Report

Managing Volatile Tax Collections in State Revenue Forecasts

This report, a joint initiative of The Pew Charitable Trusts and the Nelson A. Rockefeller Institute of Government, will help policymakers better understand how volatile state taxes affect the accuracy of revenue projections. It examines data from 1987 through 2013 and reveals that predicting how much money state governments will raise has become more difficult than ever. The increase in revenue forecast errors is due largely to the growing volatility of tax collections across the states. From 2000 to 2013, the size of fluctuations in tax revenue rose in 42 states. And although no state can entirely eliminate forecasting errors, this study identifies three ways to help them manage volatility.

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Overview

During his eight years as the governor of Arkansas, Mike Beebe (D) tried to avoid micromanaging the state government. “With one exception,” he said during an interview for this report. “Money. I’m fiscally conservative. I asked for a report every morning on every aspect of revenue, comparing the daily and monthly collections year over year and comparing those to the forecasts. I did watch those numbers.”1

Beebe had good reason to closely monitor his state’s finances. The amount of money states collect in taxes is harder to predict than ever. And forecasting errors can have serious consequences. Overly optimistic forecasts can prompt hurried, across-the-board spending cuts, tax increases, or borrowing when collections fall short. Alternately, forecasts that are too low can result in a one-time surplus, tempting lawmakers to cut taxes or commit to spending that is unsustainable over the long run.

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 2013.2 The analysis updates a 2011 study and includes findings from a new survey of state officials.3 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.

Endnotes

  1. Mike Beebe (then-governor of Arkansas), interview with The Pew Charitable Trusts, February 2014.
  2. The Rockefeller Institute has released a companion technical report to this report: Linda Dadayan and Donald J. Boyd, “State Tax Revenue Forecasting Accuracy: Technical Report,” Nelson A. Rockefeller Institute of Government (September 2014), http://www.rockinst.org/pdf/government_finance/state_revenue_report/2014-09-30-Revenue_Forecasting_Accuracy.pdf. The data on revenue estimates and collections are from the fall Fiscal Survey of the States conducted by the National Association of State Budget Officers and the National Governors Association.
  3. The Pew Charitable Trusts and Nelson A. Rockefeller Institute of Government, States’ Revenue Estimating: Cracks in the Crystal Ball (March 2011), http://www.pewtrusts.org/en/research-and-analysis/reports/2011/03/01/states-revenue-estimating

Related Experts

Brenna Erford

Manager, State Fiscal Health and Economic Growth

Brenna Erford manages Pew's work on state budget policy, which helps states identify ways to better manage fiscal pressures resulting from increasing economic and revenue volatility. View Profile