The debate over Ottawa’s equalization payments to economically disadvantaged provinces is not primarily about special treatment or about disincentives the program creates for recipient provinces. 

The real debate is about the proper role of nonrenewable resources within the equalization program. 

Resource revenues have been a constant trouble spot for equalization. When the equalization system was created in 1956, the formula, which sees richer provinces help poorer ones, excluded resource revenues. Half of resource revenues were added in 1962, and for the next 20 years Ottawa fiddled with the treatment of resource revenues eight times. 

In 1982, Ottawa moved to a five-province standard, excluding Alberta, and hence its huge resource revenues, from the calculation of payments to recipient provinces. More recently, Ottawa has further tinkered with the resource formula to try to reduce its disincentive effects on the provinces. And, the federal government has created a number of cash transfers into the Atlantic region (Hibernia, various development funds) to offset the impact of falling equalization payments as resource royalties grow. 

There is a good explanation as to why resource revenues have never quite fit properly within the equalization formula. Nonrenewable resource royalties are of a fundamentally different nature from other types of revenues. 

An accounting illustration provides the backdrop: 

Revenue from bread that Bill the Baker sells is income — it affects the profits and losses of the bakery. However, if Bill sells one of his ovens, the money from that sale does not enter the income statement. This sale is a balance sheet transaction. (This is a simplification: Interest on the cash from the sale may later enter the income statement, replacing the depreciation that existed before.) 

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

Nonrenewable resource royalties are quite different. According to the Canadian Constitution, the provinces own these resources. (While offshore resources legally belong to the federal government, Ottawa has granted de facto ownership to Nova Scotia and Newfoundland by allowing them to collect all the royalties.) When these resources are sold and a royalty is levied on that sale, all that changes is that the province now has a cash asset instead of an asset in the ground. 

The trouble is, equalization does not make the distinction between income and the proceeds from the sale of a capital asset. It treats royalty revenues the same as it treats personal, corporate and sales taxes. 

Equalization payments fall in response to changes in royalties even though all the province has done is convert a physical asset into a financial asset. 

The flip side to this argument is that it matters what Nova Scotia or Newfoundland does with the proceeds from the sale of the capital asset. For if royalties represent the conversion of an asset in one form to another, the resulting cash should not be used to pay for current program spending (just as it would be unwise for Bill the Baker to spend the proceeds of the sale of his oven on paying wages for his staff). In the case of the Atlantic provinces, this cash should be used to either reduce debt, or invest in long-term infrastructure. 

This is arguably what Alberta did with its royalties in the 1970s and ’80s when it diverted some of this money into the Alberta Heritage Savings Trust fund. Today, Alberta is using resource revenues to pay down its debts and increase infrastructure spending to accommodate the rapid financial and physical net immigration to the province. 

Right now, Nova Scotia receives about $1.4 billion from equalization payments each year and Newfoundland gets about $1.1 billion. These payments are made mostly from Ontario, Alberta and B.C. 

Under the current claw-back scheme, Nova Scotia keeps only 19 per cent of its royalties with 81 per cent going to Ottawa. 

It is our view that voters in Atlantic Canada should decide on the proper use of the proceeds from the sale of their capital assets, and that these assets should not be seized via the equalization back door by Ottawa. The critical point is that the sale of the asset itself should not affect the income statement — or fiscal capacity in the terminology of equalization buffs — of the provinces. 

The elimination of nonrenewable resources from equalization will mean governments can use these financial assets to improve the economic outlook of the provinces — which in turn will reduce their reliance on equalization as Ottawa reduces payments in response to the resulting growth in personal, corporate and sales tax revenues. This is precisely how once-poor Alberta escaped an earlier variant of equalization. 

By removing nonrenewable resources from equalization, Ottawa has a chance to get out of the way and let Nova Scotia and Newfoundland make a success of their own natural economic strengths. 

This would be a more equitable and economically defensible position. It would meet the goals of ending special treatment for some provinces, making the program more equitable, and it would also improve economic incentives — a public policy hat-trick all too rare in the arcane world of equalization. 

Ken Boessenkool is the Calgary-based author of Taking off the Shackles: Equalization and the 

Development of Natural Resources in Atlantic Canada, published by the Atlantic Institute for Market Studies (AIMS). 

He was recently named an Adjunct . Research Fellow of the C.D. Howe Institute. Brian Lee Crowley is president of AIMS.