Assessing forecasting risks and uncertainty

Budget Review 2015–16 Index

Kai Swoboda

Treasury’s analysis of its own forecasting processes and performance, undertaken in 2011–12, generally found that budget forecasts were ‘broadly as accurate as those of both domestic forecasters and those generated by comparable agencies in countries with similar institutional arrangements as Australia’.[1]

While this provides some reassurance about the quality of the budget estimates, what if international and domestic economic conditions don’t turn out as expected? What are the potential impacts on the economy and the budget?

There are several areas within the budget papers that provide a range of information to assist users to interpret the extent of some of the risks. Alternative sources on these issues are the views of various economic commentators and the Parliamentary Budget Office, which has recently published an analysis of the sensitivity of budget projections to changes in economic parameters.[2]

Forecasting performance and scenario analysis

Budget Paper No. 1 (Statement 7: Forecasting performance and scenario analysis) includes some qualitative and quantitative analysis of the budget estimates. This covers a summary of previous forecasting errors and includes some figures on the range of ‘confidence’ for certain current forecasts.[3]

Also included in this statement is a sensitivity analysis of the impact of two scenarios on headline economic indicators and the budget position for the budget year and the year following. These scenarios have been unchanged since the 2011–12 Budget. The modelled impact of each of these scenarios suggests that changes in economic indicators can have large impacts on the Budget outcome (Table 1).

Table: 1 Illustrative sensitivity of the budget balance to specified scenarios, 2015–16 and 2016–17[4]

  Scenario 1—reduction in nominal GDP Scenario 2—increase in real GDP
  2015–16 2016–17 2015–16 2016–17
Receipts ($b) -2.8 -5.8 4.1 4.7
Payments ($b) -0.1 0.1 -0.4 -0.3
Underlying cash balance ($b) -2.9 -5.8 3.7 4.5
Change in underlying cash balance as proportion of budgeted underlying cash balance (%) 8.2 22.5 -10.5 -17.4

Source: Australian Government, Budget strategy and outlook: budget paper no. 1: 2015–16, pp. 1–5, 7–16 and 7–18.

Note: Scenario 1 is a 1% reduction in nominal GDP due to a fall in the terms of trade. Scenario 2 is a 1% increase in real GDP driven by an equal increase in labour productivity and labour force participation.

Relative size of policy and parameter variations

Budget Paper No. 1 (Statement 3: Fiscal strategy and outlook) includes a reconciliation between the estimates of the previous budget and any intervening budget statement (such as a Mid-Year Economic and Fiscal Outlook (MYEFO)) and those presented in the current budget in terms of the extent to which changes in the underlying cash balance and fiscal balance have been due to policy change or to ‘parameter and other variations’.[5] This reconciliation provides information about how important the factors that the government can control (policy decisions) are, relative to those that it can’t (the parameter and other variations). It could be used to assess the potential impact of unanticipated changes over the next few years.

The 2015–16 Budget notes that the net change in the fiscal balance of over $61 billion for 2014–15 to 2017–18 was as a result of policy decisions of over $15 million and parameter and other variations of over $46 billion.[6] The extent of parameter variations is smaller than in recent budgets and around one-quarter of that associated with the 2009–10 Budget, which reflected the effects of the global financial crisis (Graph 1). The graph also illustrates the pattern of underestimating revenue before the crisis and overestimating it since the crisis.

Graph 1: Impact of policy and parameter changes on the fiscal balance, 2004–05 Budget to 2015–16 Budget ($ billion)[7]

Graph 1: Impact of policy and parameter changes on the fiscal balance, 2004–05 Budget to 2015–16 Budget ($ billion) 

Source: Australian Government, Budget strategy and outlook: budget paper no. 1: 2015–16, p. 3–24 (and previous issues).

Statement of risks

Budget Paper No. 1 (Statement 8: Statement of Risks) provides a high level summary of the various events that could affect fiscal outcomes. These include economic developments and certain events that have been recognised as potentially occurring coming to fruition (such as a legal outcome).

Ad hoc commentary within the budget

Also usually within Budget Paper No. 1 (Statement 1: Budget Overview and Statement 2: Economic Outlook) can be found remarks and assessment about economic conditions and factors affecting the Australian economy. These may provide a guide to the upside and downside risks that have been considered in formulating key assumptions.

On occasion, specific factors are considered. For example, while all budget papers since 2011–12 have included a discussion of the decline in the iron ore price, the 2014–15 MYEFO and the 2015–16 Budget included some specific discussion and sensitivity analysis relating to changes in forecasts for iron ore.[8] This commentary reveals the extent of the changes in forecasts for iron ore prices over recent years, with assumptions about the price revised down for 2014–15 from US$95 per tonne at the 2014–15 Budget, to US$60 in the 2014–15 MYEFO and now down to US$48 in the 2015–16 Budget.[9]

The inclusion of sensitivity analysis in the 2015–16 Budget of a further US$10 per tonne revision in the iron ore price (up or down) suggests that tax receipts would change by $2.1 billion in response.[10] This analysis allows for more transparency on the state of the budget with future movements in iron ore prices.

[1].          The Treasury, Review of Treasury macroeconomic and revenue forecasting, December 2012, p. xxii.

[2].          Parliamentary Budget Office, The sensitivity of budget projections to changes in economic parameters: Estimates from 2014–15 to 2024–25, Report no. 03/2014, November 2014.

[3].          Australian Government, Budget strategy and outlook: budget paper no. 1: 2015–16, pp. 7–3 to 7–14.

[4].          Ibid., pp. 1–5, 7–16 and 7–18.

[5].          Australian Government, Budget strategy and outlook: budget paper no. 1: 2015–16, pp. 3–17 and 3–24.

[6].          Ibid., p. 3–24.

[7].          Ibid. (and previous issues).

[8].          Budget strategy and outlook: budget paper no. 1: 2015–16, ibid., p. 2–19; Australian Government, Mid-Year Economic and Fiscal Outlook 2014–15, p. 12.

[9].          Ibid.

[10].       Budget strategy and outlook: budget paper no. 1: 2015–16, ibid., p. 2–19.


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