Equalization: Pay the people, not the governments

What does one of the world’s most prominent economists, a man whose pioneering work in the 1950s made him the father of equalization programs, think about them today? That question is particularly interesting because that economist, Nobel Laureate James Buchanan, is also a founder of public choice economics, which assumes that politicians and bureaucrats, like everybody else, act rationally to promote their own interests, to gain and keep power and to reward their supporters.

Mr. Buchanan’s theoretical defence of equalizing grants, as he called them, influenced the debate that spawned programs like Canada’s, launched in the 1950s. Today, his thinking about equalization has changed. He has come to see how easy it is for the idea to be perverted and captured by politics.

Equalization in theory discourages people in poorer regions from moving to wealthier regions, simply to be able to gain access to the better public services and lower taxes that a wealthier jurisdiction can provide. Without equalization, Mr. Buchanan fears, there will be a general loss of economic efficiency as too many people try to take advantage of public services in wealthy regions, causing a decline in the quality of those services and an exploitation of the rich provinces’ tax base.

But what the designers of Canada’s equalization system neglected to take from Mr. Buchanan’s early work was this: Equalization should be paid to individuals, not to governments. In fact, equalization would be best accomplished by differential national tax rates in the less-developed jurisdictions. In arriving at this conclusion, Mr. Buchanan was employing what would become public choice economics. He knew that to transfer the money from a federal to a provincial government would introduce a whole new layer of economic inefficiency.

If equalization is paid to individuals, they decide how to spend the money according to their priorities. They are, of course, free to vote for provincial governments that would take all of the tax differential away through higher provincial taxes. But those governments would be answerable to those voters for this decision.

Moreover, residents would likely demand less costly and more efficient and effective ways of delivering services. Newfoundlanders, for example, might wonder if they wanted to pay the full cost of having, as is the case today, the best pupil/teacher ratio in the country. Having lots of teachers on the public payroll is popular with teachers but doesn’t produce better results for students. Nova Scotia might well not have chosen to keep its steel mill operating at huge losses for so many years had equalization not passed a lot of the bill along to taxpayers in other parts of the country. And Manitobans might well balk at being the country’s highest spender per capita on health care.

All of these examples point out one of the biggest dangers Mr. Buchanan sees in making equalization payments to governments rather than to individuals. That danger is what is known as rent-seeking. In this case, when governments control huge resources, and can use those resources to confer benefits on favoured groups, people will organize to capture a share of those benefits for themselves. This is especially true when the benefits are highly concentrated on a privileged few, while the costs can be spread over many people through the tax system.

Pay equalization to governments and powerful bureaucratic interests, such as civil servants, ambitious politicians, and public sector unions see huge opportunities. Teachers in Newfoundland, steel workers in Nova Scotia and health care workers in Manitoba are just some of the examples of how equalization creates opportunities for rent-seekers in equalization-receiving provinces to combine and exert strong political pressure on local politicians to get some share of the money. And local taxpayers have less reason to react to this behaviour than if they had to pay the whole bill.

Existing bureaucracies will vigorously oppose any move to shift equalization payments from governments to individuals. People will try to protect the rents they have in the current system. But payments to individuals would ensure that citizens living in poorer regions of the country have the resources to get public services at current levels with no loss of present income. Perverse incentives on provincial government behaviour would be removed, and those same governments and their voters would be more accountable for their provincial spending. And Ottawa would get to send checks directly to residents of the less-developed jurisdictions in Canada, rather than to famously ungrateful provinces.

Designing the tax rebates presents its own challenges, and would require some careful thought, but in our view, Mr. Buchanan has challenged Canadians to think afresh about imagining an equalization system that escapes the trap of powerful provincial rent-seeking.

Michel Kelly-Gagnon is President of the MEI, Brian Lee Crowley is President of the Atlantic Institute for Market Studies (Halifax), Peter Holle is President of the Frontier Center for Public Policy (Winnipeg).