On June 1st, the Parliamentary Budget Officer (PBO) released its latest Economic and Fiscal Outlook (www.parl.gc.ca/pbo-dpb). The PBO expects the deficit to be somewhat lower in both 2010-11 and 2011-12 than those projected by the Minister of Finance in his March 2011 Budget.  However, PBO is forecasting higher deficits in the outer years with the difference widening to $11.5 billion by 2015-16. By the end of the period, the PBO is forecasting a deficit of $7.3 billion. The main source of difference is related to PBO’s concerns about the Government’s ability to secure its proposed expenditure management savings and other revenue targets proposed in the 2010 budget. To date, the Government has not provided details as to how departments and agencies will achieve these savings.

The PBO forecast does not include the initiatives announced in the March budget. This is somewhat surprising given that the Government now has a majority and has indicated that these initiatives will be reintroduced in the upcoming budget. Given the small size of the initiatives, their exclusion has little impact, with the exception of  2011-12. The PBO forecast also does not include the cost of any commitments made during the election, such as a payment to Quebec for HST harmonization, or the commitment to find $4 billion annually in “efficiency” savings.

Selecting Economic Assumptions:

The PBO has made a very important change in the way it prepares its fiscal forecast. Instead of using the average of the Department of Finance’s survey of private sector economic forecasts, the PBO has developed its own economic forecast to derive its fiscal projections. Their forecast includes their judgments on the risks involved and they are of the view that their forecast represents a “balanced” projection, which means that higher or lower outcomes are equally likely”.

We have strongly recommended in the past that the Government use the Department of Finance’s economic forecast rather than the average of the private sector economic forecasts (see “Time to Make the Budget Planning Process More Accountable, Transparent and Prudent” November 2010: www.3dpolicy.ca). The Department of Finance has a branch of about 100 professionals, solely dedicated to monitoring and analyzing current economic developments and assessing their impacts on future developments.  They maintain one of the country’s most comprehensive econometric models of the Canadian economy capable of providing medium-term economic forecasts.  Of the fifteen private sector forecast institutions consulted by the Minister of Finance, only three prepare medium-term economic forecasts. It would be better if the Government used the Department‘s forecast based on its best analysis and was prepared to defend it in public. After all this is what the Bank of Canada does.

As it turns out, the PBO forecast of nominal gross domestic product (GDP) differs only marginally from the adjusted forecast of nominal GDP used in the March 2011 Budget (see Table 1).  The components of nominal GDP represent the applicable tax bases for personal and corporate income tax revenues, which represent about 60% of total federal revenues.

Table 1

Nominal Gross Domestic Product ($ billions)

PBO forecasts a somewhat higher level of nominal GDP in 2011, but by 2015, its level is identical to that used in the March 2011 Budget.  All other things being equal, this would suggest that the PBO deficit forecast should be slightly better early in the period, which it is, but similar thereafter, which it is not. 

PBO is more pessimistic about improvements in the unemployment rate, which in turn affect employment insurance benefits and premiums.  In addition, they believe that interest rates will not increase as quickly as forecast in the March 2011 Budget in the short term.

Fiscal Forecast: the Deficit just won’t go away

So why does the difference between the two forecasts widen in the outer years? Table 2 compares PBO’s forecast of the federal budgetary balance to the March 2011 Budget forecast and the reasons for the differences.

Table 2

Comparison of Fiscal Forecasts ($ billions)

Note: Totals may not add due to rounding.

1. Policy initiatives not included in PBO projections.

2. Excludes impact of "Prudential Liguidility Management Initiative".

PBO’s deficit forecast is slightly better in both 2010-11 and 2011-12 than forecast in the March 2011 Budget. As indicated in the March 2011 Fiscal Monitor, the Department of Finance expects the deficit for 2010-11 to be somewhat lower than forecast in the March 2011 Budget and indicated that it would provide an update in the June 6, 2011 Budget.  For 2010-11, we expect the deficit to be at around $35 billion, based on our reading of the monthly result (See “Deficit Expected to be at Least $5 Billion Better than Forecast in 2011 Budget: May 2011: www.3dpolicy.ca).

After 2011-12, PBO expects the deficit to be higher than the budget forecast in each year.  It is forecasting a deficit of $7.3 billion in 2015-16, rather than a surplus of $4.2 billion.  Based on PBO’s forecast, the deficit would not be in surplus is either 2014-15 or 2015-16, even if the Government were to secure its proposed “Targeted Strategic and Operating Review” savings of $4 billion per year in those years.

As indicated earlier, PBO does not include the impact of the March 2011 Budget initiatives.  Their impact is presented in the panel entitled “Policy initiatives not included in PBO projections”[1].

There are a number of economic/forecasting factors contributing to the widening differences after 2012-13[2].  These are positive over the first three years but negative thereafter. Although the level of nominal GDP forecast by PBO is virtually identical to that used in the March 2011 Budget, there are appears to be significant differences between the two major components (personal income and corporate profits) of nominal GDP. This can have a significant impact on tax revenues.

PBO did not present their forecast of the components of nominal GDP, although they have done so in the past.  PBO is forecasting much stronger growth in personal income and therefore higher personal income tax revenues offset to some extent by slower growth in corporate profits and thereafter lower corporate income tax revenues.  We have advocated that the Department of Finance publish the components of nominal GDP with the budget.  PBO is forecasting an exceptionally strong increase in personal income tax revenues in 2011-12, which does not appear to be consistent with its projected growth in employment.

Goods and Service Tax and other tax/excise revenues are projected to be lower than that in the March 2011 Budget, given PBO’s outlook for consumer expenditures.  With lower employment growth, PBO expects higher employment insurance benefits.  However, as these higher expenses are financed by employee-employer premium rates, employment insurance premiums are higher than in the March 2011 Budget, especially in 2015-16.  The March 2011 Budget implies no increase in rates in 2015 whereas PBO assumes an increase of 10 cents as mandated under current legislation when the employment insurance account is in deficit.

PBO forecast lower interest rates over the short tem, thereby resulting in lower public debt charges.  However, in the outer years, the additional borrowing costs associated with the higher deficits results in higher public debt charges.

The major source of difference in the two deficit forecasts, however, relates to “other revenues” and direct program expenses.  The “other revenues” component is extremely volatile.  In previous budget forecasts, the Department of Finance made significant upward revisions to this component of revenues, without adequate explanation.  Both the PBO and ourselves questioned these adjustments and until a satisfactory explanation is forthcoming, believe that they were not justified.

The same concern relates to direct program expenses.  In previous budgets and updates, downward adjustments were made to this component, which were not related to policy initiatives.  Again no explanations for these adjustments were provided.  In addition, this component has been subject to a number of expenditure restraint measures.  PBO has requested details on how departments and agencies will manage these restraint measures, with no response from the Government.  As a result, it has discounted the impact of the restraint measures, pending details from the Government.  We also have expressed concerns about the profile of this component of spending and the impact of the restraint measures (see “March 2011 Budget: The Deficit That Won’t Go Away” March 2011: www.3dpolicy.ca).  This is a serious issue and unless details on how the Government expects to achieve its forecast of direct program expenses, its deficit projections lack credibility. 

The Structural Deficit That Won’t Go Away

PBO also provided an update of the structural deficit (see Table 3).  Although the Minister of Finance denies the existence of a structural deficit, he has provided no forecasts supporting his view.  The IMF in its latest report on Canada forecast a structural deficit in 2015-16 of a comparable amount.   

Table 3

Structural and Cyclical Balance Estimates ($ billions)

The outgoing Auditor General expressed concerns about a number of significant and emerging pressures facing the Government, including an ageing infrastructure, and ageing population and insufficient progress in addressing Aboriginal pressures on reserves. These pressures will grow rapidly in the second half of this decade and place additional upward pressure on the deficit unless credible offsets are found. 

[1] See Table 5.5 “A Low-Tax Plan for Jobs and Growth” March 22, 2011 Department of Finance

[2] The March 2011 Budget projections have been adjusted to exclude the impact of the policy initiatives proposed in that budget in order to be comparable to PBO’s fiscal projections.  In addition, the impact of the Prudential Liquidity Management initiative has been excluded.  Although the Department of Finance contents that the deficit impact of this initiative is neutral, both “other revenues’ and public debt charges are affected by this initiative.  This initiative would only be deficit neutral if the returns of holding the extra bank balances offset the costs of the increased borrowings.