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...spending forecasts for the year. In the last five years alone, the result has been extra fiscal room totaling $34 billion, or an average of $6.8 billion annually. But this unneeded fiscal room is turning into massive in-year spending hikes at the expense of long-term planning and tax relief.
This Commentary argues for a new approach based on the inescapable fact that surprises will always make Ottawa's bottom line vary from what was budgeted. It proposes a more realistic model for budget planners that takes uncertainties into account. This paper shows how multiple runs of this model--in which uncertain variables such as economic growth, tax yields, and interest rates vary from run to run--can help the government make educated guesses about the risks associated with a given fiscal plan.
Such an exercise would help frame a course for spending or tax relief that makes the odds of a good outcome--achieving a given debt target, or avoiding a deficit over a given period--comfortably high. It could also establish a range of "respectable" error around the bottom line outcome that, akin to the one-percentage-point band around the Bank of Canada's inflation-control target, would let Parliament steer a steady course through temporary swings in fortune.
Making a range of outcomes, rather than a point forecast, the backdrop for fiscal planning would produce targets with more substance and reliability than the current practice of arbitrarily setting aside several-billion-dollar amounts for contingency reserves. It would reduce the embarrassment of point forecasts that are inevitably missed. And it would mitigate the pressure to spend first, and ask why and how later, evident in recent budgets and legislation.
A complementary change would create a new agency to perform the probability-based modeling. Separating the creation of the economic and fiscal backdrop from the laying out of the fiscal plan avoids the appearance of conflict of interest. And institutional separation would permit open discussion of uncertainties about the economy and the impact of fiscal policy that are awkward for the minister of finance and his officials to acknowledge.
Ad hoc legislation along the lines of Bills C-48 and C-67 offers Canadians poor odds of escaping their current fiscal trap. The probability-based framework outlined in this Commentary could improve those odds.
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Since the mid-1990s, the framework for federal budgets has put avoiding deficits front and centre. This approach--exemplified in former finance minister Paul Martin's commitment to hit his fiscal targets "come hell or high water" (Martin 1995)--succeeded stunningly in ending the unsustainable borrowing that inspired it. In recent years, however, the bottom-line padding that is central to the hell-or-high-water approach has promoted unsustainable spending increases and cast doubt on Parliament's ability to control public finances.
Neither legislation to force a balanced budget nor arbitrary formulas for dividing unexpected surpluses among spending, tax rebates, and debt repurchase will address these problems. (1) A better approach would formally acknowledge that surprises will always make Ottawa's bottom line vary from what was budgeted; set targets for taxes and spending that make the odds of an unacceptably bad outcome comfortably low; and recognize that variation within a pre-established range--somewhat akin to the 1-percentage-point band either side of the Bank of Canada's 2 percent inflation target--is not a cause for political embarrassment. This Commentary outlines changes to the forecasting framework and the institutional responsibility for it that could keep Ottawa on a path to lower debt and promote better stewardship of Canada's public finances.
The Obsolete Hell-or-High-Water Framework
The roots of current federal budgetary practices lie in the unsustainable deficits of the early 1990s. The newly elected Liberal government, with Paul Martin as finance minister, won power on a platform that took a casual approach to fiscal problems. But after a weak first budget and turbulent financial markets added a threat of crisis to the mix, the government changed course. Its 1995 budget adopted a framework focusing relentlessly on short-term targets to balance the budget--a framework the finance minister said would hold the government's feet to the fire to ensure the targets were hit "come hell or high water."
Initial Success
Because ending deficits required controversial budget changes and federal fiscal credibility was low, the government initially used two complementary tactics to ensure that it hit its bottom-line target. In the early years, the projections that served as the baseline for policy initiatives used economic forecasts and fiscal assumptions that produced pessimistic outcomes for the budget balance. (2) So, middle-of-the-road outcomes--indeed, most outcomes short of catastrophe--would let Ottawa overachieve its target. A second practice, which still persists, was the resort to explicit padding--dollar amounts for economic prudence and contingency reserves--to cover unexpected revenue shortfalls or spending overruns. This practice also helped the federal government do better on average than it had projected.
The hell-or-high-water framework restored Ottawa's fiscal health. From a deficit of $36.6 billion in fiscal year 1994/95, the federal budget balance moved to a surplus of $20.2 billion by 2000/01. That swing capped, then reduced, the claim of federal interest payments on the economy. By reassuring investors that Ottawa would neither renege on its debt nor devalue it with inflation, the framework set the stage for lower interest rates and better macroeconomic performance in this decade. (3)
Later Problems
Notwithstanding hell-or-high-water's success in achieving surpluses, events since the late 1990s have shown its defects as a permanent fiscal framework. The chronic pessimism of budget projections eroded the credibility of the minister of finance personally and the government more generally. That erosion lowered the barriers to in-year spending increases in response to better-than-projected revenue. And mounting in-year spending increases have undermined Parliament's credibility as an effective steward of Canada's public finances.
This deterioration is a direct effect of overpessimism about the fiscal environment in budget after budget. Compare the annual change in federal revenue forecast in each year's budget to the change in revenue shown in the public accounts at the end of the fiscal year (Figure 1; Box 1 explains the advantages of comparing annual changes, rather than levels). In eight of the ten years since the 1995 budget, revenue has exceeded projections. Since 2000, the record is five for five, and the cumulative overrun during that period is $29.0 billion--an average of almost $5.8 billion each year.
[FIGURE 1 OMITTED]
Box 1: Measuring Federal Budget Projections against Results
The simplest way of measuring federal budget projections against actual results is to look at the projections against the most recent historical figures published in the Public Accounts. Such comparisons, however, are less informative than comparisons of projected and actual changes in revenue and spending for each fiscal year.
One problem with comparisons of levels arises from the fact that the federal government has made changes over time--most importantly, a move to more complete accrual accounting--in its recording of key revenue and spending items. The...
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