Being Dependent on Royalty Revenue is Bad Public Policy: Lessons from the Oil Crash

Steven Lamothe

Over the past year, the largely resource-based economy of Alberta has been brought to a sudden and devastating halt. With the advent of the shale oil revolution in the United States turning Canada’s main oil-buying customer into an oil exporter, and with OPEC’s unwillingness to constrain its oil supply, combined with the global oil demand slowdown, the price of oil has collapsed, taking the Alberta economy with it. As a result of tens of thousands of workers related to the oil sector being laid off, the Alberta unemployment rate has quickly risen by 2.3 per cent since this time last year, from 4.7 per cent to 7.0 per cent. This rapid economic deterioration in Alberta is in stark contrast to the economic conditions just two years ago, when the Alberta economy was widely considered to be a major driver of economic growth in Canada.

Whether Alberta should have or could have implemented public policy aimed at diversifying the provincial economy—in order to prevent this type of crash—is subject to considerable debate. However, a clear area of irresponsibility on the part of the Alberta government has to do with how it managed the province’s public finances during the years of high oil prices and the economic boom. These policy errors should not be ignored, and should serve as a dire warning and teachable lesson to other provinces that may end up with a resource boom in the future.

During the years of rapid economic growth driven by high international oil prices, the Alberta government took in massive amounts of oil royalty revenue. For the 2013-2014 fiscal year, for example, the last year before oil prices started their rapid decline, the government took in $9.578 billion in royalty revenues, or approximately 21 per cent of total revenue. In total since 2000, non-renewable resource revenue has made up an average of almost 30 per cent of all annual Alberta government revenue. This revenue can be extremely useful if managed properly or responsibly, like being put into a rainy day fund or being used for diversification efforts. However, the Alberta government was neither properly nor responsibly using these non-renewable resource revenues while they were still rolling in.

Instead, the Alberta government used this extra revenue to increase spending while at the same time keeping taxes as low as possible. This created a gap between standard tax revenue the Alberta government was receiving and its funding commitments, which it was financing with oil revenue. The benefits of this budgetary strategy are obvious, the government could spend more on government services while keeping taxes low, which is essentially any politician’s dream.

However this was an incredibly risky strategy for two key reasons. First, once this budgetary strategy is adopted, it becomes very difficult to change, because in order to fill the gap between spending and general tax revenue, the government would have to cut spending, increase taxes, or both; something no rational politician would ever want to do. Second, if oil prices collapse, the difference between expenditures and revenues becomes very large, resulting in large budget deficits that are both difficult to eliminate and economically dangerous, especially over the long term. The end result of this strategy for Alberta is a government that currently faces a massive budget deficit and relatively little political leeway to tackle it effectively.

Unfortunately, although Alberta has been the Canadian pioneer of this risky strategy, it is not the only province that practices it. Both Saskatchewan and Newfoundland rely on resource revenue to fund their spending commitments. Although Saskatchewan is weathering the storm brought on by the oil price collapse relatively well due to its strong potash and metal mining industries, Newfoundland is not.

The Newfoundland and Labrador government, in addition to having to deal with an economic contraction similar to the one faced by the Alberta government, also faces a fiscal crisis much more dangerous, which threatens to do even more damage to the provincial economy. In 2013-2014, the Newfoundland and Labrador government took in 32 per cent of its total revenue from resources royalties, a higher percentage than both Alberta and Saskatchewan. When the price of oil began to fall, the Newfoundland and Labrador budget deficit began to skyrocket to dangerous levels. Currently, the Newfoundland and Labrador budget deficit is projected to be the largest recorded in its history at $1.96 billion, or 7 per cent of total GDP, and is expected to rise again next year. This ballooning deficit presents a clear financial danger to the province, but the provincial government, like the one in Alberta, doesn’t have many tools at its disposal if it wants to prevent a political disaster. The government would either have to increase taxes, cut spending, or both, all of which are politically risky policies to put in place, but all seem inevitable given the circumstances, unless oil rebounds soon.

Although the provinces of Alberta and Newfoundland would clearly have been better off if they had saved some of their resource revenue, history tells us that these same mistakes will likely be repeated in the future. Alberta, for example has been through this exact same situation before in the late 1980’s after oil prices collapsed. However, when oil prices recovered in the early 2000s the government proceeded to make the same mistakes by funding major spending commitments with resource revenues. Unfortunately, it appears that the hard lessons learned from dependency on resource royalties during bad economic times are quickly forgotten once good economic times return.

 

Steven Lamothe is a 2017 Master of Public Policy candidate at the University of Toronto School of Public Policy and Governance. Originally from Fort McMurray, Alberta, he previously completed a Bachelor of Arts degree in Economics from the University of Calgary. His areas of policy interest include environmental policy, energy policy, and public finance. 

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One response to “Being Dependent on Royalty Revenue is Bad Public Policy: Lessons from the Oil Crash

  1. Pingback: Globalization - End of an Era? | George Dus·

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