Economic Outlook and Fiscal Review 2005 - Annex I Ontario's Economic and Revenue Outlook

2005 Ontario Economic Outlook and Fiscal Review

ANNEX I

Ontario's Economic and Revenue Outlook

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Introduction and Overview

This annex outlines Ontario's current economic and revenue outlook.¹ It discusses how these have evolved since the 2005 Budget. Although the global economic environment is constantly changing, as are Ontario's growth prospects, the province's economic outlook is positive and the fiscal plan remains on track.

During the first half of 2005, the Ontario economy demonstrated considerable resilience in the face of higher oil prices and the strong Canadian dollar. The average private-sector forecast for Ontario real growth in 2005 has increased from 2.3 percent at the time of the 2005 Ontario Budget to 2.5 percent currently. Based on the positive developments to date, the Ministry of Finance real gross domestic product (GDP) growth assumption for 2005 has been increased from 2.0 percent at the time of the 2005 Ontario Budget to 2.2 percent currently.

While Ontario's economic growth has exceeded expectations during the first half of 2005, the sharp increases in oil prices and the Canadian dollar since Hurricanes Katrina and Rita have affected the province's growth prospects for the future. Private-sector forecasts for Ontario real growth in 2006 have decreased from 2.9 percent at the time of the 2005 Ontario Budget to 2.6 percent currently.

¹ This document is based on economic data available at October 26, 2005.

Ontario Economic Outlook
(Per Cent)
	2003	2004	2005p	2006p	2007p	2008p
Real GDP Growth	1.7	2.8	2.2	2.6	3.2	3.3
Nominal GDP Growth	3.3	4.7	4.1	4.5	4.8	5.0
Unemployment Rate	7.0	6.8	6.7	6.5	6.3	6.1
CPI Inflation	2.7	1.9	2.3	2.2	1.8	1.9
p = projection.
Sources: Statistics Canada and Ontario Ministry of Finance.

Private-sector forecasters expect Ontario's real economic growth to average 2.9 percent annually over the 2005 to 2008 period. This forecast reflects the interplay of external forces, including the stronger Canadian dollar, interest rates, the health of the U.S. economy and higher oil prices. Over the past few years, both oil prices and the Canadian dollar have moved in a direction that has restrained Ontario's economic growth. From 2001 to 2004, real GDP increased by an annual average rate of 2.3 percent, compared to its 20-year average of 3.0 percent. Employment is expected to rise by 1.2 percent in 2005, following a 1.7 percent gain in 2004. This has resulted in modest gains in personal income and spending.

Over the 2007 to 2008 period, growth is expected to improve as the economy adjusts to the strong dollar and higher oil prices. Private-sector forecasters expect real output to rise by 3.2 percent in 2007 and 3.3 percent in 2008. These projections of economic growth support the outlook for revenue growth over the 2005-06 to 2008-09 period. The Ontario Ministry of Finance's revised planning assumptions for 2005 to 2008 are at or below the private-sector average.

The Ontario economy has added 193,100 net new jobs since September 2003. This year, average annual employment is expected to grow by 77,000 jobs. There have been strong job gains in wholesale and retail trade; education; finance, insurance, real estate and leasing; and construction. Job gains have lowered the unemployment rate to 6.4 percent in September 2005.

Ontario employment is expected to increase by 1.4 percent in 2006, following an estimated gain of 1.2 percent in 2005, or 167,000 jobs over this two-year period. Economic growth is projected to strengthen in 2007 and 2008, generating an additional 242,000 jobs, an average increase of 1.9 percent a year. This will bring Ontario's unemployment rate down to 6.1 percent in 2008.

Ontario is part of the North American manufacturing heartland and is well situated to serve major Canadian and U.S. markets. Ontario's top 10 manufacturing export industries — contributing 89 percent of total manufacturing exports — enjoy significant skills and knowledge advantages, as well as competitive labour costs, when compared to the United States.

Ontario's top 10 manufacturing export industries have a higher proportion of their workforce that have completed postsecondary education than their counterparts in the United States. In Ontario, about 48 percent of the workforce in these industries have completed postsecondary education. In the United States, 32 percent have completed postsecondary education.

Ontarios Top 10 Manufacturing Export Industries Skills Advantage (2001)
Share of Workforce with Completed Postsecondary Education
	Ontarios Skills Advantage %*	Ontario %	U.S.%
Motor Vehicle and Equipments	16	43	27
Chemicals	12	60	48
Machinery	27	60	33
Primary Metals	25	47	22
Computer and Electronics	16	70	55
Plastic and Rubber	13	37	24
Food	19	39	20
Pulp and Paper	16	42	26
Fabricated Metal	25	47	22
Furniture	18	36	18
Total	16	48	32
* Ontario's percent of workforce with completed postsecondary education minus that of the United States.
Ages 25 and older. Numbers do not add due to rounding.
Sources: Statistics Canada, U.S. Bureau of Labor Statistics, and Ontario Ministry of Finance comparisons based on OECD standardized educational attainment categories.

For seven of the top 10 manufacturing export industries², Ontario labour costs (wages plus health costs) are lower than in the United States at 81.8 cents US (the average exchange rate for the past 12 months). These seven Ontario industries contribute 72 percent of the province's total manufacturing exports. The industries with the highest labour-cost advantage in 2003 included computer and electronics (15 percent), the automotive sector (12 percent) and chemicals (11 percent). The projected 2006 exchange rate of 84.4 cents US for the Canadian dollar in this report would reduce the labour-cost advantage for these Ontario industries by roughly three percentage points, although they remain competitive.

² These include motor vehicle assembly and parts; chemicals; computer and electronics; plastic and rubber; food; fabricated metal; and furniture.

The short-term economic outlook is strongly influenced by events originating outside Ontario, such as oil prices, the high Canadian dollar and U.S. economic growth. The provincial government has little or no influence over these developments, but it does influence the long-term trends that ultimately determine the standard of living in Ontario.

As stated in the October 2005 Throne Speech, the government is aiming to strengthen Ontario's underlying advantages, which will help maintain strong growth in the face of increasing global competition and volatility.

The $6.2 billion Reaching Higher plan announced in the 2005 Budget will invest in postsecondary education and training over the next five years, further strengthening the competitive advantage of Ontario's economy and supporting the Ontario Government's Strong People, Strong Economy priority.

 

 

Additional information on Ontario's economic performance can be found in Annex VI, Economic Data Tables .

Section I: Ontario Economic Outlook

This section outlines the Ontario economic outlook for 2005 to 2008. In order to establish reasonable fiscal plans, the government monitors and consults with private-sector forecasters to develop a set of economic projections. The assumptions about Ontario's economic performance that are used in fiscal planning are typically at or below the average private-sector forecast.

Currently, private-sector economists, on average, expect Ontario real GDP growth of 2.5 percent in 2005, 2.6 percent in 2006, 3.2 percent in 2007 and 3.3 percent in 2008.

Private-Sector Forecasts for Ontario Real GDP Growth
(Per Cent)
	2005	2006	2007	2008
Conference Board (October)	2.4	2.9	3.4	3.4
Global Insight (October)	2.9	2.5	2.8	3.0
Centre for Spatial Economics (August)	2.4	3.0	3.0	3.0
University of Toronto (September)	2.8	2.1	3.4	3.6
Bank of Montreal (August)	2.7	3.4	-	-
RBC Financial (October)	2.4	3.1	-	-
Scotiabank (October)	2.3	2.0	-	-
TD Bank (September)	2.6	2.7	-	-
Nesbitt Burns (October)	2.3	2.3	-	-
CIBC World Markets (October)	2.3	1.8	-	-
Average	2.5	2.6	3.2	3.3
Source: Ontario Ministry of Finance Survey of Forecasts (October 2005).

Changes in Private-Sector Forecasts for External Factors

Although Ontario's economic performance so far in 2005 has exceeded expectations in terms of output, employment and incomes, there have been a number of developments in the global economy that pose significant challenges.

Oil prices have risen higher and faster than almost any forecaster had projected. Other key commodity prices have increased sharply as well, including natural gas, metals and minerals. This raises costs for Ontario's businesses and consumers.

As commodity prices have climbed this year, the Canadian dollar's appreciation has gathered momentum. The currency touched a 13-year high against the U.S. dollar in late September 2005. This hinders the ability of Ontario businesses to compete in the global economy. However, the high dollar benefits some Ontario households and businesses by lowering the cost of imported consumption goods and investment in machinery and equipment.

The U.S. economy has continued to grow at a strong pace, close to the projections underlying the 2005 Ontario Budget. The devastation caused by Hurricanes Katrina and Rita temporarily disrupted the U.S. economy, but rebuilding efforts may stimulate activity in the final months of 2005 and the first part of 2006. High levels of consumer debt and the massive U.S. fiscal and current account deficits raise questions about the sustainability of U.S. economic growth.

Short-term interest rates have remained close to levels expected in May 2005. Long-term rates, however, have been significantly lower than expected. The Bank of Canada has increased its target for the overnight interest rate twice in the past two months, and has signalled that there are likely to be additional increases in the coming year.

The table below highlights the changes since the Budget in the average private-sector forecast of several external factors that are key determinants of Ontario's economic growth.

Key External Factors Affecting Ontario's Economy
Average Private-Sector Forecast
	2005 Outlook		2006 Outlook
	2005 Budget May	Current October	2005 Budget May	Current October
Canadian Dollar (Cents US)	82.0	82.4	82.4	84.4
Crude Oil ($ US per Barrel)	49.1	57.4	44.5	59.1
U.S. Real GDP Growth (Per Cent)	3.4	3.5	3.3	3.3
3-month Treasury Bill Rate (Per Cent)	2.6	2.7	3.3	3.5
10-year Government Bond Rate (Per Cent)	4.5	4.1	5.0	4.5
Sources: Consensus Economics, Blue Chip Economic Indicators and Ontario Ministry of Finance Survey of Forecasts.

The most significant change in private-sector forecasts has been a dramatic rise in the outlook for oil prices. At the time of the Budget, forecasters projected crude oil prices would average $49.10 US per barrel in 2005 and ease to $44.50 US in 2006. Since then, assessments of the price of oil have been revised substantially higher, with the average private-sector projection now $57.40 US per barrel in 2005 and $59.10 US per barrel in 2006.

Forecasts of the Canadian dollar currently average 84.4 cents US for 2006 — two cents higher than projected at the time of the Budget.

External factors have a significant bearing on the performance of the Ontario economy and deviations from their projected path can cause the province's growth to be slower or faster.

The table on the next page shows the typical range for the first- and second-year impact of changes in these external factors on the real growth of our economy. These estimates are based on historical relationships and illustrate the upper and lower bounds for the average response. The results show the implications of changes in key assumptions in isolation from changes to other external factors. The combination of other circumstances can also have a substantial bearing on the actual outcome. The range of possible impacts reflects a variety of factors. For example:

• A percentage point increase in U.S. real growth would add 0.3 to 0.7 percentage points to real growth in Ontario in the first year. In this case, the range in part reflects the fact that the impact on Ontario growth depends on the composition of U.S. growth.
• A five-cent rise in the Canadian dollar would reduce Ontario real growth by 0.2 to 0.9 percentage points in the first year. This range reflects a number of uncertainties, such as the extent to which firms pass lower import costs through to domestic prices for goods and services in Canada.
• A sustained $10 US per barrel increase in the price of world crude oil would lower U.S. growth and trim Ontario's real growth by 0.3 to 0.7 percentage points in the first year. This impact assumes a matching rise in natural gas prices since it is a substitute source of energy. The range is due in part to uncertainty regarding the degree to which higher energy costs affect consumer and business expectations and behaviour.
• A one percentage point rise in nominal interest rates would reduce Ontario real GDP growth by 0.1 to 0.5 percentage points in the first year. Real growth would be reduced further in the second year, owing to the length of time it takes for monetary policy changes to affect spending. Higher interest rates discourage interest-sensitive spending such as housing and durable goods purchases. The range in part reflects the extent to which the negative impact would be offset by higher interest income.

Impacts of Changes in Key Assumptions on Ontario Real GDP Growth*
(Percentage Point Change)
	First Year	Second Year
Canadian Dollar Appreciates by Five Cents US	-0.2 to -0.9	-0.7 to -1.4
World Crude Oil Prices Increase by $10 US per Barrel	-0.3 to -0.7	-0.1 to -0.5
U.S. Real GDP Growth Increases by One Percentage Point	+0.3 to +0.7	+0.4 to +0.8
Canadian Interest Rates Increase by One Percentage Point	-0.1 to -0.5	-0.2 to -0.6
*Impacts based on changes being sustained.
Source: Ontario Ministry of Finance.

Changes in the Economic Outlook for 2005

The Ontario economy has shown remarkable resilience to date in the face of mounting external pressure from higher oil prices and the stronger Canadian dollar. Data thus far in 2005 show the actual performance of the Ontario economy has exceeded expectations. This has led to a cautious upward adjustment to the Ministry of Finance economic outlook for 2005.

Real GDP is now expected to increase by 2.2 percent in 2005, up from the Budget's projection of 2.0 percent. As a result of stronger economic growth, job creation has been stronger, with employment now expected to increase by 1.2 percent, above the 1.0 percent projection in the Budget. The better showing in the labour market has bolstered the consumer sector. Personal income is projected to increase by 4.2 percent this year, compared to the Budget forecast of 3.8 percent, while the outlook for retail sales growth has been raised from 4.0 percent to 5.0 percent. Housing starts are projected to reach 78,600 units this year, up from the Budget view of 75,400. The business sector is performing better than anticipated as well, with corporate profits expected to grow by 5.2 percent in 2005, compared to the Budget assumption of 3.0 percent.

The table below shows changes in key forecast components compared to the Budget projections for 2005.

The Ontario Economy in 2005
(Per Cent Change)
	2005 Budget	2005 Fall Update
Real Gross Domestic Product	2.0	2.2
Personal consumption	2.6	3.2
Residential construction	0.8	0.8
Non-residential construction	1.8	1.6
Machinery and equipment	10.3	5.2
Exports	2.0	1.1
Imports	4.9	2.8
Nominal Gross Domestic Product	3.9	4.1
Other Economic Indicators
Retail sales	4.0	5.0
Housing starts (000s)	75.4	78.6
Personal income	3.8	4.2
Wages and salaries*	3.6	4.1
Corporate profits	3.0	5.2
Consumer Price Index	2.1	2.3
Labour Market
Employment	1.0	1.2
Job creation (000s)	65	77
Unemployment rate (per cent)	6.7	6.7
*Includes supplementary labour income.
Source: Ontario Ministry of Finance.

Oil Prices

Oil prices have risen dramatically over the past three years, more than doubling from under $30 US per barrel in September 2003 to a record $70 US in late August of this year. The steep increase in oil prices over this period reflects, in large part, strong global demand, particularly from China, and the lowest level of worldwide spare production capacity in three decades. Other factors have played a role as well, including political unrest in key oil-producing regions.

The main drivers behind the dramatic rise in oil prices are likely to remain in place in the near term, augmented by the disruption of production and refining capacity in the Gulf of Mexico. As a result, the average private-sector forecast, measured by Consensus Economics, is for high oil prices to persist. The price of crude oil is projected to be $62.00 US per barrel in January 2006, easing to $57.30 US in October 2006. It should be noted that there is a considerable difference of opinion among forecasters about the likely path of oil prices, with forecasts for October 2006 ranging from a low of $48 US per barrel to a high of $75 US.

Over the longer term, many forecasters expect crude oil prices to ease to about $50 US in 2007 and 2008, reflecting a better balance between supply and demand. Though a moderation from current levels, this would still be well above the price range expected for oil as recently as June.

Crude oil is a key commodity for all major industrialized economies, particularly the United States, which consumes about a quarter of global production. The Ontario economy is vulnerable to high oil prices because it imports virtually all of the oil required to meet consumer and business demand.

In the current environment, three major factors suggest it is unlikely that the run-up in oil prices by itself will significantly slow U.S. economic growth:

• The recent rise in oil prices has been driven in large part by demand. The increase has been more gradual and of longer duration than during previous periods, when sharp and sudden withdrawals of oil supply caused wild price fluctuations. For example, the price of crude oil jumped 168 percent in 1974, 152 percent between 1978 and 1980, and 111 percent between 1998 and 2000. By comparison, oil prices increased 59 percent between 2002 and 2004, and a further 39 percent in 2005 (based on the average private-sector forecast for 2005) — a total increase of 120 percent over these three years. The difference in the recent period has been the persistence in price increases, with crude oil up a record nine straight quarters.
• In inflation-adjusted terms, the price of oil today remains well below the record levels reached in the early 1980s.
• The U.S. economy is less reliant on energy than in the past. Energy intensity, as measured by the ratio of energy consumption to U.S. real GDP, has declined by about 50 percent over the last 35 years.
• The Ontario economy is also more energy efficient. Since 1981, Ontario real GDP has almost doubled while the province's consumption of petroleum products has risen by about 17 percent and consumption of natural gas has risen by only 48 percent.

U.S. Economy

The U.S. economy is expected to grow by 3.5 percent in 2005, easing from a gain of 4.2 percent in 2004, the fastest pace of growth since 1999. Economists expect growth to moderate but remain healthy. The Blue Chip Economic Indicators survey calls for U.S. real GDP growth of 3.3 percent in 2006 and 3.2 percent in both 2007 and 2008.

The strength and composition of the U.S. expansion are key determinants of the pace of growth in Ontario. The U.S. economy is Ontario's largest export market. Exports to the United States accounted for over 90 percent of Ontario international merchandise exports in 2004, led by the automotive sector at 45.3 percent of the total.

There are a number of risks to the U.S. outlook. Taken together, surging energy prices, rising interest rates and burgeoning personal debt levels could begin to dampen household spending. The potential for softening house prices could reduce funds available from home-equity financing. Higher gasoline prices appear to have curbed, at least temporarily, consumer demand for vehicles, especially models with low gas mileage.

There is concern that the record size of the U.S. budget and current account deficits leave the economy exposed to a potential cutback in foreign capital inflows. As of the second quarter of 2005, the U.S. current account deficit was equivalent to 6.3 percent of GDP, surpassing 2004's record of 5.7 percent. Government spending associated with post-hurricane rebuilding is providing near term stimulus, but soaring import prices for commodities and other materials are expected to push both the fiscal and current account deficits higher in 2006.

Over the past decade, U.S. growth has been driven by domestic demand, while international trade has been a drag on economic growth. If confidence in the U.S. economy were to weaken, the U.S. dollar could depreciate sharply, causing interest rates to rise rapidly, weakening overall U.S. economic activity. Ontario's economy, which is closely tied to the U.S. economy, would also suffer in such a scenario. However, forecasts for continued U.S. economic growth indicate that economists expect the current account and fiscal deficits to be reduced gradually over time without an abrupt setback. Forecasts for U.S. real GDP growth in 2006, among the over 50 forecasters surveyed by the Blue Chip Economic Indicators, range from 2.5 to 4.0 percent.

The Canada-U.S. Exchange Rate

The Canadian dollar has appreciated markedly against the U.S. dollar over the past three years. Since early 2002, the dollar has risen 38 percent against the U.S. currency, reaching a 13-year high of over 86 cents US in late September 2005. The Canadian dollar has also appreciated against other currencies recently, rising over 13 percent against the euro and close to 11 percent against the Japanese yen since last December. The Canadian dollar's strength in recent years is a reflection of solid economic fundamentals and rising commodity prices.

The rapid increase in the Canadian dollar is a challenge for Ontario manufacturers who sell their goods in an increasingly competitive global marketplace. Manufacturers, who make up 21 percent of Ontario's economic activity, are responding by investing to raise productivity. In addition, production is moving towards higher value-added products.

About 60 percent of Ontario machinery and equipment is imported from the United States. The higher dollar lowers the cost of machinery and equipment imports that help to increase productivity. At the same time, the higher dollar increases the purchasing power of Ontario consumers by lowering prices for imported consumption goods and reducing the costs of travelling outside Canada.

There is considerable difference of opinion about the future path of the dollar. Private-sector forecasts for the average value of the dollar in 2006 range from a low of 80.5 cents US to a high of 88.5 cents US, averaging 84.4 cents US.

Private-Sector Forecasts for the Canadian Dollar
(Cents US)
	2003	2004	2005p	2006p	2007p	2008p
Average	71.4	76.8	82.4	84.4	82.9	83.6
High	-	-	-	88.5	86.4	85.9
Low	-	-	-	80.5	79.8	81.0
p = private-sector survey average.
Sources: Bank of Canada and Ontario Ministry of Finance Survey of Forecasts (October 2005).

Exports Face Competitive Pressures

Facing the significant challenges of a high dollar and high oil prices, Ontario export volumes are expected to increase marginally in 2005, rising by only 1.1 percent. Ontario exporters are adjusting to the higher dollar by increasing productivity, lowering input costs and shifting towards higher-value products. Over the medium term, exports are expected to strengthen, supported by rising demand in the rest of Canada, the United States and other regions of the world.

The auto sector accounted for 45.3 percent of Ontario's merchandise exports to the United States in 2004. Although U.S. auto sales in 2005 are likely to be close to last year's pace of 17.3 million units, this has required heavy incentives such as "employee discount programs," which are likely shifting sales from the near future. Private-sector forecasters expect U.S. auto sales to ease to 17 million units in 2006 and remain close to that level in 2007 and 2008. Weak profits will limit the auto industry's capacity to keep relying on incentives to sustain sales. Ontario's share of North American vehicle production has risen from 15.7 percent in 2003 to an estimated 16.4 percent in 2005. Over the medium term, Ontario auto exports will benefit from new production lines, including the new Toyota plant in Woodstock, which is scheduled to begin production in 2008.

Machinery and equipment exports, which accounted for 19.8 percent of the province's merchandise exports in 2004, are up a modest 2.0 percent so far this year, as firms face more intense international competition. As manufacturing firms adjust to the higher dollar, Ontario's machinery and equipment exports are expected to strengthen. Real business investment on machinery and equipment in the United States is projected to increase by 11.7 percent in 2005 and 9.6 percent in 2006.

Industrial goods and materials exports (such as iron, steel, other metals, rubber and plastics), which account for about 20 percent of Ontario's merchandise exports, have been the strongest export category this year, up 8.1 percent on a year-to-date basis. Overall world economic growth is strong, leading to buoyant demand for industrial materials. Increased demand for industrial goods and materials from the rest of Canada, the United States and the rest of world will contribute to strengthening Ontario exports of these products.

China and India have become growing markets for Ontario exports. Over the past four years, Ontario merchandise exports to India increased dramatically, climbing 76 percent, followed by China (up 63 percent), Europe (up 36 percent) and Japan (up 12 percent). Over the medium term, China's economy is expected to grow by over 8.0 percent per year and India's growth is expected to be close to 7.0 percent per year, creating opportunities for Ontario exporters to increase sales to these countries.

Other provinces and territories are also important markets for Ontario's exports. Sales to other provinces have increased from 26 percent of total exports in 2000 to 29 percent in 2004. Higher energy prices dampen growth in central Canada but provide a boost to the energy-producing regions in the rest of Canada. Ontario exports of goods and services to the rest of Canada are expected to grow, driven by strong demand in Western Canada.

 

 

Interest Rates and Inflation

Over the past two months, the Bank of Canada has increased its benchmark target for the overnight interest rate by a total of half a percentage point, to 3.0 percent. The major factor pushing the Bank of Canada to raise interest rates is its perception that the Canadian economy is operating at close to full capacity. According to the Bank of Canada's quarterly Business Outlook Survey , the proportion of firms expecting inflation to exceed the Bank of Canada's two percent target rose from 64 percent in the spring survey to 87 percent in the autumn. It is expected that the Bank of Canada will continue to increase interest rates over the next year to contain potential inflationary pressures and prevent the rise in energy prices from becoming embedded in higher inflation expectations.

Canadian three-month treasury bill rates are expected to rise from 2.7 percent in 2005 to 3.5 percent in 2006 and average 4.2 percent in 2007 and 2008. Ten-year Government of Canada bond yields are expected to increase modestly, rising from an average of 4.1 percent in 2005 to 4.5 percent in 2006, and an average of 5.5 percent over the 2007 to 2008 period. This results from further tightening of monetary policy in conjunction with growing global demand for funds, including the need to finance the U.S. fiscal and current account deficits.

Since June 2004, the U.S. Federal Reserve Board has raised interest rates 11 times, bringing its key target for the federal funds rate to 3.75 percent. Like the Bank of Canada, the Federal Reserve is concerned with the potential for higher energy costs to fuel a broader increase in other prices and to raise expectations of inflation. Short-term U.S. interest rates are currently 75 basis points above the equivalent rates in Canada. The Federal Reserve is expected to continue raising interest rates at a measured pace, implying the negative Canada-U.S. interest rate gap will persist.

Canadian Interest Rate Outlook
(Annual Per Cent)
	2003	2004	2005p	2006p	2007p	2008p
3-month Treasury Bill Rate	2.9	2.2	2.7	3.5	4.0	4.3
10-year Government Bond Rate	4.8	4.6	4.1	4.5	5.3	5.7
Ontario CPI Inflation Rate	2.7	1.9	2.3	2.2	1.8	1.9
p = projection.
Sources: Bank of Canada, Statistics Canada and Ontario Ministry of Finance.

The key aim of the Bank of Canada's monetary policy is to keep core inflation at two percent, the midpoint of its one to three percent target range. The Bank's favoured measure of core inflation (the Consumer Price Index (CPI), excluding the eight most volatile items³ and the effect of any tax changes on prices) has remained below the Bank's target rate of two percent for 21 straight months. However, total CPI inflation in Canada rose to 3.4 percent in September, reflecting, in large part, higher gasoline prices.

The Ontario CPI inflation rate is expected to average 2.3 percent in 2005. Petroleum product prices have been the major contributor to inflation this year. So far this year, gasoline prices have increased 12.9 percent and home heating fuel is up 24.2 percent. The higher value of the Canadian dollar has lowered the cost of imported goods for consumers and businesses, helping offset upward pressure on inflation from rising energy prices. On a year-to-year basis, total Ontario CPI inflation in September was 3.3 percent, or 1.7 percent excluding energy. The 2006 inflation rate is projected to be 2.2 percent. Over the 2007 to 2008 period, inflation is projected to average 1.9 percent annually.

³ The eight most volatile items include fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, inter-city transportation and tobacco products.

 

 

 

Household Sector

Over the past few years, solid job creation, strong income gains and a low interest rate environment have resulted in healthy growth in household spending. Average wages and salaries per paid worker are projected to increase by 2.9 percent this year, contributing to an estimated 4.2 percent rise in total personal income, compared to 3.8 percent in 2004. The growth forecast in employment, wages and incomes supports the outlook for increasing Personal Income Tax and Employer Health Tax revenues over the forecast period.

Real consumer spending on goods and services rose 3.7 percent over the first half of 2005, compared to the same period in 2004. Real consumer spending is expected to rise by 3.2 percent in 2005, matching the pace in 2004. Consumer spending is forecast to grow by 2.9 percent per year over the 2006 through 2008 period. The growth in consumer spending can be expected to boost Retail Sales Tax revenues over the forecast period.

While total retail sales are up 5.1 percent over the first eight months of 2005, gas-station sales are up 13.3 percent, reflecting higher gasoline pump prices. The higher gasoline pump prices also have had a dampening effect on household spending on discretionary items such as apparel, restaurant meals and travel.

Ontario's housing market has remained strong, with housing starts projected to total 78,600 units in 2005. Over the past few years, starts have averaged 82,000 units, the strongest four-year pace of homebuilding activity since 1990. For 2006, starts are expected to ease further, reaching 73,500 units, and to average 75,800 units per year in 2007 and 2008. The projected pace of new home construction is in line with underlying demographic requirements.

According to private-sector forecasters, home resales are expected to decrease 0.5 percent in 2005, following four consecutive years of record-breaking activity, and to decline a further 4.5 percent in 2006. House price gains are expected to moderate. Private-sector forecasters expect average resale house prices to rise 7.6 percent in 2005 to $263,800 and to rise 3.9 percent in 2006 to $274,200. Rising incomes and low mortgage rates will help keep housing affordable. Mortgage payments for an average-priced home as a share of after-tax household income are projected to rise modestly, but to remain well below levels of the late 1980s.

Consumer spending on household-related items has performed well. Over the first eight months of 2005, sales of household items and building supplies, which include furniture, electronics, home centres and garden store sales, are up 3.8 percent compared to a gain of 2.2 percent for the previous year.

Consumer spending growth has outpaced income growth, leading to a drop in the savings rate. The savings rate was 1.1 percent in the second quarter of 2005 — the lowest on record. The savings rate does not adequately reflect consumers' finances because it does not include certain sources of income, such as pensions and capital gains, and does not fully capture increases in personal wealth. Rising house values have boosted household wealth, contributing to the willingness and capacity of households to increase spending and debt levels. Despite record-high debt levels, household debt costs remain low by historical standards. Low interest rates and steadily rising personal disposable incomes have contributed to the healthy position of household finances. The ratio of Canadian household debt costs to personal disposable income was 7.7 percent in the second quarter of 2005, compared to an average of 8.1 percent since 1980.

Business Investment Leads Growth

The outlook for business investment in plant and equipment remains robust over the forecast horizon. Diminishing spare capacity, rising profits, healthy balance sheets and lower equipment prices are stimulating strong investment spending. Currently, both the Canadian manufacturing industries and the total industrial sector are operating at a historically high 86.7 percent rate of capacity utilization. The corporate debt-to-equity ratio has trended downward since the early 1990s, reflecting improved profit performance. Ontario profits are expected to grow by 5.2 percent in 2005. Over the 2006 to 2008 period, profits are expected to increase at an annual average rate of 3.4 percent, a slower rate than the overall economy. The Corporations Tax revenue outlook is quite prudent, given the historic volatility of corporate profits growth.

With Ontario firms importing about 60 percent of their capital equipment, the 38 percent appreciation of the Canadian dollar since early 2002 has substantially lowered the Canadian-dollar cost of imported machinery and equipment. This is encouraging much-needed investment in productive capital and enhancing Ontario's long-term competitiveness.

Over the past two years, real business investment in machinery and equipment has led overall economic growth, climbing a healthy 7.7 percent in 2004, following a 9.2 percent advance in 2003. Growth in machinery and equipment expenditures is expected to be broad based in 2005, led by the manufacturing and mining sectors. Real business investment in machinery and equipment is expected to rise by 5.2 percent in 2005. Machinery and equipment investment is forecast to increase by 6.8 percent in 2006, and by an average 6.2 percent per year over the 2007 to 2008 period. After declining by 5.2 percent in 2004, non-residential investment outlays are expected to advance 1.6 percent in 2005, 3.1 percent in 2006 and an average of 3.5 percent annually over the 2007 to 2008 period.

 

 

Economic Outlook Comparison with G-7 Countries

Despite the challenges facing Ontario, private-sector forecasts expect the province will remain among the fastest-growing industrial jurisdictions over the 2005 to 2008 period.

According to private-sector forecasts, over the 2005 to 2006 period, real GDP growth in Ontario is projected to average 2.6 percent a year, trailing Canada as a whole and the United States. However, during the 2007 to 2008 period, private-sector forecasters believe Ontario's prospects are brighter and expect the pace of Ontario real GDP growth to improve to an average of 3.3 percent a year, ahead of all G-7 countries.

Ontario and G-7 Economic Outlook, 2005 to 2008
Real GDP Growth (Per Cent)
	2005	2006	2007	2008
Ontario	2.5	2.6	3.2	3.3
Canada	2.8	3.0	3.0	2.9
United States	3.5	3.3	3.2	3.2
France	1.5	1.8	2.1	2.1
United Kingdom	1.8	2.2	2.2	2.2
Germany	0.8	1.2	1.4	1.6
Italy	0.0	1.1	1.4	1.6
Japan	2.1	1.7	1.7	1.3
Sources: Consensus Forecasts (October 2005) and Ontario Ministry of Finance Survey of Forecasts (October 2005).

DETAILS OF THE ONTARIO ECONOMIC OUTLOOK

This table shows the key details of the updated economic outlook for 2005 to 2008.

The Ontario Economy, 2003 to 2008
(Per Cent Change)
	Actual		Projected
	2003	2004	2005	2006	2007	2008
Real Gross Domestic Product	1.7	2.8	2.2	2.6	3.2	3.3
Personal consumption	3.2	3.2	3.2	2.5	2.9	3.2
Residential construction	3.2	4.1	0.8	-1.3	2.2	2.5
Non-residential construction	1.3	-5.2	1.6	3.1	3.5	3.5
Machinery and equipment	9.2	7.7	5.2	6.8	6.3	6.1
Exports	-0.3	5.3	1.1	2.0	3.3	3.6
Imports	4.1	6.9	2.8	2.9	3.4	3.7
Nominal Gross Domestic Product	3.3	4.7	4.1	4.5	4.8	5.0
Other Economic Indicators
Retail sales	3.4	3.2	5.0	3.6	4.0	4.4
Housing starts (000s)	85.2	85.1	78.6	73.5	74.9	76.6
Personal income	3.0	3.8	4.2	4.2	4.7	4.7
Wages and salaries*	3.8	3.9	4.1	4.3	4.8	4.9
Corporate profits	-2.9	14.7	5.2	1.9	4.1	4.3
Consumer Price Index	2.7	1.9	2.3	2.2	1.8	1.9
Labour Market
Employment	2.9	1.7	1.2	1.4	1.8	1.9
Job creation (000s)	173	108	77	90	117	125
Unemployment rate (per cent)	7.0	6.8	6.7	6.5	6.3	6.1
*Includes supplementary labour income.
Sources: Statistics Canada, Canada Mortgage and Housing Corporation and Ontario Ministry of Finance.

Section II: Ontario Revenue Outlook

The revenue outlook reflects the economic outlook and associated risks. Since the 2005 Ontario Budget, the economic growth outlook for 2005 has strengthened, while the outlook for 2006 and 2007 has weakened. In addition, new information on revenues from processing 2004 Personal Income Tax and Corporations Tax returns led to an increase in the 2004-05 Personal Income Tax and Corporations Tax estimates, which boosts the base upon which growth for these taxes is projected for 2005-06 and beyond.

A cautious approach has been adopted for developing the revenue outlook for 2005-06 and beyond. While economic growth in calendar-year 2005 is stronger than projected in the 2005 Budget, it is forecast to weaken towards the end of 2005 and into calendar-year 2006. As such, the 2005-06 prudent outlook assumes no further revenue increase based on economic growth. In addition, given the historic volatility of Corporations Tax, the outlook is cautious with respect to the proportion of the 2004 tax returns-based increase in Corporations Tax that is carried forward in the revenue outlook.

The medium-term revenue outlook for 2006-07 and beyond will be updated in the next Budget. At present, higher revenues from processing 2004 Personal Income Tax and Corporations Tax returns and stronger 2005 economic growth must be balanced against slower expected near-term economic growth and the risks arising from higher oil prices, interest rates and the Canadian dollar.

2005-06 Revenue Outlook

Total revenue in 2005-06 is currently projected to be $82,132 , an increase of $445 from the 2005-06 Budget Plan.

Summary of 2005-06 In-Year Revenue Changes Since Budget
($ s)
Taxation Revenue
Personal Income Tax	225
Corporations Tax	240
Gasoline Tax	-20
		445
Total Revenue Changes		445

The 2005-06 Personal Income Tax and Corporations Tax revenue outlooks have been increased by $225 and $240 respectively, due to higher revenues from processing 2004 Personal Income Tax and Corporations Tax returns.

The Gasoline Tax revenue forecast for 2005-06 has been lowered by $20 , due to an expected decrease in the volume of gasoline purchased as a result of higher pump prices. Ontario's Gasoline Tax is a volume-based tax. Unlike the federal government and some other provinces, Ontario sales tax does not apply to gasoline pump purchases, and therefore sales tax revenues also do not benefit from higher pump prices.

Medium-Term Revenue Outlook

Medium-Term Fiscal Outlook
($ billions)
	2005-06	2006-07	2007-08	2008-09
Revenue
Taxation Revenue	58.2	60.6	63.4	66.7
Government of Canada	13.2	12.9	13.6	14.0
Income from Government Enterprises	4.0	4.2	4.1	4.1
Other Non-Tax Revenue	6.8	7.0	7.3	7.5
Total Revenue	82.1	84.8	88.5	92.2
Note: Numbers may not add due to rounding.

The medium-term outlook for 2006-07 to 2008-09 is unchanged from the 2005 Ontario Budget. Higher revenues from processing 2004 Personal Income Tax and Corporations Tax returns and stronger 2005 economic growth might be expected to boost the outlook over the medium term. Weaker growth in 2006 and 2007 and risks related to higher oil prices, interest rates and the Canadian dollar, however, warrant maintaining the outlook unchanged at this time.

Total revenue in 2008-09 is projected to be $92.2 billion, an increase of $10.1 billion over the revised 2005-06 forecast of $82.1 billion. This represents an average annual growth rate of 3.9 percent between 2005-06 and 2008-09.

Taxation revenue is forecast to increase by $8.5 billion between 2005-06 and 2008-09, with annual growth averaging 4.6 percent. This is consistent with nominal GDP average annual growth of 4.8 percent from 2005 to 2008.

Federal Payments to Ontario are forecast to increase by $0.8 billion between 2005-06 and 2008-09, with annual growth averaging two percent. The forecast is based on current federal-provincial agreements, funding commitments and formulas for major health and social transfers. The decline in revenues in 2006-07 compared to 2005-06 is primarily due to the final transfer in 2005-06 from past federal Canada Health and Social Transfer Supplements and Medical Equipment Trust Funds.

Income from Government Enterprises is forecast to remain fairly flat over the medium term. The revenue increase in 2006-07 is mainly due to projected increases in Ontario Power Generation Inc. (OPG) net income arising from the government's electricity reforms, including fair and stable prices for electricity provided by OPG. The decline in revenue in 2007-08 is a result of a decline in OPG net income, which reflects the government's decision to close coal-fired generating plants. Liquor Control Board of Ontario net income is forecast to rise over the medium term based on increasing sales. Ontario Lottery and Gaming Corporation net income is expected to remain flat over the forecast period due to continued competitive pressures on border casinos and the expected continued strength of the Canadian dollar against the U.S. dollar.

Other Non-Tax revenue is forecast to increase by $0.7 billion between 2005-06 and 2008-09, with annual growth averaging 3.5 percent. The increase in Other Non-Tax revenue is due primarily to projected increases in the volume of vehicle and driver licence registrations, sales of electricity purchased from non-utility generators and reimbursements in respect of ongoing increases in Provincial expenditures.

Section III: Potential Risks to Provincial Revenues

A growing economy with rising incomes, corporate profits and consumer spending generates higher revenues to pay for public services. Taxation revenues comprise the largest category of Provincial revenue. Of the total $82.1 billion in revenues forecast for 2005-06, $58.2 billion or about 71 percent is expected to come from taxation revenues. Three revenue sources within this category — Personal Income Tax, Retail Sales Tax and Corporations Tax — account for about 55 percent of total revenues. Inherent in any multi-year forecast is uncertainty about the future, making cautious and prudent planning a critical element of any deficit-reduction plan.

This section highlights some of the key sensitivities and risks to the fiscal plan that could follow from unexpected changes in economic conditions. It should be cautioned that these estimates, while useful, are only guidelines and can vary depending on the composition and interaction of the potential risks.

Selected Economic and Revenue Risks and Sensitivities
Item/Key Components	2005-06 Assumption	2005-06 Sensitivities
Total Revenues
– Real GDP	2.2 percent growth in 2005	$615 revenue change for each percentage point change in real GDP growth. Can vary significantly depending on composition and source of changes in GDP growth.
– GDP Deflator	1.9 percent increase in 2005
– Canadian Interest Rates	2.7 percent three-month treasury bill rate in 2005	Between $60 and $310 revenue change in the opposite direction for each percentage point change in interest rates.
– U.S. Real GDP	3.5 percent growth in 2005	Between $185 and $430 revenue change for each percentage point change in U.S. real GDP growth.
– Canadian Dollar Exchange Rate	82.4 cents US in 2005	Between $25 and $110 revenue change in the opposite direction for each one cent change in the Canadian dollar exchange rate.
Total Taxation Revenues
– Revenue Base1	3.3 percent growth in 2005-06	$550 revenue change for each percentage point change in nominal GDP growth. Can vary significantly depending on composition and source of changes in GDP growth.
– Nominal GDP	4.1 percent growth in 2005
Personal Income Tax Revenues
– Revenue Base	5.1 percent growth in 2005-06
Key Economic Assumptions
– Wages and Salaries	4.1 percent growth in 2005	$220 revenue change for each percentage point change in wages and salaries growth.
– Employment	1.2 percent growth in 2005
– Unincorporated Business Income	4.0 percent growth in 2005
Key Revenue Assumptions
– Net Capital Gains Income	3.9 percent growth in 2005	$3 revenue change for each percentage point change in net capital gains income growth.
– RRSP Deductions	4.4 percent growth in 2005	$14 revenue change in the opposite direction for each percentage point change in RRSP deductions growth.
– 2004 Tax-Year Assessments2	$18.9 billion	$380 revenue change for each percentage point change in 2004 Personal Income Tax assessments. 4
Retail Sales Tax Revenues
– Revenue Base	3.9 percent growth in 2005-06
Includes:
– Taxable Household Spending	3.5 percent growth in 2005-06
– Other Taxable Spending	4.4 percent growth in 2005-06
Key Economic Assumptions
– Retail Sales	5.0 percent growth in 2005
– Nominal Consumption Expenditure	5.2 percent growth in 2005	$90 revenue change for each percentage point change in nominal consumption expenditure growth.
Corporations Tax Revenues
– Revenue Base	0.3 percent decline in 2005-06
– Corporate Profits	5.2 percent growth in 2005	$65 revenue change for each percentage point change in pre-tax corporate profit growth.
– 2004-05 Tax Assessment Refunds3	$1.1 billion payable in 2005-06	$22 revenue change in the opposite direction for each percentage point change in 2004-05 refunds.4
– 2004-05 Tax Payments Upon Filing	$0.6 billion receivable in 2005-06	$12 revenue change for each percentage point change in 2004-05 payments upon filing or assessment payments.4
– 2004-05 Tax Assessment Payments	$0.6 billion receivable in 2005-06
Employer Health Tax Revenues
– Revenue Base	3.0 percent growth in 2005-06
– Wages and Salaries	4.1 percent growth in 2005	$30 revenue change for each percentage point change in wages and salaries growth.
Ontario Health Premium Revenues
– Revenue Base	4.6 percent growth in 2005-06
– Personal Income	4.2 percent growth in 2005	$20 revenue change for each percentage point change in personal income growth.
Gasoline Tax Revenues
– Revenue Base	0.4 percent growth in 2005-06
– Gasoline Pump Prices	93.1 cents per litre in 2005	$5 revenue change in the opposite direction for each cent per litre change in gasoline pump prices.
Fuel Tax Revenues
– Revenue Base	1.0 percent growth in 2005-06
– Real GDP	2.2 percent growth in 2005	$10 revenue change for each percentage point change in real GDP growth.
Land Transfer Tax Revenues
– Revenue Base	0.8 percent growth in 2005-06
– Housing Resales	0.5 percent decrease in 2005	$10 revenue change for each percentage point change in both the number and prices of housing resales.
– Resale Prices	7.6 percent growth in 2005
Health and Social Transfers
– Canada-wide Revenue Base	$27.2 billion in 2005-06
– Ontario Revenue Share	37.3 percent in 2005-06
– Ontario Population Share	38.9 percent in 2005-06	$40 revenue change for each tenth of a percentage point change in population share.
– Ontario Basic Federal PIT Share	44.3 percent in 2005-06	$10 million revenue change in the opposite direction for each tenth of a percentage point change in Basic Federal Personal Income Tax base share.
1. Revenue base is revenue excluding the impact of measures, adjustments for past Public Accounts estimate variances and other one-time factors. 2. Ontario 2004 Personal Income Tax (PIT) is a forecast estimate because 2004 tax returns are currently being assessed by the Canada Revenue Agency. 3. Corporations Tax refunds arising during 2004-05 are still an estimate because tax returns for corporate fiscal years ending in Ontario's 2004-05 fiscal year are still being assessed by the Tax Revenue Division of the Ontario Ministry of Finance. 4. Now that 2004-05 Public Accounts of Ontario have been finalized, any change in 2004 PIT assessments or 2004-05 Corporations Tax revenues will have a dual effect on 2005-06 revenues through: a) a change in the revenue base upon which this year's growth is applied, and b) a revenue adjustment applied against the current year in respect of any variance from the estimate included in the 2004-05 Public Accounts.