Managing Volatile Tax Collections in State Revenue Forecasts

Source: Nelson A. Rockefeller Institute of Government, and the Pew Charitable Trusts, March 2015

…To better understand how volatile state tax revenue designated for deposit into the general fund affects the accuracy of projections, The Pew Charitable Trusts and the Nelson A. Rockefeller Institute of Government studied errors in forecasting state revenue by examining personal income, sales, and corporate income tax data from 1987 through 2013. The analysis updates a 2011 study and includes findings from a new survey of state officials. It also draws from current literature and interviews with government finance experts and elected officials. The research shows that:
• Forecasting errors are on the rise, and the increase is driven by the growth of revenue volatility —year-to-year swings in tax collections.
• Corporate income taxes are the hardest to estimate; sales taxes are relatively easier.
• Estimating errors are larger during and after recessions but also occur during expansions.
• Smaller states and those that are dependent on a limited number of economic sectors for their tax revenue tend to have larger percentage errors than more populous or economically diverse states.
• The timing of forecasts matters; the longer the time between the forecast and adoption of the state budget, the less accurate estimates will be.
• Changing the mix of taxes in a state does not necessarily improve the accuracy of revenue forecasts.

No state can entirely eliminate forecasting errors. Unexpected economic turns, new legislation, the rise and fall in housing values, and changes in federal policy, such as the 2013 budget deficit reduction plan known as the “fiscal cliff,” guarantee that estimating revenue will always be imprecise. These factors can drive revenue volatility, contributing to the difficulty of accurately estimating the money coming into state coffers. And the resulting shortfalls or surpluses may complicate lawmakers’ efforts to craft and execute balanced budgets over several years.

Pew’s research demonstrates that an effective way to manage unpredictable revenue is by designing an evidence-based reserve, or rainy day, fund that is built upon an understanding of economic changes that affect revenue. The ideal fund would include a provision tying reserve deposits to unexpected windfalls and have a maximum size based on observed patterns of volatility in the state.

In addition, Pew recommends that state officials prepare and update revenue estimates as close as possible to the start of the budget year and that they regularly analyze errors and sharpen forecasting techniques and assumptions to reflect changing economic conditions…