Recent reports suggest that the federal government may be seeing some improvements on the deficit front due to increases in revenue.  However, no such luck seems to be gracing Ontario.  Indeed, the Drummond’s report forecast of continued lackluster revenue growth for Ontario due to its weak economy has placed Ontario’s government in a bind. 

  As a result, the Ontario government is planning tough negotiations with its doctors and is going to confront its education sector spending via compensation freezes for teachers and other workers.  As well, combining tax credits for low incomes into the Ontario Trillium Benefit and converting the payments from a lump sum at tax time to payments spread out over the year almost smacks of a desperate attempt to slow down cash outflow in order to make the books look better.

What can save Ontario? What Ontario really needs is dose of robust American economic growth.  The US economy accounts for almost 80 percent of Ontario’s exports and exports account for about 50 percent of Ontario’s GDP.  If one plots Ontario nominal provincial government revenues (in Canadian dollars) against nominal US GDP (in US dollars) for the period 1965 to 2010 and estimates a linear regression, one gets an almost perfect fit with an R-squared of 0.99.  (Figure 1) Each billion dollars of US nominal GDP correlates with 6.8 million dollars in Ontario government revenue.

Figure 2 shows actual Ontario provincial government revenue and predicted revenue from this regression for the period 1965 to 2011 as well as forecasts for 2012 and 2013 using U.S. nominal GDP forecasts constructed by BMO Capital Markets Economics (March 2, 2012).  Oddly enough, Ontario’s revenues in 2009 and 2010 were higher than the model predicts – likely the result of increased federal transfers.  While Ontario may still be a net fiscal contributor to the Canadian federal system, it has been receiving growing amounts of federal transfers.  Between 2007/08 and 2011/12, federal transfers to the provinces rose from 48.6 to 58.5 billion dollars  – an increase of 20 percent.  Over the same period, Ontario’s federal transfers grew from 12.7 to 17.8 billion dollars  -an increase of 40 percent.

The U.S. is expected to see increases in its nominal GDP (from 15.1 trillion in 2011 to 16.5 trillion by 2013) but the increases are still weaker than past increases and as a result Ontario’s revenue using this estimated equation will go from a fitted value of 101.2 billion in 2011 to only 111 billion by 2013.  One can expect actual revenues to be a bit higher than these forecasts as a result of the recent federal bounty flowing to Ontario.

For the period 1997 to 2007, nominal US GDP increased at an average annual rate of 5.5 percent and Ontario provincial government revenue grew at 6.4 percent.  For the period 2007 to 2011, US GDP growth averaged 2.4 percent and Ontario revenue growth at 3.9 percent.   US GDP nominal growth for 2012 and 2013 is projected at 4.2 and 4.7 percent – still below the average for the 1997 to 2007 period but an improvement from the 2007 to 2011 period.

There is one caveat to all this.  This time, the U.S. economy may not be enough. Even if the US economy begins to experience substantially higher GDP growth, what if there has been a structural shift in the relationship between Ontario provincial government revenues and the US economy?  Given the decimation of the auto sector, pulp and paper and Ontario manufacturing in general, what if the rising tide of US economic recovery does not life Ontario’s economic boat this time and by extension its government revenues? Surely, these are the type of questions that must keep Ontario’s premier awake at night.