Equalization Payments

What Are Equalization Payments?

An equalization payment is a transfer payment made to a state, province, or individual from the federal government for the purpose of offsetting monetary imbalances between different parts of the country or between individuals. Equalization payments represent wealth or income redistribution between regions, jurisdictions, or administrative districts. Equalization payments may help equalize economic outcomes across regions, but they also tend to subsidize or bailout fiscally irresponsible regional governments and create significant moral hazard.  

Understanding Equalization Payments

Equalization payments are commonly known as "transfer payments" because they represent transfers of wealth and income directed by the government from some people to others. "Equalization payments" is the preferred term among proponents of such policies because of the positive connotation widely attached to the concept of equality. 

In many countries, there is a vast diversity between states and provinces in terms of the quality of economic institutions, government taxing and spending policies, natural resource endowments, labor force characteristics, etc., that result in different economic outcomes such as availability of employment, economic development, personal incomes, and regional tax bases. In order to equalize these economic outcomes, higher level governments can impose wealth and income transfers that take from richer parts of the country and transfer to poorer areas. 

In general they take the form of a program at the national level that involves explicit payments from some regional governments (payers) to the national government, which then redistributes direct payments among others (receivers). The size and manner of these payments may be based on a number of economic and political considerations. Unsurprisingly, these policies tend to be quite popular among recipients.

Equalization Payments in Different Countries

Although there is no single formalized equalization payment program in the United States, the many various federal spending programs, social assistance, and federal grants to states tend to have a similar effect, creating net payer and net receiver states with respect to net federal transfers. Programs such as entitlements like Medicaid and Social Security, defense spending, and block grants to states for various purposes are disparately distributed across states but are not explicitly targeted at directly reducing differences in regional economic outcomes. 

On a global scale, formal equalization payments are commonly distributed in other countries, including Canada, Australia, and Switzerland.

Equalization Payments in Canada

In Canada, the federal government frequently provides equalization payments to less wealthy Canadian provinces to equalize their ability to generate tax revenues. In 2019–2020, five provinces received $20.5 billion in equalization payments from the federal government. Until the 2009–2010 fiscal year, Ontario was the only province to have never received equalization payments. Meanwhile, Newfoundland, which had been receiving payments since the program's creation, no longer requires equalization payments and is considered a net contributor.

Canada's territories are not included in the equalization program; the federal government addresses territorial fiscal needs through the Territorial Formula Financing (TFF) program.

Equalization Payments in Australia

In 1933, Australia introduced a formal system of equalization payments to compensate states and territories with lower capacities to raise revenue. The objective is full equalization, in which each of the six states, the Australian Capital Territory, and the Northern Territory has the capacity to provide services and infrastructure at the same standard — if each state or territory made the same effort to raise revenue from its own sources and operated at the same level of efficiency.

Equalization Payments in Switzerland

Equalization payments were first introduced in Switzerland in 1938 in the form of conditional grants. These varied according to the tax capacity of the cantons. In 1958, a constitutional article authorized the federal government to equalize fiscal disparities. Christopher Hengan-Braun, a Swiss economist, helped guide the Swiss federal government through the process of balancing the country's fiscal disparities.

Moral Hazard of Equalization Payments

Equalization payments, like any government wealth and income transfers, run the risk of creating a substantial moral hazard among recipient jurisdictions. Many differences in economic outcomes across regions are the result of factors that are in whole or in part matters of choices made by regional governments or their residents, such as the quality of economic regulation, the taxing and spending habits of governments, and the willingness of local governments and voters to accept the trade-offs that come with economic development. 

To the extent that these factors are at play, equalization payments function as subsidies for poor choices by regional governments and voters as well as, conversely, as a penalty imposed on regions whose choices are more favorable to positive economic outcomes. This creates a moral hazard where regional governments are incentivized to make decisions that may be popular with local voters but delay economic outcomes in the region and oppose decisions that encourage local economic growth and fiscal stability.