Why Budget Forecasts Are Often Wrong

The province’s financial update released shortly before Christmas did not bring tidings of comfort and joy. It is not just that the forecast was much worse than the spring budget. It also emphasized how volatile some of the numbers can be.

The spring budget had predicted a deficit of $98 million for 2015-2016, on the way to a balanced budget in 2016-2017. That was a year earlier than promised in the Liberal election platform.

Now the numbers are moving in the opposite direction, with a forecast deficit for the current year rising to $241 million—up from $123 million only two months earlier. Although some of the deterioration comes from one-time causes, a substantial portion comes from weaknesses in labour market income and corporate earnings, which are likely to continue.

Given the evident volatility, it would be unwise to predict with any certainty what next May’s budget will look like. There are three numbers that will be especially important.

Pension Valuation Adjustment (PVA): Most of the costs in this badly-named category are for non-pension benefits to public sector employees.

The biggest single non-pension piece is $25.4 million for public sector long service awards. These benefits are virtually unknown in the private sector. Eliminating future accruals is a key element of the government’s efforts to balance the books.

There is also $17.7 million for retirement health benefits and $9.5 million for accumulated sick leave.

About $31.8 million of the PVA is actually related to pensions, of which $17.2 million is for the Teachers’ Pension Plan (TPP). Both numbers are likely to grow when final accounting is done for the current year, because poor stock market performance will mean pension funds underperform. Canadian equities are down 10% for the year,which will be only partly offset by better performance in foreign markets.

Even without that, the TPP amount is scheduled to rise rapidly in future. This area will be a continuing source of bad news for the government.

Equalization Payments: Nova Scotia will receive $1.77 billion in the current year. The complicated formula by which this is calculated is based on the notion that provinces with less-than-average opportunity to generate tax revenue will receive payments from the federal government to help bridge the difference.

The calculations are based on a three year average, so changes are not too abrupt. The total amount of payments goes up every year based on nominal growth in the economy, even if the disparity between provinces shrinks.

That is what will happen starting this year as the “have” provinces—which include British Columbia, Alberta, Saskatchewan, and Newfoundland—experience sharp drops in resource revenue. Ontario received $2.4 billion of the $17.3 billion pool this year. It may become a “have” province in the next year or two—not because of its own growth, but because of the challenges faced by current “have” provinces.

The total pot will nevertheless continue to increase, so this could produce a big win in future years for the other five “have-not” provinces. There is already considerable political lobbying for formula adjustments by various provincial finance ministers, so many different outcomes are possible.

Offshore Royalties: The most astonishing number in the Minster’s presentation was a $98.2 million reduction in royalties. Subject to certain minimums, those royalties are about a third of net revenues.

This reduction results from changes in the estimate that Exxon has made in the cost of decommissioning the Sable offshore infrastructure, as well as the latest guess about how much revenue from future production there will be to help pay for it.

Further volatility is entirely possible. As a small consolation, the number suggests a significant economic activity for the province in the abandonment project.

Good financial managers try to limit the volatility to which they are vulnerable. For the province, that is possible with respect to the Pension Valuation Adjustment, but has not been achieved for the TPP. The only way to limit volatility for Equalization Payments is to become a “have” province and not dependent on them. Any resource royalty can be subject to big fluctuations—that is why Alberta expects a $6 billion deficit this year.

In Nova Scotia’s present context, we could easily see more big surprises when the next budget is presented in the spring. Any forecast of balanced budgets in future will need a considerable margin for error to be credible.

Happy New Year!


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