State Revenue Forecasting Best Practices: A Dangerous Concept

August 15, 2011

Using another state's successful methods of estimating revenues to accurately forecast those of your own is prohibitively risky.  Yet state legislators ask how to do just that.  Facing fiscal woes, many states' representatives want to know which states have been successful and how they have accomplished their goals.

However, by its very nature, forecasting is an imperfect science.  It is the practice of predicting outcomes which have yet to be observed.  Yet it is a necessary evil when state legislators budget for the upcoming year.  They must forecast revenues in order to determine how much the state can prudently spend.

According to a recently released paper by The Pew Center on the States and The Nelson A. Rockefeller Institute of Government, "States Revenue Estimating: Cracks in the Crystal Ball," a disturbing trend has taken shape:  Revenue estimate errors have grown over the last 23 years and are even worse during times of fiscal crisis.  The last three economic downturns have been no exception.  In addition, the number of states making errors is growing.  So too are most states' budget gaps.

However, policy makers should not hastily use the best practices of other states. Doing this places their own states at great risk.  This is why the authors of the Pew/Rockefeller study explicitly state their reasons for not directly comparing states.  "There are a number of factors that contribute to a state's ability to predict revenues with accuracy-including national economic forecasts state officials rely on to estimate their revenues, a state's tax structure, its economic base and the budget processes in place."

Hopefully, it is generally known that each state has a somewhat different tax structure and budget process.  Discussions during revenue forecasting and budget gap meetings at The National Conference of State Legislators 2011 Summit, however, showed that many legislators fail to take economic bases into account when looking for best practices.

Each state has a unique economic makeup due to tax expenditures, natural resources, and location, to name a few.  These differing conditions affect when and to what extent certain financial shocks hit individual states and, thus, when legislators are most likely to incorrectly forecast revenues.  It logically follows that strategies proving successful are generally generated during incomparable initial conditions.  Stuart Bretschneider and Larry Schroeder offer examples of different forecasting techniques for different revenue resources in "Revenue Forecasting, Budget Setting, and Risk" (Socio-Economic Planning Sciences, Vol. 19, Issue 6, 1985, pp. 431-439).

Even though legislators are forecasting tax revenue (a single source), the sources of this revenue examined in the Pew/Rockefeller study are three-fold:  individual income, corporate income, and sales taxes.  The sources of each of these also matter, relying heavily on the economic base of the state.

Comparing apples to oranges is harmlessly pointless in a literal sense.  Unfortunately for states whose legislatures consider budget gap-reducing strategies based solely on what has worked elsewhere, the consequences of comparing one state to another could have economically dire consequences.

Follow David Logan on Twitter @Loganomix

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