If we want to understand Canada’s unique and often confusing equalization program we must first have a grip on what fiscal federalism is and how it works. Fiscal federalism is said to be concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government." German-born American economist Richard Musgrave is credited with having founded the theory of fiscal federalism in 1959. Musgrave’s main argument was that federal government systems have the ability to solve many of the issues faced by local governments and therefore have the responsibility of providing the balance and stability needed to overcome disruptive issues like uneven distribution of wealth and lack of widely available resources. Musgrave further theorized that federal governments should manage a nation's money from the top and give it to more local governments (states in the US and provinces in Canada) who in turn would then have the power to distribute it locally as needed.
In Canada, there are two primary types of transfers, conditional and unconditional. A conditional transfer from a federal body to a province, or other territory, involves a certain set of conditions. If the lower level of government is to receive this type of transfer, it must agree to the spending instructions of the federal government. An example of this would be the Canada Health Transfer. An unconditional grant is usually a cash or tax point transfer, with no spending instructions. An example of this would be a federal equalization transfer.
The concept of fiscal federalism can be further broken down into two other sub categories, vertical and horizontal fiscal relations. The notions related to horizontal fiscal relations are related to regional imbalances and horizontal competition. Similarly the notions related to fiscal relations are related to vertical fiscal imbalance between the two senior levels of government, that is the centre and the states/provinces. This leads us to the subject matter of this article, the equalization program.
The most important principle of Canada’s Equalization Program of addressing fiscal disparities between provinces has been a major source of debate in Canadian politics, between the federal and provincial levels of government, as well as between provinces. Please note the Canadian territories do not participate in the equalization program. The program is reported to have the goal of ensuring citizens in all provinces have access to roughly the same level of social services, such as education and social assistance, without having to pay exorbitant levels of taxation. In order to perform this action the program looks at the revenue each province can generate based on personal income tax, corporate tax, sales tax, property tax and 50 per cent of resource revenues.
As a result, the equalization program is also at the center of addressing any vertical and horizontal imbalances. Vertical imbalance is said to occur when the responsibilities of one level of government are disproportionately large compared with its share of revenues. These imbalances are addressed either by a transfer of responsibilities and/or revenues from one level of government to another. For example, the Canada Health Transfer and the Canada Social Transfer are meant to address vertical imbalances by transferring funds from the federal government to the provinces. A horizontal imbalance is within one level of government; in the case of Canada, between the various provincial governments. This sort of imbalance occurs when some provincial governments have much weaker fiscal capacities than others. Traditionally, this has included provinces such as Quebec, Manitoba and those in Atlantic Canada; although recent years have seen a break from tradition, with economic juggernaut Ontario becoming a “have-not” province for the first time since the establishment of the program and Newfoundland becoming a “have” province.
The controversy mainly surrounds precisely how equalization payments should be calculated. Two issues are said to be central to this debate: calculation of the national standard and calculation of individual provincial fiscal capacities. (Please note that I will address the popular arguments that state Equalization encourages dependency and equalization is unfair to richer provinces in a subsequent article.) The reason why the program is so hard to understand is because of the number of items that are used to determine a province’s fiscal capacity and therefore inform the basis for “the equalization formula”. 2007 saw the number of items significantly be reduced from thirty-three to five comprehensive items; which include, personal income tax, business income tax, consumption tax, property tax and natural resources.
Picture entitled, "Canada", taken by Alex Indigo on December 21, 2006, obtained through Creative Commons (https://flic.kr/p/4eDBug)