While it is commonplace to assert that needs to make the transition from a resource-based economy and society to a knowledge-based economy and society, the dramatic rise of China and India with their insatiable appetites for resources has driven home to Canadians that there are still huge rewards to being hewers of wood and drawers of water. Nowhere is this more true than in the energy sector, where activities associated with oil and gas development and exports are serving to ensure that Canada’s overall economic growth remains in the respectable range. This is obviously good news for Finance Minister Jim Flaherty: Ottawa’s overall revenues are certainly buoyed by the performance of the energy sector, even if most of the direct energy-related revenues accrue to the producing provinces.

However, the irony here is that these burgeoning provincial energy revenues are interacting with Canada’s approach to horizontal and vertical fiscal imbalance in ways that ensure that Flaherty’s budget must address what arguably qualifies as the most intractable distributional tug- of-war that Canadian federalism has ever experienced. Fiscal imbalance has all the markings of a negative-sum economic and political game, and it will therefore take adroit steward- ship to convert it to a mere zero-sum game.

Anyone who is even mildly interested in the arcane details of fiscal federalism, let alone equalization, could see this challenge coming " a tripling of energy prices under the five-Canada province standard was bound to trigger huge revenue differences across provinces on the one hand and to lead to confisca- tory tax rates for non-Alberta energy producers on the other. But when Prime Minister Paul Martin in rapid succession tossed out Canada’s traditional approach to equalization and then effec- tively promised Newfoundland and Nova Scotia that there would be no equalization clawbacks on their energy revenues, Canada’s system of equalization payments imploded.

The purpose of the ensuing historical overview is to high- light the reality that fossil energy has always created challenges for the operation of Canada’s Equalization Program but as well has also played and continues to play a pivotal role in the political, economic and even constitution- al evolution of the federation itself. For example, as problem- atical as the National Energy Program was, it arguably facilitated the passing of the Canada-US Free Trade Agreement. The convenient entry point to this history-cum- analysis is to cast our attention back a half-century ago to the advent of Canada’s Equalization Program.

While the analytical (and rhetorical) underpinnings of equalization may have been best expressed in the Rowell- Sirois Commission’s recommendations for regional adjust- ment grants, the 1957 introduction of our formal Equalization Program had its origins in more practical considerations. Specifically, following on the recommendation of the mid- 1950s Tremblay Commission (Quebec’s Royal Commission of Inquiry on Constitutional Matters), Quebec instituted its own personal income tax (PIT) system. Since the provinces had the constitutional right to levy direct taxes under section 92(2), Ottawa feared that this would trigger a series of separate income taxes across the provinces. Therefore, in 1957, Ottawa agreed to transfer shares of the three so-called standard taxes to the provinces " 10 percent of the PIT, 9 per- cent of the corporate income tax (CIT) and 50 percent of succession duties. Since these transfers were on a deriva- tion basis, i.e., in line with what was actually collected in the various provinces, this meant that the richer provinces would receive larger per capita trans- fers. The federal solution to this resulting revenue inequality was to launch Canada’s formal Equalization Program, which, in its inaugural version, guaranteed that all provinces’ revenues from these shares of the standard taxes would be brought up to the per capita level of the aver- age of the richest two provinces. Hence, by the very nature of the top-two-province standard (TTPS) there could be only one non-equalization-receiving province " in this time frame it was Ontario. Note that equaliza- tion payments come from Ottawa’s revenues; provinces do not contribute directly.

At this juncture, it is important to recognize that equalization has played another key role in the evolu- tion of our federation. Over the years the federal government transferred pro- gressively larger shares of the PIT and CIT to the provinces, which made Canada one of the most tax-decentral- ized federations in the world. Arguably this tax decentralization would not have been politically acceptable to the ”œhave-not” provinces were it not for the existence of equalization. In this sense, equalization also benefits the rich provinces, since it allows them to reap the benefits of their superior tax bases.

In the 1962 quinquennial revision of the tax arrangements, the share of PIT entering the equalization formula was increased to 16 percent (with an interim increase to 13 percent in 1958). For pres- ent purposes, however, the importance of the 1962 revisions is that natural resources entered the formula for the first time, thereby beginning a complex and volatile relationship that has influenced the evolution of Canadian federalism well beyond the fiscal arena. The concern at issue in this time frame was that resource-rich Alberta was receiving equal- ization. To prevent this, the formula was expanded to include resource revenues " 50 percent of the three-year average of provincial resource revenues would now be eligible for equalization. While this would exclude Alberta from receiving equalization, it would have substantially increased the total level of equalization. To temper this expansion the equaliza- tion standard was reduced from the TTPS to a national-average standard (NAS).

This modification was short-lived. Following up on its 1963 election plat- form, the new Pearson government restored the TTPS standard and removed resource revenues from the formula, replacing them with the ”œresource-rev- enue override”; henceforth, 50 percent of the resource revenues accruing to a province would be deducted from that province’s equalization entitlement. The return to the top-two-province standard meant that Ontario was again the only ”œhave” province, but the resource- revenue override precluded Alberta and BC from receiving equalization.

The 1967 fiscal arrangements repre- sented a watershed in the evolution of equalization. First, they introduced the representative tax system (RTS) approach to equalization, which calcu- lates a province’s fiscal capacity for each revenue source as the product of the relevant national average tax rate and the province’s tax base. Second, the program became comprehensive in the sense that all provincial taxes and revenues (including a catch-all miscella- neous-revenues category) and some local ones as well were now subject to equalization. Third, 100 percent of resource revenues entered the formula, classified in over a dozen rev- enue categories (e.g., new oil, heavy oil, mined oil, Crown leas- es, natural gas). Fourth, the NAS again became the standard. Finally, the logic of the RTS is that if one can easily identify a new revenue base, then one can make it a separate category for formula purposes, which explains why there were about a dozen energy revenue categories.

The 1972 arrangements largely involved tinkering " removing medicare premiums and racetrack rev- enues from the miscellaneous category and creating separate revenue categories for them.

It is clear then that resource revenues, and particularly energy rev- enues, were a complicating factor even before the energy price shocks. Indeed, and as will become evident, the period 1967 to 1973 is the only period in the history of Canada’s Equalization Program when 100 percent of both energy revenues and energy tax bases was included in the formula.

Enter the first energy price spike, which sent the world price of oil from about $8 in 1972 to $40 in 1974 (in 2004 Canadian dollars). Canada’s reac- tion was immediate and dramatic. First, we froze the domestic energy price, initially at $4 per barrel in 1974 dollars when the actual Canadian dol- lar world price was $10 (see the orange and red lines, respectively, on figure 1). Consequently and simultaneously, Ottawa imposed a $6 per barrel tax on exported oil, where this export price rose automatically to bridge the gap between the domestic price and the continuing-to-rise world price. Part of the rationale for this tax was to gener- ate funds to subsidize foreign oil imports entering eastern Canada in order to maintain the uniform and policy-determined price of gasoline across the country.

In this same time frame, the energy- producing provinces substantially increased their royalty rates for oil and gas, which Ottawa countered in part by disallowing the deduction of these roy- alty payments for purposes of corporate income tax calculations. Motivating much of this was the interplay between equalization and energy prices. Calculations made at the time indicated that if Canada went to world energy prices in 1974, equalization payments would have tripled, Ontario would have become a have-not province, each addi- tional dollar of energy revenue accruing to the producing provinces would have cost Ottawa 75 cents in equalization, and the overall equalization bill would have been such that it would have required a 25 percent increase in overall personal income taxation.

Not surprisingly, Ottawa’s series of measures (subsidized prices, export taxes, disallowing provincial royalties for CIT) still fell way short of what the minority Trudeau govern- ment could live with on the fiscal front. Therefore, abruptly and without consultation, Ottawa altered the equal- ization formula. So-called basic energy revenues (defined as the energy rev- enues that existed in 1973-74) would continue to be equalized in full, while only one-third of additional energy rev- enues would henceforth enter the for- mula. Among other things, this would allow Ottawa to gradually raise the fixed domestic price without putting the federal fiscal house in jeopardy. From Alberta’s vantage point, Ottawa’s overall approach to the glob- al energy price shock was viewed as an effective confiscation of their rents: revenues that ought to be flowing into provincial treasuries were being effec- tively transferred to Canadians in the form of subsidized domestic energy prices on the one hand and transferred to Ottawa via the export tax on the other. And these forgone royalties soared as the difference between the world price and the domestic price likewise soared.

The 1977 reworking of the fiscal arrangements attempted to fine- tune the relationship between energy revenues and equalization. One change was the introduction of a resource cap: energy-related equalization could not exceed one-third of total equalization. The second was to jettison the ”œbasic and additional” approach to energy revenues and to replace it by allowing 50 percent of all non-renewable resource revenues to enter the formula. This was a strategic error since, as domestic energy prices rose, the 50 per- cent regime generated much larger equalization flows than did the basic- additional variant, especially when international prices skyrocketed in connection with the 1978-79 Iranian revolution and the 1980 Iran-Iraq war. The intriguing but obviously very trou- bling consequence of this strategic error was that the province of Ontario became entitled to equalization pay- ments for each and every fiscal year from 1977-78 to 1981-82.

Ottawa’s way of dealing with Ontario joining the ranks of the have- not provinces was to prevent it retroactively from receiving equalization. This was accomplished by a provision of Bill C-24, passed in 1981, commonly referred to as the ”œpersonal income override” which stated that a province with per capita personal income above the national average was ineligible for equalization. Although it was cast in these general terms, it affected only Ontario (as planned!). Ontario agreed to this override, on the understanding that Ottawa would rework the program in ways that would ensure that more of the cost of equaliza- tion would be paid by those provinces triggering the increases, i.e., by the ener- gy-rich provinces. However, and as already noted, Alberta could mount a claim that it was contributing enor- mously to Ottawa and the rest of Canada and Canadians via the federally legislat- ed low domestic oil price.

With the Iranian revolution and the Iran-Iraq war, global prices doubled from their already high levels. This left our domestic price at some- thing like 40 percent of this new glob- al level. It was not just Canada’s Equalization Program that needed an overhaul; Ottawa’s overall approach to energy policy was in shambles.

Enter the 1980 National Energy Program (NEP), which imposed a range of new taxes directly on the oil patch, exacted a levy to support Canadian ownership of the energy sector, intro- duced the PIP (Petroleum Incentive Program) grants, which steered explo- ration away from the provinces to the Canada lands, and introduced the infamous ”œback-in provision” whereby the federal government could reserve for itself a 25 percent interest in all existing and future petroleum rights on Canada lands. It was not surprising that the reaction from the oil patch, and from Alberta, was openly hostile. This impasse was alleviated somewhat by the 1981 Canada-Alberta Energy Pricing and Taxation Agreements (EPTA), which allowed a more rapid increase in the domestic price. Under the EPTA, the actual domestic price for 1986 was to be $58. By then, however, world prices had collapsed to $20, and since then Canadian prices have remained at world levels. Essentially, therefore, world energy prices col- lapsed to Canadian levels and effec- tively unwound the bite of the NEP.

But not quite, since the oil patch was still concerned that Ottawa was able, with abandon, to tax and regulate the energy sector, which is, after all, under provincial ownership. Without going too deeply into detail, the resource provinces were able to lobby successfully to have section 92A enshrined in the Constitution Act, 1982 as part of the over- all Charter and patriation package. Section 92A granted the provinces exclu- sive legislative authority over the devel- opment, conservation and management of natural resources, as well as the ability to raise money and to tax with respect to natural resources, forestry and sites for hydro power generation. From the resource provinces’ standpoint, section 92A may well provide additional insur- ance against future federal intrusion in the resource areas, especially in times like the present when domestic energy prices have topped C$80 per barrel.

The NEP remains indelibly etched in the psyche of Albertans, ready to emerge when their interests are deemed to be at stake. One of the ear- lier occasions related to the Canada-US FTA. Former premier Peter Lougheed was an ardent supporter of the FTA, arguing that among other reasons the FTA would ensure that there could never be another NEP. Lougheed even tried to rally Ontario on side, by mak- ing the point that Ontario should view the energy provisions of the FTA as Alberta’s Autopact.

In the meantime, the principle of equalization had become so accepted by provinces and Canadians that it was enshrined in the Constitution Act, 1982 as section 36(2) (appropriately, on the occasion of its 25th anniversary). While embraced in principle, in practice the program lay in shambles. In the 1982 fiscal arrangements, the priorities of the federal government with respect to equalization were twofold: to find a way to minimize or in any event to reduce the impact of energy on the for- mula, and to find a way to exclude Ontario via the operation of the formu- la, not via arbitrary and retroactive decrees. The resulting flurry of research activity included the 1982 Parliamentary Task Force on Federal- Provincial Fiscal Arrangements and the 1982 Economic Council report, Financing Confederation: Today and Tomorrow. Beyond these reports, specif- ic proposals in the early 1980s time frame included: two-tier systems; rev- enue sharing pools; equalizing for both revenue means and expenditure needs as in Australia; full NAS equalization with 100 percent inclusion of resources; schemes that called for NAS with partial resource inclusion (the NAS-20 proposal of Saskatchewan); an intriguing proposal from Quebec for having a single category for resources (defined by actual revenues) that would be equalized via the disparities arising from an average of broad-based tax bases (essentially PIT, CIT and provincial sales taxes) rather than the much larger disparities arising from the resource bases themselves; and so on. All of this should be very familiar, since most of these proposals surfaced again over the last year or so.

The initial federal proposal in the November 1981 budget called for an Ontario standard. Since all provinces’ per capita revenues would be brought up to Ontario’s level, by definition Ontario could never be a have-not province. Moreover, given that Ontario had little in the way of an energy revenue base, an Ontario stan- dard would minimize the impact of energy on the formula. In the event, and persuaded by the provinces that a single province might end up being too volatile a standard, Ottawa adapt- ed the famous five-province standard (FPS), where the five provinces includ- ed in the FPS are BC, Saskatchewan, Manitoba, Ontario and Quebec.

Excluded are energy-rich Alberta on the high side and the four Atlantic provinces on the low side, where the populations of the two were then roughly equivalent. While 100 percent of resource revenues was included in the formula, the resource tax bases in Alberta and the Atlantic provinces were excluded. Drawing from recent data, in 2003 the FPS embodied only 39 percent of all resource-revenue bases in Canada (i.e., 61 percent were in the excluded provinces). This means that a province with no fossil energy, such as New Brunswick, would receive only 39 per- cent of the energy equalization that it would receive under a full NAS stan- dard. On the other hand, because Alberta’s base and the east coast offshore base are not in the formula, provinces like Saskatchewan now become very rich in terms of energy resource tax bases, and therefore become subject to very high clawback rates.

All in all, however, the FPS was a stroke of political genius in that it effectively survived for a quarter- century. As a result, the period between 1982 and the recent and on-going energy price spike was relatively calm on the equalization front. The princi- pal exception was the east coast off- shore oil and gas discoveries, and the Atlantic and Nova Scotia Offshore Accords that provided some sheltering of their energy revenues (on a sliding scale over 10 years) from equalization clawbacks. As these accords matured, Ottawa ensured that both provinces qualified for the so-called generic solu- tion, namely that if a province has 70 percent or more of an equalization tax base, then it can shelter 30 percent of these revenues from entering the formula; i.e., the maximum equalization clawback will be 70 percent. In order to ensure that Newfoundland and Nova Scotia would qualify for this 70 percent inclusion rate, they were given separate tax bases for their offshore revenues " one for Newfoundland and one for Nova Scotia " so that by definition they have 100 percent of the tax base, not just the needed 70 percent.

However, major concerns over the operations of the FPS came to the fore with the revelation that Saskatchewan’s energy-related equaliza- tion clawbacks (i.e., the reductions in equalization it would otherwise receive because it is a ”œhave” province for ener- gy) actually exceeded its total revenues from its energy sector " $1.126 billion versus $1.038 billion, for an average clawback rate of 108 percent. These con- fiscatory equalization clawbacks occurred for several reasons. The first has already been noted: with Alberta’s base out of the formula, Saskatchewan becomes a very rich province and for some of the resource categories it has close to 100 percent of the formula tax base, with correspondingly high clawback rates. Second, even though Saskatchewan had over 70 percent of the base in almost all of the resource cat- egories, it was not allowed to qualify for the generic solu- tion because Ottawa arbitrar- ily required Saskatchewan to have at least 70 percent of the overall tax base, including the tax bases of the non-FPS provinces. This is double jeopardy. A third reason is that somewhere in the back rooms of the equalization secretariat, decisions were effectively made that Saskatchewan is collecting significantly less revenue than it should be. This led to further increases in Saskatchewan’s tax bases for selected energy categories in the formula, thereby exacerbating the clawbacks: e.g., rev- enues from the category ”œsales of Crown leases” in 2000-01 were $61.5 million and the associated equalization clawbacks were $145 million, for an aver- age tax rate of 236 percent. With appro- priate changes, the possibility still existed to put equalization back on track, but this possibility ended in the immediate aftermath of Paul Martin’s minority elec- tion victory in June of 2004. The July 2004 Council of the Federation meeting unanimously proposed to increase equal- ization to its previous high level (2001) and then to increase it annually. To the surprise of many, Prime Minister Martin in the October 2004 First Ministers’ Conference did restore equalization to its previous high and then set it on a sched- ule to increase by 3.5 percent annually over the next decade. This effectively jet- tisoned Canada’s traditional approach to equalization. Hitherto, the equalization formula generated both the total amount of equalization and its distribu- tion across the receiving provinces. Henceforth, the total for any year would be fixed, so that the role of any formula would only be to allocate this fixed pool across the recipient provinces. Intriguingly, in this context, whether 100 percent or 0 percent of energy rev- enues/royalties is in the formula is irrele- vant in terms of the overall payments. But it will obviously have a major impact on their distribution.

The final policy decision in this evo- lution of equalization milestones is at the same time the most inexplicable and most inappropriate. In the final days of the 2004 election, Prime Minister Paul Martin, in private communication with Newfoundland and Labrador premier Danny Williams, committed Ottawa to effectively ensuring that the equalization clawbacks on east coast offshore energy (including energy-related revenues like CIT) would be reduced to zero. After a series of very public negotiation sessions, a deal to this effect was consummated in early 2005. While Newfoundland and Nov Scotia energy revenues would still enter the formula, any equalization clawbacks on these revenues would be repaid to these provinces via the workings of a revised set of the Atlantic and Nova Scotia Offshore Accords. Given that the value of energy-related revenues accru- ing to Newfoundland and Labrador at, say, US $60 per barrel of oil would be approaching $900 million or $1,800 per capita, and given that, after equaliza- tion, this province is now only about $500 per capita below Ontario, the per capita revenue of Newfoundland will easily surpass that of Ontario and of all other provinces except Alberta and maybe BC and Saskatchewan.

The reaction to this was fast and furious. Saskatchewan, with near-confis- catory clawbacks still in place, demand- ed the same deal as Newfoundland and Nova Scotia. Ontario leapt into the fray, essentially demanding what it did in the early 1980s, namely, that equalization should not increase unless the energy- rich provinces were made to pay a larg- er share of what were, after all, energy-driven equalization increases. Beyond this, Ontario argued that it was unfair that its Canada Health and Social Transfer (CHST) was clawed back to the tune of a billion dollars (in line with the 1977 tax-point transfer provisions) when arguably richer provinces like BC, Saskatchewan and Newfoundland and Labrador were not subject to these claw- backs. In the end, Ontario obtained a deal of sorts from Ottawa.

Often referred to as an integral part of the east-west ”œglue” of the fed- eration, equalization appeared to be imploding into a series of bilateral per- sonalized deals.

This unwinding of Canada’s tradi- tional approach to equalization with no acceptable alternative in view led to a flurry of academic and think-tank research and proposals for reworking equalization. In general, the spectrum of proposals closely resembled that of the 1980-82 period, with recommendations for 100 percent, 50 percent, 20 percent and even 0 percent inclusion rates for resources in any new formula. With oil prices hovering at US $60 per barrel and with provinces able to pocket all these royalties (unlike the first energy shock, where potential energy rents were trans- ferred to Canadians in terms of low ener- gy prices), the implications were critically important. In the face of widening provincial revenues, would all provinces be able to continue to provide reasonably comparable levels of public services at reasonably comparable levels of taxes?

In order to provide guidance with respect to the way forward, two formal studies were commissioned from the fed- eral Department of Finance’s Expert Panel on Equalization and Territorial Formula Financing and the Council of the Federation’s Advisory Council on Fiscal Imbalance. The latter recommend- ed 100 percent inclusion of all revenues to be equalized to the NAS. Should this generate a level of equalization deemed to be excessive, then its recommendation would be to scale this standard down on an equal per capita basis until the ”œappro- priate” overall amount of equalization is achieved. The Expert Panel recommend- ed that we return to our long-standing tradition of allowing the formula to gen- erate both the total amount and the dis- tribution of equalization payments. Beyond this it recommended 100 percent nclusion for non-resource revenues but only 50 percent inclusion of resource rev- enues. It then added a problematic rider: no equalization-receiving province should end up with more revenues than the richest non-equalization-receiving province. Phrased differently, this is an ”œOntario cap.” For purposes of imple- menting this cap, the Expert Panel defines revenues as 100 percent of all rev- enues. Clearly this is a 100 percent claw- back until the energy-rich province loses all equalization, after which the clawback obviously falls to zero. Essentially, this puts Saskatchewan back into a situation where equalization clawbacks again effectively confiscate its energy revenues until it crosses the threshold and becomes a ”œhave” province.

Word has it that the 2007 budget will likely opt for the Expert Panel’s 50 percent inclusion plan. If true, hopefully it will incorporate a more flexible version of the Ontario cap. Given that Premier Williams continues to rail against Ottawa, one might surmise that the Martin-Williams offshore deal will be unwound. This would put Nova Scotia, Newfoundland, Saskatchewan and perhaps BC all in the same camp of facing very high taxback rates. Finally, as with the Council of the Federation report, the Expert Panel also recommends scaling down the standard on a per capita basis, if the resulting equal- ization total is deemed excessive.

While the purpose of this overview is to focus on the interaction between energy and Canadian federalism, there do exist other alternatives that bring more parameters into play in order to try to escape the zero-sum nature of the hori- zontal balance game. They adhere to the Dwight D. Eisenhower dictum: if you can’t solve a problem, enlarge it. One approach to enlarging the equal- ization issue is to combine horizontal and vertical balance transfers into an integrated whole. That is, we would fol- low Australian practice and address hor- izontal imbalance via the overall system of federal-provincial cash transfers. By way of a proposal along these lines, consider the following two-tier scheme. Tier 1 would be an equalization pro- gram, say, along the Expert Panel lines but without the confiscatory cap. The overarching second tier would involve the monies associated with the vertical balance transfers (i.e., the former CHST, which has become CHT, CST, etc). These CHSTs are now revenue-tested (or clawed back) to a degree for Ontario and Alberta, because they have per capi- ta PIT/CIT revenues larger than the national average. But any such revenue- testing or clawback provisions should relate to the overall revenues of the provinces " own-source revenues plus equalization " and not to a subset. Therefore the second tier would involve the vertical transfers that made up the former CHST. These would become rev- enue-tested equal per capita transfers. Revenue-testing could work as follows. For provinces that have overall per capi- ta revenues (own-source revenues plus equalization) above, say, 110 percent of the natural average, each additional revenue dollar above this 110 percent threshold would result in a 20 cent decrease in their CHST payment. To ensure that Ottawa does not benefit from this scheme, the clawbacks would then be reallocated to all provinces on an equal per capita basis. Obviously, the parameters can be varied. Were the Conservatives to opt for an Equalization Program with zero inclu- sion of natural resources (e.g., along the lines of their election platform), this second overarching tier might embody, say, a 30 per- cent clawback on the CHST transfers in order to offset some of the larger inter- provincial revenue dispari- ties that would exist if resources were removed from the Equalization Program. In any event, the principles should be clear: the second tier is doing some overarching equaliza- tion because we cannot agree how to manage this in an equitable or acceptable manner within the stricter confines of the formal Equalization Program.

By way of conclusion, energy prices and energy policy have obvious- ly had an enormous impact on the political economy of Canada, running the gamut from the constitutional dossier, to the FTA and Canada-US rela- tions, to the politics of the federation, to federal-provincial relations and, of course, to Canada’s system of equaliza- tion payments. In terms of equaliza- tion, the challenge for the Harper Conservatives and Finance Minister Flaherty in particular is to find a stable, formula-based and equitable frame- work that serves to once again allow all provinces to work together in our nation-building project. The inherent- ly zero-sum nature of any solution makes this a daunting challenge. But this will not be the last of the energy- related challenges that Canadians must confront. The complex and controver- sial relationship between the environ- ment and the energy sector is already waiting in the wings.