forecast
Source: http://www.inc.com

By Alessandra Cepparulo, Francesca Gastaldi, Luisa Giuriato, & Agnese Sacchi of IDEAS

The importance of fiscal forecasting

The importance of public finance control has increased over time, as many developed countries are currently facing record debt and deficit levels associated with structural economic imbalances. These circumstances enhance the necessity of sound institutional system growth and highlight the need to reinforce budgetary procedures. But, no procedure is effective without reliable fiscal forecasts. Fiscal forecasts are, in fact, the main signals relied upon by forward-looking private agents, forecasters and analysts and for implementing fiscal discipline under domestic and supranational fiscal rules, such as the Stability and Growth Pact for Economic and Monetary Union countries.

Unfortunately, forecast errors in budgetary variables are frequent. When systematic, they are a source of concern, as they signal misconduct in fiscal policymaking, undermine the government’s credibility and compromise long-term fiscal sustainability. In this respect, Italy shows a tendency towards biased forecasts: since 2000, the country’s actual deficit has systematically deviated from its planned value, with average variations of about 10% of the target value (Figure 1). Even though a large and growing literature has analysed the nature and the causes of errors in fiscal forecasting – mainly by comparing aggregate revenues, expenditures and budget balances in different countries – little attention has been paid to the forecasts of single budgetary lines and the detailed modelling of the different stages of the budget process.

Figure 1: General Government: planned and actual deficit (1998-2009, million EUR).

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Click for larger image. Source: Authors’ elaborations.

Budgetary implementation errors in Italy

In a manuscript recently published in the Journal of Public Policy, we try to address both omissions focusing on the Italian case, due to the fact that this country severely suffers from many of the pitfalls in fiscal forecasting that have been outlined in the literature (e.g., fairly imprecise revenue forecasts; systematic revenue shortfalls due to excess optimism; mistaken output growth projections; shortfalls of implementation from planned adjustments in public expenditures due to Italian governments’ poor capacity to control spending over time). Indeed, our results demonstrate that, over the considered period (1998-2009), implemented budgetary plans systematically fall short one year ahead of ambitious planned adjustments for the main public finance aggregates. Moreover, inefficiency in budget deficit forecasting arises more from the expenditure lines than from the revenue lines (Figure 2). The average implementation error – measured by the difference between actual fiscal outcomes and their planned changes – for the aggregate expenditures is larger, signalling that the policymaker is, in general, not able to stick to his initial plans and repeatedly resorts to ex post increases. Facing these results via several empirical methods, we try to find the determinants of these errors and the potential solutions.

Figure 2 – General Government: planned changes and implementation errors (average 1998-2009, million EUR).

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Click for larger image. Source: Authors’ elaborations.

In this respect, GDP surprises seem the best candidate – as expected – to explain implementation slippages on the revenue side supported by a positive and statistically significant correlation. This means that, at the early stages of the budget preparation, the policymaker is guided by the forecasted evolution in the business cycle to determine the taxes yield, but this is no longer true for the implementation stage where other-than-growth factors intervene, e.g., the search for fiscal space to accommodate the corresponding increases in expenditures in-year one-off measures is determined by significant changes in the economic environment that the policymaker cannot control (e.g., increases in international oil prices, changes in asset prices) and by the composition of GDP growth.

Parliamentary session, on the other hand, appears as the main determinant of severe expenditure drifts. During the Parliament’s budgetary session, political constituencies, the government’s ideology and lobbies exert powerful pressures on the draft budget, which is presented and discussed.

Any possible corrections?

According to our results, the solution of the implementation error problem cannot come simply from introducing new and more sophisticated forecasting techniques. The political source of the repeated slippages calls for more institutionally-oriented solutions. For sure, more discipline and rigor could help. Indeed, the slippages affecting fiscal forecasts are also favoured by the current set of fiscal rules in Italy, which does not actually impose any strong corrections in relation to the budgetary drifts. Besides, a reduction in the margins of opaqueness, which the present system allows, could also contribute to higher accountability and reliability in the budget documents. In this perspective, the Parliament could debate and vote for a binding fiscal framework or set strict ceilings on spending decisions before the government tables the budget, as the legislature’s endorsement of fiscal targets should help the enforcement of and compliance with fiscal limits.

In line with the requirements of the renewed Stability and Growth Pact (Directive 85/2011 and Fiscal Compact provisions), a solution could come from the recently created fiscal councils. These offices will monitor national accounts and compliance with numerical fiscal rules; they will assess the underlying assumptions of fiscal and macroeconomic projections as well as macroeconomic effects of the major legislative packages and public finance sustainability. Of course, this will favour an improvement of the quality of the released data and provide a benchmark against which government forecasts are compared and discussed, or they could be directly employed in the budget preparation. Anyway, the result will be an increase of transparency on the budget drafted by the government. Finally, provisions for error corrections would reduce the scope for forecast manipulations.

Overall, no single receipt can break the mix of profligacy and ambition that lies at the core of fiscal illusion in public decision-making, but the compound effect of different provisions could help reduce the margins of opaqueness in budgeting and restore official documents’ reliability.

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