APEC assessment of Budget 2007 and Equalization

From the Atlantic Provinces Economic Council:

June 13, 2007

APEC releases study on the Equalization Options of Budget 2007 for the Atlantic Provinces

APEC is today releasing a new report on the implications of the proposed changes to the Equalization program for the four Atlantic provinces. The report entitled Assessing the Equalization Options of Budget 2007 for the Atlantic Provinces has been prepared by Professor Paul Hobson of Acadia University and Professor Wade Locke of Memorial University, both Senior Policy Advisors of APEC.

Following on the recommendations of the Expert Panel on Equalization, the new Equalization program includes the re-establishment of a ten province standard, simplified measures of fiscal capacity and a more predictable and stable payment system that is formula driven. The new program also reverses a pre-election commitment to exclude natural resource revenues, and includes 50% of these revenues.

The study provides estimates of the revenue flows to the four provinces under the current program (Fixed Framework) and the new Equalization program for each fiscal year from 2007-2008 to 2019-2020, the year in which the Nova Scotia and Newfoundland and Labrador Offshore Accords expire. These simulations utilize publicly available data projected forward, based on certain key assumptions. In particular, it is assumed that the aggregate of the fiscal equalization payments under the Fixed Framework will grow at an annual rate of 3.5% (as currently specified by legislation) and that non-oil and gas fiscal capacities for all provinces grow at an annual rate of 1.4% (the aggregate rate of growth of per-capita fiscal capacity in Canada over the last ten years). In addition, the simulations take into account changes to the Fiscal Arrangements Act, and to Offshore Accord legislation as detailed in the Budget Implementation Act (Bill C-52).

The Atlantic Accord, signed in 1985, and the Canada-Nova Scotia Offshore Petroleum Resources Accord, signed in 1986, gave Newfoundland and Labrador and Nova Scotia, respectively, the right to collect royalties and to levy taxes on offshore operations as if the resources were on provincial land. In addition, the Accords provide Equalization offset provisions to compensate for potential reductions in Equalization payments as these additional revenues come on stream. The 2005 Nova Scotia and Newfoundland and Labrador Additional Fiscal Equalization Offset Payments Act provided for additional Equalization offset payments to Nova Scotia and Newfoundland and Labrador to ensure that each province would receive 100 percent of the benefit of its offshore revenues. That is, offset payments would ensure no claw back of offshore revenues through Equalization.

The summary revenue implications for each of the four Atlantic provinces are provided in the table below. Nova Scotia, New Brunswick and Prince Edward Island are better off financially under the new Equalization program for two years and thereafter are disadvantaged by the revised Equalization program. Newfoundland and Labrador is immediately worse off under the new program.

Specifically, the impacts on the provincial treasuries are:

o Nova Scotia - $159 million increase in revenues for the first two years under the new Equalization program, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $1.4 billion less under the new Equalization program than under the Fixed Framework;
o New Brunswick - $68 million increase in revenues for the first two years under the new Equalization program, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $1.1 billion less under the new Equalization program than under the Fixed Framework;
o Prince Edward Island - $7 million increase in revenues for the first two years under the new Equalization program, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $196 million less under the new Equalization program than under the Fixed Framework;
o Newfoundland and Labrador - $654 million reduction in revenues for the first two years under the new Equalization program, an increase of $22 million in the third year, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $1.4 billion less under the new Equalization program than under the Fixed Framework. It should be noted that Newfoundland and Labrador will no longer be a recipient of Equalization after 2008-2009, under both the Fixed Framework and the new Equalization program. [Emphasis added]

Beyond 2007-2008, both Nova Scotia and Newfoundland and Labrador can choose to permanently opt into the new Equalization program or remain under the Fixed Framework. The results clearly indicate that both provinces should remain under the Fixed Framework. Since other provinces were not offered this choice, this would result in an unprecedented situation in which two distinct Equalization programs are operating simultaneously, a situation which is not likely to be sustainable.

Furthermore, Equalization payments under the new program are constrained by a fiscal capacity cap. For purposes of the cap, fiscal capacity is measured, on a per-capita basis, as the sum of non-resource fiscal capacity, one hundred percent resource fiscal capacity, (pre-cap) Equalization entitlements and payments under the Accord legislation (applicable only to Nova Scotia and Newfoundland and Labrador). Total fiscal capacity of a receiving province cannot rise above that of the lowest non-receiving province. Should it do so, Equalization payments are to be reduced accordingly.

The Budget Implementation Bill contains significant changes to the 1985 Atlantic Accord, and to the 2005 Nova Scotia and Newfoundland and Labrador Additional Fiscal Equalization Offset Payments Act, necessitated by the introduction of the new Equalization program. The protection provided by the Accords is undermined by any Equalization reductions caused by the fiscal capacity cap, since any reductions amount to claw backs of Accord payments. In the authors’ view, this violates both the letter and the spirit of the Accords. [Emphasis added]

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The Atlantic Provinces Economic Council is an independent, non-profit research and public policy organization that seeks to advance the economic development of the Atlantic region.

-srbp-

Equalization cold war heats up

The coming battle between the federal government and the provinces over federal transfers and the battle among the provinces over federal-provincial finances started to heat up over the past couple of weeks.

The heat came from comments by federal intergovernmental affairs minister Michael Chong and federal finance minister Jim Flaherty that the offshore deals since in 2005 have wrecked Equalization, the major federal transfer to provincial governments.

Such is the sensitivity of the issue that last Friday, Flaherty issued a statement, reported in Saturday's Telegram, that

“"[m]edia reports suggest that the government is considering scrapping the offshore agreements reached last year with Nova Scotia and Newfoundland and Labrador....

"“This is both factually incorrect and misleading. During a brief media availability today in Toronto, I made no mention of Nova Scotia or Newfoundland and Labrador by name nor did I use the words oil and gas."”

The Equalization Top-Up

Equalization is a pretty simple concept: in order to make sure that provincial governments have similar levels of revenue with which to provide key services, the federal government transfers some of its revenues to each qualifying provincial government based on a formula.

As the Bond Papers put it in January 2005:

Basically, Equalization is like a wage top-up scheme for provinces. The federal government figures out a national average amount of revenue each province should get per person. Fall below the average and the province gets a cheque from Ottawa. Meet or exceed the average and you get nothing. No province pays into the program; the money comes from federal government revenues. As it stands right now, Alberta and Ontario make more than the national average and get no Equalization. Saskatchewan will join them in the "have" category, as some call it, within the next year. All the other provinces get some amount of Equalization. Quebec gets as much as all the others combined because the money is paid out based on population.

In 1957, when the program started provinces were topped-up to the average of the top three provinces. Alberta received Equalization until 1964, but once its income went above the average it didn't get a penny in Equalization. In 1967, the average was based on all 10 provinces and since 1982 it has been based on five selected.

The January 2005 Deals

The offshore deals signed by the Mulroney administration with both Nova Scotia and Newfoundland and Labrador contained sections that allowed both provinces to collect a special federal transfer based on growth in provincial government revenue from offshore oil and gas development. For a period of 12 years, both provinces could collect a declining payment called an Equalization offset that was designed to protect the provinces from dramatic declines in Equalization as offshore revenues grew.

Several administrations Newfoundland and Labrador sought to amend the offset provisions of the 1985 Atlantic Accord to extend the offset benefits over a greater period of time or, as in the case of the original Williams proposal in January 2004 to effectively hide all oil and gas revenue from Equalization in perpetuity.

Both in the original Accord discussions and for each subsequent federal administration, one of the major concerns was addressing demands from the two Atlantic provinces without undermining the basic principles on which Equalization operated. The solution in 1985 was the declining offsets, which were temporary.

In January 2005, the solution was to link the added offsets to Equalization entitlement: if a province no longer qualified for Equalization, then it also no longer qualified for the added offset. While Equalization can be spent by a provincial government on any public purpose, the Martin-Williams deal indirectly linked continued offsets to improve long-term economic benefits for the province, particularly to debt reduction.

It's about Ontario

At the root of the Chong and Flaherty comments are fundamental misunderstandings about the January 2005 offshore deals that have been prevalent since at least February 2005. In a perverse way, both supporters of the Williams-Martin deal and its detractors have the same fundamental misunderstanding of the deals.

But more importantly, both Chong and Flaherty reflect the sensitivity in Ottawa these days to Ontario's concerns about federal transfer payments to the provinces. Ontario has been campaigning for some time about the unfairness of the current system and Ontario Premier Dalton McGuinty's comments last winter were just part of that.

Flaherty's speech last Thursday was in Whitby, just east of Toronto and he made it a point to remind people that he used to be the Ontario treasurer:

"I acknowledge the spending pressures on the provinces. I was here," said Flaherty, who was Ontario's finance minister under former premier Mike Harris from 2001 to 2002. [Emphasis added]

Ontario concerns still there; plus Quebec and more

In that context, Ontario is no more inclined to accept the Stephen Harper proposal for Equalization changes than there were to accept the January 2005 offshore deals.

After all, both talk about hiding certain types of income from Equalization and serve, after a fashion, as a distortion of how provincial government income is calculated. The Harper proposals - which would remove all non-renewable resource revenues from the Equalization formula -
would see some provinces lose Equalization entitlements while others would benefit greatly.

But fundamentally, the Ontario concern would remain. Simply put, Ontario is concerned that the overall impact of federal transfer programs has created a situation where Ontario is being shortchanged. That's the point that, fundamentally, Flaherty was agreeing with when he sympathized with Ontario's supposed plight.

The Harper proposals adversely affect more provinces than Ontario, however. Any province which does not derive a significant chunk of its revenue from non-renewables would be at a disadvantage under the Harper changes. While some, like Saskatchewan, would benefit greatly, others, including Quebec would see a decline in their transfers.

In the end, it may well be the political costs of introducing the Harper changes that may scuttle them or at least delay their implementation. After all, changes to Equalization require unanimous consent of all provinces. With the Conservative guarantee that no province will be adversely affected by the changes, in order to move forward, Stephen Harper and his finance minister Jim Flaherty might have to put in place offset arrangements for almost half the provinces in the country.

Ultimately, that would make a mockery of the idea of keeping the fundamental Equalization program intact and treating all provinces equitably, while recognizing special circumstances. Those special circumstances were recognized in the offshore deals in 1985 and 2005 but they were limited to two provinces.

The Newfoundland and Labrador Impact

For Newfoundland and Labrador, there is little chance the offshore Equalization deals will be scuttled. No federal administration would repudiate a legitimate agreement between Ottawa and one or more of the provinces. However, all other things considered, no additional offsets will probably flow this year and for the next four or five years under the 2005 agreement since Newfoundland and Labrador will likely no longer qualify for Equalization.

That said, the looming federal-provincial fracas over Equalization could lead to some tense moments and an uncertain future for the province's share of federal transfers, in general.

Missing from the local discussion has been an understanding of what the provincial government is actually seeking. As noted at the Bond Papers a month ago, Danny Williams' proposal for Equalization reform fits with the way Equalization has operated for most of the past 40 years. It would also give full effect to the Atlantic Accord 1985 and its 2005 supplement. That is fundamentally at odds with the position supported by Loyola Sullivan - the Harper plan - which will take some time to negotiate and may never be put in place as currently proposed.

Add those considerations to the statements coming from federal minister Chong and Flaherty and one cannot say for certain how Ottawa proposes to address concerns from all provincial governments about federal transfers to the provinces.

Given Flaherty and Chong's evident distaste for the local offshore deals and their sympathy for Ontario's arguments, it also isn't clear how the new Harper administration will account for deals that have been blamed for destroying the Equalization program.

Danny Williams may well have to fight to keep the deals from being factored in to discussions on the so-called fiscal imbalance that will consider more than just Equalization.

The looming Equalization War, that has been in a sitzkreig stage since the election, is heating up.

Equalization: the Experts Report; Williams reacts

Some months ago, we predicted a war among the province's over Equalization reform.

There have been some skirmishes as the forces gathered, most notably Ralph Klein's ludicrous claim that if Ottawa touched Alberta's natural resource revenues, then Alberta would leave the Equalization program. The only thing this bluster demonstrated was that Klein has no idea how Equalization works.

A few more shots were fired Monday with the release of the report by the Expert Panel on Equalization and Territorial Financing. Premier Danny Williams doesn't like the report at all, claiming Newfoundland and Labrador would lose $200 million annually in Equalization payments.

In an effort to discredit the report before Newfoundlanders and Labradorians had a chance to read it, Williams described the report as having "Ralph Goodale's fingerprints all over it". He called the report nonsense, and true to form, some commentators are backing Williams with nothing more than Williams condemnation.

Still, Williams insisted he was confident that Prime Minister Stephen Harper would do the right thing and not implement the report. He gave no reasons to justify his optimism.

The panel on Equalization and Territorial financing, appointed in 2005, comprised five experts in federal provincial fiscal relations. It was chaired by Al O'Brien, the former deputy finance minister in Alberta and included Fred Gorbet (Strategy Solutions), Robert Lacroix (CIRANO), Elizabeth Parr-Johnson (Parr Johnson Consultants) and Mike Percy (U of A Business School).

Their report is a comprehensive survey of the current issues in Equalization and includes recommendations based on almost two years of consultations. There is a simple description of the Equalization system itself and the basic objectives of the program. If nothing else, the comprehensive nature of the report reflects the considerable abilities and varied perspectives of the five panelists who authored it.

The Government of Newfoundland and Labrador did not make a submission to the panel during its consultations. New Brunswick and Saskatchewan did.

In the section on resources, the panel recommended two things in particular that are of interest to Newfoundland and Labrador.

First, the panel recommended using actual revenues to calculate entitlements, as opposed to the current estimating system. This creates a problem since it penalizes provinces who actually collect royalties below the national average and rewards those provinces taxing above the average.

Second, the panel recommended shielding half of resource revenues from the calculations, irrespective of whether those resources are renewable (like hydro power) or non-renewable (such as oil and gas). This was felt to be an acceptable compromise between total inclusion which was seen as not giving provinces benefit of the resource development and the unfairness of full exclusion which would create a situation in which some provinces had considerable revenues that were not being taken into consideration when calculating entitlements.

There are two specific sections of the report that will affect Newfoundland and Labrador. First, the panel recommends the inclusion of all resource revenues (renewable and non-renewable). There is also a specific recommendation on hydroelectric revenues which would collapse the existing approach into one using the actual revenues. The rationale is excerpted below.

13. All resource revenues should be treated in the same way.

The Panel sees no reason to distinguish between different types of resource revenues. Therefore, the treatment of all resource revenues should be the same whether those revenues arise from oil and gas, onshore or offshore resources, forestry, potash, other minerals, or hydroelectricity.

The measurement of fiscal capacity related to hydroelectricity deserves special mention. In most cases, provinces with substantial hydroelectricity resources have chosen to develop and distribute those resources through Crown corporations. For the most part, provinces have also chosen to provide electricity to their residents at low prices rather than charge full prices. Instead of capturing economic rent and generating government revenues, they give their residents the direct benefit of lower-priced electricity.

Under the current [Representative Tax System] RTS approach, a portion of provincial revenues from hydroelectricity is counted in one tax base (the water rentals base), while a portion of the profits of Crown corporations paid to provincial governments is considered in the same way as profits of private corporations. Some have suggested that this approach underestimates the revenue-generating capacity of provinces in cases where they charge less than the full economic value of the electricity.

The Panel considered a number of options for the treatment of hydroelectricity in the Equalization formula. Consistent with its position that all resource revenues should be treated in the same way, the current water power rentals base should be folded into a single resource revenue base and measured by actual revenues. In addition, the Panel recommends that the remittances from Crown corporations involved in resource extraction and development, including hydroelectricity Crown corporations, should be included as part of a province‚’s resource revenues and not as business income.

It is unclear what impact this change will have on Newfoundland and Labrador in the current situation or in a situation involving theLowerr Churchill development. Certainly the use of actual revenues, as opposed to estimates, eliminates the problem identified and resolved in the 1982 federal-provincial agreement on Upper Churchill revenues.

Second, the panel included a specific recommendation dealing with the offshore transfer agreements with Newfoundland and Labrador and Nova Scotia in 2005. There is also a sample calculation of how the cap would work. This is worth quoting in its entirety so there can be no confusion.

14. A cap should be implemented to ensure that, as a result of Equalization, no receiving province ends up with a fiscal capacity higher than that of the lowest non-receiving province.

Consistent with the Panel'’s principles, Equalization should provide equity among provinces. However, it should not result in less wealthy provinces having a greater fiscal capacity than provinces that do not receive Equalization.

The Panel'’s recommendations for including 50 percent of resource revenues in the Equalization formula will benefit receiving provinces with resource revenues. However, in some scenarios, a receiving province like British Columbia, Newfoundland and Labrador, or Saskatchewan could end up with a higher fiscal capacity after Equalization than a non-receiving province like Ontario. That runs counter to a fundamental principle of equity that should underlie any changes to the Equalization program.

Consequently, the Panel recommends that a fiscal capacity cap be implemented. To determine a province'’s post-Equalization fiscal capacity and whether or not it is entitled to Equalization, the Panel's view is that 100 percent of a province'’s resource revenues should be included in calculating a province'’s fiscal capacity for the purposes of the cap. If a province'’s resulting fiscal capacity is higher than that of the lowest non-receiving province, then its entitlement to Equalization would be capped. While some might suggest that less than 100 percent of resource revenues should be included in the cap for a variety of reasons, in the absence of reliable and comparable information, the Panel'’s view is that including 100 percent of resource revenues in determining a province'’s fiscal capacity for purposes of calculating the cap is appropriate.

The Panel understands that implementation of its recommended cap is complicated by the existence of separate Offshore Accords for Newfoundland and Labrador and Nova Scotia. In the case of Nova Scotia, its fiscal capacity continues to be lower than the lowest non-receiving province, so the cap does not apply. But in the case of Newfoundland and Labrador, the combination of resource developments in the province along with the Panel'’s proposed revisions to the Equalization formula mean that Newfoundland and Labrador'’s fiscal capacity (including own-source revenues, payments from Offshore Accords and Equalization) is expected to be higher than the lowest non-receiving province.

In the Panel'’s view, this contradicts a fundamental principle. It is not within the Panel'’s mandate to suggest that the Offshore Accords should be changed. However, we believe that the principle should be upheld. If Newfoundland and Labrador'’s fiscal capacity after Equalization is higher than the lowest non-receiving province, the cap should apply regardless of the Offshore Accords and the province should not receive Equalization payments that put them above the cap. The Panel understands that, under their 2005 Accord, Newfoundland and Labrador is protected from losses in Equalization payments. It'’s up to the federal government to determine how this should be resolved. In the Panel'’s view, the principles of Equalization should not be compromised nor should the Equalization program be adjusted to accommodate the Offshore Accords.

Would this approach cause a reduction in Newfoundland and Labrador's Equalization entitlements? The answer is almost certainly yes in the medium-term, once the Equalization system's transitional provisions come into force. Newfoundland and Labrador's entitlement in the next two to three years will decline in any event as its own source revenues grow from offshore oil, mining and other growth in the economy. This would likely amount to $100 to $200 million annually over the same time frame noted by Premier Williams on Monday, even without the expert panel's recommendations being implemented.

However, as the expert panel notes throughout the report, Equalization is supposed to decline as a province's own-source revenue grows and ultimately surpasses the national average to receive the federal transfer.

This notion is one of the fundamental premises contained in the 1985 Atlantic Accord and, to a large measure reaffirmed by the temporary nature of the transfers envisioned by the 2005 offshore accord. Premier Williams is simply wrong when he claims that there was a flaw in the 1985 accord on Equalization or that the accord was subsequently misapplied. He has been wrong before and the admission of one of his fundamental misrepresentations - that the province actually lost oil and gas revenues - is contained in the opening clause of the 2005 offshore deal.

There is no surprise that the Accord offsets were included in this panel report. The Bond Papers noted January 2006 that it would be difficult to keep these Equalization-related payments off the table.

As well, Bond Papers noted in February 2006 that Danny Williams proposed a different approach to Equalization in late 2005 that was at odds with the Harper proposal to remove non-renewable resources from the calculation of entitlements.

In his letter to federal party leaders, Williams proposed that Equalization be based on a formula which includes all provincial sources of revenue in calculating per capita fiscal capacity based on a 10 province standard. As a result, Alberta's economic performance would produce a significant cash result for this province. Williams also proposed that debt servicing costs be considered when calculating entitlements.

There is no explanation as to why Premier Williams appears to have abandoned his own proposal which are essentially similar to the recommendation of the expert panel to include all resource revenues.

Equalization for beginners or why Loyola Sullivan gets $400 million from oil this year

Offsets. Clawbacks. Have. Have not.

Equalization is at the heart of the current Atlantic Accord dispute. Yet if you put a gun to the head of the average person at the nearest Tim Horton's, I doubt they could explain it.

Well, here is a simple explanation.

Every province in the country collects revenue (or income, if you prefer) from taxes and fees. We know them all too well - HST, personal income tax, corporate income tax, car licensing fees, park fees.

That money goes to pay for the services the provincial government provides, like health care, education, and provincial parks.

For just about as long as Canada has been a country, different provinces have raised different amounts of taxes on their own. It's pretty obvious that some provinces would be richer than others. In order to even that situation out, the federal government transferred some of its revenue to the provinces. The federal government established the current Equalization program in 1957 after years of debate and discussion with the provinces. The concept of Equalization was enshrined in the constitution in 1982.

Basically, Equalization is like a wage top-up scheme for provinces. The federal government figures out a national average amount of revenue each province should get per person. Fall below the average and the province gets a cheque from Ottawa. Meet or exceed the average and you get nothing. No province pays into the program; the money comes from federal government revenues. As it stands right now, Alberta and Ontario make more than the national average and get no Equalization. Saskatchewan will join them in the "have" category, as some call it, within the next year. All the other provinces get some amount of Equalization. Quebec gets as much as all the others combined because the money is paid out based on population.

In 1957, when the program started provinces were topped-up to the average of the top three provinces. Alberta received Equalization until 1964, but once its income went above the average it didn't get a penny in Equalization. In 1967, the average was based on all 10 provinces and since 1982 it has been based on five selected.

Over the years, some provinces like British Columbia and Saskatchewan have moved back and forth between the so-called "have" (no Equalization) and "have not" (get Equalization) categories.

Like any top-up scheme, as a province's own revenue goes up, the Equalization goes down. That's a pretty simple idea. A province doesn't really lose money; as its own income grows, the top-up is replaced by the growth in revenue.

Under the Atlantic Accord, Newfoundland and Labrador gets an extra payment so that as its oil income grows, Equalization doesn't drop as fast as it otherwise would. It was intended to last for 12 years to give the provincial government a chance to make some headway on its debt and infrastructure after years of hard times. There are current seven years left in the offset under the Accord.

In 1993, the Chretien government also gave Newfoundland and Labrador the chance to hide 30% of its oil income from Equalization each year until oil production ceases once the Accord offsets run out. It's called the generic solution because some other provinces can access it as well for other types of revenue.

The provincial government's proposal since June 10 would work this way. Instead of the offset or the generic solution, the federal government would give the province an amount equal to all of the province's direct oil income in a year, even if the province didn't qualify for Equalization. That's it in a nutshell.

The latest federal offer was to give the province an amount equal to the drop in Equalization from year to year caused by growth in oil revenues, until the province doesn't qualify for Equalization. After that, the province would only get 100% of its oil and gas revenues.

This gets confusing because the provincial government has been explaining the whole arrangement as those something was being taken away when actually it isn't.

Take an example from today with the Atlantic Accord, the generic solution and no new offshore deal. If the provincial government earns $100 million in oil revenues, Equalization would only use $70 million as the provinces oil income when it calculates the province's income.

If the province would have gotten $100 million in Equalization without that new oil revenue, Equalization doesn't drop by $ 100 million. Only $70 million of the oil money is used in the formula, so as far as Equalization is concerned the provincial government is entitled to $30 million.

The result? The province gets $100 in oil revenue PLUS $30 million in Equalization for a total of $130 million.

That's why Brian Peckford can say the Atlantic Accord delivers more money than oil revenues would alone. He's absolutely right.

In 2003, Newfoundland and Labrador earned a little over $123 million in oil royalties (taxes), but that does not include all direct income like corporate income tax. Under the Atlantic Accord the provincial government also received $178 million as an Equalization offset.

Newfoundland and Labrador 2003

Oil Royalties and Offsets

$123 million + $178 million = $301 million

Loyola Sullivan won't explain it to you that way, but those numbers are taken from the provincial government's own budget and the federal Department of Finance website.

This year, the provincial government will receive more than that in direct oil revenues alone. Including the existing offset or generic solution approaches, Newfoundland and Labrador's direct oil revenues in 2004 will likely be close to $400 million.

That's without any new deal.

"Reality Check" reality check on Equalization and the Family Feud

The crew that put together's CBC's usually fine "Reality Check" can be forgiven if they missed a few points by a country mile in a summary of the Family Feud.

Forgiveness is easy since the issues involved are complex and  - at least on the provincial side since 2003 - there has never been a clear statement of what was going on.  Regular Bond Papers readers will be familiar with that.  For others, just flip back to the archives for 2005 and the story is laid out there.

Let's see if we can sort through some of the high points here.

With its fragile economy, Newfoundland and Labrador has always depended on money from the federal government. When they struck oil off the coast, the federal government concluded it would not have to continue shelling out as much money to the provincial treasury. N.L.'s oil would save Ottawa money.

Not really.

Newfoundland and Labrador is no different from most provinces in the country, at least as far as Equalization goes.  Since 1957 - when the current Equalization program started - the provincial government has received that particular form of federal transfer.  So have all the others, at various times, except Ontario.  Quebec remains one of the biggest recipients of Equalization cash, if not on a per capita basis than on a total basis. Economic "fragility" has nothing to do with receiving Equalization.

In the dispute over jurisdiction over the offshore, there was never much of a dispute as far as Equalization fundamentally works.

Had Brian Peckford's view prevailed in 1983/1984, Equalization would have worked just as it always has.  As soon as the province's own source revenues went beyond the national average, the Equalization transfers would have stopped.

Period.

That didn't work out.  Both the Supreme Court of Newfoundland (as it then was called) and in the Supreme Court of Canada, both courts found that jurisdiction over the offshore rested solely with the Government of Canada.  All the royalties went with it.

In the 1985 Atlantic Accord, the Brian Mulroney and Brian Peckford governments worked out a joint management deal.  Under that agreement - the one that is most important for Newfoundland and Labrador - the provincial government sets and collects royalties as if the oil and gas were on land.

And here's the big thing:  the provincial government keeps every single penny.  It always has and always will, as long as the 1985 Accord is in force.

As far as Equalization is concerned, both governments agreed that Equalization would work as it always had.  When a provincial government makes more money on its own than the national average, the Equalization cash stops.

But...they agreed that for a limited period of time, the provincial government would get a special transfer, based on Equalization that would offset the drop in Equalization that came as oil revenues grew.  Not only was the extra cash limited in time, it would also decline such that 12 years after the first oil, there'd be no extra payment.

If the province didn't qualify for Equalization at that point, then that's all there was.  If it still fell under the average, then it would get whatever Equalization it was entitled to under the program at the time.

The CBC reality check leaves a huge gap as far as that goes, making it seem as though the whole thing came down to an argument between Danny Williams and Paul Martin and then Danny and Stephen Harper.

Nothing could be further from the truth, to use an overworked phrase.

During negotiations on the Hibernia project, the provincial government realized the formula wouldn't work out as intended. Rather than leave the provincial government with some extra cash, the 1985 deal would actually function just like there was no offset clause. For every dollar of new cash in from oil, the Equalization system would drop Newfoundland's entitlement by 97 cents, net.

The first efforts to raise this issue - by Clyde Wells and energy minister Rex Gibbons in 1990 - were rebuffed by the Mulroney Conservatives.  They didn't pussy foot around. John Crosbie accused the provincial government of biting the hand that fed it and of wanting to eat its cake and "vomit it up" as well.

It wasn't until the Liberal victory in 1993 that the first efforts were made to address the problem.  Prime Jean Chretien and finance minister Paul Martin amended the Equalization formula to give the provincial government an option of shielding up to 30% of its oil revenue from Equalization calculations.  That option wasn't time limited and for the 12 years in which the 1985 deal allowed for offsets the provincial government could always have the chance to pick the option that gave the most cash.  It only picked the wrong option once.

The Equalization issue remained a cause celebre, especially for those who had been involved in the original negotiations.  It resurfaced in the a 2003 provincial government royal commission study which introduced the idea of a clawback into the vocabulary.  The presentation in the commission reported grossly distorted the reality and the history involved. Some charts that purported to show the financial issues bordered on fraud.

Danny Williams took up the issue in 2004 with the Martin administration and fought a pitched battle - largely in public - over the issue.  He gave a taste of his anti-Ottawa rhetoric in a 2001 speech to Nova Scotia Tories. Little in the way of formal correspondence appears to have been exchanged throughout the early part of 2004.  Up to the fall of 2004 - when detailed discussions started -  the provincial government offered three different versions of what it was looking for.  None matched the final agreement.

The CBC "Reality Check" describes the 2005 agreement this way:

The agreement was that the calculation of equalization payments to Newfoundland and Labrador would not include oil revenue. As the saying goes, oil revenues would not be clawed back. Martin agreed and then-opposition leader Harper also agreed.

Simply put, that's dead wrong.

The 2005 deal provided for another type of transfer to Newfoundland and Labrador from Ottawa on top of the 1985 offset payment.  The Equalization program was not changed in any way. Until the substantive changes to Equalization under Stephen Harper 100% of oil revenues was included to calculate Equalization entitlements.  That's exactly what Danny Williams stated as provincial government policy in January 2006, incidentally.  The Harper changes hid 50% of all non-renewable resource revenues from Equalization (oil and mining) and imposed a cap on total transfers.

As for the revenues being "clawed back", one of the key terms of the 2005 deal is that the whole thing operates based on the Equalization formula that is in place at any given time. Oil revenues are treated like gas taxes, income tax, sales tax, motor vehicle registration and any other type of provincial own-source revenue, just like they have been as long as Equalization has been around.

What the federal Conservatives proposed in 2004 and 2006 as a part of their campaign platform - not just in a letter to Danny Williams - was to let all provinces hide their revenues from oil, gas and other non-renewable resources from the Equalization calculations.  The offer didn't apply just to one province.  Had it been implemented, it would have applied to all. 

That was clear enough until the Harper government produced its budget 18 months ago. What was clear on budget day became a bit murky a few days later when Wade Locke of Memorial University of Newfoundland began to take a hard look at the numbers.

Again, that's pretty much dead wrong.

It became clear shortly after Harper took office in 2006 that the 100% exclusion idea from the 2004 and 2006 campaigns would be abandoned in favour of something else.  There was nothing murky about it at all. So plain was the problem that at least one local newspaper reported on a fracas at the Provincial Conservative convention in October 2006 supposedly involving the Premier's brother and the Conservative party's national president. That's when the Family Feud started.

As for the 2007 budget bills which amended both the 1985 and 2005 agreements between Ottawa and St. John's, there's a serious question as to whether the provincial government actually consented to the amendments as required under the 1985 Atlantic Accord.

The story about Equalization is a long one and the Family Feud - a.k.a the ABC campaign - has a complex history.  There's no shame in missing some points.  It's just so unusual that CBC's "Reality Check" was so widely off base.

-srbp-

The uncivil Civil War #nlpoli

At the heart of the ongoing civil war between Danny Williams’ provincial Conservatives and Stephen Harper’s federal Conservatives is the claim by Williams that Harper broke his 2006 election promise on Equalization.

Williams wrote to each of the federal party leaders and asked the leaders to state their party’s position on Equalization.

Gimme your lunch money, dork: the sequel

That $10 billion Equalization debt thingy is curious, dontchya think? The Premier and his followers bandy it about like it was fact.

Where did it come from?

Wade Locke. Well, at least one set of assessments done by the Memorial University economist.

Funny thing, though, if you look way back to last June, you'll find a study Locke did for the Atlantic Provinces Economic Council (APEC), along with a buddy of his, Paul Hobson, an economist from Acadia. Hobson, incidentally proposed a totally different approach to the treatment of resource revenues, one that went completely unnoticed in all the fooferah over the past couple of years.

Anyway, Hobson and Locke, point out that all four Atlantic provinces are adversely affected by the new Equalization formula:

Nova Scotia - $159 million increase in revenues for the first two years under the new Equalization program, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $1.4 billion less under the new Equalization program than under the Fixed Framework;

New Brunswick - $68 million increase in revenues for the first two years under the new Equalization program, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $1.1 billion less under the new Equalization program than under the Fixed Framework;

Prince Edward Island - $7 million increase in revenues for the first two years under the new Equalization program, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $196 million less under the new Equalization program than under the Fixed
Framework;

Newfoundland and Labrador - $654 million reduction in revenues for the first two years under the new Equalization program, an increase of $22 million in the third year, and reduced revenues in each year thereafter compared with the Fixed Framework: in aggregate, the province receives $1.4 billion less under the new Equalization program than under the Fixed Framework. It should be noted that Newfoundland and Labrador will no longer be a recipient of Equalization after 2008-2009, under both the Fixed Framework and the new Equalization program. [Emphasis added]

Now this was before the Nova Scotia side deal which also works for Newfoundland and Labrador as well. But notice, in particular, the figure for New Brunswick. You see, the lovely province slightly to the west doesn't get much of its own cash from non-renewable resources. The reduced pot of cash involved in the new Equalization system doesn't work quite as well for them as the old way of doing things.

That's not really the whole story though.

Flip back to Ken Boessenkool's 2001 paper for the Atlantic Institute for Market Studies wherein the whole idea of taking non-renewables out of the Equalization calculation was laid out. At that time, the 10 province standard without non-renewables may have only dropped this province's Equalization transfer by a paltry $3.0 million but new Brunswick would have lost over 10 times as much cash and that's just by changing the way the formula was worked out.

The impact of various ideas for Equalization reform was also presented by the O'Brien expert panel. Go back and take a look at that report again since it includes a very good overview of Equalization and the history of the program.

You see, that's one of the things some locals keep forgetting. The Harper Equalization promise wasn't made to just one province. It was party policy across the country, affecting potentially every province. Some provincial governments like Saskatchewan and Newfoundland and Labrador may have thought it was absolutely wonderful. Others? Not quite so enthusiastic.

That's the political situation - painfully and patently obvious at the time of two successive general elections - that makes it seem foolish for any provincial government to have banked on it or even expected it to be politically feasible. No surprise that the federal government went with the expert panel's recommendations and why most provinces have accepted it. The new system isn't perfect, but at least it works. And for provinces like Manitoba and new Brunswick it works considerably better than taking all non-renewable resources out of the formula.

Beyond banking on a completely unrealistic expectation, there's something else in all this some people in Newfoundland and Labrador like to ignore: After 2009, Newfoundland and Labrador won't qualify for Equalization any more under either the new scheme or the old one. As Locke and Hobson note, the provincial government would receive - by their calculation - about $1.4 billion less under the new approach compared to the Fixed Framework.

$1.4 billion.

Where does that figure turn up again?

The Public Accounts, Volume I, note 4 on page 37, released just this week:

The deferred revenue totalling $1,646.2 million consists primarily of $1,458.5 million relating to the Atlantic Accord (2005), which represents the unearned balance of the $2.0 billion advance payment received in 2005-06. In addition, the deferred revenue balance consists of $51.7 million relating to Federal Government funding for various health care initiatives, $44.9 million relating to Federal initiatives in support of post-secondary education, public transit and affordable housing, $16.4 million relating to gas tax initiatives, $62.3 million relating to entities in the education sector, $7.4 million relating to entities in the health sector, and $5.0 million related to other miscellaneous programs. These amounts will be recognized as revenue in the periods in which the revenue recognition criteria have been met. [Emphasis added]

Curious, huh?

It's likely a coincidence, but remember that when the provincial government signed the 2005 transfer deal - it wasn't about offshore oil revenues, by the way - the up front cash was offered and accepted because both the federal and provincial governments knew that, at least for Newfoundland and Labrador, it offered more cash than would be obtained before the province went off Equalization if the thing was just run on a year-to-year basis.

At the time the deal was signed, both public and government estimates were that Newfoundland and Labrador's provincial government fiscal capacity would put it off the top-up scheme called Equalization such that the second eight year phase was unlikely to be realized. As the premier noted at the time the transfer deal was signed, the whole thing came down to a discussion of the cash - the quantum, as he put it - and by simply adjusting the assumed average price of oil, the up front cash went from $1.4 billion from October to $2.0 billion in January 2005.

Poof, the deal was done. Never mind that the principles laid out in the January deal were actually inferior in some respects to the October offer. It was the up front cash that counted.

All of this should be a reminder that provincial governments across the country all look at the federal government as a source of cash. There's nothing new in this at all. The pretexts vary, but the demand is still the same. Danny Williams is looking for $10 billion or so based on what he calls a broken promise. Dalton McGuinty has a figure double that and earlier this month he went looking to Ottawa looking for another $350 million. Just this week, the arch-provincialist party the Bloc Quebecois put $15 billion of demands on the table as its price for supporting Stephen Harper's Conservatives. Saskatchewan is looking for cash, too.

Just to give a real sense of just how much the $10 billion - for example - is merely a pretext for the usual game of federal-provincial relations, look back at the letters Danny Williams sent to Stephen Harper through December and into January. The 'ask', to use Danny Williams sales talk, is the federal shares in Hibernia, which he appears to want for free. Harper doesn't dismiss the subject out of hand, as some local media erroneously reported. rather he clearly leaves the door open to discussion on a purchase price.

But the question that goes begging is why Danny Williams would be prepared to trade off an old demand of his demands in settlement of supposedly new and humiliating grievance of The Broken Promise. If The Broken Promise was both as new and as grievous as the rhetoric would suggest then it could only be genuinely settled with some new compensation.

Not so. And the willingness to trade off - to say yes to less - isn't really a constructive effort to settle an account. Take a look at what else would supposedly settle the grievance and you see a raft of things the provincial government has been seeking for some time or something else that's cropped up lately.

What we have here is old-fashioned federal-provincial relations but reduced to a highly dysfunctional set of confrontations. As noted here before, the entire thing, at least in Newfoundland and Labrador's case, is now structured in a way to frustrate the sort of political discussions that have worked on small and large projects in the past.

But that's not just a function of Danny Williams' style, although his partisans will be quick to leap forward and spew the Blackberry Talking Point du jour. Even in the most intense period of the "Fair Deal" crusade, federal-provincial relations still managed to function. Back room chats, informal exchanges and formal proposals flew back and forth between Ottawa and St. John's. There was a resolution to the major impasse, but there were also other issues that were addressed. Take the offshore board thing as a case in point. The federal and provincial governments engaged in all sorts of discussion out of public view in an effort to resolve the issue. Read the decision in Ruelokke v Newfoundland and Labrador; the evidence is there.

Like the old saying, it takes two to tango and in the current dysfunction in federal-provincial relations it takes two to tangle. The resolution to the problem may well come in the next federal election but it won't because of any ABC campaign by any one politician. You see, just looking at Newfoundland and Labrador, one can see that historically the province tends to vote anything but Conservative, whether we mean the current version of the party or the old Progressive Conservative crowd. There are some compelling reasons in front of the voting public that are likely to reinforce that tendency next time not just locally but across the country.

The old game of "Gimme me your lunch money" won't vanish. That's too entrenched in the federal-provincial system. But there is a possibility that the next federal government will take a different view of how the system should operate, one that restores the sort of political accommodation and compromise that has made Canadian federalism as successful as it has been.

And locally, when the provincial government gets a sense that things are different, well, maybe it will start focusing on those "other things to talk about" everyone has raised lately in the cell phone story. They'll start talking about fiscal responsibility and about the policies needed to sustain the province's new-found status as a major economic engine for the country.

Bullying for lunch money - looking for handouts to pay the bills - is the domain of the insecure and weak. It's time we moved on to something else. Heaven knows the province as a whole is long since past that sort of stuff even if some politicians and their supporters still have an entire forest of chips on their shoulders.

-srbp-

[h/t to Dulse and Fog for the APEC link]

The change Locke found

In Wade Locke's original analysis, he used the assumption that Equalization offsets provided for in the 2005 offshore revenue agreement and enabled by the Nova Scotia and Newfoundland and Labrador Additional Fiscal Equalization Offset Payments Act, S.C. 2005, c. 30, c. 85, would continue as originally intended.

Under that Act as it currently stands, the additional offset is calculated based on the difference between what the provincial government received in Equalization under the formula in use at the time.

The Equalization changes contained in the 2007 budget gave the Government of Newfoundland and Labrador an option of which Equalization formula would apply.

However, s.84 of the budget implementation Act (C-52) makes a significant change to the 2005 implementation Act by imposing a definition of the Equalization system in use at the time to mean the O'Brien formula.

84. The definition “fiscal equalization payment” in section 18 of the Act is replaced by
the following:

“fiscal equalization payment” means (a) for the purposes of section 22, the fiscal equalization payment that would be received by the Province for a fiscal year if the amount of that payment were determined in accordance with section 3.2 of the Federal-Provincial Fiscal Arrangements Act, without regard to section 3.4 of that Act; and,

(b) for the purposes of sections 24 to 26, the fiscal equalization payment that would be received by the Province for a fiscal year under Part I of the Federal-Provincial Fiscal Arrangements Act if the Province’s total per capita fiscal capacity were the amount determined by the formula

A + B + (C / F)

where

A, B, C and F have the same meaning as in the definition "total per capita fiscal capacity" in subsection 3.5(1) of that Act.

As a result, even in a year in which the province used the existing Equalization system (100% of resource revenues included), the additional offsets would be reduced since the O'Brien formula already offsets half of resource revenues.

Additionally, the use of the O'Brien formula, which includes a cap on payments, the proposed changes in the budget implementation legislation would change the meaning of s. 22 of the 2005 implementation Act. Under the current meaning of that legislation, no additional offset payment would be received if the provincial government did not receive an Equalization payment.

In the operation of the Equalization system and the offsets agreements as currently in effect, no payment would be paid if the province did not qualify for Equalization. However, under the O'Brien formula, the province may qualify for Equalization, but receive no payment in years where a combination of all revenues (own source plus Equalization plus Equalization offsets) exceeds the per capita fiscal capacity of the lowest non-recipient province.

Given the amendments contained in Bill C-52, Newfoundland and Labrador would actually receive no offsets at all in any year where its Equalization payment were reduced to zero as a result of the O'Brien cap.

There is no obvious reason for making this change. If the federal government wanted to give effect to both the 2005 agreement and the 2007 budget - allowing for choices - Bill C-52 would necessitate only modest changes, if any, to the implementation acts for 1985 Atlantic Accord and the 2005 agreement.

Equalization changes: Williams and Harper/Sullivan compared

Provincial finance minister Loyola Sullivan is claiming that Stephen Harper's proposals for Equalization reform are perfect for this province but his claim suggests that he and premier Danny Williams are once more at odds over the province's finances.

Their last public conflict came in June 2004 during the offshore discussions when Sullivan backed Stephen Harper in preference to the provincial government's position, represented by Danny Williams. That's the same basic problem again, but it certainly isn't clear that Loyola Sullivan, whose love of digits borders on being a pathological condition, is correct in his math.

Given the importance of these issues to the province and in light of the coming federal-provincial negotiations on federal transfers, a frank assessment of the merits of the province's position will be necessary if the general public are to fully appreciate the issues and the implications.

The following calculations are based on the province's mid-year fiscal statement and the current Equalization fiscal capacity determinations, using 2004/05 as a typical year to demonstrate the impacts of the two proposed approaches to Equalization.

Note: These calculations are approximations based on provincial budget estimates and estimates of per capita fiscal capacity. A more detailed analysis would be needed to produce a definitive comparison.

Danny Williams' position

In his letter to the federal party leaders, Danny William proposed a simple approach to the Equalization formula that would increase provincial transfers from Ottawa and give full effect to the Equalization offsets in both the Atlantic Accord (1985) and the January 2005 offshore deal with Paul Martin.

Under the current Equalization system, Newfoundland and Labrador would cease to qualify for Equalization within the next fiscal year and therefore would be entitled to small, declining offsets. The total value of the 2005 agreement for example would likely never exceed the $2.0 billion advanced already.

In his letter to federal party leaders, Williams proposed that Equalization be based on a formula which includes all provincial sources of revenue in calculating per capita fiscal capacity based on a 10 province standard. As a result, Alberta's economic performance would produce a significant cash result for this province. Williams also proposed that debt servicing costs be considered when calculating entitlements.

The most obvious impact of the Williams approach would be to raise the national per capita fiscal capacity above the one currently resulting from the five province standard. In 2004/05, the national standard per capita capacity would have been approximately $6600 (10 prov.) versus $6200 (five prov.) Newfoundland and Labrador's per capita fiscal capacity was $4900.

This would have provided $878, 900, 000 in Equalization based on a population of 517, 000 people.

Since Newfoundland and Labrador would likely remain an Equalization receiving province over the entire 16 years of the offshore deals, the province would receive Equalization offsets for its oil royalties equal to 100% of those revenues. Oil and gas revenues in that period will exceed all other non-renewable revenues.

This would have produced an Equalization offset of approximately $234, 420, 000 in 2004/05, for a total of $1, 113, 320,000.

That does not include the province's non-renewable resource revenues which the provincial government collects and retains in full.

The Harper/Sullivan Approach

The federal Conservative proposal for Equalization would calculate provincial entitlements on a 10 province standard but without using revenues from non-renewable resources.

The most obvious impact of this approach would be to keep the national per capita fiscal standard at or below the current level established using five provinces. Newfoundland and Labrador's fiscal capacity would be reduced by the amount of natural resource revenues, which for the purpose of this example will be estimated at $248, 845, 000 or $481 per capita.

This produces an Equalization entitlement of $920,777, 000. ¹

Since offshore oil and gas revenues are already offset under this model, no further transfers would flow to the province under either the 1985 or 2005 offshore agreements.

Discussion

1. The major advantage of the Williams approach for the 2004/05 sample year is the impact of the offshore Equalization offset agreements. This produces revenue over and above Equalization entitlements since they compare the province's per capita capacity without offshore royalties to its entitlement under the 10 province standard that includes Alberta's natural resource revenues.

2. It should be noted that in 2004/05, mining revenue was slightly more than $14, 000, 000. Since no one has released provincial revenue figures from Voisey's Bay production there is no way, at this point, of determining the longer term impact of the Harper/Sullivan approach compared to the Williams proposal.

3. That said, as provincial offshore revenues increase, the level of additional offset from the 1985 and 2005 accords increase directly for the full 16 years of the 2005 deal. Unless mining royalties were to exceed the considerable sums coming from offshore oil and gas in the next decade, the 1985 and 2005 agreements should deliver their full potential. This should more than make up for any Equalization declines owing to growth in mining royalties under the Williams proposal.

4. Neither the Williams nor the Harper/Sullivan proposal offsets the impact of a major renewable resource revenue development such as construction of the Lower Churchill.

5. The Williams proposal offers the potential for additional revenue from adjustments related to debt servicing costs that are not contained in the Harper/Sullivan approach. These figures are not included here since they are unknown and cannot be calculated. Williams did not make any suggestions as to what weight he expected to be given to debt servicing costs in making the Equalization calculations.

6. Overall, it is incumbent on Loyola Sullivan to make public his own departments calculations of the financial impacts of both the Williams and the Harper/Sullivan models. Sullivan's public pronouncements to date have been vague, bordering on the vacuous.

His references to an "Atlantic Accord forever" smack of some communications director's idea of clever sound bites rather than a substantive appraisal based on disclosed evidence.

Conclusion

The following conclusions can be made:

- The Williams proposal is consistent with the general approach to Equalization taken across the country to date, in that it is formula driven and uses as many sources of revenue as possible to accurately reflect actual provincial fiscal capacity.

- The Williams approach is supported by most provincial governments and is likely to gain wider support.

- The Harper/Sullivan approach would see at least four provinces facing significant decreases in Equalization entitlements. As a result, this approach would be more difficult to implement. Changes to Equalization would require unanimous agreement of all provinces.

- The Harper/Sullivan approach is designed to reduce federal government transfers to provinces. Irrespective of the rationales offered, the primary goal of the Harper/Sullivan approach is to lower federal government transfers. Before the election, there had been some discussion that the Harper administration would address the supposed vertical fiscal imbalance by reducing federal taxation and thereby allowing the provinces to increase their own direct revenues by raising taxes.

The Harper/Sullivan Equalization changes give the federal government the ability to do exactly that by reducing federal expenditures or at least reducing the rates of increase to allow the program to function on smaller annual expenditures than might otherwise be the case..


----------------------------
Notes:

¹ [6200-(4900-481) X 517, 000]

Comment on the Provincial Government backgrounder

Following is taken from the backgrounder accompanying today's new release from the Government of Newfoundland and Labrador. I apologize for the length, but hey, it is a complex subject. I will leave aside the Premier's speech and the news release since he largely repeats the same misrepresentations and factual distortions on which the provincial government argument has been built.

Someone has asked for a more dteailed discussion of the deal, I suspect out of concern that Paul Martin has, in a phrase, "sold the shop". Although I'd hesitate to put it in these terms, I'll try and give a federal/provincial scoresheet tomorrow (01 Feb 05) that gives the objectives obtained by each government and at what cost, political or financial.

In general, this agreement represents the structure and principles of the December 22, 2004 offer from the Government of Canada with modifications typical of what is normally achieved in any negotiating process. In general, the principles of the October proposal carry forward into the December proposal; the major difference is the method used to calculate the offset.

In practice, the October formula should have produced the same financial result for the provincial government as this agreement does. The argument on the quantum produced was based solely on the price per barrel of oil, not on the method of calculation. The notion that the October deal was less lucrative than the December proposal is a completely erroneous interpretation by the Government of Newfoundland and Labrador, repeated without question by local news media.

Backgrounder

100% guarantee

Newfoundland and Labrador will receive 100 per cent of our offshore revenues, free from any clawbacks while we are an equalization-receiving province, for the full life of the agreement (subject to meeting conditions of the second eight-year renewal triggers). [Comment: As presented, the provincial government has accepted an offset in the first two years which is actually less than direct revenues. They key aspect of this section is that the offset continues only as long as he province qualifies to receive Equalization; this is definitely not what the province sought and therefore represents a significant gap between goal and result. While the province may resume offsets if it qualifies again for Equalization within the first eight years, this is highly unlikely to occur. If the province no longer qualifies for Equalization in the second eight-year phase, the offsets drop to zero within two years.]

Enhanced protection when off equalization

Newfoundland and Labrador will still receive the full benefits of the protection offered by the Atlantic Accord. The existing Accord's offset mechanism has been extended by one year to cover the full first eight-year term. During the second eight-year term, should the province no longer qualify for equalization in any year, it will receive 66 per cent of the previous year's offset payment in year one and 33 per cent in year two. Should the province requalify for equalization, the 100 per cent offset will be restored. If the province comes off of equalization again within that time frame, the transition is reset. [This is largely a theoretical protection. If the provincial government no longer qualifies for Equalization within the first eight years of this deal, then the declining offset provisions of the original Atlantic Accord apply. Getting rid of the declining offsets was the central part of the original provincial proposal in February 2004. In the most likely scenario, the province will not qualify for Equalization within the next three to five years and therefore will likely not qualify for the second eight-year offset period.]

$2 billion floor

Newfoundland and Labrador will receive an up-front payment of $2 billion (plus interest), which represents a floor on future additional offset payments above and beyond the existing Accord offset payments. This floor essentially protects the province from a decline in oil prices between $30-35US/barrel. In other words, offset payments for the first eight years will be no less than what they would be if the price of oil remains constant between $30-35US/barrel and the level of production remains at the forecasted levels. While minimizing risk to the province, this provision in no way restricts the province's ability to benefit from oil prices above this range. It will also minimize the risk of a steep decline in offset payments in years in which the province no longer qualifies for equalization. [Floor or ceiling? Take your pick. The $2.0 billion is a single amount. The interest noted in this paragraph results solely from an investment of the money received, not an additional transfer from the Government of Canada. If the province spends all $2.0 billion in a week, then it collects little or no interest. In the most likely scenario, oil prices will remain well above US$30 per barrel over the next five years and therefore the provincial government will cease to qualify for Equalization. If oil prices are well above that level, the claim that this in no way restricts the ability to benefit from high prices is misleading. High prices will push the province off Equalization. No offsets will flow under this agreement so the province reverts to the Atlantic Accord benefits (ability to set own revenues). This agreement did not enhance this situation - this is the situation that already exists! The province sets and collects its full share of direct revenues. In the ordinary course, the Equalization program protects provincial governments from steep declines in Equalization. Hence a rapid decline in offsets is simply the loss of one parachute from a two-parachute braking system.

Given the way Premier Williams has referred to this lump sum, it is not clear that the amount will actually be transferred to the provincial government in toto. It would appear that the provincial government is somehow restricted in what it can draw from a fund to be established. It may be that this amount will be deposited in the Canada Offshore Fund account already established to transfer oil revenues collected on behalf of the provincial government by Natural Resources Canada and that the province will be restricted in how much may be drawn down on an annual basis. Only the full text of the agreement and the implementation legislation will make this clear.]

All new projects are included

The benefits of this agreement will apply during the sixteen-year term to any new oil and gas discovery that is developed within its 16-year term, including Hebron-Ben Nevis and yet-to-be-discovered fields in the Orphan Basin, Laurentian Sub-Basin and offshore Labrador. [This provision applies only if the provincial government still qualifies for Equalization and qualifies for the second eight-year offset period. Otherwise, the projects are not covered. In the most likely scenario, they are not offset. This represents a loss from the June 5 agreement and from the December agreement which guaranteed a separate offset for Hebron-Ben Nevis. Bear in mind that the total amount of the cash advance is a little more than double anticipated direct revenues from White Rose. The initial goal was to double the revenues from all four projects. The post-June 10 goal was to double revenues from current and future discoveries.]

Guaranteed payments for 2004-05 and 2005-06

The equalization system is undergoing review on a national basis, with a new system to be established starting in 2006-07. As part of this review, equalization payments for 2004-05 and 2005-06 have already been determined. Therefore, it has also been possible to determine the value of the new offset payments under the Agreement in Principle. For the fiscal year 2004-05, the value of the additional offset payment to provide this 100 per cent offset will be $133.6 million. For the fiscal year 2005-06, the value of the additional offset payment to provide this 100 per cent offset will be $188.7 million. [The value of offset payments under this agreement for the first two years should not be dependent on the amounts already determined for Equalization. The offset is supposed to be based on actual revenues received and operates separate from the Equalization program. in fcat the Accord offsets in the original document are calculated on a 10 province standard. Given that oil prices are much higher and therefore revenues are much higher than forecast, these amounts fall far short of what a genuine 100% offset would be. In practice, though, this section is mooted by the lump sum payment of $2.0 billion. Therefore, it is curious that these specific amounts are highlight. Based on current estimates provincial direct revenues from oil production for Fiscal Year 2004 would be over $300 million, not the $133.6 million suggested here.]

Review mechanism for offset payment calculation

As part of the national review of equalization, the federal government will consider the recommendations of an independent panel and introduce changes to the equalization program starting in 2006-07. Given that the new offset arrangement between Newfoundland and Labrador and the federal government is dependent on the mechanics of the equalization system, our agreement contains a clearly-worded principle on how the 100 per cent obligation will be honoured, in light of any changes to equalization. As well, if the province disagrees with the federal government on how the offset payments have been calculated starting in 2006-07, the province can request that the federal calculations be audited to ensure they are consistent with the 100 per cent principle. [Without the actual wording of the clause, there is no way of assessing the accuracy of this claimed benefit.]

16-year agreement

This agreement ensures that Newfoundland and Labrador will continue to receive 100 per cent of our offshore revenues while we are an equalization-recipient province for 16 years, subject to meeting certain fiscal indicators after the first eight years. The province must receive equalization in 2010-11 or 2011-12, and our per capita debt servicing costs cannot become lower than that of at least four other provinces. These conditions only apply at the end of year eight, to determine whether the second eight-year period will be triggered. [As noted above and elsewhere, in the most likely scenario, the provincial government will cease to qualify for Equalization within the first eight year period. Theoretically, it is a 16 year deal. Theoretically, pigs can fly.]

Review mechanism after 16 years

This agreement provides for a review mechanism after sixteen years. The federal and provincial governments agree that no later than the beginning of the sixteenth year of the agreement, the two levels of government will jointly enter into a review of the agreement. [Any agreement would normally include a "re-opener" clause. Theoretically, as a matter of legal principle, the Upper Churchill contract can be re-opened based on the agreement of the signatories. If one party refuses to amend the agreement, then only a specific clause can force amendment under specified conditions. In practice, if a future Government of Newfoundland and Labrador or Government of Canada refuses to accept the results of a review, then this clause is completely meaningless.]

Most favoured agreement provision

Should the Government of Canada enter into a new offshore petroleum resource revenue agreement with another province or territory that is more beneficial to Newfoundland and Labrador, the province can opt to commence negotiations to revise this agreement. [Grammatically, this paragraph is a nonsense. It is almost impossible to conceive of a situation in which any provincial government would negotiate an agreement that actually proves more beneficial to another province than it does to itself. The Upper Churchill deal is an extremely rare exception, of course. If this clause applied in that instance it would actually apply to Quebec which, of course, wouldn't want to renegotiate a deal from which is all ready "more beneficial". hence the nonsense of the above paragraph. Throughout this entire year of Accord discussions, there is ample evidence that provincial government officials have difficulty communicating effectively in plain English. Either that or Humpty Dumpty works for the Government of Newfoundland and Labrador. 'A word shall mean...']

The 2004 war with Ottawa revisited #nlpoli

The 2004 “war” with Ottawa over a version of federal Equalization payments to Newfoundland and Labrador is an early episode in the provincial Conservative administration.

The confrontation helped propel Premier Danny Williams to unprecedented heights of popularity.  This, in turn, affected the rest of his tenure as Premier.  It was a critical element in his quest for political hegemony in the province during his first term.

In SRBP’s review of Ray Blake’s new book on federal provincial relations, there are some comments about Blake’s chapter on Danny Williams and the war with Ottawa in 2004. The review wasn’t the place to get into that.  The subject is too big. 

This post will explain the problems with Blake’s accounts and with other accounts of the period.

Which is to be Master? Part 3

F. The Williams administration’s rationale for change

The Williams administration is seeking changes to the Equalization offset provisions of the Accord so that the province will receive both direct and indirect revenues and the maximum possible Equalization payments. The provincial government’s position is based on three contentions.

First, reductions in any Equalization payment attributable to increased non-renewable resource revenues amounts to a “clawback” since these resources are finite. Second, as David Norris has argued for example, declines in Equalization amount to added revenue for the Government of Canada and hence violate the commitment that Newfoundland and Labrador should be the principal beneficiary. Third, the existing offset mechanism will run out before the most significant revenue benefit can be realized. Let us examine these in order.

The non-renewable “clawback”: The Equalization program has consistently operated as a form of top-up for certain province’s revenues. Any increase in a province’s own-source revenues would mean a lowering of the top-up amount. If Newfoundland and Labrador experienced a growth in revenue from information technology, it could reasonably expect to see its Equalization entitlement reduced. Newfoundland and Labrador is treated like all other provinces when it comes to the application of the Equalization program.

Clawback is a simple concept and applies in many areas of individual and business life. A clawback is defined by the Concise Oxford Dictionary as meaning to “regain gradually or laboriously, to take back (allowance by added taxation, etc.)” WordNet and Dictionary.com similarly define clawback as “finding a way to take money back from people that they were given in another way; ‘the Treasury will find some clawback for the extra benefits members received’”.

Since the Government of Canada remits in full offshore revenues to the Government of Newfoundland and Labrador, and applies no special tax or levy on those revenues, there is no clawback of these revenues as the term would be generally understood. Since the Atlantic Accord contains specific provisions to offset losses in Equalization, there is also no clawback of direct offshore revenues in that sense either.

The “clawback” argument is based on the contention that non-renewable resources hold a special status among provincial revenue sources. As the argument goes, these resources are finite and hence the period of time in which a province can derive benefit from the resources is finite. A province cannot achieve maximum benefit from non-renewable resources if it loses Equalization as revenues grow from these non-renewable resources. Hence these revenues should be exempted in some fashion from the Equalization calculation.

Two aspects of the argument on non-renewable resource “clawback” approach are worth considering in greater detail.

First, no source of revenue will exist for all time. Non-resource enterprises that generate sales tax and corporate and personal income taxes succeed and fail based on many factors. Western countries, states and provinces, that a decade ago made substantial income from the information technology sector and call centres, are now watching these revenues migrate to India and other Asian countries.

Even supposedly renewable natural resources such as fish can be destroyed by folly or a fundamental misapprehension of the circumstances affecting the health of the stocks. The reasonable lifespan of a mine or oil field may be 50 to 100 years. It took a mere 50 years for human misadventure to decimate the supposedly renewable fish stocks that had fed most of the Western world for five centuries.

Second, the “clawback” argument is one most often advanced by advocates of increased federal Equalization transfers to provinces. No one should forget that the Equalization program is funded entirely through federal general revenues. In other words, a significant portion of federal revenues derive from the very same sources for which the provincial governments claim a theoretical exemption from Equalization. Logically, what is sauce for the provincial fiscal goose should be sauce for the federal gander. The federal government holds obligations to provide services to residents of Canada just as the provinces do. Therefore, if one accepts that some revenues come from “non-renewable” sources, it would be logical for the federal government to seek the same exemption for its revenues as the one demanded by some provinces.

It is beyond the scope of this paper to calculate the level of federal funding from “non-renewable” sources. Were the amount to reach $10 billion – approximately the total outlay for Equalization – it is conceivable that the federal government would seek to eliminate the Equalization program altogether, possibly transform the system to one of low-interest loans or seek to control how province’s spend the Equalization transfer.

The 85:15 revenue split: In the overhead slide presentation, the provincial government includes several colourful charts that purport to show that the federal government receives 85 per cent of revenues from the offshore with the Government of Newfoundland and Labrador receiving only 15 per cent. A similar argument and similar slides are also found in the report of the Royal Commission on Renewing and Strengthening Our Place in Canada and in two research papers completed for that Royal Commission, one by David Norris and the other by John Crosbie.

Sadly for those wishing to assess the argument, none of these documents contains the data used to compile the charts. Neither the provincial government overhead slides nor Mr. Crosbie’s paper contain any figures. Mr. Norris does provide some evidence of his calculations. David Norris was a member of the provincial government team that negotiated the Atlantic Accord. A former provincial deputy minister of finance, Mr. Norris is currently a senior advisor to Premier Danny Williams. In 2002/2003, Mr. Norris served as senior researcher for the Royal Commission on renewing and strengthening our place in Canada. Mr. Norris is also author of one of the research papers the Royal Commission released with its final report. The fiscal position of Newfoundland and Labrador is broad overview of the provincial government’s financial status. It includes prominent sections on offshore revenues that undoubtedly form much of the basis for current government policy. In it, Mr. Norris argues, among other things that “The revenue analysis concludes that the Government of Canada is the “principal beneficiary” of future offshore oil revenues.” Given the obvious connection between Mr. Norris and current government policy and the fact that his paper is reasonably detailed, the remainder of this section will discuss the revenue split argument as he presented it.

Mr. Norris’ conclusion follows a lengthy preamble in which he sets the bases for his remarks and his assumptions on revenues and relative amounts flowing to each of the provincial and federal governments. He also quotes from section 2 (c) of the Atlantic Accord, the now famous “principal beneficiary” clause and deduces that “[a]ccordingly, revenue offset provisions were incorporated in the Accord which were intended to protect the province against sharp downturns in equalization entitlements.” He produces a chart showing the revenue sharing based on his analysis.

[Table 3-1 ]

On the face of it, his argument is persuasive. It does not stand up to closer scrutiny, however.

One of the fundamental problems with any economist’s projections is that they are based on assumption. Adjust the assumptions and the outcomes change, sometimes dramatically. Aside from the traditional economist’s folly of assumption, there are at least five reasons to doubt the validity of Norris’ contention.

First, the “principal beneficiary” provisions of the Atlantic Accord are undefined. It is erroneous to conclude that the phrase is synonymous with provincial government revenues. As a member of the negotiating team for the Atlantic Accord, Mr. Norris may be privy to information that does not exist in the public domain. Until such time as his contention is properly documented, we must remain skeptical of it. The matter of principal beneficiary is dealt with in greater detail below.

Second, as discussed above, the Atlantic Accord is based in part on the premise that the Equalization program would continue to apply. Knowing the premises on which the Accord was based, it is ludicrous for Mr. Norris and others to argue now the opposite of what was said 20 years ago. That single point is sufficient to cause Mr. Norris to remove the Equalization adjustment from his revenue chart above. Eliminate that single contention and the revenue sharing split moves from being a 76:24 split favouring the federal government to a 62:38 split favouring the province.

Third, the Accord’s Equalization offset provisions were never included in any public statement as being part of the revenue sharing arrangement between the Government of Canada and the Government of Newfoundland and Labrador. Mr. Mulroney’s original proposal is absolutely clear on revenue sharing: “Newfoundland will be entitled to establish and collect resources revenues as if these resources were on land.” As such, it is ludicrous to now suggest that the Government of Canada and the Government of Newfoundland and Labrador intended Equalization to be used in the calculation of relative incomes. In fact, the Atlantic Accord makes no mention of how much revenue or what proportions of revenue are to flow to each order of government. The intention of the two parties, as evident from the signed agreement, is merely that the province may have the opportunity to raise such revenues as it can.

Fourth, and flowing in the same vein, the Accord Equalization offset provisions are not structured to ensure that the flow of maximum financial benefits to the province, i.e. revenues plus offsets, are timed to coincide with the maximum level of revenues based on actual development of the offshore fields. Simply put, the offset provisions begin when oil reaches a defined level - irrespective of value. They decline until an arbitrary period has expired, in this case 12 years. As it turned out, and indeed as anyone may have reasonably expected in 1985, production from one discovery was sufficient to trigger the offset provisions. It would be ludicrous to suggest that anyone believed all four commercially-viable discoveries that existed in 1985 could have been fully developed and in production within four years. Hence it is virtually impossible for the existing offset provisions to have coincided with a period of maximum revenue for the province using both the provincial government’s revenues plus Equalization offsets.

Fifth, even if one allows that his contentions about revenue sharing are correct, Mr. Norris presents only a portion of the revenues flowing to the province. As noted in Section D of this paper, the province is entitled to collect revenues of no fewer than six general types. In addition, the provincial government receives indirect revenues from such sources as personal income tax, new business start-ups and revenues that come from the construction and development phase of each project.

In his chart, Mr. Norris includes only royalties, which the federal government does not claim and corporate taxes, which are in fact collected by both the federal and provincial governments. The total economic impact of offshore oil development is not considered in his argument. If these wider sources of revenue are included in the province’s claim or the paper by John Crosbie, sadly, we cannot tell since they have not made this information public.

The offset runs out too soon: Under the existing Atlantic Accord Equalization offset formula, the period of maximum potential benefit expired last year. The maximum offset existed only for the first four years after the oil production trigger was reached. Within that time, the provincial government received the largest type of Equalization offset. After four years, the level of offset declines, such that while provincial direct revenues may well grow as White Rose and later, Hebron/Ben Nevis, come on stream, the level of additional money received from the Equalization offset will diminish by 10% per year. On this point, proponents of an amendment to the Atlantic Accord are correct. That is what the Accord provides.

In assessing this argument, it is important to compare the intentions of the Trudeau and Mulroney governments on the revenue issue. The intention of the Mulroney government is clear: the Government of Newfoundland and Labrador would receive the right to set its own direct revenues for offshore resources, as if the resources were on land. Additionally, for a period of 12 years, the province would receive additional money in the form of an Equalization offset. The province would also receive local job and industrial spin-off benefits. That is what the Atlantic Accord provides; that is what has occurred.

The Trudeau government approach was different in one key respect. “The province will receive all provincial-type taxes and the largest remaining federal tax, the Petroleum and Gas Revenue Tax, the PGRT. No one can question the generosity of this proposal. When would the provincial government be expected to share some of these revenues with other Canadians? Not until the Newfoundland Government’s fiscal capacity reached 110 per cent of the national average, with an adjustment for regional unemployment that would now raise this to about 125%.”

More significantly, the Trudeau revenue sharing arrangements reflect the strategic policy commitment the Government of Canada was prepared to make prior to 1984. The federal proposal, made in September 1982, ‘ “recognizes the Government of Newfoundland and Labrador’s fundamental goal of attaining economic development and self-sufficiency by creating a strong and diversified provincial economy able to contribute fully to prosperity throughout Canada.” This goal is shared, the document states, by the Government of Canada.’

Therein lays the major flaw in the Atlantic Accord as it was originally proposed and signed: the duration of the province’s maximum potential revenues (direct revenues plus Equalization offsets) is determined by oil production levels, irrespective of the actual market value of the oil or the impact of oil development on overall fiscal capacity. Under the Trudeau proposal, it would have been linked to overall economic development.

Given the nature of industrial megaprojects of the type offshore Newfoundland and Labrador, it is not at all surprising that each project takes a considerable period of time to bring on stream. The Hibernia development agreement was signed in September 1990; first oil was achieved fully seven years later. It was fully two years after that date that Hibernia reached a sufficient level of production to trigger the Accord’s Equalization offset provisions.

Admittedly, the provincial government did not have the benefit of experience in making its calculations about the Atlantic Accord’s various benefits. However, as the overhead slide presentation indicates, the provincial government apparently anticipated rapid development of the existing fields, continued offshore discoveries at the pace experienced between 1979 and 1984/85, higher royalty regimes and oil prices remaining at then-prevalent levels.

It is beyond the scope of this paper to assess the validity of these assumptions in detail. Such an effort has not been undertaken to date and, in fact, much of the information required would be exempt from public disclosure since they were contained in documents submitted to cabinet. On the face of it, however, it would appear that the provincial government used optimistic projections when assessing the Mulroney offer. Any downward revision of their assumptions – for example, lower per barrel prices for oil – and the revenue impacts alter significantly.

Interestingly, according to slide 7, the provincial government expected that “have status” for Newfoundland and Labrador, i.e. that the province would no longer receive Equalization was “a foregone conclusion”. The one data table from 1985 that has been released (overhead slide 9) does not appear to support that contention, at least in so far as the chart might represent an anticipated worst case scenario. “Revenue and Equalization – 1985 Expectation” examines only royalties, instead of all revenue sources, and only from the Hibernia project. The graph clearly shows that royalties alone from Hibernia would not be sufficient to replace Equalization. In fact, anticipating the Accord offset provisions would begin in 1991, the graph shows the province expected Equalization transfer to climb beginning in 2004/05 and exceed pre-Hibernia levels by 2013.

That said, there can be no doubt that the Atlantic Accord Equalization offsets are working as intended by the Government of Canada and the Government of Newfoundland and Labrador. The provincial government expectations provided in the overhead slide presentation are not reflected in any aspect of the Atlantic Accord or the subsequent implementation legislation.

Given several years of experience and based on the intention of the federal government prior to 1984, it is possible to make a case for amending the Accord’s Equalization offsets. This will be addressed below.

Continued in Part 4