The Minister of Finance presented his Economic and Fiscal Update on November 8th in preparation for planning the 2012 budget.  The Update incorporates the October average private sector economic forecasts and an increased “adjustment for risk” for 2011-12 to 2013-14, as well as an increase in employment insurance rates of only 5 cents (employee rate) for 2012, rather than the 10 cents set in legislation As a result, the balanced budget target is delayed from 2014-15 to 2016-17, prior to the inclusion of the Targeted Strategic and Operating Review Savings (now called “Deficit Reduction Action Plan Saving Target”). We have been forecasting for some time that the deficit would not be eliminated in 2014-15, as has the Parliamentary Budget Office (PBO) (http://www.3dpolicy.ca/content/we-are-committed-eliminating-deficit-2016-budget-2012; http://www.3dpolicy.ca/content/don-t-bet-surplus-2014-15-or-2015-16). This note presents our assessment of the “credibility” of the latest Update as a basis for budget planning. Overall we find the latest Update lacking in transparency, accountability, and a realistic assessment of economic and fiscal prospects and risks.

1.Overview of Revised Forecasts

Table 1 compares the June 2011 Budget economic forecast for nominal Gross Domestic Product (GDP), adjusted for prudence, to the November 2011 Update forecast.

Table 1: Change in Nominal Gross Domestic Product ($ billions)

Nominal GDP – the applicable base for budgetary revenues - has been revised down by $43 billion in 2012 from the June 2011 Budget planning assumption.  Of this downward, $20 billion was due to an increase in the risk adjustment.  In 2013, nominal GDP is $42 billion, of which $10 billion is due to an increased in the risk factor.  The underlying adjustment of $32 billion is carried-forward into the future years with no increase in the risk factor. 

Short-term economic forecasting is difficult enough but uncertainty about economic prospects usually increases, not decreases, over the medium term. As a result, the normal practice is for the amount of “risk adjustment” to increase not decline as is the case in the latest update.  From 2012, the risk adjustment factor should have increased by $10 billion per year, rising from $30 billion in 2012 to $70 billion in 2016.  This would have reduced revenues by $10.5 billion in 2016-17, rather than $1.5 billion.

The Parliamentary Budget Officer (PBO), in its November 2011 Update, is much more pessimistic about Canada’s medium-term economic prospects.  The decline in nominal GDP is about twice as large over the medium term than that used in the Government’s latest Update. The TD bank, one of the few organizations that does medium-term forecasting, is also much more pessimistic.

The inadequate level of “risk adjustment” in the forecast seriously undermines the “credibility” of the latest fiscal update as a basis for budget planning.

Table 2 shows the changes in the fiscal projections since the June 2011 Update.  The downward revisions to revenues are much larger than would be indicated using the Department of Finance’s “rules of thumb”.  This is because the largest downward adjustment was to “Other revenues”, a component largely unaffected by changes in nominal GDP.  In previous commentaries, we felt that this component was grossly overstated.  These adjustments are appropriate but are unrelated to current economic developments. 

Table 2: November 2011 Update: Budgetary Balance: Change from June 2011 Budget ($ billions)

In 2011-12, the downward revisions to budgetary revenues and the increase in the risk factor are more than offset by lower expenses.  As noted in our assessment of the monthly Fiscal Monitor results to date (http://www.3dpolicy.ca/content/federal-deficit-outcome-2010-11-lower-expected-deficit-will-still-not-be-eliminated-2014-15), employment insurance benefits and direct program expenses were running well below the June 2011 Budget projections and the current Update acknowledges this.  The recovery of the $1.6 billion in HST harmonization costs accounts for the downward revision to transfers to other levels of government.  Even with this downward revision to total expenses, there is still an extraordinary and unexplained large difference between the Estimates tabled to date and the revised November 2011 Update estimate for total expenses.  It appears that total expenses are still over stated and current Fiscal Monitor results to date support this view. 

Thereafter, the downward adjustments to budgetary revenues more than offset the downward adjustments to total expenses, the latter primarily due to the lower outlook for interest rates on public debt charges. In addition, the 5-cent cap on employment insurance rates reduces revenues by $0.6 billion in both 2012-13 and 2013-14.  An increase of 10 cents was assumed in the June 2011 Budget. However, by 2015, premium rates increase by 10 cents rather than remain unchanged as assumed in the June 2011 Budget.

On balance, the deficit is between $7.5 billion and $8 billion higher over the period 2012-13 to 2015-16.  Only if the Government fully realizes its savings from the Debt Reduction Plan Savings Target would the budget be balanced in 2015-16, but just.

In previous commentaries, we have also questioned the forecast for direct program expenses.  This component includes transfer payments, excluding the major transfers to persons and other levels of government, the amortization of capital assets, expenses subject to freeze, as set out in the March 2010 Budget, and other expenses. 

Table 3 shows the annual growth rates of the components and the annual average change over the period 2010-11 to 2016-17.  The annual profile of the totals and the resulting totals appear suspect.  The transfer component is affected in the early years by the ending of the measures contained in the Economic Action Plan.  This raises questions as to the large declines in 2013-14 and 2014-15, well after the final year of the Economic Action Plan.  There were no measures announced in previous budgets which would explain the declines beyond 2012-13. The profile for “operating budgets subject to freeze” also appears questionable, especially in 2016-17.  And there is no justification for the increase of only 0.4 per cent in 2016-17 in “other operating expenses”.  On balance, direct program expenses in 2012-13 could be under stated by as much as $2 billion, rising to $3 billion by 2016-17.  AS a result, a balanced in 2016-17 could be in jeopardy, even if the Government is successful in securing the $4 billion in Deficit Reduction Action Plan Savings.

Table 3: Growth in Direct Program Expenses (per cent change)

The profile for Direct program expenses in the November 2011 Update clearly indicates that the proposed Deficit Reduction Action Plan savings will need to come from program cuts rather than efficiency measures.      

Table 3: Growth in Direct Program Expenses (per cent change

Finally, the Public Accounts for 2010-11 and the Fiscal Monitor for August 2011 incorporated a number of classification changes.  However, these were not incorporated in the November 2011 Update, rendering comparisons among the various sources more difficult.  There is no reason why the Update did not incorporate these changes.

In summary,  apart for 2011-12, the forecast of the deficit appears overly optimistic and it is extremely unlikely that the budget will be balanced over the current planning framework.

2. What has changed since the June 2011 Budget or even Last Fall?

It is difficult to understand why today’s revised economic and fiscal projections were not included in the June 2011 Budget.  The second quarter National Accounts, which granted did not come out till August, reported a decline in real GDP.  Closer monitoring of the second quarter would have indicated that the “average” private sector forecast, which was based on the first quarter results, was overly optimistic.

Furthermore, what has changed on the international front?  As we reported last year (http://www.3dpolicy.ca/content/how-credible-october-2010-fall-economic-and-fiscal-update), the near collapse of the EURO during the Greek crisis cannot be seen as a minor “blip” soon to be forgotten. The EURO countries are confronted with the need for a major rebalancing, with the so-called peripheral European countries facing the need for major fiscal rebalancing and with it slower growth. This adjustment process will take years (http://www.3dpolicy.ca/content/what-mess-euro-and-us-are-and-it-won-t-get-better-soon-how-should-canada-respond).

In the United States, the economy struggles under the continuing burdens of balance sheet restructuring and extremely weak employment growth. Research shows that after a recession, brought on by financial collapse, the length of time for the economy to return to potential can be as long as seven years. In some cases, there is even a permanent loss in potential output. This seems to be the growth track the U.S. economy is on, with forecast growth averaging around 2 per cent and the unemployment rate remaining stubbornly high, in the 9 to 10 per cent range. This implies a long period during which the economy will operate below its potential output.

The U.S. government is painfully aware of the political, social, and economic costs of such slow economic growth and stubbornly high unemployment. Talk of a “lost decade” in the U.S. is becoming commonplace.

Emerging market economies, at first glance, seem to be doing remarkably well, but with export markets weakening, it is unlikely that domestic demand will be able to step in to fill the gap. Stronger domestic demand growth in the emerging countries will not happen without major changes in domestic policy, particularly in China. This is now beginning to happen, but it will take many years to make the Chinese economy more reliant on domestic demand.

And finally and regrettably, one of the main causes of the financial meltdown, the exchange rate imbalances between the U.S. and China, still remains unresolved. The world can no longer rely on the American consumer to pull it along and not every country can be a net exporter.

In Canada, the recovery is very fragile, without any solid private sector footing.  It has been running on government “steroids”, most of which was withdrawn at the end of 2010-11, the strength of the housing sector and heavy personal consumption.  The latter two will leave middle-income families with high debt burdens and exposed to higher interest rates. This is certainly not desirable and definitely not sustainable. Eventually private sector investment will have to take over from the consumer and government, if the recovery is to strengthen.  But to date, this hasn’t happened.

So we should not be surprised that the economic and fiscal forecasts were revised down.  Nothing has really changed since last fall, except the government’s acceptance of this reality. Regrettably, the Department of Finance has still not made enough adjustment in its planning assumptions.

3. The Update Should Have Included Finance’s View of Potential Economic Growth, the Output Gap, and how long it will take to eliminate this Gap

The PBO and private sector economists are predicting that Canada’s economic potential will average less than 2 per cent per year over the period to 2014 and beyond. This would represent a reduction of 1 per cent in potential output growth since the year 2000.

The reasons for this decline are twofold: first, the decline in the trend labor force growth, resulting from the aging of the population and a fall in the long-term employment rate; and second, continuing low productivity growth.

This will mean a decline in the growth of government revenues with obvious implications for budget planning. The PBO, and some private sector economists, including us, believe the deficit has a significant and growing structural component. This is due not only to the reduction in potential economic output but also to the mismatch between tax revenues and program expenses, given the significant reductions in taxes and increases in spending.

This Update should have provided the Government’s assessment of the impact of the change in demographics. It is inconceivable that the Department has not done its own research on this issue.

This undermines the “credibility” of the forecast for budget planning purposes.

4.The Update Should Have Been Presented to the Finance Committee

For the third consecutive year, the Minister of Finance presented his Update outside Parliament.  We continue to feel that these Updates should be presented to the House of Commons Standing Committee on Finance for its review and assessment.  The Committee has been holding cross-country pre-budget consultations to hear the views of Canadians on what should be included in the upcoming budget.  A vital component in these consultations is the government’s updated economic and fiscal projections.  However, once again, the government has undermined Parliament and the Committee.   

5. The Update Should Have Included More Information on the Views of the Private Sector Economists and Their Forecasts in Order to Develop a Credible Medium-Term Fiscal Track

In preparation for the Fall Update, the Minister of Finance recently met behind closed doors with 14 private sector economists to discuss the future of the Canadian economy.

However, much more information should have been provided on the forecasts of the private sector economists, not just the “average” forecast. We need to be given the range of forecasts and an explanation of why they differ. Taking the “average” of widely different views cannot be justified on statistical grounds when the biases are in one direction.  Furthermore, although 14 forecasters may have provided their economic forecasts for the short term, there are only three or four forecasters who undertake detailed medium-term economic forecasts.  This raises questions on the consistency between the short- and medium-term forecasts.

We should also have been given the forecast of the Department of Finance and justification for not using it as the basis for budget planning instead of an “average”. The “average” has turned out to be wrong too many times. Moreover, the reason given for using the average of private sector forecast was not a recommendation of the 1994 Ernst and Young report ”Review of the Forecasting Accuracy and Methods of the Department of Finance.  That report concluded that the Department of Finance had the best record for forecast accuracy but that the Government should consult more regularly with private sector economists.  The only reason for using an “average” is to avoid political responsibility for the forecast, if it turns out wrong, and “to put the blame on others (http://www.3dpolicy.ca/content/time-make-budget-planning-process-more-accountable-transparent-and-prudent).

6.Why Do We Still Have the CEIFB?

In this Update, the Minister of Finance again scooped the Canada Employment Insurance Financing Board (CEIFB) by announcing that the employee premium rate for 2012 would increase by 5 cents, rather than the 10 cents assumed in the June 2011 Budget.  The CEIFB is mandated to recommend a rate for 2012 by the end of November.  The Government has scooped the CEIFB in every year since its creation.

Under the current projection, the EI Operating Accounts will not be in a surplus position until 2015.  Under current legislation, employee premium rates cannot change by more the 10 cents a year until the Account achieves a “surplus” of at least $2 billion. This implies that the CEIFB is required to recommend a rate increase of 10 cents a year to at least 2015.  And in all probably, the Government will announce beforehand a lower rate.  This raises the question as to why there is a CEIFB.  It is an issue that should be seriously discussed in the current consultation round on the EI rate-setting process (http://www.3dpolicy.ca/content/employment-insurance-premium-rate-setting-let-s-get-it-right-time).