Don't bank on PEFO projections

In recent years, the reputation of Treasury forecasts has suffered a dent or two. While volatile economic conditions may make forecasting difficult, some of the blame must lie with the unrealistic assumptions underlying certain forecasts.

And so it is with the Pre-election Economic and Fiscal Outlook (PEFO).

The 'Estimate' period in the latest PEFO shows debts, deficits and economic uncertainty for the next two years, while the 'Projection' period for the two years after that shows prosperity and low unemployment.

The simple fact that the budget position has deteriorated by more than $10 billion since the May budget should show the folly of predicting events four years into the future. However, there are other reasons why the Projection of a surplus in 2016/17 is a chimera.

According to the Charter of Budget Honesty Policy Costing Guidelines, the Estimates 'take into account cyclical variation in economic activity' – which means they are based on actual and expected economic data and what the Treasury really thinks might happen.

The Projections on the other hand are based on long-term averages and unrealistic assumptions. They assume that the economy will return to 'trend' growth, unemployment and inflation. It doesn't reflect the best guess that Treasury has about the economy at that time. Nor is any thought given to how the economy might move from the second Estimate year to the first Projection year.

This is why the projected 'major economic parameters' are basically the same in the 2010 PEFO and the 2013 PEFO, and both are so similar to the (pre-GFC) 2007 PEFO.

One other thing about the PEFO Projections is it presumes that government will announce no new major spending initiatives over the next four years.

Major new or expanded spending initiatives of the last four years such as: Paid Parental Leave; carbon tax compensation; Gonski; DisabilityCare; and the Schoolkids Bonus, to name but a few gives a sense of how unrealistic excluding new spending initiatives is.

Collectively, assumptions of a return to trend and the exclusion of new spending manufacture a surplus in 2016/17, not any expected economic prowess from the government.

By assuming a return to trend, PEFO effectively assumes that global economic challenges (such as the chaos in Europe, China's retreat from double-digit growth, and the continuing slow US recovery) will be resolved by 2015/16. It also assumes a smooth transition for Australia post-mining boom.

Receipts are effectively assumed to be 1.2% higher as a proportion of GDP by 2016/17 (as if we haven't had enough problems with overestimating revenue). This will be driven by company tax revenue, which will increase by more than 8% from 2014/15 to 2015/16, and income tax, which will increase by $40 billion over the four-year period.