Should Budgetary Revenue Projections be Deliberately Pessimistic?

Posted by Ian Lienert

When budget revenue projections are conservative, governments receive pleasant surprises – they benefit from more tax and nontax revenues than planned, which allows debt to be reduced faster than planned or, alternatively, expenditure to be higher. In contrast, if budget revenue projections are too optimistic, it is difficult to cut back expenditure, at least in the short-term. This can result in public debt increasing to a level higher than desirable, assuming market deficit-financing is available. In countries where debt market financing is unavailable, there is likely to be an undesirable build-up of payment arrears.

An IMF Occasional Paper published in 2007 examined the budget forecasting experience in eleven OECD countries. It found that in 8 of the 11 countries, revenues were underestimated during the late 1990s and early 2000s. Canada was the country that most strongly underestimated tax and nontax revenues. The countries for which revenue projections erred on the optimistic side during the observation period were France, Germany and the United States. It may be concluded that OECD countries leant towards revenue projection conservatism during this period.

In chapter IV of Occasional Paper No. 258, an IMF staff team first examined the institutional arrangements for budget forecasting processes in Australia, Canada, France, Germany, Italy, Netherlands, New Zealand, Sweden, Switzerland, United Kingdom and United States. The study then analyzed forecast errors -- forecasts minus outcomes -- for various macroeconomic and fiscal variables. The statistical analysis was generally conducted for a nine year period, from 1995 to 2003.

Concerning institutional aspects, the study noted that, whereas budget projections are prepared by the Ministry of Finance (or the equivalent) in all countries, the degree to which the forecasting process is formalized varies. Some countries prepare stylized forecasts with some cross-checks with sectoral and revenue experts (e.g., Sweden, Switzerland). Others use detailed model-driven processes maintained by technical experts (e.g., Australia, France and the United States). Some countries reassess their fiscal forecasts after consulting with the private sector (e.g., Australia, Canada). In the United States, the Congressional Budget Office (CBO) plays a similar role – it provides a view independent from that of the “ministry of finance” 1/. In the case of the CBO, there is a mandate to prepare 10-year projections of major fiscal variables based on current legislated policies. A few other countries have established congressional or parliamentary budget offices (see, for example, the blog of July 21, 2008, on the recent establishment of such an office in Canada; http://blog-pfm.imf.org/pfmblog/2008/07/canada-creates.html ).

With regard to revenue forecasting, Canada stands out as the country with the most consistent and largest underestimation of budget revenues. Canada’s GDP forecasts were deliberately conservative during 1995-2003: actual economic growth was on average ½ percentage point higher than that assumed in budget projections. Inflation (the GDP deflator) was also underestimated, by 0.2 percentage points. All tax and nontax revenue components were underestimated (the forecasting records of four different taxes were analyzed).

Statistical tests were conducted to detect whether, during the small sample period, there were systematic tendencies to underestimate nominal GDP, total revenues and nontax revenues during the 1990s and early 2000s. This analysis revealed that Canada, New Zealand, Sweden, and the United Kingdom all exhibited a consistent bias in either the macro forecasts or for aggregate fiscal revenues. In all countries, errors in output projections tend to explain a substantial share of revenue errors. Canada stood out as the country where a number of small, unidirectional forecast errors led to the overall bias towards conservatism in revenue projections.

For full results, see the “Budget Forecasting” chapter in IMF Occasional Study 258 Northern Star: Canada’s Path to Economic Prosperity, published in 2007 and available for purchase – see http://http://blog-pfm.imf.org/pfmblog/2008/07/canada-creates.html. The chapter is based on a more comprehensive study, IMF Working Paper/05/66, How Do Canadian Budget Forecasts Compare with Those of Other Industrial Countries? prepared by Martin Mühleisen, Stephan Danninger, David Hauner, Kornélia Krajnyák, and Bennett Sutton in March 2005 (see http://www.imf.org/external/pubs/cat/longres.cfm?sk=18080.0). The preparation and publication of these studies were strongly supported by Canadian officials.

Blog comments on the study

The research is solidly-based and includes a battery of statistical tests for errors in macroeconomic and fiscal variables; it also discusses the interaction between forecast variaiable. Although the study is now beginning to become a little dated, it indicates that the majority of selected OECD countries leaned towards pessimism in their budgetary revenue projections. However, it is difficult to generalize this conclusion for the 11 countries examined. The reasons are:

• Limited time series and lack of strong results. The sample period is less than 10 years. Also, statistically significant results that indicate a forecasting bias towards conservatism were obtained for a few countries only.

• Buoyant economic growth in sample period. The late 1990s and early 2000s was characterized by a period a buoyant economic growth. This resulted in both growth and budget revenues being higher than assumed. If the time series were to be updated to include the worldwide weakening of economic growth in 2008, for example, the results would mostly change somewhat.

• Data caveats. The study acknowledges the various data caveats needed for postmortems of forecasting errors. Both “budget projections” and “actual” outcomes can be revised, depending on each country’s budget and statistical reporting processes. These impinge on the empirical analysis. For example, supplementary budgets that are substantially different from initial budgets adopted by parliament can materially affect the entire analysis.

• Country specific factors play an important role in these results—but these can be changed over time. OECD countries periodically review their projection methods, including ways of assuring forecast quality (the study examines relevant issues).

• For example, the “prudence factor” and budget contingency reserves affected the results for Canada. During 1994 to 1998, prudence was explicitly incorporated into the Canadian forecasts by deliberately adopting budget forecast assumptions that were more pessimistic than private sector forecasters. During these years, the Department of Finance based budget projections on lower economic growth and higher interest rate assumptions than the average of private sector forecasters (on which Canada relies more heavily than other countries). This practice was helpful for contributing to the reduction in public debt, which had built up to worrisomely high levels in the early 1990s.

• Is revenue forecasting pessimism desirable? The results for Canada suggest that GDP and revenue forecast pessimism is desirable when a strong fiscal adjustment and reduction in debt is necessary. However, Canada stopped deliberately making conservative model-based forecasts after the worst of the fiscal crisis of the early 1990s was over. Clearly there are limits to which a strong ministry of finance can continue deliberate revenue projection pessimism, especially given that, in annual budget negotiations, spending ministries are likely to be more aggressive in obtaining the available “fiscal space” to maximize their budget revenues. Also, in countries where legislatures have considerable scope for changing the executive’s draft annual budget – strong amendment powers – parliament/Congress may increase budget expenditures if it suspects that the executive has deliberately been pessimistic in its revenue projections. When these tradeoffs occur, there may be a case for the ministry of finance to prepare realistic, rather than pessimistic, GDP and/or revenue projections. Clearly the case for realistic forecasts is stronger in countries whose fiscal and public debt positions are sufficiently comfortable.

1/ The “ministry of finance” function in the United States is performed by an Office of Management Budget (for spending projections) and a Department of Treasury (for revenue and debt projections). These two executive departments are complemented by a Council of Economic Advisors – the trio agrees on macroeconomic projections and forecast assumptions.

2/This is the reason why Japan was excluded from the sample. In the late 1990s, Japanese fiscal policy was implemented largely through supplementary budgets, whose projections differed significantly from those in initial budgets (because of intentional policy changes). In view of Japan’s fiscal policy responses during the Asian crisis (in particular), it would be very difficult to compare Japan’s forecast errors with those of the other countries, where supplementary budgets were admittedly adopted, but had a lesser budgetary impact.

Comments

[Evelyn Guzman]

The pessimistic budgetary revenue projections worked for Canada so perhaps it's a good thing when there is a need to lower the country's debt. At least, Canada showed it was able to ride out the crisis in the 1990's. I can see the trouble when Congress suspects that the executive level is being overly underestimating its revenue, then Congress may increase budgetary expenses.

Evelyn Guzman

[ahrainey]

1.0 GOVERNMENTS IN THE UNITED STATES

It is important to understand the "structure" of the U.S. Government.

1.1 FEDERAL GOVERNMENT. There is the 'national' or federal government. The Office of Management and Budget(OMB)under the "Executive Branch" (President)undertakes revenue projections. The Congressional Budget Office (CBO) undertakes revenue projections for the legislative branch (Congress = U.S. House of Representatives and U.S. Senate). The Federal Government is not bound by any "balanced budget" restrictions and issues its own debt, through the U.S. Treasury.

1.2 STATE GOVERNMENT. Each of the 50 States and the Government of the District of Columbia, Guam, and Puerto Rico require the Executive (Governor) to prepare revenue projections and the Legislative Branch to also prepare revenue projections. As state constitutions require balanced budgets and as rating agencies (Moody's, Standard and Poor's, Fitch) assess the demographic, commercial, fiscal, and financial health of the states must go to private sector when issuing debt.

1.3 MUNICIPAL GOVERNMENTS. Each Town, Borough, City, and County require the Executive (Mayor, County Executive) to prepare revenue projections and the Legislative Branch (City or Town or County Council) to also prepare revenue projections. As cities and counties and boroughs require balanced budgets and as rating agencies (Moody's, Standard and Poor's, Fitch) assess the demographic, commercial, fiscal, and financial health of the town or city or county or borough must go to private sector when issuing debt.

2.0 HOW STATE AND MUNICIPAL GOVERNMENTS IN THE UNITED STATES CONDUCT "PROJECTIONS". Expenditure projections extend several years into the future. A period of at least three years (or longer if necessary) is undertaken to evaluate how costs may change over time, to isolate non-recurring costs or savings, and to understand the implications of costs once fully phased in. Fund level and government-wide expenditure projections are prepared and documented so that they may be linked with the accounting system and integrated into overall financial projections. All expenditure projections should identify service level assumptions and key issues that may affect actual expenditures. Expenditure assumptions are also described in relation to revenue assumptions. An expenditure projection is prepared based on one set of assumptions (covering multiple periods); or, multiple projections using alternative sets of assumptions may be prepared in order to more clearly identify the impact of different scenarios.

Projections are available to stakeholders prior to making budget decisions. Inclusion of multi-year projections in a formal budget document, at least in summary form, is undertaken.

Assumptions for expenditure projections are consistent with related revenue and program performance assumptions. A review of expenditure projections for individual programs, particularly those with significant unexpected increases or decreases, is critical. Projections identify direct costs or both direct and indirect costs. However, if only direct costs are identified, then a discussion accompanying the projections address indirect impacts. Projections of maintenance and operating costs for any capital expenditures, as well as debt service expenditures, are also prepared. Documentation clarifies key issues related to expenditures, highlight critical assumptions, and discuss recurring and non-recurring items. Forecasting variances are analyzed to improve projection methodologies.

3.0 IS PESSIMISTIC REVENUE FORECASTING DESIRABLE? No. Forecasting does not need a "pessimistic" bias. A government's revenue base will be what it will be. If the economic base (the North American Industrial Classification System (NAICS) provides a sector analysis of revenue sources by NAICS code)is struggling, then the government objectively factors in this downturn. The key is the stated assumptions of these downturns. The Equal Employment Opportunity (EEOC) Occupation Codes also show the types of jobs that are being lost within the local, state, regional or national economy.

The revenue projections will always be objective. When the payers of revenue are matched against NAICS and EEO Occupation Codes in the United States, then one can project the 'cuase' and "effect" of economic downturns in an "objective" (not pessimistic) manner. The key in "FUND ACCOUNTING" is also the FUND BALANCE that is projected and the use of the FUND BALANCE in terms of a contingency or a reserve. But to purposely be "pessimistic" is irresponsible.

[David Dzidzikashvili]

Should Budgetary Revenue Projections be Deliberately Pessimistic?

Revenue projections fall victim to political games and politics in general, I think that's the primary determinant of how pessimistic or optimistic would revenue projections be. Besides, you need public support for different programs and more pessimistic budgetary projections basically guarantee public support. Generally I think more optimistic projections would do much more good, because dealing with less money becomes far greater challenge than having more money than planned.

[Trey]

Prudence is the keyword, when it comes to budgetary revenue projections. Thus, we not saving that it should necessarily be pessimistic or optimistic.