Proceedings of the Standing Senate Committee on
National Finance

Issue 24 - Evidence

OTTAWA, Wednesday, October 24, 2001

The Standing Senate Committee on National Finance met this day at 5:47 p.m. to examine the effectiveness of and possible improvements to the present equalization policy in ensuring that provincial governments have sufficient revenues to provide reasonably comparable levels of public service at reasonably comparable levels of taxation.

Senator Lowell Murray (Chairman) in the Chair.

[English]

The Chairman: Honourable senators, we are meeting again in our study of equalization. We have two witnesses tonight. We will try to divide our time more or less equally between the two although, as always, I am in the hands of the committee.

Our first witness has commented and written extensively on this subject. You have some of his writings in your file. He is Ken Boessenkool, President of Sidicus Consulting Limited, an economic and public policy consulting firm. Mr. Boessenkool has published extensively on public policy issues, including papers on federal-provincial transfers, provincial welfare, the tax treatment of family, and monetary policy. He was formerly a policy advisor to the provincial treasurer of Alberta, a policy analyst with the C.D. Howe Institute, and an economic policy adviser to an opposition party which is nameless in his biography but which I can tell you with some certainty is now the official opposition in Ottawa. In May this year he wrote a paper entitled:"Taking off the shackles: Equalization and the Development of Non-renewable Resources in Atlantic Canada," that was published by AIMS, the Atlantic Institute for Market Studies.

Mr. Boessenkool told me privately that he advised the Alberta government on its implementation of the single-rate personal income tax, the first province in the country to do so.

Mr. Boessenkool has an extremely interesting background and has written some provocative papers on the subject. I welcome him with great pleasure and invite him to make an opening statement.

Mr. Ken Boessenkool, President of Sidicus Consulting Limited: Honourable senators, I have a fair number of remarks to make. I believe a paper has been passed out: "Ten Reasons to Remove Non-renewable Resources from Equalization." I hope to move through this list quickly, making brief comments on each reason. I have been told that you prefer to listen to my opening statement and then ask me questions.

After 44 years and $180 billion in equalization spending, the Atlantic Provinces are only barely more able to meet the needs of ordinary citizens with their own revenue sources than when equalization was first introduced in 1957. On average, about 40 per cent of provincial budgets in the four Atlantic Provinces comes through federal transfers. A big chunk is in the form of equalization.

The time has never been better, however, for the Atlantic provinces to lessen their dependence on federal transfers and to become masters of their own fate. The picture is positive for the newly emerging offshore oil and gas industry in Atlantic Canada. Within a few years, Newfoundland is projected to be producing about 40 per cent of Canada's conventional oil. A natural gas pipeline, possibly the first of several, already connects Nova Scotia with New England. It appears that offshore and onshore petroleum resources may be discovered in or around virtually every province in the region.

The development of natural resources, primarily oil and gas but other minerals also, creates the conditions in which economic growth in the region could well outstrip that in the rest of the country. Unfortunately, however, because of the treatment of natural resources in equalization, the potential for growth and realizing that potential are two different things for Atlantic Canada.

To address this problem, I have recently proposed, in my paper mentioned by Senator Murray, that non-renewable resources be removed altogether from the equalization program. To explain why, I will now give you the top ten reasons for removing non-renewable resources from equalization. I guarantee that will be one top-ten list that you will never hear from Mr. Letterman.

The first reason is that resource revenues have been nothing but trouble for the equalization program. When equalization was created in 1956, resource revenues were not included. Half of resource revenues were added in 1962. For the next 20 years, particularly during the 1970's OPEC crisis, Ottawa fiddled with the treatment of resource revenues within equalization eight times.

In 1982, under the constitutional renewal, Ottawa moved to the current five-province standard, excluding Alberta and hence its resource revenues from the calculation of payments to recipient provinces. It also excluded the Atlantic provinces.

More recently, Ottawa has made some special bilateral deals with recipient provinces by further tinkering with the resource formula to try to reduce its disincentive effects. Ottawa has created some special cash transfers to a number of the provinces in the Atlantic region, such as Hibernia and various developmental funds, to offset the impact of falling equalization payments as resource royalties grew. In short, resources have never been a good fit within the equalization program.

The second reason is that removing non-renewable resources would vastly simplify the program. Of the 33 revenue bases used in the equalization formula, 11 of them are directly related to non-renewable resources and 10 to oil and gas.The categories include "new oil," "old oil," "heavy oil," "mined oil," "third-tier oil," "heavy third-tier oil," and, in case something was missed, "other oil," as well as two categories of "offshore oil and gas" and "natural gas." The eleventh category is "other mineral resource revenues."

Eliminating these tax bases from the formula would vastly simplify equalization and eliminate the number of tax bases in the formula by one-third.

The third reason is having non-renewable resources in equalization produces perverse incentives. Equalization exists to provide the less wealthy provinces with funds to bring their revenues up to a common or a standard level. The very existence of the program and the amounts of money involved demonstrate Canadians' willingness to share across provincial boundaries. Nevertheless, equalization payments can work against provinces' economic best interests when those payments punish recipients for responsible development of their non-renewable resources. To wit, any increase in revenue from these resources is taxed back from a province's equalization payment by as much as 100 per cent. As a result, recipient provinces have little incentive to reduce their reliance on equalization in favour of developing provincial resources.

At a time when fiscal policy is moving away from high marginal tax rates and welfare traps, equalization treatment of resources is rather peculiar. My proposal eliminates the anomaly. It moves the equalization program away from the equivalent of high marginal tax rates on provincial non-renewable resource revenues and from the incentive trap this produces for recipient provinces, particularly the Atlantic provinces.

Having non-renewable resources in the formula causes fiscal problems for Ottawa is the fourth reason. In his seminal book, Social Canada in the Millennium, published by the C.D. Howe Institute, Professor Tom Courchene notes that Ottawa's approach to non-renewable resources has been to try and downplay their role over the course of time. The federal government has done so because volatile oil and gas prices have produced large potential swings in the cost of the equalization program. That explains why Ottawa currently excludes Alberta from the calculation of equalization entitlements. However, that means that the program does not properly reflect the average fiscal capacity in the ten provinces. It only reflects the fiscal capacity in five provinces.

The fifth reason to remove non-renewable resources from equalization is because it is arguably unconstitutional to have resource revenues in equalization. The Charter puts the ownership of, and the legislative power over, non-renewable resources exclusively with the provinces. Section 92A in particular restricts the right to make laws regarding non-renewable resources to the provinces. Subsection (4) of the same section grants to the provinces the power of direct taxation of non-renewable resources.

Section 125 strengthens this provision by stipulating that lands belonging to a province that include non-renewable resources are not to be taxed.

I will add a caveat on this comment. Offshore resources are treated differently. Legally, they belong to the federal government and not to the provinces. However, I make the argument in my paper that Ottawa has granted de facto ownership to Nova Scotia and Newfoundland of these offshore resources because it has allowed these provinces to tax them. In effect, not legally but de facto, the provinces own those resources because Ottawa has allowed them to collect royalties on those resources.

In reference to the provinces and natural resources Dan Usher has noted that the Constitution gives the provinces ownership of the tree, as well as the entitlement to the fruit. Ottawa in my view has questionable jurisdiction when it comes to redistributing these resources across the country using equalization.

The sixth reason is that having non-renewable resources in equalization does not make economic sense. In my view, there is a good explanation as to why resources never quite fit properly within the equalization formula. From an economic point of view, non-renewable resource royalties are of a fundamentally different nature from other types of revenues. I will provide you with an accounting illustration. Consider a bakery. The revenue from the bread that Bill the baker sells is his income, in effect, the profit and losses of the bakery. It shows up on his income statement. However, if Bill the baker sells one of his ovens, the money from that sale does not enter his income statement. It is not income but the proceeds from the sale of a capital asset.

The taxes on personal and corporate income, as well as sales, are like revenue from the sale of bread. They are properly considered income for the purposes of providing public services.

Non-renewable resources are quite different. As I just pointed out, the Constitution gives these resources to the provinces. When these resources are sold and a province levies a royalty on that sale, all that has changed is that the province now has a cash asset instead of a liquid asset in the ground.

Unfortunately, equalization does not make the distinction between income and the proceeds from the sale of a capital asset. It treats royalty revenues the same as personal, corporate and sales taxes. Equalization payments fall in response to changes in royalties, even though all the province has done is to convert a physical asset, oil and gas in the ground, into a financial asset by selling that for cash and levying a royalty on the sale.

Reason number seven is the equalization formula double-counts the fiscal capacity from resources.

A second economic argument is that the "rents," or pure economic profits from the extraction of natural resources, are effectively capitalized in other prices in the wider economy. To provide an example, I have a graph in the paper that shows this rather explicitly. House prices and wages in Alberta, for example, track oil and gas prices remarkably well. These movements in the prices of other tax bases, wages and housing prices, for example, reflect the additional fiscal capacity that results from the discovery and exploitation of non-renewable resources. Since these other tax bases: wages through personal income tax, and housing prices, through a common measure of property taxes are included in the equalization formula, natural resource revenues do not need to be included.

Scholars defend the capitalization argument and the fact that the United States has no equivalent to Canada's equalization program despite wide variation in fiscal capacities across the States. The predominant U.S. view is that differences in fiscal capacities between, say, New York and Mississippi are reflected, or in the economists' terms, are "capitalized" in differences in wages and other prices such as property values. Therefore equalization is unnecessary.

If Mississippi collects fewer taxes to provide fewer services, it also gets to pay lower wages to provide those services. If New York collects more revenues from its tax bases, it also must pay higher wages to provide those services. There is already an economic adjustment that takes place.

Clearly Canada is not willing to go that far because we have an equalization clause in our constitution, but I put it out there for your consideration.

Removing non-renewable resource revenues would allow the equalization program to reflect all the provinces' fiscal capacity, rather than just the five provinces as the current standard does. This is reason number eight. Because non-renewable resources in Alberta would no longer produce large swings in the program cost, Alberta, along with the Atlantic provinces, could be returned to the formula.

A 10-province standard would therefore be truer to the spirit of section 36 of the Constitution, the so-called "equalization clause," than the current five-province standard.

Removing non-renewable resources would mean very small adjustments for recipient provinces, and this is number nine in the reasons for removing non-renewable resources from equalization.Had my proposal been in place, what would it have meant for the recipient provinces in the 1999-2000 fiscal year? The presence of offshore oil and gas revenues in Newfoundland would have meant a $6 reduction in its per capita payment compared to the status quo, under my proposal.

The remaining Atlantic provinces, as well as Quebec and Manitoba, would have seen a drop in their per capita entitlement by between $44 and $69 per capita. Equalization entitlements are measured on a per-person basis. A table in my paper lays out all the numbers, including the total millions-of-dollars impacts.

The most pronounced impact of the proposal would have been for Saskatchewan, where the per-capita entitlement would have more than doubled as a result of eliminating oil, non-renewable gas, and potash revenues from the formula.

When these reductions are put up against total provincial revenues, the total dollar reduction in all provinces would be very modest, around 1 per cent or less of total revenues in all these provinces.

From Ottawa's perspective, the total cost of the program under my proposal would drop by a modest $33 million, mere peanuts in a $10.8 billion program.

Are these reductions manageable? Per capita equalization entitlements have fluctuated wildly in the past two decades. The average annual change in entitlements has been more than $75 per capita in Newfoundland and in New Brunswick, about $60 for Manitoba and Saskatchewan, and about $30 per capita in Quebec. Therefore, historical changes have been within the range that I am contemplating here. In addition, these reductions are smaller than the increases these provinces have seen in equalization payments in recent years, as a result of both strong growth in Ontario and Minister Martin's removal of the $10 billion equalization cap.

The final reason is that the politics of the proposal look good.

I will now conclude with some remarks on the politics of the proposal.

The equalization program, as you all know, is subject to quinquennial reviews, next scheduled for 2004 or 2005, during which all of the provinces and Ottawa together look at the program, make any agreed upon changes, and ratify it for another five years. Therefore, proposing changes that lack broad support across provinces is probably a pointless exercise.

Removing non-renewable resources from the equalization program would likely receive support from both ends of the country. Newfoundland and Nova Scotia have an obvious interest in detaching equalization from non-renewable resource development, particularly as oil and gas production ramps up in the coming few years.

On the other side of the country, and particularly in Alberta, they have an equally obvious interest in any move that would result in provinces having greater autonomy over the development of natural resources. This is why we recently saw Premier Hamm and Premier Klein having very friendly discussions about this issue. Ontario would not likely oppose the proposal, as the impact on that province is minimal or non-existent.

A bigger hurdle might be Quebec, New Brunswick and Prince Edward Island, which would face small reductions from the new formula without the compensation of greater ability to tax existing developments of non-renewable resources.

Consider, however, the pull of four counterweights. First, the changes would represent only 1 per cent of provincial revenues. Second, for every province except P.E.I., the payments would still be larger than those received as recently as two years ago. Third, the decrease from the status quo would be smaller than the recent increase from lifting the $10 billion ceiling or equalization cap. Fourth, and more importantly from people who know more about natural gas and resources in the Atlantic provinces, it is now widely accepted that the St. Lawrence Basin is one of North America's last remaining major hydrocarbon-bearing basins. Quebec, New Brunswick, and Prince Edward Island are all clamouring to negotiate offshore agreements with Ottawa in case oil and gas are found within their waters.

Onshore drilling is proceeding right now in New Brunswick. The whole eastern end of the country may soon be seeing important oil and gas revenues in the foreseeable future. If these four counterweights are not enough, in my view, Ottawa could easily offer a transition mechanism, which it has done many times in the past, guaranteeing payments at the old level until the new formula caught up, so that no province would lose anything.

In conclusion, given support from east and west and little or no resistance from the centre, Ottawa is unlikely to oppose this proposal. It would mean little to the federal government's bottom line. It would continue to protect the federal balance sheet from the vagaries of the price of non-renewable resources, particularly oil and gas. It would provide a means of substantial simplification of the program, what I could call an intergovernmental "hat trick," not often seen in the arcane world of Canada's intergovernmental relations.

Senator Bolduc: What is the impact for the federal government if non-renewable resources were removed from the formula?

Mr. Boessenkool: The cost of the program would drop by $33 million.

Senator Bolduc: If it lies in the interests of most of the provinces and federal government to remove non-renewable resources from the program, why are they still in?

Mr. Boessenkool: Do you want a political answer to that or a different answer?

Senator Bolduc: Both. Let us have both.

Mr. Boessenkool: First of all, once you open up Pandora's box it is like the Constitution. One makes a sensible proposal and suddenly many provinces come forward with proposals that are much less sensible. My understanding is that Minister Martin is very concerned about opening up one part of the program and having everyone else come to the table with their various little concerns. I believe that is part of the reason.

The complexity of this program makes it difficult to take a small piece. I think this is where a committee such as yours and the other committees in the house can make a persuasive case to say: Maybe we do not need to review everything but, given what is going on in Atlantic Canada and that Premier Klein has been very supportive of this, a very strong case can be made for examining this one peculiar piece of equalization and fixing it in a way that would leave the Atlantic provinces better off.

Does that answer your question?

Senator Bolduc: Yes. I must say that I have always thought that assets should not be included in equalization. To me, in terms of economics, including assets makes no sense.

The Chairman: I hope you know that Senator Bolduc was trained at the University of Chicago.

Mr. Boessenkool: I have some friends who have been trained there too. It is a very good place.

On each of these points I can make a few more remarks. The idea of these resources being capital assets is not just something that economists in think tanks, like me, think up. If you look at what Alberta has done with their natural resources in the last 25 years, you will see an example. The Alberta Heritage Savings Trust Fund was created for a number of reasons. One reason was that the people of Alberta realized that their non-renewable assets that were in the ground were assets that should benefit all future generations.

I released a paper this past week. Its topic concerned Alberta's fiscal situation and I was fairly critical of the fact that in the last two years Alberta has started to spend too much of its non-renewable resources. Twenty years ago it put this money in the Heritage Fund. In the past five or six years it has been using this money to pay off debt. In both cases it took a long-term asset approach to non-renewable resources. Really, Alberta is where I got the idea for this proposal for the equalization program.

Senator Bolduc: The Alberta example is part of the argument but its result is actually is the main part. The Alberta practice has had a perverse economic effect.

Mr. Boessenkool: In the paper I make the point that the way non-renewable resources are treated in the formula actually gives the provinces an incentive to spend this money as quickly as they can and to bring it in their annual revenues, because the federal government reduces their equalization payments when their royalties go up. There is actually an incentive for the Atlantic provinces not to treat these revenues as long-term capital assets, as Alberta has done when they paid down debt and set up the Heritage Fund. Because it is in the formula, the Atlantic provinces are forced to bring incoming revenues into their current revenues unless they want to adjust their expenditure side. I believe that is perverse.

Senator Bolduc: That is, in my opinion, the strongest argument against it.

Mr. Boessenkool: Brian Lee Crowley often makes a case that I find difficult to make because I come from Alberta. He says that when Alberta developed their non-renewable resources, for every buck they got, the federal government did not take a dollar away. Why should we be treating the Atlantic provinces any differently?

Senator Bolduc: The problem is that resources in the Maritimes are federal resources.

Mr. Boessenkool: Some of them are.

Senator Bolduc: They have been considered provincial.

Mr. Boessenkool: My arguments get into a little bit of trouble there, since offshore resources legally belong to the federal government. Nevertheless, the federal government has been treating such resources as provincial right from the beginning. Newfoundland and Nova Scotia are levying royalties on these offshore resources. I argue that, Ottawa has considered these resource revenues to be provincial.

I understand from speaking to Mr. Crowley at the Atlantic Institute for Market Studies that a fair amount of onshore activity is going on as well. In this instance a case can also be made for Voisey's Bay.

Senator Bolduc: I am surprised because New Brunswick is aware that something might happen also in the Gulf of St. Lawrence, but the minister of finance from New Brunswick said he is still against it. I would not have taken that position.

Mr. Boessenkool: I remember the minister's comments well, and was equally surprised, as was the Premier of Alberta. He had been speaking to Premier Hamm and they had gotten along fairly well on this issue, which in Canada is something remarkable. It is not often that Alberta and some of the Atlantic Provinces can see eye to eye on some of these kinds of issues. It was surprising, in my view, to see the Premier of New Brunswick take quite a different view.

The Chairman: I think your points on the politics of the proposal are sound. However, when the Minister of Finance Paul Martin was last spring we discussed this very issue with him. He poured cold water on it. He was not enthusiastic.

The officials take the view: Why should we treat those revenues differently? The provinces do not treat them any differently. It is a rather circular matter.

To make matters worse, Premier Harris not too long ago spoke with some acerbity against the proposal of Premier Hamm. I do not know quite what to make of that.

I suppose the principle of the thing is that as the province's fiscal situation improves equalization entitlements should diminish. Generally, that is a very easy proposition to sell to people.

Mr. Boessenkool: I make a point in the paper that the development of non-renewable resources in Alberta and other provinces is a principal driver of economic growth elsewhere. Mr. Crowley wrote an opinion piece on this very point soon after Mr. Harris made his comment, that one must distinguish between what is driving economic growth and the resulting economic growth. I have no argument with Premier Harris on the one hand: If the personal and corporate income tax revenues and sales tax revenues in New Brunswick and Nova Scotia go up by 100 per cent, their equalization payments should go down. Those are real revenues that they can spend.

A non-renewable resource, however, is a capital asset, or stock, and not a flow. I do not think it correct to not allow provinces to develop their own non-renewable resources. Mr. Crowley wrote an op-ed that made that point to Mr. Harris.

The Chairman: Are you saying we should go back to the ten-province standard?

Mr. Boessenkool: Yes. If the eleven non-renewable resource tax bases are removed, then you can return to a ten-province formula and not have these wild swings in the formula, all driven by Alberta and natural resource prices. The numbers that I quoted to you about the effects on the program are the result of going to ten provinces and then taking out the non-renewable resources. Again, it is all in the paper from the Atlantic Institute for Market Studies, which is available to be downloaded on line, or I could have copies provided to the members, if they wish.

The Chairman: Just to give some comfort to the provincial treasurer from Prince Edward Island, would you like to give us your assurance that in your scheme there will be some transitional compensation for such a province that would lose in the beginning?

Mr. Boessenkool: There are a number of things to consider. One is that the small reduction that would result from my proposal is much smaller than the recent increases that P.E.I. has seen. More importantly, at the time of the big changes made in 1967, 1972, and 1982, the federal government said to the provinces: You are here now. The new proposal will put you here but will grow you at a different rate. If you are here now, then we will start you on the new one here and we will let the formula catch up to that, and when it hits where you were before, then we will start pushing you up.

Ottawa has done that a number of times in the past. There is no real reason why they could not calculate the new entitlement and give the assurance that the entitlement would never drop below what it was a few years ago.

The interesting thing is that as the rest of the economy goes down in Canada, we could see a fairly substantial drop in equalization. I have not recalculated these numbers with the new economic forecast in them but I am beginning to think that if I did, the numbers would show an improvement.

The Chairman: We will ask the P.E.I. treasurer, when she comes to the table, whether they have been doing any number-crunching along those lines.

Senator Stratton: While I agree with what you are saying in principle I believe it would be wonderful to get everybody off the negative side and on to the positive side.

In Manitoba we have a wonderful renewable resource called hydroelectric energy. We also have a wonderful renewable resource that is water. In this day and age, water and the export of it is a subject everybody considers heretical. Although this issue is not on the table yet, it will be soon.

Politics being the art of the possible, how could you sell your proposal or make it palatable to those provinces that will be hit? A $4 per capita loss may not seem like much, but when at the level of $40 per capita, it starts to hurt when you talk in terms of provinces that lack that stature. There has to be something offered in return if you are going to take out non-renewable resources. Senator Murray has suggested a transitional period. The best provincial response to the idea would at least be neutral, if not on side. Do you have any ideas on that?

Mr. Boessenkool: I believe in a transitional mechanism such as I just described, where current levels are guaranteed. Moving forward is one way to do that. My paper gives the calculations for 1998. In 1998, most provinces saw a one-year increase in their equalization payments in a range from $98 to $125 per capita. Why? Did their costs of delivering services change? No. Did their revenues go down in the Atlantic provinces? No. What happened? Ontario grew like a mad dog and drove up the average tax base in the country. The Atlantic provinces suddenly received a large increase in equalization.

Therefore, to my way of thinking, you take the good with the bad. If this proposal results in at least two provinces, if not all four Atlantic provinces, being able in the future to benefit from the development of natural resources, to move to a natural gas and oil-based economy on par or somewhere like Alberta, why would you not do it? Why would you not be able to trade off the short-term small losses for the long-term gains, especially when in the last of years there have been some fairly substantial increases in the equalization payments.

When I was working for the finance minister of Alberta we had discussions around the table about equalization. As soon as one province puts something on the table where anyone's payments go down, it is a political non-starter. Then you are into the realm of developing transition mechanisms. I have one in the paper because I have been in politics long enough to know you need those things. There are a lot of smart people in the Department of Finance.

Given the political coalition of the Western and the Atlantic Provinces, both with natural resources, over the long term, I do not put it beyond the federal government to develop a workable transition mechanism.

Senator Bolduc: I wish you good luck.

Senator Christensen: We were talking about actual resources. However, these terms seem to blur when you discuss non-renewable and natural resources. Water and hydroelectric power are renewable resources. We are, however, also talking about minerals and diamonds. They are non-renewable resources. Is that correct?

Mr. Boessenkool: Thank you for that clarification. My paper makes a very clear distinction between renewable resources and non-renewable resources.

Renewable resources are not excluded. Forestry stays in the formula. Quebec Hydro stays in the formula. Manitoba Hydro stays in the formula. They are all renewable resources.

Consider that when a resource is renewable, there is an annual, measurable income stream. This is different with a non-renewable renewable resource. Once you sell a barrel of oil, you cannot put it back in the ground. Once you cut down a tree, you can grow a new tree. Thank you for that.

Senator De Bané: Please give me your opinion concerning the following proposal. Equalization in the long-term is bad because, in the same way that transfers to individuals create dependency, unconditional transfers to the public finances of the province can also create dependency. Hence, irrespective of the formula, equalization may have a perverse effect. Would it not be more difficult and challenging but much more promising if the federal government, instead of sending a cheque to a province, devised policies that would allow each province to attain the maximum of its economic potential? This is a lot more difficult than to send a cheque to a province and then devise policies that are not sensitive to the economic problems and issues of each province.

I am wondering whether equalization, which in 1957 was a revolutionary idea, today may have a perverse effect, similar to cash transfers to individuals.

Mr. Boessenkool: Speaking in general terms, I see the goal of equalization that allows provinces to develop their own policy in an autonomous way. This is why we have an equalization program that is unconditional. When equalization was devised, a political bargain was struck among the provinces that could afford to raise their own revenues and design their own programs, and with the provinces that could not. That bargain recognized that there are weaker provinces in this country that, if left to their own vagaries, they would not be able to provide the services the provinces of Alberta and Ontario are able to provide. Therefore, the bargain provides them with unconditional transfers so that all of us can develop our provincial sets of policies in a more decentralized way than seen in many other countries.

When you talk about the dependency of equalization, I agree you can make the case. My case against non-renewable resources is partly a dependency case but there are more substantive arguments behind it. When I hear "dependency of equalization," I worry a little about us losing this great thing we have; a decentralized country. Part of the reason we have a decentralized country is because we provide these monies to all provinces so that can run their own services.

Secondly, at the C.D. Howe Institute, I studied the changes in cash transfers from Ottawa to the various provinces, and in particular the components of those transfers. If you examine the amount of money coming from equalization to the Atlantic provinces, Quebec, Saskatchewan, Manitoba and the others, it makes up a very small component of all inter-regional transfers in Canada. In economic terms, if you have a constant transfer going to a province over a long period of time, there is not that much argument that such a transfer causes a lot of dislocation. The problem arises when transfers shift up and down a lot. The shifts can cause economic dislocations by their sheer size.

I found that transfers from the unemployment insurance program; transfers from various special cost-shared programs that Ottawa has had with the provinces over the years; transfers as a result of special bilateral agreements between Ottawa and provinces far and away swamped the equalization program in terms of their possible economic dislocation effects.

When people ask me if equalization is having a negative incentive effect, if it is creating dependency in the Atlantic Provinces, I say you can make that case. However, against that must be set this great deal we have in Canada that allows us to have decentralized provinces.

Furthermore, to the extent that there is dependency, in my view, the problem is not equalization. We should fix employment insurance and these one-of deals that go on and all of the non-employment insurance programs that operate under employment insurance.

C.D. Howe Institute recently published a paper showing that only 40 per cent of expenditures in the employment insurance program actually go to people who are unemployed and claiming employment insurance benefits. A myriad of other programs Ottawa is paying for have an extremely poor track record of success.

The Chairman: Transfers from the federal treasury to individuals include EI and Old Age Security. What about programs like health, post-secondary education and social assistance all of which are more or less subsumed in the CHST?

Mr. Boessenkool: I wrote a paper in 1996, at the C.D. Howe Institute, about the tremendous amount of unfairness in the move from the former Canada Assistance Program and established programs financing to the CHST, which kept all the old disparities of those prior programs. However, to the great credit of Minister Martin in the last six or seven years, we have moved closer to an equal per-capita transfer in the CHST.

A program like equalization is meant to redistribute. I return to my previous point that if equalization is the program explicitly being used to redistribute, programs outside of equalization should treat Canadians as Canadians no matter where they live. We already have a program that redistributes among provinces. Hence, the CHST should be equal per capita, requiring equal eligibility standards for employment insurance programs across the country. Expenditures on the non-insurance part of employment insurance should be spread equally across the country. It is my view that these expenditures should not be made by the federal government, but by the provincial governments. However, that is a topic for another day.

We have an explicit, constitutionally divined, redistribution program in this country called equalization. However, we also have all these other programs which "super-equalize" that are causing many more problems than equalization has.

The Chairman: I agree with you. Mea culpa: in terms of the cap on the cap. I could go into the background of that in considerable detail but will not.

However, when the Premier of Newfoundland was here the other day, he was incensed that the change to a more per capita driven formula has worked to the disadvantage of that province. He indicated that 600,000 people in Winnipeg is one thing; 600,000 people spread over a territory the size of Newfoundland and Labrador is quite another, and our transfers for programs like that cannot be totally beholden to some mathematical formula.

Mr. Boessenkool: This is the classic "needs" argument for equalization and/or the CHST. Given my decentralization leanings, that proposal causes me some concern. It means giving Ottawa a freer hand in the way in which it tells provinces how to conduct their affairs.

Australia is an example of a needs-based equalization program. Not only are differences in fiscal capacity measured on the revenue side but also differences in capacity and need on the expenditure side. Over time, the Australian Federal Government has taken several of these programs out of the equalization formula and created certain bilateral programs through which it dictates to the states exactly how they have to run these programs. I think such programs would be to the detriment of our country.

I have some sympathy for the idea of a needs indicator in equalization and/or the CHST in theory. However, the political side of me worries about Ottawa telling the provinces how they ought to run their affairs.

The Chairman: The devil is in the details.

Senator De Bané: Mr. Boessenkool, I submit that it would be a lot more promising if the federal government took into consideration the geographic, or spatial, dimension of the federal system, instead of just telling the Department of Finance to do the math and send the appropriate cheques to the provinces. That is a lot easier, but we have seen the consequences. They have not been very promising.

Incidentally, Quebec has established a task force to look into those matters and are going to table their report within a month.

Equalization was put into the Constitution in 1982 because Mr. Trudeau had to pay that price in order to secure the support of some premiers for the Constitutional initiative. I believe if each department took into consideration the aspirations and economic potential of each province that equalization would be a lot more promising in the long-term.

My second question challenges the question: Should we or should we not include natural resources, whether renewable or non-renewable? I believe one of the flaws of our constitution is that the Fathers of Confederation placed natural resources, whether renewable or not, in the provincial jurisdiction.

Within one country some people may be wealthier than others because they are more dynamic than others or because they are more hard-working than others.In Quebec, we have the Beauce region adjacent to the American border where one finds the most dynamic private entrepreneurs. They have no resources. They go to the States and cut lumber there, import it back to the Beauce region to produce furniture, and then export the furniture. The region's rate of unemployment is lower than the Quebec average. I understand that is because they are more hard-working.

However, within the same country some people are wealthier than others because they are sitting on this or that asset for which they are not responsible.

From a political point of view, if you had to rewrite the Constitution, would you say that natural resources should be part of the provincial domain or the federal domain? Should the federal government send a cheque either to the people or to the provincial government? In short, should natural resources belong to the province or to the state?

Mr. Boessenkool: We have a constitution that has assigned these matters to the provinces. Should those resources be national resources as opposed to regional resources? In Canada we have made a tremendous political bargain, with differences in wealth and different approaches to policy across the country. I believe those are part of what makes Canada great. Some of those differences arise from resources.

The provinces with those resources today will not always have them tomorrow. In the early 1900s there arose a situation where Alberta was the poor boy of Confederation and the Atlantic provinces the rich boys of Confederation. I have just completed a paper warning Alberta that its supply of natural resources do not belong to just this year but to the future generations of Albertans. Who is to say that in 50 years the Atlantic Provinces may be back up on top as rich boys if Alberta misuses the resources it has today.

We have a dynamic federation. If these resources in the ground drive economic activity in other areas of the economy and this is taken into account in a redistribution program called equalization, we are, in fact, sharing the benefits across the country in a way that we should.

I am concerned about the approach of taking the resources we have in the ground today, selling them and spending all of the money today. Whether done on a national basis or a provincial basis, the issue is more how we are treating the resources in the ground. We are still a heavily resource-dependent country. We ought to be careful about the incentives we create for provinces to develop their resources and spend them.

I am unconvinced that provincial ownership has made the matter worse than it would have been had the resources been nationally owned. The development of natural resources in Alberta means there is other economic activity in Alberta that, if included in a national equalization program, would be reflected in the degree of sharing we do across the country.

The Chairman: We will have to take a blank sheet of paper and start reinventing the country. If we were starting all over again, somebody at this table might think that education should be in the federal jurisdiction.

Years ago Premier Hatfield of New Brunswick made a speech at Mount Allison University, in Sackville, New Brunswick. An academic stood up and made a big speech that education, certainly post-secondary, should be in the hands of the federal government. Ottawa should take it over, and did the Premier agree? Mr. Hatfield answered: "No." The academic said: "Why not?" Mr. Hatfield said: "I will give you one reason. If the federal government took over post-secondary education, there would only be one university in New Brunswick and it would not be Mount Allison." That ended the argument.

Senator Mahovlich: I believe that water is a renewable resource. Do you agree with that?

Mr. Boessenkool: I agree with that.

Senator Mahovlich: Water flows from province to province. Water could become a big problem. If you start taking water out of our country, what will happen to the fish?

Mr. Boessenkool: The nice thing about selling our water is that we get it back when it rains.

Senator Mahovlich: I do not agree. You are going to get fooled on this issue.

Mr. Boessenkool: I am out of my jurisdiction.

Senator Mahovlich: I think you are. Look at the problem with floods you have had over there.

The Chairman: Thank you for a very interesting and quite provocative presentation. We have enjoyed it very much.

I would like to hear from you, if there are any changes you would think should be made in the equalization program. I noticed in the piece you did for AIMS that you did deal with some of the proposals that Professor Courchene made. We are going to have him here, and Dan Usher is coming next week. For anything you would like to send us that you have already done or want to do for us in terms of other changes you think might be made in the equalization program, we, Parliament and the country would be in your debt.

Mr. Boessenkool: I encourage you also to have Mr. Crowley here as well from the Atlantic Institute for Market Studies.

The Chairman: We are trying to get him.

Colleagues, we will turn now to the Treasurer of Prince Edward Island.

The Honourable Patricia Mella has been in the Prince Edward Island legislature since 1993. She has served as leader of the opposition, the Progressive Conservative Party, in that province, and since 1996 as Provincial Treasurer, minister responsible for the P.E.I. Public Service Commission, the P.E.I. Liquor Control Commission, the P.E.I. Lending Agency, and Status of Women. She is accompanied by the Director of Economics, Statistics and Federal Fiscal Relations in the Prince Edward Island Treasurer's Department, Mr. John Palmer, whom I welcome also on your behalf.

Committee members have copies, in English and in French, of Ms Mella's presentation. I now invite the Honourable Patricia Mella, Provincial Treasurer of Prince Edward Island, to make her opening statement.

Hon. Patricia Mella, Provincial Treasurer, Government of Prince Edward Island: Mr. Chair, committee members, I am delighted to be here. I consider it a privilege and opportunity to speak to the committee. I wish you well in your deliberations.

Since Senator Mahovlich is here, I will note that when I was leaving home I told my daughter that I was going to appear before a Senate committee, and Frank Mahovlich was on it. She said: "Who is Frank Mahovlich?"

Senator Bolduc: She must be under 30. Too young to remember.

Ms Mella: Of course, I was able to explain that I was around for the Original Six, and I knew exactly who Frank Mahovlich was. I think your concern about water has more to do with outdoor rinks, perhaps, than anything else.

Senator Mahovlich: That is where I got my start.

Ms Mella: Mr. Chair, I am pleased to have this opportunity to present the views of my province with respect to the equalization program.

The inclusion of this program in the Canadian constitution signifies its extreme importance to all Canadians. After five years as provincial treasurer, I find myself the longest serving provincial minister of finance. During this period my concerns over the inadequacies of these vital program have grown. On April 26 this year I joined my colleagues from the neighbouring Atlantic provinces to make presentations to the Commons' standing committee on finance concerning Bill C-18 and amendments to the Fiscal Arrangements Act. That amendment specifically concerned the equalization ceiling that continues to be of serious concern to the provinces.

My remarks this evening address a broad range of equalization program issues.

As provincial treasurer, I have on many occasions expressed my government's concern over the various aspects of the program. I have done this through correspondence with the Minister of Finance, through private discussions with him and discussions at federal-provincial ministers' meetings.

In addition, the province has played a vocal role at provincial-territorial meetings of ministers of finance and premiers in support of the program. There have been exchanges of correspondence between my premier and the Prime Minister on the subject on several occasions. Premiers and provincial finance ministers all agree that the equalization ceiling must be removed immediately, and that work be undertaken to develop a strengthened and fairer formula. This could be achieved through a move to a ten-province standard and comprehensive revenue coverage. These points were repeated by ministers of finance at their Vancouver meeting as recently as October 11.

Notwithstanding the strong case for improving the adequacy of the program, the federal government to date has steadfastly chosen to defend the status quo. Through the course of this presentation, I hope to clarify the many aspects of this ongoing debate.

I am sure you have heard from various quarters concerning the issue of the alleged disincentive effects of the present formula, the unnecessary complexity of the formula, and the unfairness of the claw-back effects of the program for resource revenues. I will comment on these important points in turn.

Prince Edward Island has a major vested interest in ensuring that the equalization program is understood, is accepted, is properly measured, and is adequately financed. We count on the federal government to ensure that the program adequately meets its constitutional objective. While equalization may not be well understood, vast numbers of Canadians rely on this program to maintain a balanced playing field across this country for government services and tax levels.

The program is essential to my province's finances as it continues to be our single largest revenue source. The personal income tax, for example, contributed $161 million in revenues to the province in 1999-2000, while equalization was recorded at $256 million.

Our present dependence on equalization is not something we are happy about. We do take pride in the fact that over the long-term the percentage contribution of federal transfers to our revenues has been shrinking. In the early 1980s equalization formed 32 per cent of our revenues. Today it is 28 per cent. As our economy expanded relative to that of other provinces, so our dependence has declined. Last year Prince Edward Island led the country in employment growth.

Let me begin by discussing the response of the federal government to provincial concerns.

I have reviewed the varying responses to the federal government to calls for improvement. The common thread appears to be that the present program works well; that it was never cutback, like other federal programs, during the 1990s; that it has delivered large increases in dollars to equalization-receiving provinces; and that the balance of the ceiling, the floor and the standard are important to maintaining the program.

We find it particularly troublesome to be told by federal ministers that the equalization program has never been cutback when other programs were, and that somehow this provided receiving provinces with a special benefit. I note recent comments by Minister Dion to my premier in that regard. Comments at the Commons finance committee in April by federal officials emphasized that the program had grown by 33 per cent since 1993. This suggests that the present program has been very generous. These remarks entirely ignore the basic purpose of the program, the automatic nature of the payout of equalization entitlements, and the large improvement in federal and provincial finances in recent years.

We must remember that we need the program to function adequately in order to allow provinces to deliver provincial government services that are reasonably comparable without resorting to extraordinary high levels of taxation.

The whole purpose of the program is to provide a level playing field for our people and our businesses so that the Canadian economy is able to function at its optimum. The program is all about horizontal balance between provinces. If the program fails in some measure, then levels of education, or health, or highways or other provincial services will deteriorate and taxes will be forced up, causing provincial economies to suffer.

It is my firm belief that the federal government has perpetuated the myth that poorer provinces have been treated particularly well in order to justify continuing cost-containment for the program.

I want to be clear that the equalization program did not confer favourable treatment to less wealthy provinces during the cutbacks of the 1990s. In fact, the payout from the program was in decline through most of that decade when all levels of government were struggling with deficits and shrinking revenues.

The federal public accounts show that 1999-1992 federal payments to provinces for equalization were $9.9 billion, in 1996-1997 9.4 billion, and even less in the intervening years. Only since 1997 have they shown any upward trend. For P.E.I., equalization revenues peaked in 1990-1991 at $206 million and fell off to a level as low as $158 million in 1993-1994. It did not regain previous levels until 1997-1998. Equalization-receiving provinces also endured the cutbacks to the CHST, as well as effects of EI changes and other reductions in federal spending.

While the federal government may claim that the program was not explicitly targeted for cutbacks in this period, it should be recognized that the formula itself delivered the reductions automatically. Further, moves by the federal government to lower the ceiling in those years did reduce entitlements in total by over $3 billion. In more recent years, the entitlements have increased, but this is simply the formula working, reflecting the growing provincial revenues and responsibilities.

It is extremely discouraging to hear the federal minister and his counterparts pretend that they have somehow improved the program when they have actually reduced the adequacy of the program by adding further constraints to it.

It is extraordinary to observe the degree of publicity the federal finance minister and his colleagues have accorded the release of increased entitlements, as though they have improved the program following many years of stagnation.

The recent growth has come in a period of unprecedented buoyancy in the economy. This buoyancy has automatically raised both provincial and federal revenues. The equalization program is actually a shrinking burden to the Canadian taxpayer. In the early 1980s the federal government committed 8 per cent of its revenues to equalization. Today, the proportion is more like 6 per cent.

Equalization has not kept pace with the growth of the Canadian economy over the long term. Twenty years ago, the ratio of equalization to gross domestic product was 1.30 per cent. Today, it is a mere 1.04 per cent. These percentages have been on a downward trend for a very long time.

The federal government has successfully reduced the role of the program over time, while disregarding our calls for sustaining the program to adequately meet its constitutional goals. Perhaps the federal government has come to believe its own rhetoric and has convinced itself that the program is more than adequate.

However, we believe that the present administration prefers to tightly control the program payout and to restrict unconditional grants to provinces wherever possible, notwithstanding the basic purpose of the equalization program. The status quo does serve that purpose well.

At the heart of the present formula is the five-province standard that was adopted in the early 1980s. At that time, the federal government had proposed a standard based on Ontario's capacity. Their main concern was the influence of Alberta's oil and gas revenues on entitlements. Taking Alberta out of the standard was regarded as a necessary step.

Since then, Alberta's fiscal fortunes have soared and fiscal disparities between Alberta and the rest of Canada have increased very significantly. A standard based on a true average of provincial fiscal capacities would clearly improve comparability. Thus, we believe a ten-province standard is needed.

In terms of revenue coverage, the equalization formula only provides the correct result if it encompasses all provincial revenue sources. Clearly, some provinces choose to depend on some revenues more than others. The formula must take the sweep of all revenues into account. It would not be sensible to move to a ten-province standard with less than comprehensive revenue included. The federal government did take steps to reduce revenue coverage in the last renewal, which not only increased fiscal disparities, but also made the formula much more complex.

At present, the ceiling dictates the total level of entitlements to be paid out. Total entitlements are estimated by the Department of Finance and if they exceed the ceiling, then the entitlements for each receiving province are scaled back by the amount of the excess on a per capita basis.

I, along with my Atlantic counterparts, argued with the federal minister that Bill C-18 contradicted the Prime Minister's commitment to premiers in September of 2000 to allow the formula to grow with GDP. It also has lowered the ceiling to an unprecedented degree and at a time when federal surpluses were burgeoning. By dropping the ceiling by over $1 billion per year, the federal government has raised the risk of the ceiling controlling the equalization payout on an ongoing basis.

Notwithstanding denials from the federal finance department that this was likely, their most recent estimates show the ceiling impacting on entitlements for the year 2000-2001 as they had for 1999-2000. Atlantic ministers argued that if the ceiling were not removed, at a minimum it should not be lowered by the $1 billion amount.

There is nothing in the constitutional commitment to suggest there are circumstances whereby the program should be constrained by an artificial dollar limit. The ceiling effectively prevents the program from achieving its fundamental objectives. It is for this reason that it is so disagreeable to us. The ceiling is essentially an add-on to the basic formula.

The floor provision and the special rule for unique resource revenues, the so-called 70/ 30 rule, are also add-ons to the formula. They not only add-on to the complexity of the program but they are, I believe, of questionable value. These add-ons confer a special benefit to the provinces that qualify for them, and that benefit can be to the cost of the less well-off provinces.

Manitoba finance has pointed out on several occasions that the floor provision is unlikely to be triggered by provinces other than those endowed with significant natural resources.

Further, the 70/30 rule is designed specifically for provinces with unique resource endowments. It is not surprising that the major beneficiary of these special additions to the basic formula at the present time is the province of Saskatchewan. By comparison to other receiving provinces, its own source fiscal capacity is high, and its receipt of equalization is volatile, given the volatility of natural resource revenues.

The result of these special provisions is that additional fiscal capacity is provided to such a qualifying province, raising it above the five-province standard that the rest of us have to live with.

For example, in 2000-2001, effective equalization is to raise the fiscal capacity per capita in Saskatchewan to $6,405. For P.E.I., Manitoba and Quebec, it is $6,058. To put this in perspective, this extra equalization for P.E.I. would be worth $48 million, an amount equivalent to the total revenue that we get from gasoline and liquor taxes combined.

A less obvious result of the way that the special provisions work is that provinces such as P.E.I., Manitoba and Quebec, who are unlikely to qualify for the floor provisions, not only are provided a lower fiscal capacity but actually have their entitlements adjusted downwards because somebody else is above the standard.

This is not an academic situation. The latest entitlements indicate that the floor payment for Saskatchewan is $270 million. This amount triggers a ceiling reduction, thus lowering the entitlements for all provinces. This means that the less well-off provinces are compensating the well-off provinces in such a case.

The provinces of Nova Scotia and Newfoundland are similarly conferred an equalization entitlement that is higher than that available to non-resource based provinces through the 70/30 provision. They are given this in light of their offshore revenues. If the offshore royalties accelerate to extremely high levels, as some predict, this provision could raise fiscal capacities per capita in such cases to levels higher than in the province of Ontario. In other words, these provisions allow equalization to raise the fiscal capacity of provinces with offshore royalty revenues to levels substantially higher not only to that of receiving provinces but even to non-receiving provinces. This is surely not an acceptable situation.

We find the application of these special rules bizarre and inequitable. They are a serious distortion of the basis of the equalization program. The program is to equalize fiscal capacity, not distort it. It is our belief that governments that desire special relief from the so-called claw-back effects of the formula should be provided that compensation somewhere else and not through equalization.

If the federal government is determined to keep the ceiling, then the special 70/30 rule and the floor rule should be removed from the calculation. Better still, remove all three: the ceiling, the floor, and the 70/30 rule, and let the program work as it was intended when it was put into the Constitution. This would go a long way to helping the public to understand the program and toward it becoming an equitable program.

I would now like to turn to other issues that have been raised in a more general debate.

First, there is a tax on the formula itself. There appears to be a growing body of ill-informed literature that suggests that the present formula over allocates equalization to receiving provinces and that it should be abandoned in favour of a macro-type of formula based on economic criteria. There are also some who claim that the representative tax system, the present system, is an incentive for receiving provinces to discourage economic development and allow taxes to go too high. Several studies by the C.D. Howe Institute and the Atlantic Institute for Market Studies have been quite pointed on these issues.

We are concerned that these institutes' opinions carry far too much weight, because the overwhelming body of academic literature indicates that the present representative tax system delivers the correct result by estimating actual fiscal disparities that exist.

The formula does this by measuring the shortfall in revenues that each province might have from an array of taxes actually in place. Essentially, it aims to directly compensate each province's inability to raise revenues given what is available to them by comparison to the national norm. Implicit in this approach is that a province's relative fiscal capacity is determined by representative tax practices across Canada, and actual revenues generated.

By contrast, a macro formula would be based on economic criteria such as GDP or personal income and be divorced from actual tax practices. One consequence of this approach is that it ignores choices by governments concerning the adoption of measures such as progressive income tax, sales tax exemptions, exemptions aimed at poorer Canadians and a variety of tax credit schemes to lower the tax burden on low-income people. In addition, such an approach understates the role of resource revenues available to the rich provinces. The result of moving away from this representative tax system would be to severely penalize the poorer provinces, particularly the provinces with few natural resources such as P.E.I.

Those who would claim that the representative tax system acts as a disincentive to economic development have never produced sound evidence of this. In fact, P.E.I. commits a very large part of its budget to economic development.

The main focus of all provinces is on employment and improved standards of living for all its citizens. It would be politically foolish for us to focus on efforts of raising our equalization dependency through discouraging economic advancement. As I noted earlier, we take no joy from our reliance on equalization. I can categorically state that the representative tax system that now exists does not act as a disincentive to economic development.

Another issue concerns complexity. Everyone wants as simple formula. In fact, the heart of the present formula is quite simple. It estimates the revenue that could be generated by each revenue source, using standardized estimators and a provincial average tax rate, and compares that to what could be generated if there was a five-province standard. The equalization entitlement is the sum of the differences from all revenue sources. It is basically an exercise in addition and subtraction.

Where the program is complicated lies in first, the extended number of entitlement estimations involved; second, the statistical manipulations required to identify the revenue bases; and third the add-ons that I previously discussed.

Given the immensity of the task at hand, it is not realistic to believe the program could ever be very simple, though the removal of add-ons would help reduce complexity. Federal decisions concerning the reduction of formula changes on a transitional basis in the last renewal added much complexity to the system. In any given year, three entitlements can change. This both adds to the complexity of the programs and has major implications for budgetary planning.

We have seen major swings in revenues in good times and the reverse in poor times, but I do not know of an acceptable solution to that problem. Some would suggest that the macro approach would simplify the program. Closer investigation, however, shows that it would add a new level of complexity and volatility.

We feel that the representative tax system that now exists must be retained as it provides the basic structure necessary to measure fiscal disparities. Many of the anomalies that the present program produces are the result of add-ons, not the formula.

In summary, the equalization program is an essential part of the public finances of Canada. It has a signal role in leveling the playing field across this country so that all persons and businesses can access reasonably similar services at reasonably similar levels of taxation.

The program is a declining part of the federal fiscal requirements. Its absolute amount will automatically rise and fall with economic conditions. It has not been a burdensome program to the national finances.

The federal government has not enhanced the program for many years. Rather, steps have been taken to reduce the standards by moving to five provinces and gradually lowering the ceiling. Recent federal claims that receiving provinces have somehow been treated favourably are not only misleading, they are insulting to equalization-receiving provinces like P.E.I., who must struggle to maintain provincial services with inadequate funding.

The representative tax system is the basis to the present formula. It can be shown that this formula provides the correct results in terms of estimating fiscal disparities. Suggestions that a macro-type formula is simpler and better should be rejected on both theoretical and practical grounds. Concerns over the alleged disincentive effects are misplaced and unproven. Claims that a macro approach can improve this are not acceptable.

The ceiling is a direct attack on the very goals of this program. The recent federal decision to further lower it by unprecedented amounts is most injurious to the program. The ceiling must go.

The removal of the 70/30 rule and the floor provision should be seriously considered. These add-ons to the basic formula have distorted the program, introduced inequities to the results, and added complexity to the formula. In the context of the ceiling, their impacts are even more inequitable. They should be removed from the ceiling application if it remains.

The standard presently in application is resulting in increasing disparities between Alberta and other provinces. A ten-province standard will allow the formula to more properly reduce fiscal disparities. Finally, the program can only work adequately with comprehensive revenue coverage.

The Chairman: In view of what we heard tonight and what you know to be true from your experience about these significant fluctuations in entitlements do you think it incautious to agree to do away with the floor? Who knows when you may need it.

Ms Mella: The chances of Prince Edward Island's revenue sources getting so high that we it be affected by the floor are very, very remote. I believe that we should be doing away with the floor, the ceiling and the five-province standard. The floor is to the benefit of the province of Saskatchewan, at the present time. The province of Saskatchewan, would not receive the equalization it is receiving if there was not a floor.

We have had very serious fluctuations in equalization over a period of years, one of which we are experiencing as we sit here. We know that is because we have an equalization formula based on the national economy's performance. We have to be able to foresee, just like the federal government has to be able to foresee, when there is a turndown in the economy. When that occurs, there probably will be a slowdown in the revenues that we receive from equalization.

The Chairman: When did you bring in your last budget?

Ms Mella: Last April.

The Chairman: The situation may have changed since then.

Ms Mella: It has.

The Chairman: Are your officials looking at the numbers now? Bank of Canada Governor David Dodge this very day was heard to say publicly that the economy would be anemic right through next year. You will be scaling downward, unless you lowball your numbers, as some ministers of finance have been known to do. You do not, of course, but others do it. You will be scaling down your forecasts in terms of equalization entitlements, will you not?

Ms Mella: That is correct. We have already done that.

The Chairman: Do you know what the order of magnitude of the reduction might be?

Ms Mella: The equalization drop is about $30 million.

The Chairman: You will probably get 30 million less than you forecast last April.

Mr. John Palmer, Director of Economics, Statistics and Federal Fiscal Relations, Government of Prince Edward Island: The floor operates by working between entitlements between years. What we find over the present period is that entitlements have changed over previous years. Entitlements for several years will go up and down at the same time. The floor only affects you if you have one entitlement here going down to entitlement there. If all the entitlements are rising up and down, the floor does not work. It simply provides protection for a large decline from one year to the next. That is been our recent experience within the last couple of weeks. When the entitlements were changed, they were changed for several years at a time.

The way the floor works in the formula, you have to have a very sizeable reduction from one year to the next for it to work at all. It was changed in the last renewal. It is a very significant step to go into the floor.

The Chairman: Will you get $30 million less than you thought you might in equalization payments because the economy has turned out to be less buoyant?

Ms Mella: That is approximately right.

Mr. Palmer: That includes changes to several years. That was my point.

The Chairman: Of course. Yes.

Ms Mella: There are prior-year adjustments.

The Chairman: I understand them too.

Ms Mella: The bottom line is, it is about $30 million less than what we had put in the budget.

The Chairman: We always like those prior-year adjustments, especially when they work to our advantage.

Ms Mella: This week I went to the public and told them what are situation is. We have second-quarter results now. I said that the combined effect of a declining economy, prior-year adjustments, which nobody understands but us, I guess, and the circumstances since September 11, have led to a reduction in equalization for this particular fiscal year of about $30 million. We will be trying to find a significant part of it on our return home.

Senator Bolduc: Do you think that having no floor would be inequitable for Saskatchewan because it might have a sudden fall in agriculture prices? Saskatchewan is probably more sensitive to agricultural international trade than the other provinces.

Ms Mella: That is a pretty sensitive topic in my province. Last year we got hit with something called the potato wart.

Senator Bolduc: It is not the same type of thing.

Ms Mella: Proportionately it is. Agriculture is our biggest single source of revenue. Not in terms of dollars leaving the province, but proportionately, agriculture is the biggest single industry in the province.

Senator Bolduc: I know you had some difficulties with the U.S. but they amounted to a three-month conflict that was resolved. This is not the case with Saskatchewan.

The Chairman: Saskatchewan's problem is world prices for wheat and so forth.

Senator Bolduc: Would it not be inequitable to get rid of the floor?

Ms Mella: I do not think so.

Senator Bolduc: Even for Saskatchewan?

Ms Mella: Even for Saskatchewan. We all have very serious fluctuations in the market prices of all kinds of commodities, some for two years, some for five years, some for three months.

Senator Bolduc: Even though you are a smaller province, you still have the stabilization program. You have a very important tourism industry in your province. You have good agricultural economy. In Saskatchewan, however, it is a different type of agricultural economy.

Ms Mella: Well, I am not here to argue against Saskatchewan.

The Chairman: Your premier is a native of that province, as I recall.

Ms Mella: Yes, he is. We are proud of him and of that.

A lot of people in this country do not really understand that equalization is not about economic development.It is about fiscal disparities.

Equalization was put in the Constitution to ensure that a person living in Summerside, Prince Edward Island, would receive comparable education and comparable healthcare to a person living in Toronto or Regina. It was not about the person on Prince Edward Island having a job. It was not about us having economic development initiatives. It was about basic Canadian services that all Canadians believe they are entitled to. If that were not the case, everyone would be moving to Toronto, or to Alberta, or to wherever the jobs are.

The people moving would be ignorant, because would not be educated. What we do in Prince Edward Island is spend 21 years educating people then those people go to the other provinces and produce for 25 years. Then, because they love P.E.I. so much, they return to Prince Edward Island for the last 20 years. The province gets them at the bottom end where they are expensive and at the end when they are close to death, when they are also expensive, and the other provinces get them in between.

Senator Bolduc: What you say is a little unfair. If the quality of life were not so high, those people would not return. It is a matter of distribution, really.

The Chairman: Madame Minister, do I gather correctly that Prince Edward Island does not support Nova Scotia and Newfoundland in their efforts to have non-renewable resources removed from the formula?

Ms Mella: Absolutely not. If Nova Scotia and Newfoundland want to negotiate with Ottawa on some kind of a deal where they can get compensation so that they can spend resource money for development or whatever, more power to them. However, the whole idea of equalization is simply that if you generate your own revenue, you are not going to get both. The whole idea is, if you can generate revenues within your province, every dollar you generate, you lose a dollar in equalization. That is the point of equalization.

We have on Prince Edward Island a significant aerospace industry. For every dollar that we make in our own revenues through aerospace, we lose one full dollar in equalization. If we make a dollar, we lose a dollar.

That is what equalization is. As your own revenues grow, you lose equalization and you are less dependent on this program. You are more self-sufficient. That is exactly what has been happening on P.E.I., contrary to what people will say about this being a disincentive. What government in their right mind would take office and work to keep the economy from developing so they could get a cheque from Ottawa in equalization? I have not met anybody who is that distorted. Obviously, we are all looking to develop the economies of our provinces. What is good for Nova Scotia is good for us and vice versa. So we are all into developing our economies. Equalization is not about economic development.

Mr. Sean Murphy, the M.P. from half my district, anyway, is chairing an economic initiative for the Atlantic region. I have a great fear that somebody will come along and say: This would be a great replacement for equalization. Let us just divvy up a whole lot of money for economic development and let them be. That reflects a poor understanding of equalization.

Equalization is about providing essential services to Canadians that would be somewhat similar across the country. You do not have to die at 60 if the average age in the country is 80. It is not about economic development. I think a lot of people have misconstrued that on many occasions.

The Chairman: In that respect, Senator Bolduc has a point. The quality of life has improved very considerably and not just in Prince Edward Island. Perhaps it did not need to improve there, as it is always been pretty good. However, in other parts of Atlantic Canada the equalization program and other stabilizers have had a beneficial effect on the quality of life.

Ms Mella: Are you referring to equalization?

The Chairman: I am referring to equalizations and other federal programs.

Ms Mella: There is no question about it. That is why we argue that the formula should be left as is.

The Chairman: There is no place in Atlantic Canada where the life expectancy is 60 years, for example.

Ms Mella: No, there is not. I was just using it as an example of services. If the access to services for health, for example, is at a certain level across the country, it should not be any less in P.E.I. or in Nova Scotia or in Newfoundland or in Manitoba. It should be comparable.

The Chairman: Will you take the same, principled position about revenues from non-renewable resources if, as expected, you start making a lot of money from the hydrocarbon potential in the St. Lawrence basin?

I will read to you, as I read to your friend Mr. Peter Mesheau from New Brunswick the other day, a couple of sentences from the paper by Mr. Boessenkool:

As already noted, New Brunswick, Prince Edward Island, and parts of Quebec fall within the St. Lawrence basin, which experts believe has major hydrocarbon potential. These provinces are already talking about trying to obtain offshore equalization regimes like those of Newfoundland and Nova Scotia. My proposal, which was to take non-renewable resources out, would guarantee a better deal automatically.

Would you take the same principled position if you started making a lot of money?

Ms Mella: I do not know where that information came from. I have never heard my premier or myself or anybody in my government ever taking that position. We do have some on-land drilling going on right now.

The reality is that 100 per cent of the royalties from these resources go to those provinces. Hence we are talking about 130 per cent, not 30.

My argument would still be if we are fortune enough that we discover gas or oil or something else that would be a lucrative natural resource, I think common sense dictates that if we can get revenue through our own sources, we are not entitled to it twice.

That is what equalization is about. If we can work out a deal with the federal government in terms of divvying up the money coming from the resource, we could do that. That is up to provinces to negotiate. In my mind, however, it is contrary to what equalization is, which is an equal fiscal capacity.

Someone may suggest that the oil is going to run out or the gas is going to run out and therefore it is different from potatoes. At the present time we have 110,000 acres of potatoes. That is probably not sustainable. We only have about 300,000 acres of available land. In addition, a three-year rotation is required for potatoes to grow. So we do not know whether or not that is a renewable resource. It is only renewable if we look after the land.

The same thing goes for fish. Is fish a renewable resource? It is not if you are talking about cod or certain other fish. Who knows what resources are renewable? We cannot predict what they are. Once you get into that kind of philosophical discussion, however, the equalization discussion is all over the map.

Senator De Bané: Madam, did I hear you say that equalization has nothing to do with economic development, but has more to do with helping people to afford basic public services. This is the reason why André Raynault, a former president of the Economic Council Of Canada wrote an essay the main theme of which was that equalization has a perverse effect of creating dependency.

However, I do not think we will agree on that.

Would you please tell me the size of the economy of P.E.I.?

Ms Mella: It is $3 billion

The Chairman: That is GNP.

Senator De Bané: What is the size of the provincial budget?

Ms Mella: It is $880 million.

Senator De Bané: What would be, in your opinion, the approximate total aggregate of the federal government in P.E.I.?

Ms Mella: Do you mean the total transfers?

Senator De Bané: Yes. Whether it is EI or the public servant wages at Veteran Affairs, I am asking about all federal government transfers or outlays to the province.

Ms Mella: I really do not know the answer to that. I know what we receive in equalization payments and CHST, but I do not know what the income is from federal employees.

Senator De Bané: You cannot include equalization because it would be double-counting.

My assessment is that the public sector, which is the provincial government and the federal outlays in P.E.I. must exceed 50 per cent of the size of the economy of that province. Would you agree with that?

Mr. Palmer: I don't think so.

Ms Mella: No. Probably they would exceed 38 or 35 per cent.

Senator De Bané: The provincial government budget is a third of that province. Eight hundred and eighty million of $3 billion is almost a third of the size of the economy. Those are public expenditures made by the provincial government. I submit if you add to that the federal expenditures in that province, you reach the size of the public sector in P.E.I. that is not far from 50 per cent.

When I look to the different census divisions of P.E.I., compared to the one of Cape Breton or Newfoundland, most of the census divisions in Newfoundland, despite those substantial reductions you have correctly identified, the per capita income in the different census divisions in P.E.I. are still higher than what you have either in Cape Breton, most of the census divisions in Newfoundland, the lower St. Lawrence north shore, and so on.

It was not surprising that when your government and the federal government proposed to build a bridge to link that province to New Brunswick, there was some opposition to it by a substantial minority. Did everyone want a bridge to allow the people of P.E.I. to be part of North America? Many people said, no that would endanger our way of life and would have negative effects on our style of living. Economic development should give way to that.

I have to confess to you that it troubled me a lot.

Ms Mella: The numbers are not correct. The first challenge was to convince people that it was an engineering possibility. Many people thought that it could not be done because of tides and the depth, the fish, the ice and other factors. They just felt it was not like building a bridge elsewhere. However, once people realized that it was technologically possible, the percentage of support for the bridge was around 75 per cent.

Every province has its tree-huggers and has people who would rather not be concerned about revenue growth. They are concerned about keeping things as they are. I am old enough to feel that the old times were not the best of times. I think people are much better off now than they were when my mother was around and I have no desire to go back to those good old days. However, there were some treasured things about the old days that people liked to hold on to. They do not want to be in traffic. They do not want fast food. They like to be able to walk in the yard and see a bird instead of hearing a truck. A certain percentage of the population in every province just does not want to change, but I do not think that Islanders are unlike anyone else.

The Chairman: Are you still refusing to import nuclear power from New Brunswick?

Ms Mella: No.

The Chairman: It was the case one time.

Senator Bolduc: I think we got the message.

The Chairman: If there are no further questions, I will thank the minister and Mr. Palmer for coming tonight. This has been extremely entertaining. We have had now three of the governments in Atlantic Canada before us. We will be hearing from Nova Scotia in due course and, I believe, from Manitoba.

Ms Mella: Did we all bring you the same message?

The Chairman: No. Not quite.

Senator Bolduc: That is our problem.

The Chairman: We thank you very much.

The committee adjourned.