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Ottawa, June 20, 2005
2005-043

Minister of Finance Tables Study on Government’s Economic and Fiscal Forecasting

Related Documents:

• Letter
• Review of Canadian Federal Fiscal Forecasting, Processes and Systems

Minister of Finance Ralph Goodale today released an independent study by economist Dr. Tim O’Neill of the Government of Canada’s approach to economic and fiscal forecasting used in budget planning.

The Minister tabled the study—Review of Canadian Federal Fiscal Forecasting: Processes and Systems—in the House of Commons.

"We commissioned this study last September to get an independent assessment of our economic and fiscal forecasting," said Minister Goodale.

"Our fiscal record—seven consecutive federal surpluses—is the best in the G-7. But we wanted to make sure we are equipped with the best processes and projections possible. This report offers comprehensive, concrete recommendations on increasing the transparency of information and improving the quality and analysis of the data we use."

A summary of the study findings and recommendations is contained in the attached letter from Dr. O’Neill to Minister Goodale.

Dr. O’Neill is an independent consultant and the former Chief Economist and Executive Vice-President of BMO Financial Group. He was the first Canadian economist to be elected to the Board of Governors of the U.S.-based National Association for Business Economics, and served as its President in 2003. He holds a Ph.D. in economics from Duke University.

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The Hon. Ralph Goodale, MP
Minister of Finance
Department of Finance Canada
140 O’Connor Street
Ottawa, Ontario
K1A 0G5

Dear Minister:

It is my pleasure to deliver the completed report, Review of Canadian Federal Fiscal Forecasting: Processes and Systems, as commissioned by you last September.

The objective of this study was to assess the accuracy of the Government of Canada’s fiscal results over the last 10 years, and to propose changes to the federal budget process that might improve the accuracy of forecasting and, ultimately, the conduct of public policy.

In preparing this report, extensive consultation was carried out with some 30 individuals, comprising private sector forecasters and other individuals within Canada and abroad, familiar with the issues involved. As well, a quantitative analysis of forecast accuracy was carried out jointly by the Policy and Economic Analysis Program (PEAP) of the Institute for Policy Analysis at the University of Toronto, and the Center for Inter-university Research and Analysis on Organizations (CIRANO). The report also draws on the study conducted by the International Monetary Fund, at the request of Finance Canada, comparing Canada’s forecasting record with other G-7 and OECD countries.

The report found a number of points of concern with the forecasting process. My analysis has led me to conclude that most of these concerns can be addressed within the current forecasting structures by improving transparency, data accuracy and analysis.

However, a key conclusion of the analysis of forecast accuracy is that the government’s commitment to never run a deficit under any circumstances has contributed significantly to the persistent upside surplus surprises. Accordingly, the report concludes that the government should consider adopting a different rule that is more appropriate to its fiscal circumstances and to its increased focus on medium- to long-term commitments.

Further, although I do not propose the creation of an independent agency for forecasting, there may be a role for such an agency to undertake analyses of medium to long-term economic and fiscal issues. This would better inform Parliament’s and the public discussion of longer-term budget options.

ISSUES AND CONCERNS

The process of consultation found overwhelming agreement on two fundamental points.

• First, the consistent underestimate of future surpluses was argued to constitute a problem – although some argue it is a better problem to have than running deficits – because it hinders public and Parliamentary debate about the main budget choices available: between tax cuts, increased spending, and/or debt reduction.

• Second, the large majority of those interviewed saw this record of larger-than-forecast surpluses as the logical outcome of two forces – the government’s determination to stay out of deficit, combined with several years in which the Canadian economy grew faster than expected.

Related findings of the report, which come out of both the analysis and consultations, include:

• At the outset, it is important to get a proper broad perspective on the issue of forecast accuracy. A budget balance, whether surplus or deficit is the difference between two large numbers – revenues and expenditures. A small error in either or both can translate into a large error in the difference between the two.

• There is a sharp divide among economists interviewed on the government’s no-deficit commitment. Most said it was too rigid and might, during a period of severe economic weakness, compel the government to raise taxes or cut spending, and so worsen the downturn. But a few felt that any deficit, however small, must be avoided because it would put the government on a "slippery slope" back to the kind of persistent, large federal deficits seen in the 1980s and early 1990s.

• The research indicates that the underlying economic forecasts applied in the fiscal planning process have not been particularly accurate, and, on several occasions, contributed significantly to fiscal forecast errors. Economists themselves pointed to persistent and significant data revisions by Statistics Canada as frustrating their efforts to predict economic growth.

• However, it is the process of converting economic forecasts (such as GDP growth, GDP inflation and interest rates) into projections of federal revenue and spending that stands as a major source of the fiscal forecast accuracy problem.

• The government’s target of a 25% debt-to-GDP ratio was seen by most experts as a reasonable target, easily achievable through a combination of decent economic growth and small federal surpluses. Almost all experts endorsed the continued use of the annual Contingency Reserve (usually $3 billion) and a further allowance for economic prudence.

• Most of those consulted dismissed the benefits of setting up in Canada a body resembling the U.S. Congressional Budget Office to provide an arm’s-length check on the government’s fiscal forecast. But there was broad support for new institutions that might enrich the debate over budget issues by conducting research on a variety of long-term fiscal issues, such as the impending retirement of the baby-boom generation.

RECOMMENDATIONS

Given these observations, my report proposes recommendations for possible changes in fiscal forecasting processes in four areas. These are:

The Need for Transparency

1. In the Budget and the fall Economic and Fiscal Update, fully explore the key risks and uncertainties in the economic forecast, and discuss their implications for fiscal projections.

2. In the Budget and fall Update, provide details on the rules of thumb used to estimate the impacts of key economic variables on revenue and expenditure categories.

3. In major fiscal documents, spell out the details of the reconciliation between National Accounts-based economic forecasts and the Public Accounts-based fiscal forecasts.

4. In the Budget, provide documentation of the long-term (10-year) track record of Finance’s fiscal forecast accuracy.

5. Produce a quarterly update of the current year fiscal forecast indicating the factors which have caused any material changes to occur.

6. Increase the number of formal briefings by Finance to the House of Commons Standing Committee on Finance by at least one additional session in the early summer.

Improving Accuracy and Timeliness of Data

7. Statistics Canada and the Department of Finance jointly examine the causes of significant GDP data revisions, and explore options for mitigating them.

8. Undertake research into changes in the relationship between the economy’s performance and major categories of federal revenue.

9. Improve monitoring of key government operations; in particular, better tracking of Crown corporation earnings, and of departmental expenditures.

Fiscal Rules (Government Budget Targets)

10. Shift from the no-deficit target to a fiscal rule of achieving a surplus, on average, over the economic cycle.

11. If the no-deficit rule is maintained, adopt a formal and structured process for dealing with greater-than-expected surpluses. This would explicitly provide for allocations of such a surplus ‘surprise’ between tax cuts, spending, and debt reduction.

12. Consider setting the government’s debt-to-GDP ratio goal below the current target of 25% – to 20% or even 15% – to ensure that future fiscal challenges (especially the demographic revolution of the retiring baby boomers) can be met.

Possible Institutional Changes

13. The House of Commons Standing Committee on Finance discontinue the hiring of its own economic forecasters to provide separate quarterly fiscal projections. There should not be a separate fiscal forecast agency, like the U.S. Congressional Budget Office.

14. Create a small agency within government to focus on the medium- to long-term fiscal implications of structural factors like changing age demographics and productivity growth, and of policy initiatives such as changes in tax structures.

In conclusion, Minister, it has been my pleasure and privilege to undertake this study for you and the Department of Finance. I believe improvements can and should be made in the federal approach to fiscal forecasting – and that by doing so, the process can be strengthened to provide more open and effective public policy, to the benefit of all Canadians.

Yours sincerely,

Tim O’Neill
O’Neill Strategic Economics