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Quebec Premier Francois Legault chairs a premiers virtual news conference with premiers John Horgan, B.C., Jason Kenney, Alberta, and Scott Moe, Saskatchewan, onscreen, on March 4, 2021 in Montreal.

Ryan Remiorz/The Canadian Press

Politicians in Alberta and Quebec have both made policy decisions to shoulder some of the cost of living for their citizens, but the consequences for fiscal federalism are much different.

In Alberta, successive governments over decades have avoided imposing a provincial sales tax, a key part of the province’s identity as a low-tax jurisdiction. In Quebec, successive governments over decades have kept electricity rates artificially low, a key part of that province’s belief in hydroelectric power as a benefit to be shared.

The ultimate impacts are similar: Both Albertans and Quebeckers get a substantial break on their cost of living, even as their respective provinces give up billions in potential revenues.

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Yet, the equalization system, under which poorer provinces receive billions of dollars each year from the federal government, treats those decisions very differently. Alberta’s decision is for the most part ignored, with its fiscal capacity calculated as if the province had a sales tax.

But the same is not true of Quebec’s decision to forgo electricity revenues. In that case, the rules of the equalization system don’t disregard that policy choice. Instead, those actual revenues, even though artificially low, are used in equalization calculations.

The gap between Quebec and other parts of the country is substantial. Hydro-Québec estimates that a Montreal residential consumer pays an average of 7.3 cents a kilowatt hour, based on monthly electricity use of 1,000 kwH. By comparison, a consumer in Halifax pays 16.89 cents, in Ottawa 10.3 cents, in Toronto 11.1 cents, and in Calgary 14.83 cents. In Manitoba, consumers pay 9.6 cents, reflecting that province’s decision to also keep electricity rates artificially low.

The result is that Quebec receives billions more in annual equalization payments than it would have if its forgone hydro revenues were treated in a similar manner to Alberta’s non-existent sales tax. (Manitoba also benefits, but to a much smaller degree.)

If Quebec’s forgone revenues were counted, the province would lose billions. And it would lose billions more if Ottawa were to decouple the calculation of equalization payments from the growth of the economy, as the charts below show.

Right now, Ottawa will spend $20.91-billion on equalization in the coming 2021-22 fiscal year. Those equalization payments are made by the federal government from its revenue. The provinces do not contribute any funds; their residents do, through paying their federal taxes.

As the chart below shows, Quebec receives just more than three-fifths of that amount, $13.1-billion, reflecting both the size of its population, and its relatively poor economy, compared to the national average.

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But that determination of “poorer” depends in part on the decisions made on how to calculate fiscal capacity, or the ability of each province to raise revenue. For taxes, that determination is made on capacity, not the actual revenue collected. Average tax rates are applied to the economy of each province, resulting in a fiscal capacity.

That’s why Alberta’s lack of a sales tax doesn’t have much of an impact on the province’s fiscal capacity under equalization. The system uses the average rate of sales tax for all the provinces, and ignores the fact the province doesn’t actually have such a levy.

However, the lack of an Alberta PST isn’t totally ignored. Its absence does decrease the national average for sales taxes. And if Alberta were to introduce a sales tax, it would increase the national average somewhat.

The treatment of natural resource revenue, including hydroelectricity revenue, is different. For natural resources, actual – not potential – revenue is used. So, the money Quebec could make, but chooses not to, from increasing electricity rates to the national average does not get counted when fiscal capacities and equalization payments are being calculated.

“There’s no intellectual justification for this treatment,” says Trevor Tombe, a University of Calgary economist who has extensively studied the equalization system.

But Prof. Tombe notes the possible political perils in tweaking the equalization formula to change how Quebec’s hydro revenues are treated. The Diefenbaker government proposed changes in the early 1960s that would have reduced payments to Quebec. The Pearson Liberals campaigned against those changes in the 1963 election campaign. Equalization was one among many issues in an election in which the Progressive Conservatives saw their seat count tumble in Quebec, while the Liberals increased theirs, going on to form a minority government.

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Michael Smart, a University of Toronto economist, agrees with Prof. Tombe’s assessment, saying that counting actual rather than potential natural resource revenues runs counter to how the equalization system should work.

He says the treatment of natural resource revenues has been a perennial issue within the equalization system. When Saskatchewan was receiving payments, it protested over the treatment of its revenue from heavy oil, less lucrative than Alberta’s lighter crude production.

Equalization payments to Quebec would drop sharply if the province’s electricity revenues were to be assessed on their potential, as is the case with taxes, according to the FinancesoftheNation.ca calculator, which allows for what-if modelling. The chart below shows the effect of increasing average electricity prices by 3 cents per kWh, which would put Montreal consumers on about the same footing as those in Ottawa, as well as increasing Manitoba rates by 1 cent per kWh.

As shown in the chart below, Quebec’s payments would drop to $9.29-billion in fiscal 2021-22, a decline of 29 per cent. Ontario would be the chief beneficiary, receiving what are called “adjustment payments” that ensure that equalization-receiving provinces don’t end up better off than non-receiving provinces.

The payment to Ontario reflects one of the many oddities that have been embedded into the complex equalization system since it was established in 1957. Twelve years ago, Ottawa decided to link the growth in equalization payments to the three-year average change in national gross domestic product.

Then, the change was seen as a way to limit the growth in equalization, by decoupling it from Alberta’s soaring fiscal capacity. Now, the reverse is true – Alberta’s declining energy revenues, and fiscal capacity, result in the GDP formula pushing up Ottawa’s equalization expenditures.

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The equalization program would be transformed if that rule were to be scrapped along with a change in the treatment of Quebec’s electricity revenues. As this third chart shows, Ottawa’s overall equalization outlay would fall to $15.36-billion. The adjustment payments to Ontario would disappear, and payments to Quebec would decline to $7.5-billion, a drop of $5.6-billion from the amount the province will actually receive in 2021-22. (Payments to the Maritime provinces would rise slightly in this scenario.)

Groups in Alberta have pushed for this kind of change, precisely because it would reduce the cost of equalization and free up billions in federal tax dollars, which could be used to boost other kinds of transfers to the provinces, or alternatively, to cut federal tax rates.

Such a change was examined 12 years ago, when a commission headed by veteran civil servant Al O’Brien proposed a new structure for equalization. But the commission veered away from proposing such changes, in part because of the difficulties involved in determining what theoretically higher revenue Quebec and Manitoba might be earning from electricity.

Prof. Tombe says the methodology shouldn’t be difficult: A national average electricity rate could be calculated, similar in principle to how tax capacity is arrived at.

Prof. Smart says he isn’t quite as convinced that it would be a simple task to rework equalization to align the treatment of tax and natural resource revenues. But it should be done, he says. “There’s no quick fix here. But the current system is unfair and inefficient, and we should try to do better,” he wrote in an e-mail.

Tax and Spend examines the intricacies and oddities of taxation and government spending.

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