Are fiscal stabilization reforms a slap in the face or a modernization?

by Trevor Tombe. Originally published on Policy Options
December 8, 2020

With all the attention paid to rising COVID-19 cases, expansions to various federal emergency support programs, ongoing political machinations south of the border, and Canada’s $382-billion projected deficit, you’d be forgiven for missing changes to Canada’s fiscal stabilization program announced in the recent federal fiscal update.

But Alberta’s premier, Jason Kenney, sure noticed. It’s a “slap in the face,” he said in response to the announced changes.

Alberta Finance Minister Travis Toews was less overdramatic but agreed the reforms “fall well short of the proposal endorsed by premiers from every province and territory at (the) Council of the Federation.” Even former Alberta premier and current opposition leader Rachel Notley was unimpressed.

The federal government, meanwhile, calls its reforms “modernizing” and says they “provide a more effective backstop to provinces that face an extraordinary drop in revenues.”

At a time when provinces across the country are under intense fiscal strain and looking for as much support as they can get, it’s worth cutting through the political spin to unpack what was announced and what the reforms to fiscal stabilization might mean. In my view, they are a modest but meaningful change to an increasingly important transfer program.

What Is fiscal stabilization and how was it changed?

Federal support for provincial finances is nothing new. It’s at the core of Canadian federalism. And since the original terms of Confederation, federal transfers have provided “floors” of some form or another for provincial revenues.

But since 1967, a broad form of provincial revenue insurance has existed in what’s called the Fiscal Stabilization Program. I won’t go into full details, but interested readers can explore the full history, functioning, and reform options for the program in this recent IRPP paper. I’ll only briefly summarize the program here.

Originally, it provided payments to any province whose revenues declined by more than five per cent from one year to the next — for reasons other than provincial tax changes, of course. It was meant to help cushion the blow to provinces experiencing a large economic shock, such as a severe recession. Essentially, the federal government would absorb the full cost of the shock beyond the first five per cent drop, which would be borne by the province.

Today, it functions a little differently but its core components are straightforward. A province receives a payment if:

• Total revenues decline by more than five per cent and if either:
  1. Non-resource revenues decline by more than five per cent or
  2. Resource revenues decline by more than 50 per cent.

(Technically, this way of describing the program only works after certain minor reforms announced in the fiscal update. But even the previous program worked almost like this. If you’re brave, you can visually compare the old and the new formula here and here.)

But, importantly, regardless of how much provincial revenues decline, stabilization payments are capped by a ceiling. And the most important reform to the program announced in the fiscal update was to ease this cap.

Easing the cap on stabilization payments

Since 1987, stabilization payments have been constrained by a $60-per-person limit. Alberta, for example, has roughly 4.3 million people, so any stabilization payments it receives could not exceed roughly $250 million.

This is very limiting. So the government opted for a simple change: index the cap to Canada’s rate of nominal GDP growth per person. The immediate effect is to nearly triple the cap to $170 per person today, which will also gradually rise over time.

This matters. Since provincial own-source revenues have been (somewhat) stable as a share of overall economic activity over time, indexing the cap to GDP makes sense. And it fully reverses the severe deterioration in the real value of the stabilization program, as I illustrate here (figure 1).

It’s the first meaningful change to the program since 1995, and the first meaningful expansion in nearly a half century. And it will benefit many provinces almost immediately.

Stabilization payments to Canada’s provinces due to COVID-19

My estimates as well as some private-sector forecasts suggest that five or six provinces may qualify for stabilization payments in 2020. And if each hits the cap (which is not an unlikely scenario) then Ottawa is on track to pay out roughly $6 billion total to the governments of British Columbia, Alberta, Saskatchewan, Ontario, Quebec, and Newfoundland and Labrador. This is more than double all previous payments to all provinces under the program throughout its entire history and more than $4 billion above what an unreformed program would have paid.

It is therefore a meaningful reform.

Indeed, other than the $20-billion Safe Restart Agreement, it’s the largest single increase in federal transfers to provincial governments this year.

If my estimates are anywhere close to reasonable, the new cap will also buffer a large share of the overall revenue decline experienced by most of these provinces.

Alberta is a notable exception.

That province’s tax, liquor, and gaming revenues may fall by $3.2 billion this year (though some of this is due to corporate tax cuts, which wouldn’t count) and resource revenues may fall by $4.3 billion. Under the reformed stabilization program, it’s set to receive $750 million to help offset these losses. This is far less than the roughly $3 billion that Alberta would like to see under an uncapped program — and explains why the premier isn’t happy. Alberta was also hoping for retroactive changes to the program to boost its prior payments in 2015/16 and 2016/17. That won’t happen.

Of course, the federal government has supported and will likely continue to support provinces through ad-hoc transfers this year and next. The unique nature and scale of COVID-19 shouldn’t necessarily be used to critique the reforms to stabilization. Instead, let’s consider what “normal” shocks are for provinces and whether the increased cap is meaningful.

Is the new cap too small, too large or just right?

If historical experience is any guide, a limit of $170 per capita in payments will matter only rarely. It represents approximately 2.5 per cent of provincial revenues covered by the stabilization program, so for non-resource revenues it matters only if annual declines exceed 7.5 per cent. This is a large decline.

It’s tough to estimate precisely, since the relevant data for stabilization payments is calculated only if a province makes an application. But I attempt to approximate relevant changes in provincial tax bases using historical equalization data. Since 1981, I find a greater than 7.5-per-cent decline in adjusted non-resource revenues has only occurred three times: Alberta after the 1986 oil price crash, Alberta during the financial crisis, and Alberta after the 2015/16 oil price crash. I illustrate this here (figure 2).

Of course, the program remains of only limited support to provinces overall — since a drop of more than five per cent in non-resource revenues is a rare event, so provinces understandably want a lower threshold.

Should other reforms be explored?

At their September 2020 meeting, Canada’s premiers and territorial leaders called for the five-per-cent threshold to be lowered to three per cent and for the 50-per-cent threshold for resource revenues to be lowered to 40 per cent. They also want the cap eliminated completely, not merely eased. This would increase the scale of the program significantly, with both more frequent and larger payments.

The challenge for the federal government is to provide support to provinces without encouraging risky behaviour. Alberta is a great example of this. Its revenue is volatile largely by choice — the province opts to rely on risky resource revenues and steadfastly refuses to consider more stable sources of revenue, such as broad-based consumption taxes. To have the consequences of this decision shifted to Canadians elsewhere dampens the province’s incentive to adopt fiscal reforms to improve its own budget.

There are ways around this concern, as I explore in detail in the IRPP report. But any additional expansion to the federal stabilization program should be done only with a deeper rethink of its overall structure.

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So rather than being a slap in Alberta’s face, the changes to stabilization — however modest — are a meaningful reform to an important program.

This article first appeared on Policy Options and is republished here under a Creative Commons license.