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Canada's equalization program, which channels $16-billion in federal revenues to six recipient provinces, is up for review in 2014. According to the 1982 amendment that entrenched equalization in the Constitution, the program should enable all provinces "to provide reasonably comparable levels of public services at reasonably comparable levels of taxation." But equalization has failed dismally on both counts and is in need of major revisions.

Recipient provinces enjoy higher levels of public services than donor provinces. Everyone knows about heavily subsidized day care and university tuition in Quebec, but the disparities extend throughout health and education, with recipient provinces having, for example, fewer students per educator and more hospital beds per capita. At the same time, recipient provinces levy higher tax rates, including personal income taxes, corporate taxes, and sales taxes.

Like many well-intentioned government initiatives, equalization has failed because perverse incentives embedded in program rules lead to unintended and undesirable consequences. Here are a few examples from a long list of perverse incentives created by the very complex and often amended equalization formula.

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Receiving provinces are led to increase their tax rates even though that may lower their tax receipts by depressing economic activity (the more you tax something, the less you get of it), thereby diminishing the province's fiscal capacity. The loss is made up by increased transfers through equalization. Also, higher tax rates in recipient provinces increases the all-Canada average, thereby leading to higher transfers. In effect, equalization gives governments in recipient provinces the power to tax citizens in donor provinces.

Equalization is a negative incentive for economic growth, especially for development of non-renewable resources, because greater resource revenues lead to lower transfers. Newfoundland and Nova Scotia had to be paid, through ad hoc changes to the equalization formula, to develop their offshore hydrocarbon resources. Quebec is now blocking production of potentially lucrative shale gas fields discovered in the St. Lawrence valley. The moratorium is ostensibly based on environmental concern about fracking (despite the hundreds of thousands of wells successfully fracked all over the world without environmental damage); but behind the faux environmentalism lies the economic impact of the equalization formula, according to which Quebec would lose in transfers what it might earn in royalties.

Another unlovely consequence of equalization is its impact upon the marketing of hydroelectric power, which is classified as a renewable resource. Recipient provinces, such as Quebec and Manitoba, whose Crown corporations produce large amounts of hydro power, deliberately price their electricity at below-market rates. This confers a windfall upon the residents of their provinces while keeping the true economic value off their provincial books. If these provinces told their Crown corporations to sell electricity at market rates, they could take the surplus in the form of tax revenue or shareholder returns; but in either case they would strengthen the fiscal capacity of the provincial government, thereby diminishing transfers from equalization.

These and many other perverse incentives in equalization lead recipient governments to increase their tax rates, pump up public services, veto certain forms of economic development, and put unrealistic prices on market transactions. Generations of economists have shown the program's flaws, yet the recipient provinces have never wanted to agree to necessary changes because the current structure seems to be providing them with free money (another perverse incentive).

The federal government has recently acted unilaterally in sensitive areas such as the Canada Pension Plan, Old Age Security, and the Canada Health Transfers. In for a penny, in for a pound, we say. Federal unilateralism on equalization reform is probably the only way to reduce or root out the perverse incentives in a program in which the majority of provinces are recipients, and have become heavily dependent on the transfers over many years.

Tom Flanagan is a distinguished fellow and Naomi Christensen is a graduate student in the School of Public Policy, University of Calgary.

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