Forecasting of Expenditure - Report - 16 April 2010

Corporate Services

Scrutiny Panel

Forecasting of Expenditure

Presented to the States on 16th April 2010

S.R.5/2010

INDEX

Chairman's Foreword.......................................................................................3 Executive Summary with Key Findings and Recommendations ......................6 Panel Membership...........................................................................................9 Independent Expert Advice..............................................................................9 Terms of Reference.......................................................................................10 Hearings ........................................................................................................10 Methodology. .................................................................................................11 Structural deficit?...........................................................................................13 Treasury role..................................................................................................16 Where is the problem?...................................................................................19 What Lies Ahead?..........................................................................................23 Decisions to be made ....................................................................................25 Recommendations.........................................................................................25 Appendix 1 - Report into the forecasting of expenditure................................26

Chairman's Foreword

The Corporate Services Panel of 2005 to 2008, Chaired by the then Deputy P. Ryan, completed a number of important pieces of work. For example, it was that Panel that launched the idea of a fund for use in periods of a financial downturn, from which the Stabilisation Fund was created. It also undertook a review of the States of Jersey Financial Forecasting, producing a report (SR. 13.2008) dealing with the forecasting of income which the Minister for Treasury and Resources received favourably. Their legacy report suggested that the new Panel deal with forecasting of States' expenditure. My Panel undertook that task by creating a Sub-Panel.

It seemed appropriate to use the knowledge and understanding of Professor Michael Oliver to assist and advise the Sub-Panel. The task seemed innocuous enough at first and initial enquiries showed minor problems with the forecasting process. There was nothing that the Sub-Panel had not expected; such as the difficulties inherent in the requirement for departments to draw up forecasts of their expenditure in January of the year prior to the year concerned or the second and third year of forecasting being poor in some sectors.

However, the recognition that this did not get to the root of the problem caused the Sub-Panel to have a second tranche of hearings. Reasonable estimates were coming from the Departments and the process through the Council of Ministers seemed reasonable, resulting in an Annual Business Plan that sat broadly within expected income.

It was at the next stage in the process that the annihilation of the forecasting of expenditure for 2010 took place: the debate to approve the Annual Business Plan. In 2009, £13.1 million was added to the Business Plan almost at a stroke. No forecasting process or plan would be capable of incorporating that level of change.

It is very tempting to ask why this could happen. The second term of reference,

"To review the areas of responsibility for the operation of the forecasting process."

ensured the Sub-Panel did ask this question. The Sub-Panel asked the question at every one of the later hearings and it received a similar answer every time. "The responsibility lies with the States Assembly". Not one particular section of the Assembly but the Executive and non-Executive alike.

This in turn was found to be taking the Sub-Panel outside the terms of reference of this review because in order to deal with that conundrum, issues need to be looked at that are at the very heart of our cherished democracy. The fact that no one political position is responsible for getting this right seems, at the same time, to be both completely unacceptable in that there is nobody at the helm and yet highly desirable in order to maintain the democratic process. The problem had manifested itself clearly to the Sub- Panel. The answers have not. I am of the opinion that the answers may be buried within the structure and character of government. This is, however, beyond the remit of this report.

This took the Sub-Panel to the autumn of 2009, a time of significant activity for the main Panel with other reviews, all of which were constrained by time limits for the work to be undertaken and the reports published. In addition, the Sub- Panel noted that it was holding a view point which was highly political and needed careful consideration before moving forward. The review went on hold whilst the resources became available to deal with it.

Since that point, the Comprehensive Spending Review and the Fiscal Strategy Review have been launched. Both these reviews recognise the problems faced by the Island in respect of future financial planning. A restructure of the Treasury consolidates recognition that change is needed and the Comptroller and Auditor General has submitted reports in June 2009, December 2009 and February 2010, all recognising problems with discipline in expenditure control. I consider that, as the Sub-Panel's findings are now supported by so many other pieces of work, from so many different sources, it is time for the findings to be aired.

This must, therefore, be considered as an interim report. Doubtless, the Fiscal  Strategy  Review  and  the  Comprehensive  Spending  Review  will highlight particular issues. We will return to these once the relevant reports are published. It may also be necessary to report on the efficacy of the revised structure of the Treasury.

Most importantly, it is essential to highlight that this is a time for stringent financial discipline. More fundamentally, perhaps, it is necessary to consider what the role of the Island's Public Sector should be and how all States Members address their role in this. We can no longer afford to "muddle through".

Senator S. Ferguson Chairman.

Executive Summary with Key Findings and Recommendations

The evidence obtained in the scrutiny process was not quite what the Sub- Panel had expected. Evidence shows that departments are, in the main, forecasting expenditure well, albeit that they are required to submit the estimate in the January of the year prior to the year being forecast and that perhaps the second and third years of forecasting have proved less reliable.

The forecasting of expenditure process then moves to the Council of Ministers and again, the Sub-Panel found, within the 2010 Annual Business Plan for example, evidence of forecast expenditure being restricted to the reasonably expected income of the Island.

All the work that had gone into formulating the Plan to that point then went to debate in the States Chamber. Looking at this raised serious questions for the Sub-Panel and the review was put on hold whilst it was decided how to deal with the issues.

Since that time, there is open recognition of a looming structural deficit, reviews are being undertaken by the executive in an attempt to staunch the upward spending spiral, the Comptroller and Auditor General has raised questions about financial responsibility and the States assembly added £13.1 million to the Annual Business Plan. All these aspects point to the same problem. A problem outside the terms of reference for this review and which the Sub-Panel has not attempted to answer. It does, however, raise the question:

Where must the ultimate responsibility for the Islands' spending lie?

This Sub-Panel will not look into political discipline or the structure of Government within this review.

The following are the key findings and recommendations raised by the evidence gathered during the review (the detail may be found within the report):

KEY FINDING 1 The Sub-Panel notes and approves of the Treasury Department restructure.

KEY FINDING 2 There are no powers for the Treasurer to enforce compliance with Financial Directions issued by the Treasurer under the Law.

KEY FINDING 3 Forecasting of expenditure at department level is reasonably accurate.

KEY FINDING 4 January is very early to complete an accurate forecast and does not allow for changes within the year preceding the forecast year.

KEY FINDING 5 There is no position of overall responsibility for expenditure in the Island.

KEY FINDING 6 The Sub-Panel approved of the commissioning of the Fiscal Strategy Review and the Comprehensive Spending Review.

KEY FINDING 7 There is no individual political responsibility for States expenditure.

KEY FINDING 8 Discipline is required within States debates on expenditure.

The Sub-Panel makes the following recommendations:

1. The Minister for Treasury and Resources should enable departments to produce forecasts for expenditure later than January of the year prior to the year forecast.
2. The Minister for Treasury and Resources should ensure that forecasts of the second and third years be tightened.
3. The Sub-Panel agrees with the reviews being undertaken and recommends that the Chief Minister ensures that the difficult choices likely to be exposed within the reviews be openly dealt with by the relevant Ministers.
4. The Chief Minister must find a method of ensuring strict political discipline in dealing with expenditure, with an auditable line of responsibility.
5. The Minister for Treasury and Resources must find a method of ensuring that expenditure in Jersey is income driven.

Panel Membership

The constitution of the Sub-Panel was as follows:

Senator S.C. Ferguson, Chairman Connétable D.J. Murphy

Deputy R.G. Le Hérissier

Deputy T.A. Vallois

Officer support Mr M. Robbins

The Panel recognises the assistance given by Deputy S. Pitman during the early part of the review and regrets that she was unable to participate further due to pressure of work in other areas.

Independent Expert Advice

The Sub-Panel engaged the following advisor to assist with the review: Professor Michael J. Oliver, BA, PhD, Professor of Economics, ESC Rennes School of Business, Lecturer, Highlands College Jersey, Senior Lecturer for the University of Plymouth, Associate of Lombard Street Research.

Professor Oliver submitted a report with background information to assist the Panel. See Appendix 1.

Terms of Reference

The Corporate Services Scrutiny Sub-Panel approved the following Terms of Reference:

1. To review the policies, directions and practices driving the States of Jersey financial forecasting.
2. To review the areas of responsibility for the operation of the forecasting process.
3. To review the accuracy and timetabling of the forecasting process.
4. To submit a report to the States of Jersey on 9th July 2009 (the Thursday before the last sitting of the States prior to summer break).  
5. To examine any further issues relating to the topic that may arise in the course of the Scrutiny review that the Panel considers relevant.

Hearings

Public Hearings were held on 26th May 2009 and 9th October 2009. The witnesses included the Chief Minister and the Minister for Treasury and Resources on both occasions. A full transcript of the hearings may be found on the Scrutiny website.

Methodology

The Corporate Services Panel of 2005 to 2008, under the Chairmanship of then Deputy P. J. D. Ryan, submitted a report on 2nd December 2008, titled

Review of States of Jersey Financial Forecasting (S.R.13/2008). That report dealt with aspects of financial forecasting, particularly related to the income side of States' finances. Examination of the expenditure side remained to be reviewed.

This Corporate Services Scrutiny Panel created a Sub-Panel to review forecasting of expenditure. The Sub-Panel recognised that there was much of a specialised financial nature to be investigated and considered the use of an advisor to assist. In recognising the wide range of people qualified in the field, it was decided that the personal knowledge gained by Professor Michael Oliver in his work in the role of advisor on the 2008 report and his knowledge of the requirements of the Sub-Panel made him the appropriate choice.

Following initial research by Professor Oliver, combined with the first tranche of hearings with the Chief Minister and the Minister for Treasury and Resources, the Sub-Panel requested a report from the advisor ( Appendix 1). The report was submitted to the Sub-Panel on 7th July 2009 and outlined further questions that led to the second tranche of hearings with the Ministers. This in turn meant that the initial time line set by the Sub-Panel and laid out in the fourth Term of Reference became unrealistic. Further delays then occurred due to the workload of the main Corporate Services Panel during the autumn of 2009. During that period, the Sub-Panel became aware of the reorganisation within the Treasury, the intention by the Executive to launch the Comprehensive Spending Review and Fiscal Strategy Review. As many of the points contained in Professor Oliver's report and evidenced by the Sub- Panel in hearings were due to be addressed within these pieces of work, the decision was taken to place the review on hold pending the outcome.

However, following the report submitted by the Comptroller and Auditor General in February 2010, the Sub-Panel considered publication of the report was now essential due to the serious implications of failure to control Forecasting of Expenditure.

This report reflects the work undertaken by the Panel, its key findings, conclusions and recommendations.

Structural deficit?

1.  In March 2009, the Panel received a briefing from the Comptroller and Auditor  General  who  submitted  figures  relating  to  forecasting  of expenditure in Jersey since 2001. The figures showed the steady increase in forecast expenditure not only year on year, as for example, may be the result of inflation but an escalation of the estimate for most years as the date approached. The actual spend for the year being, in most cases, in excess  of  even  the  inflated  estimates.[1]  The  figures  were  updated  in December 2009 to read as follows[2]

Comparison of expenditure forecasts published in annual budget statements 2001-2010 (£m)

Net Revenue Expenditure – Actual and forecast rate of increase (%)

4. The Sub-Panel had serious concerns about the overall spending pattern. Particularly when the net revenue expenditure annual increase was placed alongside the listed retail prices index (RPI) figures[3]

Growth of expenditure and RPI, 2002–08

12 10 8 6 4 2 0

2002 2003 2004 2005 2006 2007 2008

5. These figures clearly show that spending has been steadily outstripping the RPI almost year on year. The good years have been nothing like good enough  to  recover  from  the  damage  done  in  the  bad.  2008  being particularly poignant as it marked the precipice to the recession. There was serious concern within the Panel that a structural deficit was likely and the  reasons,  it  could  be  argued,  may  be  contained  within  the  above figures. Certainly, by May 2009, the Minister for Treasury and Resources was fully cognisant of the likelihood of a structural deficit of perhaps £50 or £60  million following  the  second annual  report from the  Jersey  Fiscal Policy Panel.[4]
6. The  urgency  of  the  problem  has  been  graphically  outlined  by  the Comptroller and Auditor General in his various reports. The Stabilisation Fund will be used to contain the problem in 2010 and 2011, however, the £120 million being used over those two years to support the automatic stabilisers  will  only  stretch  so  far  and  cannot  be  expected  to  offer assistance into 2012.
7. The situation is further highlighted in the graph on page 19 of Professor Oliver's report.

500 450 400 350 300 250 200

2000 2001 2002 2003 2004 2005 2006 2007 Year/Budget Book

Treasury role

8. The purpose of the Treasury Department, according to the executive summary of the Treasury and resources Draft Restructuring Plan, is to

"support the delivery of sustainable, high quality, value for money public services."

The Treasury's key objectives are listed as being:

• Maintaining sound and sustainable public finances
• Improving financial management to drive forward cost effectiveness of public services
• Promoting high standards of governance and accountability
• Maintaining a stable macroeconomic framework with low inflation
• Promoting a fair and efficient tax system with incentives to work, save and invest
• Maintaining the Island's reputation through the development and maintenance of international tax agreements
• Maximising the long term return on States investments
• Providing efficient and effective resource services, enabling improvements in the quality and cost effectiveness of public services

9. The Panel notes the significance of the challenges recognised by the Treasury. Not only will the looming structural deficit have to be faced and dealt with, but the following spending pressures seem unavoidable:

• Implications of an ageing population
• Rising cost of health care
• Investment in sewage and solid waste infrastructure, and
• Increasing the maintenance spend on States buildings (including schools and hospitals).

10. It  is  understood  that  the  Treasury  were  intending  to  go  to  public consultation during the summer of 2010 to assist the deliberation in these areas.
11. The Treasury has also recognised that significant restructuring will assist in meeting some of its objectives in areas such as supporting service delivery, collecting taxes and supporting the economy. Some of these changes and projects are well underway.

KEY FINDING 1

The Sub-Panel notes and approves of the Treasury Department restructure.

12. The  Sub-Panel  recognises  that  these  objectives  have  far-reaching implications in the management of the States finances. In view of the run- away figures shown previously, something clearly has to be done to gain control.  The  Treasury  maintain  that  it  will  assist  the  finance  officers throughout the States to achieve the required results through rigorous challenge of department spending and realisation of efficiencies.
13. The Public Finances (Jersey) Law 2005 is quite clear on the role of the Treasurer:

(Article) 28 Establishment of the office of Treasurer of the States

1. There is established the office of Treasurer of the States.
2. The Treasurer is the chief officer of the Treasury and as such is responsible to the Minister for the supervision of the administration of this Law and of the public finances of Jersey.
3. It  is  the  responsibility  of  the  Treasurer  to  ensure  the  proper stewardship and administration of the public finances of Jersey and, in particular –

1. to  set  financial  management  standards  for  their administration  and  for  monitoring  compliance  with  those standards;
2. to ensure that professional practices are adhered to in their administration;
3. to advise on the key strategic controls that are necessary to secure their sound financial management; and

4. to  ensure  that  financial  information  is  available  to  enable accurate and timely monitoring of their administration,

and to advise on the appropriation and budget process for each financial year.

14. In his report dated February 2010 on the Public Finances (Jersey) Law 2005, the Comptroller and Auditor General is suggesting that the Law is not clear on the States wide control and responsibilities for expenditure control.[5]  The  report  highlights  numerous  problems  relating  to  the responsibilities of the Treasurer which the Sub-Panel has not investigated in this review, other than to recognise that there are no powers for the Treasurer to enforce compliance with Financial Directions issued by the Treasurer under the Law.

KEY FINDING 2

There are no powers for the Treasurer to enforce compliance of Financial Directives issued by the Treasurer under the Law.

15. The Comptroller and Auditor General also deals with the problems of controlling the departmental budgets. The Sub-Panel considers that, in the main, the evidence provided to it during the review suggested that the forecasting of expenditure at departmental levels was reasonably accurate and professional. Therefore, the problem with the forecasting of States expenditure appears to lie elsewhere.

KEY FINDING 3

Forecasting of expenditure at department level is reasonably accurate.

Where is the problem?

16. It seems only too easy for everyone to suggest that the blame for States spending lies with someone else.
17. The Chief Minister explained the system by which the forecasting arrives at the States.

"so it starts from the department itself and the forecast - if it is a forecast - is put together by the finance team working with the officers in the department, signed off with the Chief Officer and the Minister and then that is put forward to the Treasurer on behalf of the Treasury Minister. It is then aggregated and the Council of Ministers process is very much a political process to determine within the, what they regard as, acceptable limits of spending the relevant priorities that they will then put forward to the States."[6]

It was explained further that departments were required to complete their forecasting by January of the year preceding that which the forecast was relating  to.  There  is  no  one  public  office  or  politician  responsible  by legislation for the forecasting of expenditure in Jersey.

KEY FINDING 4

January is very early to complete an accurate forecast and does not allow for changes within the year preceding the forecast year.

18. The following question was asked in the Public hearings

"Who holds responsibility (Political and Officer) for the forecasting of expenditure process?"

19. The Minister for Treasury and Resources stated:

"Ultimately  the  States  hold  responsibility  for  making  the decisions on expenditure but obviously it is a proposition that is taken to the States Assembly by the Chief Minister."

The  Chief  Minister  echoed  this  clearly  when  he  commented  that responsibility rests with politicians who may decide they want to spend more.[7]

KEY FINDING 5

There is no position of overall responsibility for expenditure in the Island.

20. Professor Oliver made numerous enquiries when researching the issues to advise the Sub-Panel. The overarching message, which is reflected in his report to the Sub-Panel of July 2009 (Appendix 1), shows that the lack of responsibility for the overall process has resulted in the recognition that although  forecasts  are  put  together  responsibly  by  the  individual departments, there is a general sense of foreboding to the effect that;

unless something awful happens, they will do nothing. If they do nothing, something awful will happen.[8]

21. The professor's report discusses the reasoning behind this so it will not be considered in depth here. The recommendations to the Panel contained within his report are summarised as follows[9]:

1. There should be a proper debate now about the future growth of public expenditure, which should address questions such as do we want a low tax economy', or do we want higher public expenditure?'

2. Efficiency savings alone will not deliver structural change to the public finances.
3. There should be specific goals set on public expenditure.
4. Fiscal policy has to be made in a more meaningful medium-term framework (3 years).
5. The Treasury needs restructuring.
6. The Strategic Plan needs to have a firmer link to the annual Business Plan.
7. There should be a contingency budget introduced for unforeseen emergencies

22. The above recommendations caused the Sub-Panel to review the evidence it had gathered to date and it called further Public Hearings with the Chief Minister and Minister for Treasury and Resources on 9th October 2009. In following protocol laid out within the Codes of Practice for Scrutiny Panels and the Public Accounts Committee, the Panel advised the witnesses of the areas intended to be discussed at the hearings. The Minister for Treasury and resources responded by sending a letter to the Sub-Panel. The letter explained that two separate and significant pieces of work were to be undertaken. The Fiscal Strategy Review and the Comprehensive Spending Review.
23. Review of Fiscal Strategy. (FSR)

Intention:

To evaluate current tax and fiscal structures to determine how to ensure they are and remain sustainable into the future. The review will develop, consult on and then bring to the States a fiscal strategy in time for the 2011 budget that will:

• ensure sustainable public finances and support economic objectives;
• plan for potential future changes in global fiscal norms and the possible impact on Jersey;
• address the potential structural deficit once the economy has recovered;
• fund essential public services;

• take  account  of  funding  sources  for  the  future  spending  pressures[10].

24. Comprehensive Spending Review.(CSR)

Intention:

Consideration of whether and if so how improvements could be made to the expenditure and business planning process. The CSR will be asked to seek savings of £50 million from the 2011-2013 business plans. Some of these savings would be used to create a contingency fund for unforeseen expenses, to fund any changes needed to make savings and to fund some growth in essential services. Targeting this level  of  savings  will  break  the  historical  cycle  of  annual  spending increases above previous forecasts. The CSR will be complemented by a  new  3  year  spending  control  process,  which  will  not  only  limit unforeseen  increases,  but  encourage greater  efficiency  and  reward those services which are most successful at controlling costs.[11]

25. Suddenly  the  concerns  of  the  Sub-Panel  which  had  been  uncovered during the process of the review were apparently recognised within the two reviews  to  be undertaken by  the  Ministers.  This  information  was  very encouraging for the Sub-Panel in October 2009. The details were given in confidence at that time although the reviews are now in the public domain. The Sub-Panel thanks the Chief Minister and Minister for Treasury and Resources for their openness at that early stage. The high level of co- operation prevented duplication of effort for both the Sub-Panel and the Departments.
26. The  Sub-Panel fully  endorses  the undertaking  of  the  reviews  and  the apparent determination shown by the Chief Minister and the Minister for Treasury and Resources to progress them.

KEY FINDING 6

The Sub-Panel approve of the commission of the Fiscal Strategy Review and the Comprehensive Spending Review.

What Lies Ahead?

27. However, despite many of the Sub-Panels' concerns being looked at, the area of responsibility for the finances of the Island has not been resolved. Neither the Chief Minister nor the Minister for Treasury and Resources has any power to control what takes place in the States Chamber. Of course, there  can  be  no  guarantee  of  support  from  other  Members  either. Therefore, regardless of the quality, accuracy or appropriateness of the forecasting of expenditure work done by numerous officers and Ministers prior to the Business Plan reaching the States, the ability to remain in budget or not' rests with the States Assembly.
28. Despite recognition of problems of short term forecasting, to meet one year  budgets,  and  having  to  prepare  budgets  in  the  January  of  the previous year, the Sub-Panel considers the departments are producing accurate  assessments  of  the  financial  needs  of  the  future,  given  the services they are required to provide. The Council of Ministers in 2009 brought forward a Business Plan to the States (P117/2009) which curtailed the estimated expenditure at an amount, which, it could reasonably be argued,  would  be  met  by  expected  income,  given  the  recession,  and cyclical problems associated with the period.
29. The next step was to have the matter debated in the States. At that point, amendments to the Annual Business Plan agreed in the debate, being £1.6million  Net  Revenue  Expenditure  and  £11.5  million  Capital Expenditure[12], meant an additional £13.1 million pounds on top of the forecasting  proposed  by  the  carefully  conceived  plans  created  at department level.

£13.1 million over budget with no direct political responsibility!

KEY FINDING 7

There is no individual political responsibility for States expenditure.

30. The  Sub-Panel  wishes  to  make  it  clear  that  this  is  in  no  manner  a comment on the content of the amendments to the Business Plan.
31. This is a multi-million pound problem, yet the departments appear, in the main, to be attempting to cut their cloth according to the requirements of their Ministers and the financial climate. This direction stems from the difficult decision-making done at the Council of Ministers level, with the assistance of the Corporate Management Board. It is accepted that these are difficult times and the balance of the forecasting process, between the services to be provided and the amount of money available, is going to fluctuate, particularly during a recession. Any lack of discipline at the point of the States debate could turn a difficult financial time for Jersey into a dangerous downward spiral. Unchanged, the process can only be a recipe for serious financial difficulties in the future.

KEY FINDING 8

Discipline is required within States debates on expenditure.

32. The February 2010 report States' Expenditure Forecasts' published by the Comptroller and Auditor General in response to questions from the Sub- Panel  sends a  clear picture of  the  consequences  of failure  to control expenditure.

GST at 12%.

Or

A structural deficit of £170 million.

That may be a worst-case scenario, or is it?

Decisions to be made

33. The questions about how the States deals with business clearly took the Panel outside the terms of reference of this review. However, in order to deal with that enigma, issues need to be looked at that may challenge the democratic procedures of the Island. The Sub-Panel therefore raises the following question

Where must the ultimate responsibility for the Islands' spending lie?

34. The answer to this question will require brave and difficult decisions relating to democracy, power and responsibility, the Sub-Panel would implore the Chief Minister to deal with the problem.

Recommendations

35. The Sub-Panel makes the following recommendations:

1. The Minister for Treasury and Resources should enable departments to produce forecasts for expenditure later than January of the year prior to the year forecast.
2. The Minister for Treasury and Resources should ensure that forecasts of the second and third years be tightened.
3. The Sub-Panel agrees with the reviews being undertaken and recommends that the Chief Minister ensures that the difficult choices likely to be exposed within the reviews be openly dealt with by the relevant Ministers.
4. The Chief Minister must find a method of ensuring strict political discipline in dealing with expenditure, with an auditable line of responsibility.
5. The Minister for Treasury and Resources must find a method of ensuring that expenditure in Jersey is income driven.

Appendix 1 - Report into the forecasting of expenditure

Professor Michael J. Oliver,

Contents

1. Introduction...................................................................................................2
2. An overview of forecasting expenditure.....................................................7

1. Expenditure planning and forecasting ..................................................7
2. Academic views on fiscal forecasting...................................................8
3. The performance of fiscal forecasters and the

appropriate procedures for fiscal forecasting......................................10

4. The fiscal time frame .........................................................................12

3. Forecasting of expenditure in Jersey........................................................13

1. The Jersey context.............................................................................13
2. Is the growth of public expenditure really out of control'?..................15
3. The expenditure planning and forecasting process............................20
4. What goes wrong with forecasts of expenditure?...............................23

4. Recommendations......................................................................................27

References..............................................................................................................32 Appendix A Fiscal Indicators and Vulnerability in Small States........................35 Appendix B Financial Planning Cycle..................................................................36

1. Introduction

From the vantage point of 2009, Reg Jeune 's infamous words from the 1980s that Jersey has got money coming out of our ears' are a distant memory. The credit crunch has been slow to arrive in Jersey, but economic activity is the Island is beginning to decelerate. The implications of this for States revenue and expenditure over the next few years appear to be bleak.

Any discussion on revenue and expenditure in Jersey cannot be fully understood without reference to the Island's unique economic and political context. Finance had established itself as an important industry in the Island's economy from the 1960s and by the mid-1970s, Jersey was well on the way to becoming a global level Offshore Financial Centre. Soon after, finance became the Island's main driver of economic growth. At the start of the 21st century, Jersey had bank deposits of over $249 billion, $500 billion was held in offshore trusts, and around $153 billion was managed in offshore funds. By the beginning of this decade, however, a whole series of overspends, a perception that the public service was overstaffed or at least inefficient in how it operated and growing expectations of public service provision was putting considerable pressure on the exchequer. Added to this, there was evidence the political structure was unable to assert itself over the bureaucracy and this led to a growing disillusionment with government.

Just over five years ago, the States of Jersey began broader reform on a number of fronts. There were major changes to the political structure when the States accepted the principles of ministerial government. For the first time, under a Chief Executive with clear powers, it was possible to run the civil service as a coherent organisation and not one that was fragmented to reflect a myriad of political committees. Matters like intelligence and statistical gathering and monitoring were also given more attention through the establishment of functions in the Chief Minister's Office such as International Relations and Statistics.

On the economic side, the States agreed to balance government income and expenditure and improve the delivery of public services (States of Jersey 2005). In June 2004, the States agreed to double the annual rate of economic growth to 2% for the next 5 years and in March 2005, it published an economic growth plan (Economic Development Committee 2005). This was followed by a series of measures which aimed to diversify the economy, increase productivity and uplift the skills of the workforce (e.g. Economic Development 2007). A new Fiscal Framework was agreed by the States in October 2006 and outlined the purpose of a Stabilisation Fund and the Strategic Reserve (States of Jersey 2006). Concomitantly, the introduction of a Fiscal Policy Panel in 2007 allowed three outside independent experts to provide comments on the appropriateness of the States financial position and forecasts.

Changes to the tax system included an Income Tax Instalment System (IT IS) to replace the existing arrangement where employees would pay income tax in one lump sum at the end of the financial year to a system similar to the UK's Pay As You Go (PAYE) arrangements. Under IT IS, it was estimated that the payment method would raise additional sums each year. In addition, a number of income tax allowances for higher income groups over a five year period were phased out in a piece of legislation known as 20% means 20%' (the implication being that Jersey's income tax rate of 20 per cent would be non-negotiable for higher earners who had previously been offered a number of allowances and had reduced their top rate of tax below 20 percent). Finally, a goods and services tax (GST) was introduced at 3 per cent in 2008, and the rate was fixed for three years and would apply it to all goods and services expect for medical supplies, prescriptions, charities, residential rents, postage and businesses with a taxable turnover of less than £300,000.

Given the difficulties in a small society to enforce any public expenditure cuts and to make far-reaching changes to the economy, these reforms would have been unthinkable in earlier times. Policymakers have noted that in past economic cycles, whenever the Jersey economy underwent a moderate pace of economic expansion there was a tendency to put off reforms and to assume that economic growth would continue unabated. The reforms that have been introduced over the last five years have been packaged somewhat differently. This time it is different, policymakers argue, and complacency will not set in at the expansionary phase in the economic cycle. They argue that the formidable challenges that have to be met in the foreseeable future encompass the expansion of new European Union economies, greater aspirations of long established competitors and demographic changes.

Despite this, these reforms do not seem to have completely quelled the escalation of tension between each of the stakeholders in the Island insofar as public expenditure is concerned. As I noted in my last report, this unease can be characterised as follows. The Treasury will announce that there is an improved outturn to a forecast, as income receipts are higher than the initial forecast. The politicians will respond to this news by blaming civil servants for not being accurate enough in their initial revenue forecasts and accuse the Treasury of under forecasting income to constrain States expenditure. The politicians will then spend some, if not all, of the extra income. Finally, the general public's reaction to all of this, after reading in the Jersey Evening Post that extra money' has been found, is a mixture of bemusement and anger. Some will question why new taxes have been introduced in the first place; others will get angry as the States approve additional expenditure and yet others will lobby politicians to spend the extra income. Invariably public expenditure continues to rise, and in recent times, extra money' appears like Manna from heaven as Jersey's economy continues to grow at rates faster than that predicted by official forecasts. Some of the interviewees summarised this situation thus: unless something awful happens, they will do nothing. If they do nothing, something awful will happen'.

It is probably fair to say that all sides are culpable in this blame game', but it clearly do not help that the political situation in Jersey is unique. There are no official political parties but 53 individual parties (each member of the States assembly). One of the advantages of political parties is that they assert discipline on their members, which leads to consistency of purpose. Unfortunately, politics in Jersey (more so than the UK!) is marked by disconnects, the law of unintended consequences and occasional rapid policy reversals (e.g. one day a debate can occur with members arguing that health expenditure should be controlled and the following week Members will just as passionately argue that extra resources need to be found to save a children's home). Those members not sitting on the Council of Ministers (CoM) have a relatively easy time because they can support propositions for extra spending and do not feel that they are responsible for the financial position that the States ends up with. Last year, the CoM brought amendments to their own Business Plan and spent more than agreed because of an impending election and this went against the advice of the Fiscal Policy Panel (usually lauded by senior politicians for the quality of their advice). To emphasize, these observations are made not to denigrate the politicians (politicians need to get re-elected, unlike academics!) but merely to highlight a system which is perhaps best not suited for rational, long-term policymaking.

To examine the issues around the forecasting of expenditure, this report is divided into three parts. First I turn to provide an overview of forecasting expenditure and relate this to some academic literature. Secondly, I turn to examine the forecasting of expenditure in Jersey. Finally, I make some recommendations.

2. An overview of forecasting expenditure

1. Introduction: expenditure planning and forecasting

As Western governments became more accountable for the use of public funds post-1945, there was a concomitant growth in budgetary procedures and institutions which led to the development of more advanced fiscal forecasting and monitoring techniques. A quarter of a century ago, Zarnowitz (1985) claimed that there was no more empirical exercise in public financial management than forecasting revenue and expenditures. By the 1980s, the developed world, with its plethora of econometric models which were used by local, federal and state governments to garnish their empiricism, were urging developing countries to become more rigorous with their forecasting procedures (e.g. Feenberg et al. 1989). The spread of scientific budgetary procedures, however, was tempered by some academics who subscribed to the view of the late John Kenneth Galbraith that the only function of economic forecasting is to make astrology look respectable'. As practical experience confirmed that forecasting was more of an art than a science, over the last fifteen years a more nuanced view has emerged which stresses that budget forecasts of revenues and expenditures should utilise very sophisticated econometric or other empirically driven approaches, but recognises that the political environment can undermine that rigour which underpins this approach (Bunn and Wright 1991).

Clearly, expenditure forecasting is a highly complex exercise and requires many forms of input which include historical data, experience, incremental approaches, judgement, hierarchical bargaining, game-playing, unit cost, trend analysis and econometric modelling. Forecasting is not a wholly technical and professional exercise that is objective and nonpartisan: each set of actors which participates in the process will have normative considerations which influence the budget process. Due to this, the need to design a procedure flexible enough to accommodate the day-to-day requirements of fiscal policy decision-making tends to create tensions with the use of appropriate tools. The main topics in the literature pick up on how practitioners and scholars have approached which procedure would best fit policy requirements and formal correctness, and these are discussed below.

2. Academic views on fiscal forecasting

In a recent European Central Bank working paper, Leal et al. (2007) reviewed the fiscal forecasting literature and some of the challenges in the field of fiscal forecasting from a practitioner's perspective. They note that generally speaking, the academic papers can be grouped into two: (i) some discuss the appropriate procedure for fiscal forecasting, in many cases by means of accuracy comparisons and (ii) others discuss the properties of the produced forecasts, in terms of (systematic) biases and violation of the rationality. Several things should be noted:

• It is not clear from a study of the literature which method fiscal and monetary authorities, international economic organisations, financial market analysts, rating agencies or research institutes should be adopting when preparing their forecasts. Some authors (Bretschneider et al. 1989) compare the forecasting accuracy of different forecasting methods and favour a combination of judgement and simple econometric equations, against time series and complex econometric models. They argue that the main reason for this is the knowledge of special events state revenue forecasters might have. Others, such as Grizzle and Klay (1994) also show evidence for combining judgement and simple methods on the basis of transprancy against more complicated or automated techniques.

• Pike and Savage (1998), Sentance et al. (1998), Giles and Hall (1998) and Willman et al. (2000) have explored the fiscal side of structural macroeconomic models. Macroeconomic models as iteration tools for preparing the budgetary forecasts allow for estimating the effects of fiscal policy on economic activity; however, it is often the case that such models are too aggregated to produce sufficiently detailed government revenue and expenditure projections, which are necessary for a thorough assessment of public finances.

• A number of authors have analysed the potential bias the political and institutional process might have on revenue and spending forecasts (Auerbach 1995 and 1996; Plesko 1988; Feenberg et al. 1989; Bretschneider et al. 1989; Shkurti and Winefordner 1989; Cassidy et al. 1989; Bruck and Stephan 2006; Jonung and Larch 2006), and the nature and properties of forecast errors within national states (Campbell and Ghysels 1995; Jennes and Arabackyj 1998; Auerbach 1999; Gentry et al. 1989; Fullerton 1989; Melliss 1996; Melliss and Whittaker 1998; Baguestani and McNown 1992; Mühleisen et al. 2005; Moulin and Wierts 2006; Strauch et al. 2004) and international organisations (Artis and Marcellino 1998 and 2001; Pons 2000; Keereman 1999 or Golosov and King 2002).

• The main lessons which Leal et al. (2007) draw from this strand of literature, some of which relate to the current study, are:

– there is evidence of the existence of systematic political and institutional bias in revenue forecasting in the case of European countries, while the evidence for the US is mixed;

– forecast quality deteriorates with the length of the forecasting horizon;

– forecasts from independent, competing agencies tend to increase forecast accuracy;

– nevertheless information matters, as outside forecasts (from independent forecasters) tend to be less accurate than inside forecasts (from staff of the relevant organisation);

– unforeseeable policy decisions and institutional changes have a significant impact on forecast error patterns across time.

3. The performance of fiscal forecasters and the appropriate procedures for fiscal forecasting

The academic literature is proliferated with papers evaluating forecast records (albeit more often for the macroeconomic side of the economy than for the fiscal side). As Leal et al. (2007) remind us, when considering accuracy comparisons over time, two things should be borne in mind. First, the information set available when generating real-time forecasts tends to be much smaller than that available when performing ex post comparisons (e.g. GDP revisions, lags or frequent revisions in the availability of fiscal data and changes in announced policy). Secondly, evaluating point forecasts of certain variables does not permit a comprehensive assessment of a set of projections where all economic and fiscal variables are jointly determined. Nevertheless, evaluating forecast accuracy is an important element of forecasting procedures. Policymakers might learn from past errors and improve their forecasts: sizeable, systematic or biased forecast errors should allow fiscal analysts to identify weakenesses in their forecasting procedures, in terms of methods, discussions or decision-making processes.

The evidence on forecast errors is illuminating. Leal et al. (2007) examined the distribution of government budget balance forecast errors for 15 European countries, taken from spring and autumn projections. They found that the distribution of projection errors appears to be slightly twisted to under- prediction of budget balances (which might be evidence for the presence of bias), particularly for current year autumn projections. In terms of bias, Bretschneider et al. (1989) have shown that a government would tend to overestimate a deficit when the loss of an underestimation is greater. Keereman (1999) and Jonung and Larch (2006) have demonstrated how public authorities may have an interest in presenting a pessimistic forecast to build in a safety margin that would allow them to meet budgetary targets, also in case of revenue or expenditure slippages. Another source of bias occurs when relevant economic variables are systematically omitted, or from errors in fiscal variables induced by systematic errors in economic variables (output gap, price variables, GDP volatility) through estimated tax/spending elasticities (see Feenberg et al. 1989; Cassidy et al. 1989; Keereman 1999; Melander et al. 2007; Artis and Marcellino 2001; Strauch et al. 2004).

In short, there are three types of errors: policy errors, economic errors and technical (behavioural) errors (Auerbach 1995). Policy errors are due to errors on the course of fiscal policy, owing to the implementation of new, not yet announced by the forecast cut-off date, fiscal policy measures or cancellation of the previously announced measures. Economic errors are those that can be explained by wrong forecasts of macroeconomic variables that are used in the budget projections (GDP, interest rates, inflation). Finally, technical errors would be due to other factors.

4. The fiscal time frame

The forecasting horizon is divided into short-term, medium-term and long-term forecasts. Short-term budgetary forecasts normally cover a time period of up to one year. Medium-term budgetary forecasts cover a time period of 2 to 5 years. Long-term budgetary forecasts covering a period beyond 5 years and up to several decades aim to estimate the budgetary pressures stemming from population ageing particularly in the areas of pension related expenditure and healthcare.

The need for placing the annual budget process in a medium- and long-term perspective goes back at least to the 1950s literature on development planning. In more recent times, medium-term expenditure forecasting was pioneered by the United Kingdom, particularly with the Thatcher Government's Medium Term Financial Strategy. Australia was another pioneer who led developed countries in reforms to control expenditure growth. Australia's forward estimates' approach aimed at strengthening the link between government policy and expenditure programs and improving the affordability of policies, by combining projections methods with institutional arrangements to enforce outcomes.