The Government’s revenue forecasting systems
1. Summary: what we found in our audit
Governments need reasonable estimates
Governments need to prepare reasonable revenue forecasts. They need this information to set their fiscal plans and priorities. In most Canadian
jurisdictions, legislators have passed balanced budget legislation. So when governments prepare their annual budget, they need a reasonable estimate of their revenues so that they can determine their spending priorities and allow for in-year emergencies. As a result, all governments tend to be prudent in forecasting revenue. The Province of Alberta is no different.
Budgeting is
difficult Forecasting revenues is a challenge, particularly those that are dependent on general economic conditions. The Government of Alberta has several revenue sources such as non-renewable resource revenues, personal and corporate income taxes and investment income that are significantly affected by economic conditions. As a result, preparing budgets and forecasts for these revenues is difficult. Non renewable resource revenues are subject to the most volatility, and the conditions causing the variations in these revenues also affect personal and corporate income tax revenues. Since the majority of the government’s revenues come from non-renewable resource revenues and income tax revenues one would expect variation between budget and actual revenues.
The objective of our audit was to see if the government has adequate systems for preparing budgets and quarterly forecasts. We also wanted to see if the budget and quarterly forecast updates provide readers with sufficient information to understand the forecasts, key assumptions and sensitivities.
We focused our work on the government’s most significant revenue sources:
non-renewable resource revenues, investment income, personal income taxes, corporate income taxes, and gaming and liquor revenues.
Government’s
The government has systems for forecasting its significant revenues and generally they are operating effectively. Departments use models to prepare revenue budgets and forecasts that rely on assumptions about economic conditions. All departments update the forecasts as new information and actual data becomes available. The government updates all revenue forecasts quarterly and discloses this information in its quarterly fiscal updates. The government’s budget and quarterly updates disclose the revenue forecasts and related assumptions and sensitivities. This helps users understand the revenue
Volume 1—Audits and recommendations The Government’s revenue forecasting systems
budget and the potential volatility in the government’s revenues. The budget for the year ending March 31, 2008, includes a new surplus allocation policy which sets out the use of any additional revenues received in the year.
Variances in revenues mainly due to factors beyond government’s control
The province’s actual revenues have exceeded budgets by over $4 billion in each of the last 4 years or an average of $5.7 billion. A significant portion of this variance is due to factors beyond the government’s control and not easily predicted by the government or other forecasters. In the past few years, economic growth in Alberta has exceeded the expectations of all forecasters.
This unexpected growth has resulted in actual government revenues that have significantly exceeded budgets. This particularly applies to variances related to non-renewable resource revenues.
Government can enhance its revenue forecasting systems and disclosure in the budget
The government can enhance its methodology for budgeting and forecasting investment income and personal tax revenues. The government also needs to improve its model for estimating corporate taxable income, which is the basis for the corporate income tax revenues budget and forecast. The government can also enhance the disclosure of revenues in the budget documents to help readers understand the key assumptions for the non-renewable resource revenues, investment income sensitivity to changes in rates of return on equity investments, and the potential volatility of the government’s total revenue budget.
The following is a summary of the reasons for the significant variances in revenues and our recommendations to improve the government’s systems:
Explaining key
assumptions • Non-renewable resource revenue—significant variances between budget and actual results are caused by supply and demand factors in the energy market. The volatility of the energy market makes it very difficult to predict prices used for forecasting non-renewal resource revenue.
Energy’s oil and gas price forecasts are typically between the low and average of other forecasters and significantly lower than actual prices.
However, the average of other forecasters has not been much more accurate when compared to actual prices in recent years. The budget discloses the range of potential volatility in the revenue based on the other forecasters. The budget documents can be improved by explaining Department of Energy’s key assumptions and how they are different from those of other forecasters and market conditions. This information is critical for the users of the budget documents to understand the budget (see recommendation no. 16, page 149).
Volume 1—Audits and recommendations The Government’s revenue forecasting systems
• Investment income—most of the past variances arise because the actual rates of return exceed the expected rates of return in the budget. Finance uses external forecasters’ estimated average long-term rates of return to prepare the investment income budget. As a result, actual results will always differ from forecasts. Finance can improve its processes by incorporating the return from active management of the Alberta Heritage Savings Trust Fund in the forecast of investment income (see
recommendation on page 142). Finance can also improve the disclosure of the sensitivity of the investment income forecast to changes in the rates of return earned on equity investments (see recommendation no. 16, page 149).
Method for
estimating • Personal income tax—the majority of the variance between budget and actual revenues is because Finance uses historical personal income growth data that can change significantly. Finance needs to improve its method for estimating historical personal income growth (see
recommendation on page
• Corporate income tax—the main reason for the variance between budget and actual revenues is the forecast of corporate taxable income.
Finance currently uses a model for estimating corporate taxable income that has not been consistent with actual results. Finance should improve its model for estimating corporate taxable income (see recommendation no.
and refunds payable
14, page 145) and corporate income tax refunds payable (see recommendation no. 15, page 146).
In our opinion, implementation of our recommendations will help
government improve its revenue forecasting processes, particularly for the corporate income tax revenue. Users of budget documents will also have better information to understand the government’s revenue forecasts and the impact of significant assumptions on forecasted revenue.
Our report
format This report includes a summary of our audit objective and scope, background and audit criteria. The report focuses mainly on our audit conclusions and recommendations for each of the six revenue forecasting systems
(non-renewable resource revenue, investment income, personal income tax, corporate income tax, transfers from the Government of Canada, and gaming and liquor) that we examined. The last section of the report focuses on the government’s public reporting of the revenue forecasts. Additional
information on the revenue forecasting systems and a comparison of the budgeted and actual revenues for each revenue forecast is included in the Appendix.
Volume 1—Audits and recommendations The Government’s revenue forecasting systems
2. Audit objectives and scope
The purpose of the revenue forecasting systems audit was to see if:
• the government’s forecasting systems used for preparing the budget and subsequent quarterly updates are adequate and produce reasonable forecasts.
• government budgets and quarterly updates provide sufficient information for users to understand the forecasts and impact of significant
assumptions on the forecasts.
To do so, we examined processes:
• at three departments—Energy, Finance, and Gaming—for preparing revenue budgets and forecasts for non-renewable resource revenue, investment income, personal and corporate income tax revenue, transfers from the Government of Canada and gaming and liquor revenue.
• at the Department of Finance—for reviewing and compiling the individual forecasts into the budget and the quarterly updates.
We also assessed the reasonableness of:
• assumptions that the departments use in developing revenue budgets and quarterly forecasts, and
• the sensitivity analyses and other information reported in the budget documents and the quarterly updates that Finance prepares.
The audit focused on the budget and quarterly updates for the years ended March 31, 2006 and 2007. In preparing our final report, we considered system changes that Finance and the departments made in preparing the budget for the year ending March 31, 2008.
3. Background
Forecasting Forecasts are
management’s best estimate
All forecasts will inevitably be inaccurate to some degree. However, forecasts should be management’s best estimate of what may occur in the future based on experience, current knowledge and expectations of future trends. Forecasts are not certain and often have assumed probabilities related to their outcomes.
In essence, revenue forecasts are management’s best estimate of the anticipated revenues to be earned during the year. Several unpredictable external factors affect certain revenue sources such as non-renewable resource revenues. The nature and extent of the uncontrollable external factors that influence each revenue source affect management’s ability to determine a reasonable forecast.
Volume 1—Audits and recommendations The Government’s revenue forecasting systems
Good forecasts and forecasting systems have the following attributes : 1
• Their methodology considers all relevant factors and assumptions and the forecasts are consistent with the methodology.
• Their assumptions are realistic and updated based on new information.
• The validity of their assumptions is challenged and verified.
• They explain the impact of non-controllable external factors on forecasting.
• They monitor actual results and continuously assess the reasonability of the methodology and assumptions.
• They consider similar forecasts and data from third party forecasters.
• They include all relevant information, such as sensitivity analyses, so readers can understand the forecast and the assumptions that underlie it.
Key
assumptions are important
The reasonability of revenue forecasts depends on the appropriateness of the methodology and the quality and timeliness of the data used to determine the key assumptions. Good systems to review and challenge the appropriateness of the forecasts and assumptions can also improve the reliability of the forecasts. Disclosure of key assumptions and sensitivities for significant revenue forecasts is also critical to ensure that readers understand the potential volatility inherent in the revenue forecasts.
Government of Alberta revenue forecasting framework Fiscal plan
(budget) The requirement for preparing government fiscal plans and ministry business plans is in the Government Accountability Act. Under this Act, the Minister of Finance must prepare a fiscal plan (budget) for the government, including total revenue and a breakdown by revenue source. The fiscal plan must explain the major economic assumptions made in preparing the plan, including the effect of changes in the assumptions. It must also describe the anticipated economic conditions for the fiscal years it covers. Within two months of each subsequent quarterly period, the Minister of Finance must report publicly on the fiscal plan’s accuracy.
In Alberta, the Fiscal Responsibility Act prohibits budget or in-year deficits (as defined by the Act). Under this Act, in fiscal 2006, non-renewable resource revenue in excess of $4.75 billion was not available for operating spending. It had to be transferred to the Alberta Sustainability Fund. This fund can be used only to help protect future operating and capital spending from short-term revenue declines. It can also be used to cover emergencies, disasters, natural gas rebates and settlements with First Nations.
1 We developed these attributes by consulting a variety of sources and selecting the ones we thought were most relevant to the Government of Alberta.
Volume 1—Audits and recommendations The Government’s revenue forecasting systems Business plans The Government Accountability Act requires ministers to prepare a business
plan for their ministry for each fiscal year, in a form and at a time acceptable to Treasury Board. Each ministry business plan must include a summary of the total revenue for the ministry, as well as any other information that Treasury Board or the minister consider appropriate. The Department of Finance uses this and other information from ministries to prepare the consolidated fiscal plan and annual budgets. Finance also obtains quarterly fiscal updates and forecasts from ministries, which it uses to prepare the public report on the fiscal plan’s accuracy.
Surplus allocation policy
In the March 31, 2008 budget, the government announced an in-year surplus allocation policy. The policy states that if the projected surplus is higher than the budget, the government will allocate one-third of the additional cash available to savings and investments, while the remaining two-thirds will be allocated to capital. At least half of the capital allocation will be used for ongoing maintenance and rehabilitation of existing capital assets.
Volume 1—Audits and recommendations The Government’s revenue forecasting systems
3.1 Variance between Budgeted Revenues and Actual Results–2002 to 2007
The chart below shows that government’s actual revenues have been significantly higher than budget for the past five years. Non-renewable resource revenue is the main reason for the difference. Personal and corporate income taxes and investment income also contribute to it.
Variance between budgeted revenues and actual results 2002 - 2007
(2) 0 2 4 6 8 10
Billions of dollars
Total Variance (0.7) 2.8 4.0 6.3 8.2 5.6
Non-renewable resource revenue (1.3) 3.4 2.9 4.9 6.6 0.9 Investment Income (0.5) (1.6) 0.8 0.6 1.0 1.2 Personal Income Tax 0.1 0.1 (0.4) (0.4) 0.8 1.6 Corp orate Income Tax 0.3 0.5 (0.3) 0.4 0.6 1.4 Transfers from Governmnet of Canada 0.2 (0.1) 0.5 0.3 (0.1) (0.3)
Gaming and Liquor 0.2 (0.0) 0.0 0.1 0.2 0.3
Other revenue 0.4 0.6 0.4 0.5 (0.9) 0.5
2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 5.6 8.2
6.3
2.8 4.0
(0.7)
Volume 1—Audits and recommendations The Government’s revenue forecasting systems
4. Criteria
Audit criteria To provide a structure at the beginning of our work, we developed and agreed with management on audit criteria to assess the systems for preparing and reporting forecasts in the budget and quarterly fiscal updates. These high-level criteria were:
1. Departments should have systems to prepare reasonable revenue budgets and quarterly forecasts. The systems should:
• clearly define the methodology for determining the forecast.
• develop assumptions consistent with economic and market conditions.
• prepare forecasts consistent with the methodology and assumptions.
• develop a range of possible outcomes and a sensitivity analysis for each forecast.
• ensure that forecasts are suitably supported and accurately compiled.
• review and challenge the reasonableness of forecasts.
• assess actual results against forecasts to evaluate the reasonableness of the methodology and the assumptions.
2. The Department of Finance should have systems for ensuring that revenues included in the budget and quarterly updates are reasonable.
3. The Department of Finance should ensure the budget documents and quarterly updates include sufficient information for users to understand the revenue forecasts and the impact of significant assumptions on the forecasts.
The following sections include our conclusions and recommendations for each of the revenue streams in relation to criteria 1. The last section summarizes our conclusion and recommendation for criteria 2 and 3.