Saturday, August 25, 2012

Explaining Equalization

Aside from the occasional careless rants, unbeknownst to most Canadians is the federal Equalization program which has been described as either a wealth-sharing scheme, the glue that holds the federation together, or a fraudulent scam. This program is worth $15 billion in 2012 alone, which, for perspective, is the total income for 450,000 average Canadians. And yet, nobody really understands what it is really for. People have tried to explain it using the legalese of the Canadian Constitution or using even more confusing economic theories. Well, to make it simple, I argue that the main purpose of Equalization is to make sure that Canadians are treated the same wherever they reside in this country.

Government redistributes wealth. It's accepted that the wealthy must pay more into the system than they receive in return. The poor, with greater need, should be provided with greater benefit. This redistribution has become one of the principle pillars of our society. Equalization is just another mechanism to aid in this redistribution.

Imagine there is only one government in Canada. Here, there are three rich people and three poorer people living in separate areas of the country. Each rich person shares a portion of their wealth with the poorer person. The burden for the rich is the same, regardless of where they reside and so is the benefit for the poor.

After the redistribution, each wealthy person is equally worse off and each poorer person is equally better off. Well, what happens when you erect borders between these areas? In the following example, there would be two rich people in oil-rich Alberta. Both are transferring to one poorer person. While in the other part of the country, there is two poorer people for the one rich person.

In effect, either the rich in Alberta each have to pay a bit less to help the poor or the poor is tremendously better off compared to his situation in a one government country. Conversely, the rich in Quebec has to pay a lot more compared to the previous example or the poor, having to share the wealth of only one rich person, is worse off. 

Either way, this demonstrates that people are treated differently depending on where they live despite living in one country. This is because provincial borders put barriers around redistribution of wealth – a principle we accepted earlier. 

Equalization addresses this by moving wealth from the rich in one part of the country to the poor in another part of the country. The fact that there are more rich people living in one part of the country and more poor people in another means that, if you are looking at this from a provincial perspective, there would be more money transferred to some provinces than others. The program exists as an extension of the federal tax and transfer system to ensure that people are treated fairly wherever they reside. A poorer person, whether they live in Quebec, Alberta, Ontario or another other part of the country would be treated the same by government.

So, in this spirit, we should stop viewing recipients of Equalization as have and have-nots, or see the situation as subsidizing Quebec or the East, but rather view Equalization for what it really is - a program that ensures that the wealthy equally pays into the system and that the poor receives equally the support that they need, regardless of where people reside. This is not a program that subsidizes Quebecers or Ontarians or Maritimers, but rather a program that helps Canadians.

Note: Before people jump on it, I'd like to admit that this is a rather simplistic explanation. There are other equity, efficiency and effectiveness arguments for and against the program that I abstracted from in writing this post because, quite simply, I didn't want to blow your mind.

Sunday, August 19, 2012

"C'est faux!"

"C'est faux Monsieur Charest!"

I've stopped trying to understand Quebec politics a long time ago. In fact, that applies to all politics. It's too subjective. It's too irrational. But, most of all, too misinformed.

Of separation, I fear the toxicity of the political issues; don't understand the legal issues; and dismiss them both as either circular or non-relevant. So, I will default to the economic issues which brings me more mental comfort.

The Quebec question has shaped this country beyond all others - affecting the social policies of Canada, our relationships with the rest of the world and the financial flows of the federation.

In many ways, Quebec has defined Canada's fiscal federalism marked by a uniquely decentralized federal government and, yet, with quite large financial flows. Since time immemorial, Quebec has been the main beneficiary of the federation. Focusing on 2009, Quebecers paid $40 billion in federal taxes and received $53 billion in federal spending (either directly on services, or transferred to individuals or the Province). This means that $14 billion was redistributed to Quebec from the rest of Canada (Figure 1).

Figure 1: Federal Financial Flows, 2009

Source: Table 384-0004, Statistics Canada

Fourteen billion dollars. I find that when numbers become larger than what's in my bank account, I lose sight of their significance. So what does this $14 billion mean? To provide a relevant example, it means that had Quebec separated, Quebecers would have paid $40 billion less in taxes in 2009. But they would have received $53 billion less in services and transfers (yes, the numbers don't add, blame rounding). So the difference is the gap, or 
  • the amount of additional taxes that they would have needed to pay to maintain current services, or 
  • the reduction in spending they would have needed to make to maintain current taxes, or 
  • the sustained increase in the deficit that they would have needed to swallow, or
  • some combination.
Well, in addition to planning tax increases in the upcoming years, Quebec already has some of the highest tax rates in Canada (and North America). Also, the competition is becoming meaner. One has to question why so many corporate HQs are leaving Quebec rather than sulking in the fact that they are. Can Quebec increase taxes even more? Yes but at a price.

Figure 2: Quebec's Tax Rates are Already the Most Progressive in Canada

Source: Canada Revenue Agency

Fourteen billion dollars isn't easy to come across on the spending side either. $14 billion is basically what Quebec is spending on education, recreation and sport in 2012-13. It's more than three times what Quebec is spending on debt servicing. And, most interestingly, it's almost half of what Quebec is spending on health and social services.

Source: 2012 Quebec Budget

Now this one is I hope a no brainer for everybody like it was for me. Quebec is projecting a balanced budget in 2013-14, which is better than some select Canadian governments. Swallowing an extra $14 billion will blow that target right out of the water - to the multiple of three. It would turn a deficit that is seemingly cyclical to one that's structural and unsustainable. 

Source: 2012 Quebec Budget

Already the most indebted province in Canada, Quebec's debt-to-GDP would certainly grow (likely grow by around 4 percentage points a year). But, the Province gets hit with a double whammy because it must take up its share of the federal budget. Other people have thrown the number 100 per cent debt-to-GDP out there, which would make Quebec one of the most indebted country in the world and growing increasingly worse.

No doubt that a fully sovereign Quebec government would redirect what was originally spent by the federal government to match Quebercers' local preferences. But a lot of what the federal government spent was just transfers to the provincial government and to people. No savings there. Quebec would likely have a military, a central bank, agricultural offices and foreign assemblies (all of these services would lack the same economies of scale by the way). So, again, little savings there. I would argue that soveriegnty would have cost Quebecers more.

But the financial impact that sovereigntists say would materialize isn't a cost but a benefit. So the real comparator to analyzing sovereigntists' arguments is not the status quo but what sovereigntists argue would be the financial benefit. Now THAT gap, between how much it would cost Quebecers for sovereignty and the financial benefit that sovereigntists suggests, is the magnitude of misinformation. And this is why, with politics in Quebec and elsewhere, I've given up on trying to understand.

Note: Despite the primacy of the economic argument here, I don't think that the political and social reasons for separation are trivial. I just think that when you are making a choice, you have to know what the costs are. Elections are marked by catchy slogans. And politics driven by logic and facts that fit within a 120 letter tweet, a cardboard sign or a 30-second TV commercial always end with regret during the hangover. That's why I focus on economics - because they don't make sense to most people, therefore often overlooked and become unexpected consequences.

Note 2: Ok, so last update here. It seems that I might have given the impression that Quebec is the sick man of Canada. It's actually not. Am I suggesting that the $14 billion dollars that flows to Quebec is not a lot of money? Well... relatively, yes. Remember that Quebec does have 8 million people living in that province and so when you look at the financial flows of the federation no a per person level, Quebec's $14 billion doesn't seem that large at all. In fact, among the provinces, PEI, Nova Scotia and the rest of the Atlantic provinces receives the most in the federation. You don't even know what people in the territories receive (some are $20,000+). Lastly, keep in mind that a lot of this dynamic is not explained by political deals or some type of targeted favours but rather by how government works. Quite simply, the rich subsidizes the poor. And in some provinces, there are more poorer Canadians, which explains these differences in net contributions and net benefits.