The Parliamentary Budget Officer (PBO) released his assessment of Finance Minister Jim Morneau’s first Update of the Economic and Fiscal Projections (Update), concluding that that the economic and fiscal projections were overly optimistic, especially in the outer years. This raises the question of whether the Finance Minister will be able to balance the budget in 2019-20 if the Government attempts to fully implement its election promises.

The PBO raises some very legitimate concerns. The Finance Department forecasts strong growth in the major revenue sources (personal, corporate and GST revenues) relative to the growth in nominal gross domestic product.  In other words, Finance Canada is forecasting an increasing tax yield – revenues as a share of GDP – over the medium term without providing any justification. Their forecast for personal and corporate income taxes and GST revenues are about $5.5 billion to $8.5 billion higher per year than the PBO forecast. This allows them to forecast a budgetary surplus in both 2019-20 and 2020-21.

The government in its November Economic and Fiscal Update committed to a fiscal plan that would be based on realistic economic and fiscal forecasts; be sustainable over the medium term, (implying a low and declining debt-to-GDP ratio); be prudent; and be transparent.

Based on PBO’s assessment, the Update appears to fail the first criterion of credibility. The private sector economists’ forecast for real GDP is overly optimistic and this carries forwards into nominal GDP, even after adjusting for prudence.  However, as the PBO correctly notes, there is insufficient detail provided to properly assess the economic projections.

The Update is sustainable as the debt-to-GDP ratio continues to decline, even after incorporating the impact of the election promises.  These also include measures which would support economic growth. The PBO fiscal forecast also shows that the fiscal structure is sustainable.

The Update includes a Contingency Reserve of $1.5 billion in 2015-16 and $3 billion per year thereafter. However, the Update assumes relatively strong growth in oil prices from $49 (WTI $US) in 2015 to $75 (WTI $US) in 2020. The PBO notes that the adjustment to nominal GDP, implied by the Contingency Reserve, would only balance the risk to the private sector outlook for oil prices.  However, it does not compensate for the private sector’s more optimistic view for real GDP.  As such, there are still considerable downside risks to the Update’s fiscal projections.

The Update follows the practice of the previous government.  To increase transparency, more detail should have been presented on the economic forecast. In addition, the Contingency Reserve should have been shown as a separate line item rather than being buried in the revenue forecast, as recommended by the PCO. When Finance Minister Paul Martin first introduced prudence in his budget projections in 1994, the prudence was buried within the major revenue and expenditure components. This was criticized by private sector economists and financial commentators, who advocated that it be shown separately. Beginning with the 1995 Budget to the 2005 Budget, the Contingency Reserve was shown as a separate line item. The Conservatives abandoned the Contingency Reserve until their 2010 Budget.  However, it was incorporated directly into the revenue forecast and not shown as a separate line item.

As PBO’s assessment clearly shows, there are significant uncertainties associated with five-year economic and fiscal forecasts.  As Mr. Morneau has quickly discovered, forecasting is more of an art than a science.

Mr. Morneau should consider whether five-year economic and fiscal projections are of any use. The OECD and the IMF recommend medium-term projections but their forecasts along with the medium-term projections of all private sector forecasters are always wrong.

In the mid-1980s, Finance Minister Michael Wilson presented different forecasts for the medium term – an optimistic scenario, a middle of the road scenario and a pessimistic scenario.

In the mid 1990’s Finance Minister Paul Martin committed to a two-year rolling budget forecast. This was very successful.

Why not combine the two?

Here is a joke for the Minister of Finance that he should keep in mind in deciding whether to do five year forecasts.

“How do you know economists have a sense of humour? They put decimal points in their forecasts”.