Tale of Two Woes – California and Ontario

August 2, 2012
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California and Ontario: Two Approaches to Managing Their Finances

A Tale of Two Crises

Recently, a fiscal crisis has erupted in both the State of California and the Province of Ontario. Each is facing a budget deficit of about $16 billion dollars. But the similarity ends there. California is moving to control spending and eliminate their deficit; Ontario is pretending that nothing is wrong.

Governor Gerry Brown of California is urgently looking at a variety of ways to control spending to bring the fiscal train back on track. He has called on the legislature to embrace significant cuts to spending. Brown is also reaching out to the public sector unions, who were instrumental in his election, and asking for a 5% reduction in pay. This in spite of the fact that the state’s two largest public-sector unions held the top two spots in spending on political lobbying, spending over $11.6 million in a non-election year.

Cuts in California would affect the most economically disadvantaged. Reductions would affect such items as childcare for mothers trying to get off welfare, healthcare for the poor, and in-home support for the needy. Nonetheless, the Democratic governor is pressing ahead. Tax increases are also being considered, including an increase on those earning over $250,000 a year.

California had a 2011 GDP of approximately $1,958.9 Billion, and a population of 37.7 million.

Ontario, with a GDP of approximately $638 Billion, and a population of 13.5 million – both roughly one third of California’s — is also facing a $16 billion deficit. The difference is that the Ontario Government does not seem to be taking the predicament seriously.

Premier McGuinty received a comprehensive report on spending in Ontario–the Drummond Report, which is a blueprint for balancing the books in a reasonable period of time. It remains largely forgotten. The Government’s effort so far is confined to a surtax on incomes over $500,000 that is initially expected to raise an extra $470 million. Even this was not a Liberal initiative, only put forward as a trade off to gain NDP support for the budget.

As for the rest, he is still giving consideration to the changes required, six months after the Drummond Report was issued.

There is a huge disconnect between the two jurisdictions when the debt in California is cause for concern and urgent government action, but in Ontario it is ‘ho hum…time for thoughtful choices.’

California is rated as one of the least friendly states for business and the investment spending that business growth brings. The key reason for this is their fiscal problems, which lead to big deficits and debt, high taxes and onerous government regulations. California had a debt of $10,463[1] per person at the end of 2011 and ranked number 45 in the US for debt. Ontario’s number is $16,638 per person. Ontario would not beat one of the 50 states for fiscal responsibility.

The Cause of the Problem

The North American economy is in a new reality and there is concern that growth will be very modest for several years to come. Coincidental to the world financial crisis, which has put the brakes on growth, Ontario is starting to get swamped by its tsunami of aging baby boomers. The leading edge of this tsunami (the first started turning 65 last year) has already strained the pension system to the point of breaking.

Clearly, over-spending by government is a large factor. Up until now, it has been a public-sector free-for-all. Ontario boasts the highest paid teachers, police officers, university professors and doctors in the world. All of this was highlighted in the Drummond Report. Ontario needs a more realistic approach to its public sector.

It has been shown in several studies, most notably by the Canadian Federation for Independent Business (CFIB), that total compensation of the public sector is approximately 30% above that of the private sector on a skill-for-skill basis. This compensation gap, shown in the CFIB Wage Watch, is based on 2006 census numbers, and has grown substantially since then as the private sector has seen wages and benefits stagnate while the public sector continues to rocket ahead.

Public-sector employees enjoy more wages, benefits and, of course, gold-plated pensions. In addition, there is a dazzling array of benefits paid out, including retirement gratuities, sick benefit payouts, vacation time lump sum, and free healthcare in retirement. None of these can be afforded in the private sector.

It is interesting to note that the deficit number in Ontario is about equal to the cost of the compensation premium for public-sector employees. For example, based on the $42 billion payroll at the Provincial level, a 30% compensation premium would equal $12.6 billion. By eliminating the premium paid to Ontario’s public-sector employees, the government could balance its budget quite easily.

How to Turn it Around

One way forward is to look at what is happening in the US — not in “red neck” states — but in ones where the Democrats have solid control: Rhode Island, where comprehensive pension reform has put the State’s financing back on solid footing; San Diego, where taxpayers said “enough is enough,” and reformed public service pensions; or Wisconsin, which brought in right-to-work legislation and curtailed the deduction of compulsory union dues.

These changes are coming to Canada too. In Canada, 80% of the public sector is unionized; in the US it is only 35%. The benefits will be proportionately greater in Canada, but so will the challenge.

The financial clout of the public-sector unions, fueled by compulsory union dues, is formidable. For example, the Canadian Union of Public Employees (CUPE), which has 600,000 members, generates a $650 million annual budget for marketing of employee demands and influencing politics. CUPE is only a portion of the 2.8 million unionized workers in Canada. In the year before the next election campaign begins, unions will spend more in public relations campaigns than the three major parties will…combined.

Nonetheless, the need for public-sector reform is obvious. It is time that the public sector participated in the revival of Canada’s economic health.

Note:
Someone responded to this op-ed with a piece in the Canada Free Press.
It provides a good analysis and facts on the key points of the issue.

Ontario is not California but we may reach the point where we wish it were.

Ontario Is Not California

Guest Column–Ian Nunn – August 7, 2012

Canada Free Press article

A comment comparing Ontario’s fiscal situation to California’s recently hit the news (e.g. Ont. compared to cash-strapped Calif.) It was meant as a warning to Ontarians. After some debate, we’ve decided to weigh in on the issue.

The issue raised above centers on a comparison of California’s fiscal situation, among the worst of all the states in the US, to Ontario’s. As we shall see, California’s situation is significantly better than Ontario’s. To make the issue clear, we reverse this statement: Ontario’s situation is significantly worse than California’s. To find out why, read on.

The Stats

We have compiled key statistics from various sources:

California Ontario
Population 37.6 m 13.5 m (est.)
Debt $388.5 B $257.5 B
Debt per capita $10,360 $19,074
GDP $2,013 B $658.0 B (est)
Debt/GDP 19.2% 39.1%
2012 Deficit $16 B $15.1 B

(Sources: Ontario Economic Update – GDP (nominal Q1 2012 x 0.7% per Q), Ontario Fact Sheet August 2012 – pop. (201106 x 1.2 % per annum), Ontario Financial Authority (debt issued), StateDebtClocks.org, California budget deficit has swelled to $16 billion, governor says)

Different sources come up with different numbers. The province has an unfunded liability of $12.3 billion in stranded debt from the provincial electricity system that the province took on but doesn’t carry on its balance sheet (as far as we know). Also see the Ontario Electricity Financial Corporation.

The deficit is somewhat harder to figure. If we look at the Ontario Financing Authority’s page on Borrowing & Debt, at the bottom, the difference between the Net Debt for 2012-13 and 2011-12 is $22.5 billion which to us is the deficit. We have noted other estimates including the Ontario Government’s, of $15.1 and $15.2 billion (see Highlights, or ONTARIO BUDGET 2012). We have an Ontario Government updated estimate as of April 25 of $14.8 billion against a fiscal forecast of $15.9 billion.

On another note, if we use real GDP estimated at $550.1 billion rather than nominal GDP and add the stranded debt to the debt issued we get a 49% debt/GDP ratio. The rationale for using real GDP is that debt is always recorded in real dollars – the value of the currency at the time the debt is created. At some later date when the debt is compared to GDP, if the GDP is measured in nominal dollars then the value of the debt is deflated. And perhaps this is precisely what the debtor hopes for. We will use the lower value calculated with the nominal GDP.

What should be noted is that Ontario’s per capita debt and debt to GDP is at least twice that of California. Perhaps the worst statistic is that the Ontario government deficit for 2012 is 94% the size of California’s.

Lies My Dad Told Me

The Premier of Ontario, Dalton McGuinty, sometimes known as “Premier Dad”, was quoted in the Toronto Sun in March in an article McGuinty insists $214B debt isn’t that bad as saying Ontario’s $214-billion debt, [is] about 35% of GDP. Is this true? In 2012 Ontario Budget: Chapter V: Borrowing and Debt Management, Ontario’s net debt is given as $237.6 billion while its actual debt is given as $257.5 billion. We say the later is the ‘actual’ debt or simply the provinces debt because this is the amount of debt that creditors hold.

The fiction or lie because the real intent here is to deceive the public – the alternative is that the Premier is naive, take your choice – is the concept of ‘net debt’. Another expression for this is attempting to put lipstick on a pig. The province defines net debt as the difference between total liabilities and total financial assets. The first comment is that this a ‘net liability’, an accounting notion, and not a net debt. The Ontario Financial Authority cited above administers the actual debt. This is the money owed creditors.

To understand the problem with this term, suppose you have a $30,000 5-year certificate of deposit (CD) with your bank, but no other liquid assets. Then you decide to buy a new Lexus. The dealer gives you a loan for $30,000. By the Ontario fiction, your ‘net debt’ is zero. Does this mean you owe nothing, that you have no debt? Hardly. The real numbers for Ontario are are in the table above and we stand by them since they all came from official Ontario government sources.

The Debt Issue in California

The Economic Policy Journal released an article yesterday titled Paul Volcker Warns on Debt of California, Illinois, New Jersey,New York and Other States that concluded the debt situation at the state level is bad, real bad. The report it is based on, Report of the State Budget Crisis Task Force, (summary report available) by Paul Volcker and Dick Ravitch identifies Six Major Threats to Fiscal Sustainability:

  1. Medicaid Spending Growth Is Crowding Out Other Needs
  2. Federal Deficit Reduction Threatens State Economies and Budgets
  3. Underfunded Retirement Promises Create Risks for Future Budgets
  4. Narrow, Eroding Tax Bases and Volatile Tax Revenues Undermine State Finances
  5. Local Government Fiscal Stress Poses Challenges for States
  6. State Budget Laws and Practices Hinder Fiscal Stability and Mask Imbalances

Further, certain large expenditures are growing at rates that exceed reasonable expectations for revenues:

  1. Medicaid programs. At recent rates of growth, state Medicaid costs will outstrip revenue growth by a wide margin, and the gap will continue to expand.
  2. Pension funds for state and local government workers are underfunded by approximately a trillion dollars.
  3. Unfunded liabilities for health care benefits for state and local government retirees amount to more than $1 trillion.

At the same time as costs are escalating, the capacity to raise revenues is increasingly impaired:

  1. Untaxed transactions are eroding the sales tax base. Gasoline taxes are eroding as well, making it more difficult for states to finance roads, highways, and bridges.
  2. Income taxes have become increasingly volatile, particularly during and after the recent economic crisis.

It is expected that the federal budget crisis will have serious spillover effects on state and local governments with a spillover effect from states to local governments:

  1. Cuts in federal grant dollars, lower spending on federal installations, procurement, and infrastructure, and potential changes to the federal tax code.
  2. State and local government cuts pose a significant risk to the overall economic and social fabric of states.

In short, state and local governments are experiencing a degrading economic situation that feeds on itself. The early results are the following municipal municipal bankruptcies in 2012:

  1. San Bernardino, population 211,000
  2. Stockton, population 292,000
  3. Bell, population 35,000

Other cities such as Compton are considering bankruptcy.

Ontario (Canada, Not Ontario California)

First, let’s review the six major threats California faces in Ontario’s context, point by point:

  1. Health care spending is or shortly will be crowding out other spending.
  2. If the Feds have to be more aggressive in deficit cutting, look for transfer payments to be capped if not reduced (already happened for health care).
  3. Underfunded retirement benefits a growing problem.
  4. Tax base is eroding with the loss of industry and the decrease in the quality of jobs (see The Service Sector in Canada), a trend that will not reverse under the provinces cost structure.
  5. Municipalities, particularly Ottawa and Toronto, are in constant battle with the province to upload costs and services while receiving a greater share of provincial revenues.
  6. NA.

The province faces the same three large expenditures, OHIP, public sector pension benefits and public sector retiree health care benefits.

The last point has to do with revenues. The current governing party has implemented a large number of tax increases. Most have been user fees and indirect forms of taxation aimed at specific assets and groups of individuals. For example, the Ontario government is implementing a program of fees of $100 to $200 for tradespeople and $600 to $700 for employers in the construction, service, manufacturing and industrial trades sectors. (see Critics call Ontario College of Trades a tax grab).

This reduces provincial income from the VAT and moves towards a position of neutral revenue. The cumulative effect of all the increases is to reduce consumption and reduce employment as employers struggle to control costs. As an anecdotal story, we recount a discussion with a local employer who was faced with increasing provincial health tax premiums. He was musing on how many employees he would have to let go to retain his profit margin. And don’t forget the Laffer curve (untaxed transactions: think Greece).

Summary

California is arguably one of the six most financially precarious states in the US. Ontario Canada, with economic statistics significantly worse than California’s, is in an exceedingly vulnerable and precarious state, unrecognized by its citizens and unadmitted by its government. Its cities are likewise oblivious to their financial precariousness. Ontario has the same fundamental problems as California of unsustainable public sector liabilities and a panoply of social benefit programs it cannot afford.

Ontario is not California but we may reach the point where we wish it were.

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