On February 1, 2011, the Department of Finance released its December 2010 survey of private sector economic forecasts.  For the components surveyed, the December results are “broadly” consistent with the September 2010 survey.

For the October 2010 Update, the Department of Finance added a ‘risk” factor to the private sector forecast for nominal gross domestic product (GDP), to reflect the uncertainties in the global economy.  The current survey for level of nominal GDP, compared to the adjusted level of nominal GDP used in the October 2010 Update, is $2 billion higher in 2010, a one-time level adjustment of about $11 billion from 2011 to 2014 and $16 billion higher in 2015.  As nominal GDP is the underlying tax base for budgetary revenues, this would suggest a marginal improvement in the fiscal forecast throughout the entire period, all other things remaining equal.

A February Budget would be based on the December 2010 forecast.  However, at the end of February, Statistics Canada releases its national accounts estimates for real and nominal GDP for the fourth quarter of 2010 and for the year as a whole.  There could also revisions to the third three quarters of 2010.  If the budget were tabled in March, these results would be incorporated, provided there is sufficient time and the changes are material.  In all probability, most of the private sector economists would only incorporate the latest national accounts results in their forecast in middle to late March, likely too late to be incorporated in a March Budget.   

As we have argued in the past (“Time to Make the Budget Planning Process More Accountable, Transparent and Prudent” November 2010: www.3dpolicy.ca), the current budgetary process is not transparent and subject to manipulation.  It also allows the Minister of Finance to hide behind the private sector forecasts rather than taking responsibility for the economic and fiscal forecasts.

There are a number of issues with respect to the current approach.  The Department of Finance surveys about 15 private sector forecasters, most of which are financial institutions.  In most cases, they focus primarily on the short-term – one to two years.  In Budget 2010, there were only three forecasters (Conference Board of Canada, Global Insight and the University of Toronto) that had large-scale econometric models capable of providing medium-term economic forecastst.  This raises issues of comparability between the short and medium term forecasts.

Most forecasters update their forecasts on a quarterly basis, following the release of the Canadian economic accounts by Statistics Canada (first quarter results published in May, second quarterly results in August, third quarter results in November and fourth quarter and preliminary estimate for year as a whole in February of the following year).  For a February or early March budget, private sector economists would not have time to incorporate the fourth quarter results the previous year in their forecasts.  This could impact on the fiscal projections, if the fourth quarter results differed from their original forecast, which is very often the case..   

There have been wide variations among private sector forecasters about future economic developments, both in the short and medium term.  At times, the government has taken this into consideration and adjusted the average private sector economic forecasts, based on the Department of Finance’s assessment of future economic developments.  In these cases, it is the Department of Finance’s economic forecast that is used, rather than the average of the private sector economic forecasts.  

The private sector economists are surveyed for only a selective number of aggregate economic and financial indicators: real gross domestic product (GDP) growth; GDP inflation, nominal GDP;, the 3-month treasury bill rate;, the 10-year government bond rate;, the unemployment rate; the , consumer price index; the exchange rate (US cents/Cdn$); and finally, and U.S. real GDP growth.  The Department of Finance decomposes the forecast values for real and nominal GDP into their its expenditure and income components, respectively.  How this decomposition is made can have a significant on the fiscal projections as different components of income have different effective tax rates.  For example, corporate profits have a much higher average effective tax rate than that personal income. 

The current process dates back to 1994, following recommendations made by Ernst & Young (E&Y) in their 1994 Report, “Review of the Forecasting Accuracy and Methods of the Department of Finance[1]”. Although E&Y recommended that the Department of Finance should establish a mechanism to increase the distance between the economic and fiscal forecasts presented in the budget and the political process, by either having the House of Commons Standing Committee on Finance engage a panel of independent reviewers to critique the government’s economic and fiscal forecasts or alternatively establish an independent agency to provide the economic and fiscal forecast.  Instead, the government at that time decided to use the average of private sector economic forecasts rather than those produced by the Department of Finance even though E&Y had concluded that the Department’s economic forecasts were consistently better than those in the private sector.

This should not be surprising. Finance has a branch of about 100 professionals solely dedicated to monitoring and analyzing current economic developments and assessing their impacts on future developments.  The branch is staffed by highly qualified and professional economists, who are recruited directly by the Department of Finance.  They maintain one of the country’s most comprehensive econometric models of the Canadian economy.  They prepare detailed quarterly forecasts of the Canadian economy as well as for Canada’s major trading partners.  They can update their economics quickly if new information becomes available. These forecasts are used internally to brief the Minister of Finance and Cabinet and to assess the private sector economic forecasts.

The Office of the Parliamentary Budget Officer (PBO) also uses the average of the private sector economic forecasts for their fiscal updates.  There is no reason to have two agencies use the same economic forecasts to produce fiscal forecasts.  The Bank of Canada uses its own internal economic forecasts for monetary policypurposes.

The Government should, once again, take full responsibility for the economic and fiscal forecasts presented in its budgets and economic and fiscal updates.  The Department of Finance’s detailed economic forecasts should be used to prepare the fiscal forecasts, rather than using the average of private sector forecasts for a selected number of major aggregate.  The Department’s economic forecasts should be compared with the average private sector economic forecasts, with differences fully explained and justified.  Forecast details on both real and nominal GDP should be publicly provided so that assessments can be made on the composition of GDP.  This should be provided on a consistent basis.  Department of Finance officials should appear on a more regular basis before committees on Parliament to explain the impact of current economic developments.  

Changing the process will open the debate on the applicable economic assumptions to use for budget planning.  It will once again ensure that the government is fully accountable and more transparent for both the economic and fiscal projections. 

[1] Review of the Forecasting Accuracy and Methods of the Department of Finance: Ernst & Young September 1994.