The Incentive Effects of Equalization Grants on Fiscal Policy

The equalization system has long been considered a vital underpinning of the Canadian federation: a means to create some purported fairness or justice among the provinces, by redistributing the wealth of provinces with larger fiscal capacities to allow those with weaker fiscal capacities to provide roughly equivalent services to their citizens. However, the mechanics of the equalization formula have long been suspected of being flawed. Since grant-receiving provinces can adjust the way their fiscal capacities are calculated and reflected in the equalization formula — by adjusting tax rates and spending, for instance — governments are confronted with incentives to design their fiscal regimes in ways that maximize the size of the grants they receive, even if the fiscal policies are designed for less-than-optimal economic efficiency. The incentive for grant-receiving governments to “game” the formula, even unconsciously, is apparent; what has remained largely unresolved is to what extent is it actually occurring. This analysis shows that indeed it is occurring, and to a measurable degree. It finds that equalization grants provide recipient provinces with incentive to raise their business and personal tax rates. This is because when a government raises its own tax rate, it raises the national standard average tax rate, which is used in the equalization allocation formula. That, in turn, raises the individual “have-not” province’s equalization-grant entitlement. Exacerbating the problem is that the tax-raising provincial governments tend to underestimate the deadweight cost that the tax hikes will have, potentially worsening the fiscal situation of a province that already faces difficult economic challenges. This analysis also finds that the equalization-grant allocation system encourages spending among recipient provinces, particularly on health-care services, resource conservation, industrial assistance, environment and housing. Results show that for every $1.00 increase in equalization grants, recipient provinces further increase spending by an additional $0.64 in total expenditure. Neither effect necessarily furthers the equalization program’s idealistic intent. The promotion of higher tax rates especially would seem to work at odds with the program’s conceptualization of a federal redistribution model. By potentially further repelling business and taxpayers from “have-not” provinces, the result could be making those provinces increasingly needy while continually reducing their citizens’ wealth. The equalization formula is not unfixable. The arrangement can be made to work even better, in a way that maintains the principle of redistributing wealth from more privileged provinces to less privileged ones, while avoiding the perverse incentives that motivate “have-not” provinces to raise taxes. If equalization grants were substituted with block grants that are unrelated to taxing capacity, taxes in grant-receiving provinces may actually decline. A $100 per capita increase in block grants is potentially associated with an up to 2.6 percentage points drop in business tax and an up to 0.26 percentage point drop in personal income tax. The result would be an equalization arrangement that could help increase, rather than decrease, competitiveness in the very “have-not” provinces that most urgently need to attract investment. Switching to block grants would not only keep the integrity of the principles behind equalization in tact, it would actually make equalization work better. for all provinces.