opportunity should supercede other considerations.

To bring about needed change, Newfoundland and Labrador simply must retain a greater share of fiscal benefits from non-renewable resource developments, like the offshore. This will not add to the federal cost of the Equalization program and, in fact, will reduce it over the longer term as we become more self sufficient. We should receive the lion�s share of the fiscal benefits until we reach the average fiscal capacity of the Equalization recipient provinces, at which time our share would begin to phase down until we reach the national average fiscal capacity. At that point, the Equalization program could retract a much greater share of the fiscal benefits so we could contribute more fiscally to the nation. To avoid getting bogged down in a time consuming re-invention of the federal support system for provinces, necessary as this may be, we believe the right practical solution is to ensure we receive a much greater share of the fiscal benefits of offshore projects, whether done inside or outside the Equalization program.

These offshore projects, by their nature, are of limited duration, and the farther one looks into the future, the less certainty we have of their impact . What we do know is that one day the oil will be gone and the opportunity it represents will also be gone. We also know that offshore development will not have the same economic impact similar resources could have onshore. At the same time, Newfoundland and Labrador lags the country in many economic and fiscal statistics, and lags our close neighbours in the Maritime Provinces.

For these reasons, the enhanced support to develop our economy should be front end loaded. It is simply fact that we face greater development and fiscal challenges than other provinces. We are more than willing to share the fiscal rewards of development with the rest of Canada, as Canada has shared with us. But first we need to draw on the natural resources that, in reality, we brought into Confederation to get our own fiscal and economic house in order. The promise of Confederation was a new opportunity to bring to fruition the aspirations for a better future. Those aspirations will remain only a far off dream, even for future generations of Newfoundlanders and Labradorians, if we fail to act now.

We would encourage this committee to examine closely the issue of transfer adequacy, as it is at the core of provincial discontent with the present fiscal arrangements. Other countries approach adequacy in different ways that may or may not be suitable in the Canadian context. Some, like Germany, redistribute the excess fiscal capacity of its wealthier sub-national governments to more equitably balance the fiscal resources of all constituent states. Others, like Australia, recognize that a revenue based equalization system, like Canada has, ignores the expenditure side of the budgetary equation. Canada�s Equalization program assumes that if each province has access to equal per capita revenue, each province will be able to provide reasonably comparable services and taxation levels. Recognition in transfer programs of the differing cost structures in the provision of services across the country, so called expenditure need, may be another way to address the adequacy issue. Our province has advocated for some time that this issue deserves more fulsome examination, and is encouraged that it is getting preliminary consideration during the 2004 renewal process.

The Myth of Who Pays

Before closing, there is one falsehood, a myth, about Equalization, that we wish to confront and encourage all to work to dispel. Too often, in particular in the media, we see it reported that it is the non-recipient provinces who pay into Equalization, and the recipient provinces who draw out. Nothing could be further from the truth. The public should understand that Equalization is paid out of the general revenues of the Government of Canada, just like every other federal program. It is the taxpayers of each and every province and territory who contribute to the general revenue of the national government, and it is the members of the national government, elected in every province and territory, who decide how those revenues will be spent in the best interests of the Canadian people.

Moving Forward

Lastly, we offer a few short summary comments. Clearly, our primary concern is with the adequacy, or, more to the point, inadequacy, of the current Equalization program, as well as federal support for provinces in general. We believe this concern is shared widely by other provincial Premiers and Finance ministers. This is reflected in repeated calls for removal of the ceiling, a ten province national average standard and comprehensive revenue coverage.

While Newfoundland and Labrador supports these calls because they are in the national interest, the challenges facing our province are more acute and they require bolder action. The most effective, and cost efficient, way to address the adequacy issue for our province is to permit us to retain a much greater share of the new revenues that offshore petroleum development will generate. This enhanced share would not be a permanent feature of transfer programs, but should remain in place only until our province catches up to other provinces in terms of generally accepted economic and fiscal measures. Whether the mechanism to accomplish this is inside or outside the Equalization program is unimportant, as long as the result is achieved. This would allow the federal government to live up to its commitment given in the Atlantic Accord that our province will be the principle beneficiary of offshore development.

When the petroleum is gone, as someday it inevitably will be, the legacy we leave to future generations should not be of a province still hobbled with lowly have not status. We believe we have a unique opportunity for change that is in danger of being lost because of lack of vision about nation building. Our vision is not of a country of haves and have nots. It is a vision of Canada where the opportunity to rise above the status quo is encouraged and supported, particularly by the national government. The economic circumstances exist now in our province that could see us realize change, but only if federal cooperation allows us to move forward rather than remain standing still. Newfoundland and Labrador deserves this opportunity.

Chart 1 - Equalization Entitlements as a percentage GDP and federal revenue, 19982-83 to 2000-2001

Chart 2 - Fiscal Capacity Disparity Index, 1972-73 to 2000 - 2001

Chart 3 - Fiscal Capacity Index (All Province Total =100)