In their article in the August 2012 issue of Policy Options, David Dodge, Peter Burn and Richard Dion contributed fresh ideas and thinking to the national discussion on fiscal arrangements. It is clear, however, that more fundamental ideas, beyond those they suggested, must be considered. The global financial crisis has thrown into bold relief the problems of economies driven by excessive public sectors and elevated feelings of entitlement for support from others. Fifty years of very large regional subsidies have not improved the relative performance of most lagging jurisdictions and have, in fact, done great harm.

To many, the idea that federal regional subsidies, such as Equalization, could be a major cause of deficient performance by regions is counterintuitive. Many people assume that money would always be helpful in these regions or credit regional subsidies of all kinds with greater regional income equality.

There are insightful critics of the current arrangements, however. In Retreat from Growth, Fred McMahon describes the burdens caused by excessive politicization of the economy and examines the extent to which federal regional subsidies are negatively correlated to economic growth.

The lessons McMahon and others have drawn can be simply summarized. Economies that are primarily driven by the culture of government and its ecology of rules, regulations, top-down management and sometimes cronyism are less likely to perform well than those that emphasize markets, entrepreneurship and well-managed but minimally necessary regulation and government intervention.

McMahon’s analysis is applied to the regional economy of Atlantic Canada. Nevertheless it also seems applicable to Manitoba and Quebec because of their dependence on transfers and the larger role of government in these jurisdictions, relative to the government role in Ontario and western Canada.

The attachment many Canadians have to Equalization and other regional subsidies is driven by a sense of historical grievance and entitlement. Moving away from policy based on grievance will clearly require shedding some very heavy baggage.

If one engages in a discussion on regional economics with Atlantic Canadians, the allegedly deleterious effects of Sir John A. Macdonald’s National Policy immediately come to the fore and are used to justify various federal payments and subsidies coming to the region now. More than 70 years of globalization and tariff reductions, including the North America Free Trade Agreement, get passing attention, if any at all. There is still a deep sense of grievance, despite the passage of time and despite the extent to which globalization has altered all important trade relationships.

The arguments made by Quebec nationalists are also related to a sense of grievance. The underlying mantra for 50 years has been that nationalists want to be masters in their own house in economics, finance, language and culture, in order to avoid unwarranted intrusions on the life of Quebec from outside.

But no jurisdiction can be a full master of its fate. The world is flat, as Thomas Friedman reminds us, and everyone competes with everyone else in everything. No jurisdiction — not the United States, not China and not the European Union — is master of its own house on matters of finance, economics, trade and language.

Any analysis of the future of Equalization and other regional subsidies must consider whether they are fair. In order to consider fairness, it is necessary to first assess the incomes of all parties so that those with the least capacity can be identified. Second, it demands assessing need, so that populations that need help are singled out. The third prerequisite for decisions to be fair is that there be systems in place to measure success, and that there be an ability to alter arrangements as conditions change.

The fact that our regional subsidy system lacks, in whole or in part, all three of these essential features has led to serious imbalances and raises important ethical questions. Peter Gusen of the Mowat Centre identified the extent to which some provinces are overequalized and others under-equalized, in significant measure due to the insufficient metrics associated with the current system and weaknesses in the other qualities needed to ensure fairness.

Avoiding moral hazard and unintended consequences are also critical in any government program. Canada’s regional subsidies fail on both counts. As Equalization and other regional subsidies took hold, recipient governments used them to build provincial civil services that are far larger in relation to population than in contributing jurisdictions. This was possible only because the costs were in large part borne by Canadians living elsewhere.

The most important unintended consequence of regional subsidies is that the structural features of the economies of recipient jurisdictions are out of phase with the patterns of the world around them. Manitoba, Quebec, New Brunswick, Prince Edward Island and Nova Scotia all have public sectors that are, relative to their sizes, among the largest in the developed world. All are between 10 and 30 percent larger than that in Greece, using OECD and Statistics Canada figures to make the comparison.

This imposes a huge burden on local economies and is likely to dull economic growth and lessen entrepreneurship. Small businesses lose when they have to compete for people in an economy dominated by big governments, national wage rates, generous government pension plans and regionally enhanced transfers to people that reduce the incentive to work.

The opaque nature of the regional subsidy system is another problem. Most Canadians have some understanding of Equalization. Few, however, understand that the federal government delivers regional subsidies in three other ways: through regionally enhanced Employment Insurance, through federal employment in recipient jurisdictions that far exceeds population servicing requirements and through subsidies that are built into ordinary operating programs.

These three delivery paths may be as large as Equalization. Yet the regional subsidies associated with them are not identified or reported. The result is that legislators and the public do not understand the full dimensions of the regional subsidies in place, which in turn means they can have, at best, only a partial understanding of their impact.

This opaque nature of regional subsidies often leads to unnecessary rancour. Immigration settlement expenditure is a good example. For several years, the Ontario government complained that federal expenditures for immigration settlement in Quebec had evolved to become significantly higher per capita than in Ontario.

This was ultimately addressed, but not before several rancorous exchanges took place. Other programs, such as Employment Insurance, have either already generated similar rancour or have the potential to do so.

These problems strain the federation. The best way to reduce these risks is to insist that there should be no « equalization » outside of Equalization.

Fifty years of regional subsidies have done great harm.

The final and probably most important area where fresh thinking is needed relates to possible new directions for the future. Given the scale of the problems associated with regional subsidies, change must be substantial. Incremental changes will only delay the needed overhaul and add to the length of the journey that will ultimately have to be made.

Two broad directions are possible.

The federal government could, as Dodge, Burn and Dion recommend, « spend more on federal investments that will create more income and build the fiscal capacity of today’s lower-income provinces. » Alternatively, Canada could embark on a major effort to restructure the public sectors in recipient jurisdictions to reduce costs, improve efficiency and ultimately reduce federal expenditures.

The first of these will not likely succeed. First, the federal government has tried it before and failed. The Prince Edward Island General Development Plan of the 1960s, Sydney Steel and many other investment projects are testimony to the failure. Second, such an effort in the current environment would exacerbate the fairness issues mentioned earlier. Third, it may not be possible at all. Governments are generally not good at picking winners and losers in modern economies.

In a slow growth world, the better approach would be a massive restructuring of provincial public sectors, shifting transfers to individuals to avoid government rent-seeking, and reducing the role of government in the economies of recipient jurisdictions.

The new direction for the future could include the following specific measures:

• Eligibility for Equalization should be made conditional on recipient jurisdictions bringing the size of their public sectors in line with levels experienced elsewhere in the developed world within the next five years, with measurable targets for each year and annual assessments of eligibility.
• Eligibility for Equalization should also be made conditional on completion of an independent review of expenditures along the lines of the Drummond Report in Ontario. In each case, provincial auditors should be asked to certify the independence  and accuracy of the reports.
• The federal government should maintain the current level of expenditure on Equalization for five years, but allocate it differently:

–  A fixed portion of the transfer should be withdrawn from governments and allocated to individuals for expenditures relating to skills training, enhanced mobility and possibly targeted tax reductions for small businesses;

–  A portion, which should rise each year, should be allocated based on the population needs of each province, not simply on the basis of revenue and tax utilization calculations.

• Ottawa should immediately engage an independent national organization to develop and implement a system to measure and report on the accessibility of programs in each province. To avoid intergovernmental conflict, these reports should avoid judgmental commentary and simply be statements of fact.
• Ontario’s legislators need to show serious and consistent leadership on fiscal federalism issues. They need to understand the gravity of the problem for Ontario and need to have an informed dialogue with all Canadians about it. Ontario needs to assert its own policy interests; in doing so, Canada will be enriched.

Canada faces debt and entitlement problems of the same general magnitude as other developed countries and the global economic environment is likely to remain challenging. Modernizing the regional subsidy system should be seen as a project that will help us manage our debt and productivity problems while at the same time fixing a major national system that greatly limits our capacity to compete in the world.

Photo: Shuttestock by Marc Bruxelle