Ontario Budget Notes

Last week’s Ontario budget was quite momentous and challenging to digest. Budget analysis was initially overtaken by the Premier’s minimum-wage musings.

The budget featured a combination of large expenditure increases and large revenue reductions. Overall, I think that it embodies the proposal from bank economists for temporary spending and permanent tax cuts. While it provides proportionally more short-term stimulus than the federal budget, it does not bode well for the longer-term investment in public services needed to renew Ontario’s economy.

Expenditures

The provincial budget increases annual program expenditures by $11.1 billion in 2009-2010 and by a further $5.1 billion in 2010-11 (p. 84). By comparison, the federal budget increases annual program expenditures by $22.3 billion in 2009-10 and by a further $7.4 billion in 2010-2011.

The Ontario budget provides more than half as much additional spending as the federal budget did for the entire country. To put this level of stimulus in context, the province accounts for less than half of the national economy and Ontario provincial expenditures currently amount to less than half of federal expenditures.

But the story does not end there. In 2011-12, the Ontario plan cuts program spending by $2.8 billion (versus that year’s planned federal cut of $1.4 billion). To balance the provincial budget by 2015-16, program spending subsequently grows by little more than 2% annually (p. 90). This rate covers the Bank of Canada’s inflation target but not population growth.

Combining the immediate 13% jump in provincial spending with the subsequent austerity yields a 26% rise over seven years, or 3.7% per year. This pace is hardly blistering if one expects long-run real GDP growth of a couple percent annually, plus a couple percent of inflation. Indeed, the budget itself projects nominal GDP growth of 3.6% in 2010 and 4.7% in 2011 (p. 67).

Although widely hailed as a big-spending budget, this plan would actually shrink the fraction of Ontario’s economic resources available for provincial public services. This reduction is required to balance the budget because Queen’s Park also chose to institute costly permanent tax cuts.

Revenues: Sales Tax

The budget’s centerpiece is the quasi-harmonization of the provincial sales tax with the federal GST. As previously noted, I think that sales tax harmonization is widely overrated as a policy option.

A particular concern was that pure harmonization would reduce Ontario’s fiscal capacity. In fact, the expanded provincial sales tax will include almost everything covered by the GST while still applying to some GST-exempt items (such as insurance premiums). As a result, Ontario’s move to a value-added tax will increase annual revenues by well over $2 billion.

Of course, the value-added tax exempts most business inputs. As reported on the front page of Friday’s Globe and Mail, this exemption will save business $3 billion annually. By temporarily continuing to tax some inputs, the government will collect more than $1 billion annually for several years (p. 134).

To me, the province’s projected gain of $2 billion in sales-tax revenue over and above these amounts implies that the new sales tax will collect some $6 billion more per year from consumers. Unfortunately, budget documents provide only the net revenue gain ($2 billion+) without any breakdown of the underlying revenue gains and losses from different sources.

The budget argues, “Studies show that most of the cost savings to business from removing embedded sales taxes are passed on to consumers through lower prices.” However, only if all of the business cost savings were passed through to Ontario consumers would $2 billion be the total cost increase for provincial residents.

In practice, some businesses will not pass on the savings and others (i.e. exporters) will pass them to consumers outside Ontario. In any case, analysis of the ultimate economic incidence of these tax changes should not prevent the Ministry of Finance from revealing their statutory incidence.

The budget aims to offset the expanded consumption tax’s regressive effect with personal income tax cuts and credits. Unfortunately, this revenue loss completely offsets the revenue gain from broadening the sales tax.

Current and former C. D. Howe Institute presidents eagerly argue that exempting business inputs will spur investment. They neglect to mention that Ontario’s existing sales tax already exempts many fixed investments such as machinery and equipment. Even so, it probably makes sense for business to pay tax on profits rather than on inputs.

Revenues: Corporate Tax

However, the provincial budget does not enact the principle of taxing profits instead of inputs. On the contrary, it slashes the provincial tax rate on corporate profits from 14% to 10%. This cut will cost relatively little while corporate profits are depressed. But when the economy and corporate profits recover, it will prevent a corresponding recovery of provincial revenues.

Budget documents estimate the corporate tax cut’s cost only through 2012-13, when it will reduce annual revenues by $1.7 billion (p. 134). But the 10% rate is not fully phased-in until July 2013, partway through the following fiscal year. When asked, Finance officials in the budget lock-up indicated an annual cost of $2.3 billion by 2014-15.

Whereas the sales and personal-income tax changes have offsetting effects on Ontario’s fiscal capacity, the corporate tax cut must be considered a large and growing drain on the provincial treasury.

For more on the inadequacy of untargeted corporate tax cuts as an economic strategy, see the USW press release.