How forecasting errors will affect the budget

Treasury’s expected to forecast 3 per cent real GDP growth, 5.5 per cent unemployment and 2.5 per cent inflation for 2013-14. This is in line with a small deficit, but real world outcomes could vary dramatically.

The Forecasting Section within the Economic Division in Treasury is getting close to finalising the economic forecasts that will underpin the 2013-14 Budget on 14 May.

The economic outlook that Treasury come up with in the next couple of weeks will be critical in determining the size of the budget deficit for 2013-14 and the path to surplus in the years after that.

In very simple terms, the stronger the outlook for the economy, the smaller the budget deficit in 2013-14 and the quicker the path to surplus thereafter.

For 2012-13, the surplus that was forecast last budget and reiterated in the Mid Year Economic and Fiscal Outlook in October, was unable to be delivered because Treasury’s forecast for nominal GDP growth was too strong. It was forecasting nominal GDP growth of 5 per cent and on the back of that, a decent flow of tax revenue into the proverbial government coffers.

The forecast was credible at the time with no one seriously questioning the economic outlook.

It now appears that nominal GDP growth will be nearer 2 per cent which is weak enough to rip something between $10 to $15 billion from government revenue in 2012-13. Treasury was certainly not looking at the economy through rose coloured glasses, rather it was a simple error that was driven by a sharper fall in the terms of trade than Treasury, or most credible market economists, were looking for.

Treasury was also forecasting nominal GDP growth of 5.25 per cent for 2013-14 and while there are ongoing reasons for optimism about the real economy, the low inflation climate and weaker terms of trade mean it will almost certainly be forecasting nominal GDP growth nearer 2.5 - 3 per cent when the budget is handed down.

These forecasts mean there is little prospect for a budget surplus in 2013-14 simple because revenue growth will be so very weak.

From the perspective of managing the economy, the surplus or deficit matters little. It is often forgotten that fiscal policy is the means to the end – the government spends and taxes to achieve a range of outcomes which at the macro level is, or should be, to keep the economy growing which delivers job creation and social decency. Even with the softer climate for revenue, the deficit is likely to be small – less than 1 per cent of GDP and quite possibly, near 0.5 per cent of GDP.

That aside, there seems little doubt that for 2013-14, Treasury will forecast real GDP growth of 3 per cent, an unemployment rate of 5.5 per cent and inflation at 2.5 per cent. If Treasury has an upbeat view on consumer demand and housing, it might lift the GDP growth rate to 3.5 per cent but in any event, the real economy continues to perform well. Any macro economist would say this is near perfect. It would be difficult to have the economy growing much faster that this without there being inflation pressures. 

The forecasts for the terms of trade and therefore nominal GDP will be the most closely scrutinised aspect of the forecasts. Treasury will factor in a terms of trade decline and with it, soft nominal GDP growth. This is the issue that makes the return to surplus slow.

Of course, Treasury could get to a surplus, or at least a projected surplus, if it ramped up its forecasts for growth in nominal GDP growth and parlayed that through estimates for tax receipts. For example, 1 per cent faster real GDP growth would deliver close to $5 billion to the bottom line. Similarly, a 1 per cent lift in nominal GDP growth adds a significant amount. This shows just how sensitive the Treasury numbers are when it comes to delivering the budget bottom line.

The end point is that whatever the Treasury forecasts for the economy are, they will inevitably be superseded by unforecastable events internationally and within Australia.

The average forecast error on the budget bottom line from budget time to the final outcome of the budget is just under 1 per cent of GDP. If the error in 2013-14 is the same as this average, it could turn out to be the case that the budget will be in surplus. This is if things surprise on the upside in the economy.

Of course, the error could be the other way – a weaker global environment, for example, would eat away at revenue and deliver a deficit near $20 billion.

For now, the direction of the error matters little. The key point is that the budget must be prudent.