May 1, 2014

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Fiscal Pulse Global Economics

Ontario 2014-15 Budget Mary Webb (416) 866-4202 mary.webb@scotiabank.com

Emily Jackson (416) 863-7463 emilyj.jackson@scotiabank.com

The Budget presents a multi-faceted plan intended to grow the economy, close the infrastructure gap, invest in people and reinforce retirement saving, alongside balanced books by FY18.

Black ink by FY18 is now more ambitious. The revised $11.3 billion FY14 deficit is $0.4 billion ahead

of Budget, encouraging but a fraction of the average annual $3.4 billion improvement over the past four fiscal years, offering FY15 less of a head start. Relative to last year’s deficit reduction plan, the projected $12.5 billion FY15 shortfall (1.8% of GDP) is $2.4 billion wider, the FY16 and FY17 gaps of $8.9 and $5.3 billion average $1.75 billion wider and the forecast FY18 zero balance compares with the former outlook for a $0.5 billion surplus. Relative to the slightly more modest deficit reduction plan in place from FY10 to FY12, the slippage over the next four years totals just $4 billion relative to the cumulative bottom line outperformance from FY10 to FY14 topping $14 billion.

For FY15, the $3.5 billion drop forecast for revenues from the year-earlier projections, before

almost $2.0 billion of Budget measures, reflects a softer economy, a narrower tax base, a $1.2 billion drop in Equalization from Ottawa and substantive prior-year revenue adjustments.

To broaden and deepen Ontario’s economic expansion, a ten-year strategy is anchored by a $2.5

billion Jobs and Prosperity Fund to attract new industry, and two dedicated infrastructure funds to allocate $15 billion to Greater Toronto and Hamilton Area transit investment over the next decade and almost $14 billion to transportation and other infrastructure projects across the rest of Ontario.

From FY16 through FY18, revenue gains are expected to step-up to an average 4.3% annually, while

total expenditure increases average 0.8% per year. Substantive longer-term savings include the government’s proposal to drop its 100% retiree benefit coverage to 50% for employees retiring after December 2016.

Net debt, as measured by Ontario, is expected to peak in the range of 41% of GDP in FY16, and start to

significantly decline in FY18. Net debt climbed $17.1 billion in FY14, $3.7 billion less than the Budget estimate given lower infrastructure outlays, with forecast increases over $16 billion for FY15 and FY16.

Long-term public borrowing of $35 billion is planned for FY15, assisted by $2.6 billion of pre-

financing that raised FY14 issuance to $36 billion from Budget estimate of $33.4 billion. A Canadian dollar green bond issue is planned for early FY15 at the same yield as Ontario bonds of comparable term and size1. For FY16 and FY17, forecast long-term financing is $37.6 billion and $32.9 billion, respectively.

1 Fiscal Pulse: Ontario Green Bonds (May 1, 2014).

Source: Finance Ontario; Finance Canada; Statistics Canada; nominal GDP forecasts: Scotiabank Economics.

Overview p. 2-4 Path to FY18 p. 4 The Economy p. 2 Budget Arithmetic p. 3 Outlook p. 4

Focused on Mid-Term Results

Infrastructure p. 5 ON Pension Plan p. 5

-8

-6

-4

-2

0

2

-20

-15

-10

-5

0

5

FY90 93 96 99 02 05 08 11 14b 17b

Federal

OntarioOntario

Balances, LHS

$ billions %

% of GDP, RHS

Ontario's Budget Balances …

0

120

240

360

10

22

34

46

FY90 93 96 99 02 05 08 11 14b 17b

Net Debt, LHS

$ billions%

% of GDP, RHS

... and Net Debt

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Overview

Revenues

The $443 million estimated improvement in the FY14 deficit in part relies upon Ontario’s generous reserve and contingency funds. Although total expenditures in FY14 are expected to be more than $600 million below Budget, they will offset just over half of the $1.2 billion revenue shortfall as tax receipts drop $1.5 billion below Budget. This year’s Budget estimates again build in substantial insurance, albeit somewhat more modest, assuming economic growth slightly lower than the average of private-sector forecasts, combined with $515 million in current and capital contingency funds plus a $1.0 billion reserve in FY15, with the latter climbing to $1.2 billion annually for FY16-FY18. The Budget assumes that Ontario’s real GDP growth will accelerate from 1.3% last year to 2.1% in 2014 and average a solid 2½% for 2015-17. The government forecasts that inflation, recently subdued and limiting tax receipts, will climb, leading to 4½% nominal GDP gains from 2015-17 after the estimated 2.7% rise in 2013. Accelerating revenue gains from an estimated 2.0% in FY14 to 4.7% in FY16 mirror the step-up in own-source receipts from a 1.9% advance in FY14 to a 5.0% jump in FY16. Supporting own-source receipts is personal income tax (PIT) growth averaging 5.8% for FY15-FY17, in part due to the 2012 fourth bracket introduction and the further bracket changes proposed for 2014. Through 2016, Ontario Lottery and Gaming income will fall short of last year’s 2013 forecast, but enhanced earnings are planned for Ontario’s other major enterprises. The revenue boost from the Budget’s tax changes is expected to climb from $900 million in FY15 to $1.1 billion in FY17. Several new or increased taxes are outlined to support the dedicated infrastructure funds (text box p.5). As well, to help offset the $1.3 billion annual diversion of existing gas tax and HST revenues from general revenues to the infrastructure funds, the tobacco tax is hiked (+$140 million in FY15) and the PIT will be restructured as of 2014 (+$635 million in FY15). The threshold for the fourth tax bracket with a 13.16% rate created two years ago will be lowered from $514,090 to $220,000 and a new bracket with a 12.16% rate will be created for incomes of $150,000 to $220,000. Annual indexation of these thresholds is not planned. The government’s other revenue-raising efforts include working with Ottawa to address the underground economy, with revenue recoveries of over $60 million for Ontario in FY14. Expenditures

Projected program spending growth is expected to decelerate from 3.7% in FY14 to 2.6% in FY15 and 0.6% in FY16, before flattening in FY17 and declining in FY18 (table, p.4). Over the next two years, cumulative program outlays will be more than $2 billion higher than forecast in Budget 2013. Annual growth in health spending of 2.2% over the next three years reflects continuing reforms in areas such as home care. Growth in K-12 education spending through FY17 is expected to be slightly higher than health, as the government proceeds with a second development plan after completing the roll-out of full-day kindergarten this September. Intensifying restraint for Ministries outside of Heath, Education (K-12 and Post-secondary) and Social Services results in an average annual drop of almost 5% from FY15 to FY17. Annual program spending reviews are proposed, targeting savings of $250 million in FY15 and $500 million in both FY16 and FY17. Compensation savings, an ongoing focus, will require modest wage increases to be entirely offset by gains in productivity. Other measures range from extending MPPs’ pay freeze since 2009 to April 2019 after the Public Accounts have

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Economic Assumptions annual % change except where noted

13p 14f 15fCanada Real GDP 2.0 2.2 2.5Ontario: Real GDP 1.2 1.9 2.2 Nominal GDP 2.4 3.3 3.8

Employment 1.4 0.9 1.1 Housing Starts,000s 61 56 54

U.S. Real GDP 1.9 2.8 3.0WTI Oil, US$/barrel 98 97 92Cda T-bills,3-mos,%** 1.0 1.0 1.2Cda Bonds,10-yr,%** 2.3 2.8 3.4Cdn Dollar, US¢ ** 97 89 88

13p 14f 15f 16f 17fOntario: Real GDP 1.3 2.1 2.5 2.5 2.6 Nominal GDP 2.7 3.5 4.4 4.4 4.6

Employment 1.4 1.1 1.5 1.6 1.4 Housing Starts,000s 61 58 60 67 69

U.S. Real GDP 1.9 2.7 3.0 2.9 2.8WTI Oil, US$/barrel 98 97 96 96 98Cda T-bills,3-mos,%** 1.0 1.0 1.3 2.4 3.3Cda Bonds,10-yr,%** 2.3 2.8 3.5 3.9 4.3Cdn Dollar, US¢ ** 97.1 90 91 92 93________* Forecasts as of March 26, 2014. ** Annual averages. Source: Ontario Finance, Statistics Canada, CMHC, U.S.Bureau of Economic Analysis, Scotiabank Economics.

Scotiabank Economics*

Ontario Finance

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confirmed balanced books in FY18 to developing a compensation framework, with severance provisions and hard caps, for senior executive. A saving of over $1.4 billion is forecast in FY18 from aligning public service retiree benefits to the private sector. Unlocking greater value from public-sector assets is planned through operational improvements, asset revitalization or asset sales. Realized gains are fore-cast from selling Ontario’s remaining interest in General Motors and some real estate parcels. The mandate for an Advisory Council on Government Assets includes maximizing returns from Hydro One, Ontario Power Generation and the Liquor Control Board, with combined FY14 revenues of $2.7 billion. Households as of 2016 will benefit from the removal of the Debt Retirement Charge1 as the Clean Energy Benefit is completed in December 2015 and a new rate-base program is implemented. For FY15 to FY17, the planned 3.5% average annual increase for social services covers a range of projects such as annual indexation of the Ontario Child Benefit as of mid-2015 after the increase this July, a 1% rise in social assistance rates for adults and the disabled this September alongside streamlined and more effective employment benefits; and, $485 million over three years to raise support for developmentally disabled adults. Ontario’s hourly minimum wage will climb 7.3% from $10.25 to $11.00 per hour in mid-2014 with annual indexation proposed thereafter. A ten-year $2.5 billion Growth and Prosperity Fund will be used to attract major industry investments in growth sectors such as life sciences and information & communications technology. To support manufacturing, a Trillium Advanced Manufacturing Network is planned. For power, the Industrial Conservation Incentive will be expanded and the Industrial Electricity Incentive introduced, offering discount rate contracts through 2024 on up to four terawatt hours of electricity annually to firms intending job creation. In the financial sector, a review of the credit union and caisses populaires legislation is planned for the Fall. Ontario is proposing prohibiting credit union insurance product promotion online if it is not allowed in their branches. Provincial FY14 infrastructure outlays, estimated to be $2.2 billion less than Budget at $10.8 billion, in FY15 will rise by $1.5 billion (+13.6%) to $12.3 billion. Over the next decade, over $130 billion of capital spending is planned. For FY15 and FY16, the dedicated fund for Greater Toronto and Hamilton Area transit will top up investment by $1.7 billion annually, as the second fund adds $1.6 billion annually to other regions’

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Ontario Budget Arithmetic $ millions except where noted

Budget Rev. BudgetPersonal Income Tax 27,578 27,512 29,172Corporations Tax 11,269 11,369 10,254Harmonized Sales Tax 21,856 20,381 21,937Ontario Health Premium 3,226 3,178 3,321Other Taxes 18,046 18,014 18,681Tax Revenue 81,975 80,454 83,365

Gov't Bus.Ent. Income 4,479 4,751 5,026Other Non-Tax Revenue 7,916 8,208 8,598Total Own-Source Rev. 94,370 93,413 96,989

Federal Transfers 22,475 22,240 21,882of which Equalization 3,169 3,169 1,988

Total Revenue 116,845 115,653 118,871

Health 48,855 48,767 50,055Education, K-12* 24,147 23,846 24,840Post-Secondary, Training 7,743 7,604.7 7,838.8Social Services 14,334 14,086 15,013Other Program Spending 21,904 22,094 21,620Total Program Spending 116,983 116,396 119,366

Debt Service** 10,605 10,556 11,010Total Expenditure 127,588 126,952 130,376Reserve 1,000 0 1,000Surplus (Deficit) -11,743 -11,300 -12,505

Long-Term Borrowing 33,400 36,000 35,000New 9,400 12,200 13,000Refunding 24,000 23,800 22,000

Annual Change, %Personal Income Tax 7.8 7.6 6.0Corporations Tax -6.8 -6.0 -9.8Harmonized Sales Tax 4.3 -2.7 7.6Total Tax Revenue 3.2 1.3 3.6

Total Own-Source Rev. 2.9 1.9 3.8

Federal Transfers 3.8 2.7 -1.6Total Revenue 3.1 2.0 2.8

Health 2.7 2.5 2.6Education, K-12* 4.3 3.0 4.2Post-Secondary, Training 5.4 3.5 3.1Social Services 5.1 3.3 6.6Other Program Spending 6.5 7.5 -2.1Program Spending 4.2 3.7 2.6Expenditures 4.1 3.6 2.7

Memo Items, %Own-Source Rev. / GDP 13.7 13.5 13.6Program Spending / GDP 16.9 16.9 16.7Budget Balance / GDP -1.7 -1.6 -1.8Debt Service**/ Revenue 9.1 9.1 9.3________* Ex FY13 one-time $1.3 bn labour cost savings & Teachers' Pension Plan.** Net of interest capitalized over construction (FY14r:$225 million; FY15b:$336 million). Source: Ontario Finance; Statistics Canada;

nominal GDP forecasts: Scotiabank Economics.

FY15FY14

1 The Debt Retirement Charge will remain on non-residential bills until the residual stranded debt is retired, likely by year-end 2018.

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capital projects. Each fund is intended to address priorities and achieve complex projects such as access roads to open up Northern Ontario’s Ring of Fire mining development, a project conditional on federal financing. Additional Measures To strengthen retirement security, the government is developing the Ontario Retirement Pension Plan (ORPP), introducing legislation for Pooled Retirement Pension Plans and consulting on a framework for multi-employer target benefit plans. The government’s reiterated concern is that individuals, particularly the middle class, are not saving enough to maintain their standard of living through retirement. Factors contributing to this shortfall include: increasing longevity, limited Old Age Security (OAS) and Canada Pension Plan (CPP) benefits, the lack of workplace pensions for two-thirds of Ontario’s working population, and the difficulties inherent in voluntary saving. The ORPP’s initial objective is to expand pension coverage to more than 3 million Ontarians with only CPP, OAS and their personal savings for retirement. As a targeted benefit plan, it adopts key CPP features, allowing integration with the CPP in the future (text box, p.5). Phasing in ORPP contributions is expected to start in 2017, coinciding with the anticipated drop in federal Employment Insurance premiums when they shift to a seven-year break-even rate. For cost effectiveness, Infrastructure Ontario’s borrowing will be through the Ontario Financing Authority. In FY14, the effective interest rate on Ontario’s total debt dropped to 3.9%; 82% of Ontario’s borrowing was completed in domestic markets; and for the fourth year in a row, the average term of issuance was more than12 years, at 13.6 years, lessening Ontario’s sensitivity to future interest rate increases. To provide ample liquidity, Ontario’s average liquid reserves approached $25 billion in March 2014, up from $8.3 billion in FY09.

Outlook

From FY10 to FY13, Ontario relied upon substantially outperforming annual deficit targets to limit the rise in its net debt and create some room for new priorities in the upcoming year. This flexibility was largely absent in FY14 and complicated by further revenue setbacks in FY15. Responding to softer revenues and several other pressing issues, such as Toronto and Hamilton’s escalating traffic congestion, the Budget offers a ten-year plan to grow the economy and foster job creation. Yet even with the Budget’s assumption that provincial growth and revenues rebound from FY16 to FY18, balanced books depend upon three years of total spending growth averaging less than 1.0%. Thus outperforming the bottom line is again required to regain some flexibility. The strengths of the government’s longer-term plan include its careful timing and the many aspects that are mutually reinforcing. Attracting and retaining new industry in Toronto, for example, will depend upon alleviating current congestion costs, with other proposals, such as reducing regulation, easing other rigidities. The drag on the economy from phasing in contributions for the Ontario Retirement Pension Plan starting in 2017 will be lessened by Ottawa’s plans to reduce a federal payroll tax, Employment Insurance premiums, as the provincial economy is expanding more strongly. Thus the government’s challenge is to effectively execute this longer-term plan to raise output and revenue growth. Its advantage, in a global economy with significant underutilized capacity, is the broadly anticipated U.S. economic recovery and the softer Canadian dollar.

Ontario’s Revised Path to FY18 annual % change except where noted

FY14r FY15b FY16b FY17b FY18bTotal Revenue 2.0 2.8 4.7 4.0 4.2

Program Spending 3.7 2.6 0.6 0.1 -0.7 Debt Service* 2.1 4.3 9.0 10.8 6.8Total Expenditure 3.6 2.7 1.3 1.1 0.1

Reserve, $ bn 0.0 1.0 1.2 1.2 1.2Budget Balance, $ bn -11.3 -12.5 -8.9 -5.3 0

Long-Term Borrowing, $ bn 36.0 35.0 37.6 32.9 n.a.________* Net of interest capitalized over construction (FY14r: $0.2 bn; FY15b: $0.3 bn, FY16b: $0.3 bn, FY17b: $0.4 bn). Source: Ontario Finance.

10

12

14

16

18

FY90 94 98 02 06 10 14r 18b

Program Spending

Revenues% of GDP

Ontario's Fiscal Gap

Source: Ontario Finance; nominal GDP forecasts: Scotiabank Economics.

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Summarized below are the revenue sources for the two ten-year dedicated funds totaling $28.9 billion. The existing Harmonized Sales Tax (HST) on provincial gasoline and road diesel taxes plus 7.5¢ from

the existing gas tax (beyond the permanent 2¢ already allocated to municipalities to fund transit infrastructure) are expected to contribute $14.5 billion over ten years, roughly half of the required funds.

Three tax increases — phasing out the small business deduction for corporations with taxable capital

over $10 million, removing the fuel tax exemption for road-building machines, and lifting over four years the aviation fuel tax from 2.7¢/litre to 6.7¢ — are projected to raise $1.5 billion (a 5.2% share).

Allocating net revenue from certain asset sales to the proposed Trillium Trust, a special fund dedicated

to infrastructure, is forecast to yield $3.2 billion (a 10.9% share). From the federal Building Canada Plan, Ontario assumes $2.6 billion (an 8.8% share). Provincial borrowing to top up the funds is expected to total $7.2 billion, representing almost 25% of

the targeted funds. When high-occupancy toll lanes become available, their revenues will be allocated to infrastructure. With the ‘First Wave” of projects under Metrolinx’s regional transportation plan under way, the fund dedicated to Toronto-Hamilton transit will focus on the next priority projects, including two-way, all-day GO rail service. Among the projects anticipated for the fund focused on the rest of Ontario is rail and bus transportation under the Ontario Northland Transportation Commission.

Ontario Retirement Pension Plan (ORPP) Similar to the Canada Pension Plan, the ORPP will be a target benefit plan, pooling longevity and investment risk, and offering predictable monthly benefits indexed to inflation. Contributions will be phased in over two years, evenly split between employers and employees, to a combined maximum of 3.8% of earnings up to a $90,000 threshold that will be indexed each year. Contributions will not be required below a certain taxable income threshold; the CPP currently uses $3,500 but Ontario will review the level. The annual benefit is expected to equal 15% of an individual’s earnings, up to the maximum threshold. This compares with the CPP at 25% of the yearly maximum pensionable earnings set at $52,500 for 2014 and indexed. Benefits will be earned as contributions are made, ensuring that younger generations are not burdened with additional costs. Arm’s length management and investment of the plan is intended. ORPP will be mandatory for employers without plans, but workers already with an employer plan will not be included. For the future, the government will consider how best to meet the retirement savings needs of the self-employed. It is expected that firms with plans such as group RRSPs may decide to join. The largest employers will be enrolled first, with their contributions phased in over two years. Smaller firms subsequently will be enrolled. When fully rolled out, $3.5 billon of annual contributions for approximately 3 million members is anticipated. Further actuarial analysis and consultation are expected to continue into the Fall, when legislation is planned.

Infrastructure