THE FINANCE MINISTER SHOULD INCLUDE A PRUDENCE RESERVE IN HIS BUDGET
The Parliamentary Budget Office (PBO) recently released its assessment of the federal government’s Fall Economic Statement and offered a number of issues for consideration by parliamentarians. One of these related to the inclusion of prudence in the government’s economic forecast.
In the March 2016 Budget, Finance Minister Morneau reduced the private sector economists’ forecast of average nominal gross domestic product (GDP) by $40 billion per year. This resulted in a prudence factor of $6 billion per year. Without this adjustment, the projected deficit would have been $6 billion lower each year.
The PBO considered this adjustment as excessive for 2016 and 2017. This appeared to be the case when the Finance Minister released his Economic and Fiscal Update on November 1st. The projected deficit for 2016-17 was revised down from the March 2016 Budget forecast of $29.4 billion to $25.1 billion. The deficit for 2017-18 was revised down from $29.0 billion to $27.8 billion.
The PBO’s economic forecast does not include any prudence, arguing that the risks to its economic forecast are balanced. This is difficult to justify, given the ongoing downward revisions to PBO’s economic forecasts. In his November Update, the Finance Minister did not adjust the private sector forecast for any prudence, arguing, as well, that the risks to the economic forecast were balanced.
It can be argued that the March 2016 Budget prudence factor for 2016-17 and 2017-18 was somewhat “excessive” but that some amount of prudence was justified. If there were no prudence in the March 2016 Budget economic projections, the forecast deficit for 2016-17 would have been higher by $1.7 billion and by $4.8 billion in 2017-18. In other words, the “excessive” prudence helped the Minister’s credibility.
The PBO was silent on the prudence factor in the outer three years of the budget plan. In those years, the prudence of $6 billion was insufficient to offset the impact of the downward revisions to nominal GDP on the deficit outlook. In other words, the Finance Minister was justified in including a prudence factor of $6 billion per year.
Although the PBO is critical of the inclusion of any prudence in the fiscal forecasts, it nevertheless claims that there are downside risks to the November 2016 Update economic forecast. This itself would appear to justify the inclusion of prudence. It would be wrong for the Finance Minister to accept the PBO view that it is not necessary to include a prudence adjustment in his budget plan.
The inclusion of prudence helps to ensure that the fiscal target(s) set by the government will be met, if not somewhat bettered. Meeting these targets is critical to the achievement of budget credibility and, therefore, Ministerial credibility.
However, in the Fall Update, the Finance Minister was ambivalent on what his fiscal target(s) actually are. In a press conference the following day, he made reference to stabilizing the debt-to-GDP ratio. He did not commit to a plan or timetable to balance the budget. Although this was the right thing to do, financial commentators and the public still view deficit elimination as an important fiscal anchor. Continual upward revisions to the deficit would undermine the credibility of the government’s economic and fiscal strategy. As such, the inclusion of prudence is important to gain and maintain credibility.
A “Contingency Reserve” was first included in the budget forecasts in 1994 by Finance Minister Paul Martin, following a review of the Department of Finance’s economic and fiscal forecasts by Ernst and Young. At first, this was done through downward adjustments to the economic forecasts. However, following protests by a number of private sector economists, it was included as a separate adjustment to the revenue and expense forecasts rather than as an adjustment to the economic forecasts.
The contingency reserve was initially set at $2.5 billion in year one and $3 billion per year thereafter. It was later changed to $3 billion per year. At that time, a second adjustment for “economic prudence” was made to the budget forecast. This was set at $1.5 billion in year one, increasing to $4 billion by year 5. As such, the total prudence in the budget plan increased from $4.5 billion in the first year rising to $7 billion in the final year
There were also strict rules around the use of the Contingency Reserve if it were not needed. It could only be used to offset errors in the economic forecast and/or to offset any errors in translating the economic forecast to the fiscal forecast. It was not to be used to finance new policy initiatives. As such, it became the government’s debt reduction plan. If not required, the Contingency Reserve would be used to reduce the federal debt. In contrast, the economic prudence, if not required, could be used to finance new initiatives.
Conservative Finance Ministers were uncertain about whether there was a need for prudence and if so how much? There was no prudence in the 2006 to 2008 budgets or in the 2010 budget. Prudence was included in the 2009 and the 2011 to 2015 budgets. The size of the risk adjustments varied from $10 to $30 billion of nominal GDP, considerably less than under the previous Liberal government.
In the April 2015 Budget, the Conservative government committed to allocating any unused portion of the risk adjustment factor to debt reduction.
To date Mr. Morneau has been silent on what happens to the risk adjustment factor if not needed to offset the impact of adverse economic developments on the fiscal projections. In the November 2016 Update, he stated that “the government will continue to evaluate risks between now and the time of Budget 2017 to determine the appropriate level of the adjustment for risk to be used in the Budget 2017 planning assumptions”.
We would strongly recommend that a risk adjustment again be included; that it increase over time given the forecasting uncertainties; that it be shown separately and not as an adjustment to nominal GDP; and finally, that if not required to offset the adverse impact of adverse economic developments on the deficit projections, that it be used to reduce the federal debt and not to finance new policy initiatives.