Revenue from non-renewable natural resources should be exempted from equalization formula says new MLI study.
OTTAWA, April 4, 2013 – Canada's equalization program suffers from widespread misunderstanding about the shared benefits of resource wealth, and encourages provinces to spend foolishly, says a new study by the Macdonald-Laurier Institute released today.
The first misconception is the mistaken belief that only a province, such as Alberta, reaps all the revenues generated by natural resource extraction.
The second is that royalties paid to the provincial government from non-renewable natural resources are a source of government income analogous to sales tax or income tax receipts.
Both views are incorrect, and contribute to the "perverse incentives" provincial governments have to recklessly spend the windfall as quickly as possible, argue the authors, Brian Lee Crowley and Bob Murphy in their report titled "Equalization Reform: Promoting Equity and Wise Stewardship", which calls for changes to the treatment of non-renewable natural resource royalty revenues in the equalization program.
The transfer program, which comes up for renewal in 2014, implicitly aims to address fiscal disparities among provinces through transfer payments to those with below-average tax bases. The equalization formula measures each province's ability to raise revenue and then makes a compensatory transfer to provinces that fall below the average.
The formula considers a province's capacity to raise revenues from more than two dozen tax and resource bases, largely consisting of personal income taxes, business income taxes, consumption taxes and property taxes.
It also counts up to 50 percent of "natural resource" revenues as income, treating them like income tax or sales tax receipts.
Currently, "natural resources" includes non-renewable resources. This violates the spirit of the equalization program and creates perverse incentives to provincial governments to spend rather than save their revenues, the authors say.
But an immediate concern if non-renewable resource revenues were removed from a province's fiscal capacity is whether this would confer an unfair advantage on resource-rich provinces such as Alberta. After all, the province receives substantial royalty payments in exchange for allowing companies to exploit its natural endowments.
However, the authors say that between a third and up to nearly half of total government revenues from natural resources already accrue to the federal government through various federal taxes alone.
"Altering the status of non-renewable resources in the equalization formula will not exclude this revenue from the federal tax base," the authors maintain.
They suggest that the correct reason to exclude non-renewable natural resource revenues lies in a better understanding the difference between a province's income and its revenue. The equalization formula is intended to balance provincial incomes, not revenues.
"From an accounting perspective, nonrenewable natural resource revenues are not income at all. They are the transformation of one type of asset into another," they said.
"Again using Alberta as an example, the royalty revenue derived from selling a barrel of oil ought not to be seen as the creation of new income, but rather the conversion of an existing asset (the oil) into another type of asset (cash).
"When these revenues are included in a province's fiscal capacity, the formula overstates the income of resource rich provinces and creates an incentive immediately to spend rather than to invest the revenue. In other words, the system encourages provinces to treat their assets as if they were income."
The authors suggest an ideal equalization formula would completely exempt provincial non-renewable resource royalties from the equalization formula if provincial governments use the money for a sustainable, long-term flow of income for their residents rather than spending on current services.
For example, a province might use resource royalties to pay down outstanding debt, allowing it to lower taxes or allocate other tax receipts to provide services (rather than servicing the debt), the study said.
Another possibility is for a province like Alberta to invest its royalties in a "heritage fund," effectively transforming its wealth from a narrow base of physical assets (such as oil sands) into a diversified collection of financial assets.
Although contributions to such a heritage fund would not be included in the equalization formula, the dividend or interest income such a fund generated could finance a perpetual flow of government services. Therefore, it would be included in the calculation of a province's fiscal capacity.
"These proposed changes to the treatment of nonrenewable natural resource royalty revenues more closely reflect the spirit of the equalization program," the authors said.
"Our suggested framework would also help provincial governments avoid excessive reliance on volatile resource revenues. As investment in Canadian natural resources grows and generates more profit, it is vital that each province use the revenues to ensure long-term prosperity."
Windfall royalties would still benefit the province's current generation, but only because a larger heritage fund (or smaller debt) would yield higher net investment earnings in subsequent periods, they suggest.
"The volatility in oil prices would translate into volatile contributions to the heritage fund (or debt repayments), not into volatile government spending on programs."
Brian Lee Crowley (twitter.com/brianleecrowley) is managing director of the Macdonald-Laurier Institute, an independent non-partisan public policy think tank in Ottawa.
Robert P. Murphy is Senior Economist for the Institute for Energy Research and, along with Brian Lee Crowley and Niels Veldhuis, is the co-author of Northern Light: Lessons for America from Canada's Fiscal Fix.
The Macdonald-Laurier Institute is the only non-partisan, independent national public policy think tank in Ottawa focusing on the full range of issues that fall under the jurisdiction of the federal government.
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