Monday, 8 June 2015

THE BUDGET COLLOQUY (PART 2) REVENUE PROJECTIONS: CLOSE YOUR EYES, MAKE A WISH, AND HOPE FOR THE BEST


Guest Post Written By: JM


The Government of Newfoundland and Labrador has a spending problem.  The problem can be masked by the temporary windfall revenues. That is what occurred in 2008-2012.  However, a responsible government plans it’s long term spending based upon a sustainable, realistic revenue stream.    


The document entitled "Budget Highlights - Balancing Choices for a Promising Future"  was a part of this masking attempt. It contained a forecast of both spending and revenue for the next 5 years.   It predicts that in 5 years the province will return to balanced budgets.  It exhibits sufficient colored graphs, and statistics to even seem believable. But believable it is not.


The following summary is taken from that “highlights” document.


 Table 1:  Consolidated Surplus / Deficit from the 2015 Budget Highlights

The province is predicting that for the 2014/2015 and 2015/2016 fiscal years revenue will be just under $7 billion.  However, by 2020/2021 there will be a $2.6 billion (37%) increase in revenue in nominal dollars.  It is this increase in revenue, rather than a decrease in spending, on which the province's rests its forecast return to a balanced budget.

Is the government’s projections for future revenue grounded in reality, or is it merely wishful thinking?  Part II of this colloquy on the 2015 Budget will attempt to answer the question.

Historical Context on Provincial Revenue

Figure 1 presents revised Gross Revenue and Gross Expenditures made from 1997 to 2013, and a forecast to 2020/2021.  The actual data comes from the “Consolidated Statement of Operations” within the annual public account documents.  The forecast data is taken from the 2015 budget highlights information provided in Table 1.  The data has been adjusted to real 2015 dollars.  Historical data has been adjusted for inflation as determined by the Bank of Canada inflation calculator, and the future data has been discounted by a 2% annual inflation rate.  


Figure 1: Inflation Adjusted Revenue Versus Expenses (Consolidated)

Figure 2 provides a summary of the sources of revenue to the provincial government.  In 2008, the province received $9.68 billion in revenues (2015 dollars).  This was underpinned by $2.5 billion in oil royalties, $2 billion in Atlantic Accord payments, and $0.5 billion in equalization payments from the Government of Canada.  By 2014 the total annual revenue was reduced to $7 billion. The figure represents nearly a 30% reduction from the peak.  However, it was still nearly $1.7 billion more in annual revenue (2015 Real Dollars) compared with the amount that sustained governments from 1997 to 2006. 


Figure 2:  Revenue By Source – Inflation Adjusted

Figure 1 clearly demonstrates that our return to balance budgets will be achieved only by the forecast increases in revenue, and not by any real reduction in public spending.  The province has decided to tackle the deficit by holding spending, and raising taxes.  This is not a balanced approach. 

By any economic measure, Newfoundland is in a recession.  Major projects are winding down, production profiles from existing offshore platforms are decreasing, oil prices appear to have returned to a historical supply/demand balance, and new offshore projects are delayed. 

Is the 10% growth in revenue (in inflation adjusted real dollars) reasonable? 

Or, is the provincial government simply sticking its head in the sand? 

From Federal Dependence to Oil Addiction

There is no better graph to demonstrate the changing economy of Newfoundand and Labrador than the one represented in Figure 3.  Inflation adjusted revenue is shown from both oil and gas, and federal sources over the past 16 years.  Also included is the % of total revenue coming from the combined sources. 


 Figure 3:  Federal and Offshore Contributions to the Revenue of Newfoundland

In 1997 the Province of Newfoundland and Labrador received nearly $3 billion (in 2015 dollars) from the Government of Canada.  The funding was received in the form of equalization, cost shared projects, and health transfers.  This sum equaled almost 50% of the revenue from the province.  Those were tough times. 

In 2013 the combined income from the two sources was about $3 billion.  It is expected that when the 2014 consolidated public accounts are released this sum will be several hundred million dollars less than the 2013 figure. 

During 2015-2016 the province’s combined annual income from Federal and Offshore royalties will be less than the federal sources alone in 1997 in real dollars! 

This is a startling statistic, and one which should send cold shivers down the spines of anyone who is concerned about the provinces finances.    

As long as our economy is strong enough such that we technically remain a “have” province, one that does not qualify for equalization, we will be in a difficult position.  That is certainly the case until Hebron royalties come online post “simple payout”, or until the price of oil returns to nearer to 90 or 100$ per barrel. 

As outlined in the post entitled "IT'S THE SPENDING STUPID",  the province must be transparent in their calculations of oil royalties going forward.   Without this information being placed in the public domain, with key inputs such as oil price and production profiles clearly visible, it is impossible to have meaningful public debate on the provinces finances, or spending priorities.   

However, there are several obvious facts which should be stated for the reader:

The first is that the existing fields are declining fast, and even if we returned to historical oil prices, their royalty payments to the provincial government would be decreasing.  This is perhaps best documented in the Wade Locke submission to the The Hebron Public Review panel.  In his submission, Locke clearly demonstrated how the oil royalties would decrease without Hebron.  This is summarized within Table 2:


Secondly, Hebron is late and more expensive than the case when Wade Locke presented to the review panel.   This has delayed the year of simple payout from 2019 to 2022.  This was reported by Tom Baird, a mathematics professor at MUN, on his twitter account, following an access to information request.  The excerpt from the request is provided below:


The reader should be reminded that the royalty prior to pay out is a modest 1%. Table 2 shows that Wade Locke anticipated royalties of $88 million per year from Hebron in the period of 2016-2020.  If payout is not achieved until 2022, Hebron will likely be contributing less than $100 million a year in Royalties for the next 5 years. 

The reader is also reminded that in the current “estimates” the Department of Finance predicts oil royalties of $1.3 billion in the 2015-2016 fiscal year.  If the price of oil does not rebound significantly, considering the reduction in production profiles, oil royalties will be less than $1.5 billion per year for the remainder of the decade.  

If federal government contributions to the province hold in the $1 billion range, then the province should be planning for a combined contribution of the range of $2.5 billion, in total.  When adjusted for inflation this is less that the amount the province received from the Federal Government in 1997. 

Brian Peckford was right in forecasting that “Someday the sun will shine...” and it did shine, but it did not last long; a fact hastened by fundamental mismanagement of all too temporary wealth.

Personal Income and Sales Tax
Within the 2015 budget the province is planning a program of new taxes to assist with returning to a balanced budget.  The list includes modest increases to income taxes, and the increase to the HST.  

Figure 4 provides a summary of the provincial revenue from both income taxes and sales taxes since 1997.  Again, this is inflation adjusted data coming from the public accounts. 


Figure 4:  Sales and Income Tax Revenues – Inflation Adjusted

The increase in revenue from both sales tax and income tax sources, over the past decade, occurred with simultaneous reductions in the levied rate.  The dramatic increase was due not only to the strong local economy. The strong economy of Western Canada and the associated remittance payments also played an important role.  However, the increase was undoubtedly also due to the robustness in the world's commodity prices (oil and minerals). 

With the collapse of the mining industry in Newfoundland and Labrador, and the ongoing weakening of the oil industry, we are in a multi-year recession.  Within the 2015 budget highlights document, the province predicts 5 years of negative growth, and reductions in employment.  This is summarized within Table 3 below:

Table 3:  Key Economic Assumptions – 2015 Highlights Document

Over the next three years, the weakening in the long term oil price will have a pronounced effect on the local economy.  Unemployment will increase, and wages will decrease in real dollars.  Bonus’ linked to companies' profitability, and generous living allowances will disappear.  This is on the local scene.  The collapse in the Alberta economy will also have a great impact particularly in the rural areas of the province.  This impact is only now starting to unfold.
   
It is therefore not clear to the author how the revenues from both income and sales tax will hold steady in the face of four years of negative growth.  

I do not believe that the increases in the tax rate will be sufficient even to hold current levels, let alone increase revenue.

The Department of Finance should be pressured to explain the economic models used to project revenue based on key economic inputs. 

In the opinion of the Author, the provincial government should be planning for a 5% reduction in sales and income tax revenue from 2014/2015 levels until the end of the decade.  

I am fearful that given the advanced stage of completion of the mega projects, and the long term outlook for commodity prices, this small reduction may be overly optimistic.  

However, $2 billion in revenue (real 2015 dollars) is a reasonable forecast for the remainder of the decade.  Unfortunately, it would be not be surprising if the fundamental long term weakness in the global commodities market results in a 10-15% reduction in real sales and income tax revenue by 2020. 

Corporate Income Tax
With the increases in GDP fuelled by oil and minerals exports, there has been an increase in corporate income taxes collected by the province.  This growth in real dollars is shown in Figure 5.  


Figure 5:  Corporate Income Tax

The 2015 estimates document shows that the province collected $470 million in corporate income tax in 2014-2015 and forecasts an equivalent number for the 2015-2016 calendar year.

It is unclear to the author how the value of corporate income taxes will remain consistent.

The Minister of Finance should be pressured to provide clarity on this forecast.  As Figure 5 effectively demonstrates, the corporate income tax in this province is pegged to oil prices and production levels.  Shouldn't corporate income taxes, therefore, follow a similar trend with royalties?

In the Author’s opinion, $500 million seems to be a realistic upper bound limit on corporate income tax for the remainder of the decade.

Other Sources of Revenue
There are additional sources of revenue for the provincial government which make up about 25% of the annual total.  This is summarized in Figure 6, an inflation adjusted figure.    As graphic depicts, revenues are relatively stable, and contribute, on average, about $1.8 billion to the province from 2006 to 2013.  This should also be a fairly reasonable assumption, in real dollars, for the remainder of the decade.  


Figure 6 – Other Sources of Provincial Revenue

What is the Source of the Additional Revenue?
In the above discussion the author has completed a very coarse “Top Down” assessment of the provincial revenue for the next 5 years by each major category.  This is an estimate which incorporates the general weakening of the economy, and the likely long term softness in oil prices.  The results of the above discussion are summarized within Table 4.

Table 4:  Authors Recommendation for Revenue Projections

In the opinion of the Author, the province should be forecasting revenue of $6.8 billion per year in 2015 real dollars.  There should be no substantial increases in revenue until “Simple Payout” is achieved on the Hebron field.  In the current oil price environment this does not occur until 2022. 

As shown in Table 1 the provincial government is much more optimistic in its revenue forecast for the period from 2016 to 2021. 

The province is forecasting a revenue in 2015-2016 which is nearly the same as is 2014-2015.  This does not make sense.  The figures do not even match those contained in the formal estimates document released by the government as part of the 2015 budget.

Statement II of the 2015-2016 estimates forecasts a $500 million dollar reduction in revenue, year over year.  Why does the budget highlights document glossy flyer not show a similar reduction in revenue?  This is surely a question for the Premier.

However, the Premier should also explain to the people of the province the methodology used to forecast the total revenue over the next 5 years.  The projections contained in Table 1 are not reconcilable with reality. 

A more reasonable revenue would be $6.8 billion in real number for the balance of the decade.  Figure 7 graphically illustrates the difference in the government’s forecast and my own. 


Figure 7 – Authors Forecasted Revenue Versus Provincial Government

In the opinion of the Author, the provincial government is overly optimistic in its projections for revenue for the remainder of the decade.  The numbers seem inconsistent with the economic reality the province is facing. 

This is a very serious subject.  Lofty projections of a return to a balanced budget surely have a disarming influence on the battle for public opinion.  

However, the public should not be fooled.

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Related to this article:



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Don Mills, CEO of Corporate Research Associates who recently spoke to the St. John's Board of Trade, is correct when he states that we have a serious fiscal imbalance in this province.   

In fact, the imbalance so so disturbing drastic action is needed now.

The glossy flyers, and the professional ads, merely serve to provide the public an unfounded sense of security in the government’s ability to manage. 

I do not possess faith in our leadership that, given these considerable fiscal challenges, it will manage the public purse properly.  

Since 2008 public policy in this province has been based on oil prices above 120 $/barrel.  The government continues to manage for the long term as if it still shares this expectation. This view is maintained despite the massive evidence which suggests oil will be in the 70 $/barrel range for a long, long time. 

Premier Davis would be wise to listen to the 2011 version of his economic advisor, Wade Locke.  In 2011 Wade Locke could have been writing the speaking notes used by Don Mills in 2015.

In short, the party is over.  The problem is, simply, this government is oblivious to that reality.

Premier Davis is just one more in the recent string of premiers content to keep buying new party dresses.    
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Editor's Note:

JM" is a researcher and writer.  While retaining his anonimity, he is a frequent contributor analysing, in particular, aspects of the Muskrat Falls project. JM's most recent essays include: IN NALCOR WE TRUSTDelusion and Deception (Part III)and The Snow Job (Part I).  His latest Posts, on the 2015-16 provincial Budget, include IT'S THE SPENDING STUPID and The Budget Colloquy (Part 1): Put Him In The Round Boat Til He's Sober.


3 comments:

  1. This is an excellent analysis. However, JM is too detailed. He/She could simplify this by concluding. The government is spending 1 Billion more a year than they can afford. This is just running the government, and not Nalcor, Hospitals etc. If they continue this until 2021 they will add 5 Billion they are planning to add to the debt, and another 3 Billion or so due to overstating the revenue. Essentially doubling the net debt.

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  2. "The Government of Newfoundland and Labrador has a spending problem". Period.

    Mankind has a 'spending problem', and will never change while Man's Greed prevails on this Big ball of mud!

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