The Minister of Finance presented his Economic and Fiscal Update on November 13th in a luncheon address to the Fredericton Chamber of Commerce, thereby again bypassing the House of Commons Standing Committee on Finance. The Update incorporates the October 29, 2012 average of the private sector economic forecasts. 

The budgetary balance has deteriorated significantly compared to that forecast in the March 2012 Budget, by $5 to $7 billion per year. A deficit of $1.8 billion is now forecast for 2015-16, instead of a surplus of $3.4 billion.  The March 2012 Budget surplus of $7.8 billion in 2016-17 is now reduced to only $1.7 billion.  A surplus of $3.4 billion is now forecast for 2017-18. 

As a result, the balanced budget target has been delayed one more time from 2015-16 to 2016-17, highlighting the difficulty in setting an annual target.  However, incorporating a more prudent “risk adjustment factor” into the forecast would result in deficits throughout the entire period. So don’t count on a surplus over the medium term, based on this Update.

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 November 2012 Update economic forecast for nominal Gross Domestic Product (GDP) – the applicable base for budgetary revenues - to the March 2012 Budget forecast.

Table 1: Nominal Gross Domestic Product ($ billions)

1. Growth rates linked to Statistics CAnada revised historical estimate for 2011.

The average of the private sector forecasts for nominal GDP has been lowered by $22 billion for 2012, about $30 billion for 2013 and 2014, and by $21 billion for 2016 from the March 2012 survey.  For fiscal planning purposes, the private sector average forecast has been reduced by a “risk adjustment factor” to help offset possible errors in the economic forecasts on the fiscal projections. In the March 2012 Budget, the “risk adjustment factor” was $20 billion per year.  In the current Update, it has been increased by an additional  $7 billion for 2012-13, but remains at $20 billion per year thereafter.  

As a result, compared to the March 2012 Budget planning assumption, the level of nominal GDP is $9 billion lower in 2012 – this consists of a “risk adjustment factor” of $7 billion and the difference between the change in the private sector average forecast of $22 billion less the March 2012 Budget “risk adjustment factor” of $20 billion. Thereafter, with no change in the “risk adjustment factor”, the change in nominal GDP for fiscal planning purpose mirrors the absolute change in the private sector average forecast.  

The Parliamentary Budget Officer (PBO), in its October 29, 2012 Economic and Fiscal Outlook Update, is somewhat more pessimistic about Canada’s medium-term economic prospects.  The decline in nominal GDP is about twice as large in 2014 and 2015 than that used in the Government’s latest Update.

Short-term economic forecasting is difficult enough but uncertainty about economic prospects usually increases, not decreases, over the medium term. As a result, one would expect that the amount of “risk adjustment” to increase not decline over time. The government’s forecast once again includes inadequate prudence. Beginning in 2013, the risk adjustment factor applied to nominal GDP should have been increased by an incremental $10 billion per year, rising from $20 billion in 2013 to $50 billion in 2016.  This would have reduced revenues by $7.5 billion in 2016-17, rather than $3 billion.  With a more prudent “risk adjustment factor”, the government would not be able to show a surplus over the medium term.

The inadequate level of “risk adjustment” in the forecast seriously undermines the “credibility” of the latest fiscal update as a basis for budget planning and the ability to claim a budgetary surplus over the medium term. 

Table 2 shows the changes in the fiscal projections since the March 2012 Budget.  There were issues in putting this table together, given the number of reclassifications announced in this Update, making comparisons to the March 2012 Budget component projections extremely difficult.  In addition, this Update again failed to incorporate the reclassification changes to Fiscal Arrangements and Alternative Payments for Standing Programs, which were included in the Public Accounts of Canada, the Annual Financial Report for 2011-12 and Fiscal Monitor. Why this reclassification change was not made in the November 2012 Update is unexplainable.

Table 2: November 2012 Update: Changes from the March 2012 Budget ($ billions)

Totals may not add due to rounding.

As reported in the Annual Financial Report for fiscal year 2011-12, the deficit for In 2011-12 was $1.4 billion higher than estimated in the March 2012 Budget.  All of this deterioration was due to lower revenues – down $2.8 billion from the March 2012 Budget estimate. Half of this impact on the deficit outcome was offset by lower expenses, with virtually all of it due to lower direct program expenses – other transfers and departmental and agency operating costs.  We find out in this update that the decline in direct program expenses would have been larger had it not been for a policy initiative.  We cannot understand why this wasn’t disclosed in the Annual Financial Report.

The budgetary deficit is expected to show virtually no improvement between 2011-12 and 2012-13.  The deficit is expected to be nearly $5 billion higher-than-projected in the March 2012 Budget.  Most of this deterioration is due to lower revenues (down $3.3 billion), new policy initiatives amounting to just over $1 billion and an increase in the “risk adjustment factor” resulting in a loss of revenues of $1 billion. 

The deterioration in revenues over the next four years is much larger than what one would expect given the Department of Finance’s “sensitivity” analysis to the changes in nominal GDP.  Budgetary revenues are over $7 billion lower than forecast in the March 2012 Budget, with all major components with the exception of employment insurance premiums (EI) are lower. In fact, the budgetary surplus in 2016-17 is solely due to the annual surplus in the EI Operating Account.

Program expenses are higher throughout the entire forecast period, primarily attributable to direct program expenses, on a status quo basis (i.e., excluding the impact of policy changes).  The Update claims this is largely attributable “ to a change in the timing of when employee pension and benefit liabilities are expensed”, due to lower-than-expected long-term interest rates. No estimates of this change are provided. It is assumed that part of this increase is offset by the changes to the federal and members of Parliament pension plans, although one would have expected these savings to be included under “Policy Decisions”.  Even with this adjustment, we believe that the outlook for direct program expenses in the outer years is understated, putting the achievement of a balanced budget over the medium term at even greater risk.   

With interest rates lower than projected in the March 2012 Budget, public debt charges are correspondingly lower.

New policy initiatives increase the deficit by $1.1 billion in 2012-13 but thereafter are virtually neutral.  These include increased expenses related to the Government’s decision not to appeal a court decision regarding the Service Income Security Insurance Plan. 
 

2. What has changed since the March 2012 Budget?

There have been two big changes since the 2012 Budget.

First, has been the significant decline in terms of trade during the first half of the year due to lower commodity prices.  This accounts for most of the decline in nominal GDP and deterioration in the deficit outlook.

Second, the risks and uncertainties that have been dampening global economic prospects have worsened.

The IMF’s October, 2012 World Economic Outlook (WEO), “Coping with High Debt and Sluggish Growth”” had some sobering messages for policy makers including Mr. Flaherty. The report warns that  “The recovery has suffered new setbacks, and uncertainty weighs heavily on the outlook. A key reason is that policies in the major advanced economies have not rebuilt confidence in medium-term prospects”.“Projected global growth, ….in 2012 and 2013 is weaker than in the July WEO Update, which was in turn lower than in the April 2012 WEO.”

In the Global Financial Stability Report the IMF begins with the observation that “Risks to financial stability have increased since the April 2012 GFSR, as confidence in the global financial system have become very fragile.”

The WEO concludes “that there is now a 1 in 6 chance of global growth falling below 2 percent, which would be consistent with a recession in advanced economies, and low growth in emerging market and developing economies.” This is a substantial increase in the probabilities of a global recession. The fact is that Japan, the U.K.  and the EURO area are already in recession

This message has only partly got through to Mr. Flaherty

He has still not made enough adjustment in its planning assumption for the next budget.

This may change in the next few weeks as the situation in the EURO are and the U.S. develops.

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

For the fourth consecutive year, the Minister of Finance has 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.   

4. 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-ac...).

5. What is the Purpose of Setting A Medium-Term Fiscal Anchor?

Since the 2008-2009 recession, the Minister of Finance has abandoned the setting of any explicit fiscal target, with the exception of stating that the budget will be balanced over the medium term.

Each Update/Budget shows a surplus over the medium term.  But with each update, another year is added, pushing the medium term out another year.  This is what the Mulroney government did in the 1980s.  They put out a five-year fiscal track, claiming that financial requirements would be eliminated by the end of the year.  Every year, they were required to extend this out one more year.  The Chretien government, dealing with a fiscal crisis, set an explicit deficit target over a two-year period with a commitment to meet it, “come hell or high water”.

The federal government, today, is not in a fiscal crisis.  As it reminds Canadians constantly, its fiscal situation is better than any other country in the G-7.  The debt-to-GDP ratio is low and in place to decline. The structure of revenues and expenses it currently has in place will result in growing surpluses over time.  However, the exact year in which the budget will be balanced cannot be determined with any certainty.  Stating that the budgetary will balanced over the medium term and then continuously revising the medium term undermines the credibility of the commitment.