Errors in State Revenue Estimates Growing in Size and Frequency

States have been making more serious errors in estimating their revenues during tough economic times, according to a new report by the Pew Center on the States and The Nelson A. Rockefeller Institute of Government. This has significant implications for policy makers who need to know how much money they will have to spend on programs and services ¬as they grapple with severe budget shortfalls.
 
The report, States' Revenue Estimating: Cracks in the Crystal Ball, found that in fiscal year 2009—the first of the ongoing budget crisis—half the states overestimated revenues by at least 10.2 percent. That equated to an unexpected shortfall of nearly $50 billion in personal income, corporate income and sales tax revenues. In a year when state policy makers faced $63 billion in mid-year shortfalls—coming atop $47 billion they already had closed when crafting their budgets—this was a significant challenge. States had to close the gaps by cutting spending, increasing taxes and fees, tapping reserves and borrowing.

The study found that the primary culprit driving more serious and frequent errors is not the states' processes, methods and techniques, but rather, the increasing volatility of the revenue streams themselves. This appears to result from states' growing reliance on income taxes and the ways in which highly fluctuating capital gains affect income tax revenue.

“The stakes are high for policy makers as they continue to wrestle with significant budget gaps,” said Susan Urahn, managing director of the Pew Center on the States. “Errors in revenue estimating have been growing in size and frequency with each recession. This makes the challenging process of balancing state budgets even more difficult.”

“States have faced increased responsibilities and expenses at the same time revenues have become less predictable,” said Thomas L. Gais, director of the Rockefeller Institute of Government. “If elected officials don't get good revenue forecasts, they're not only forced to change their budgets and tax policies after they learn about errors, they're also contributing to citizens' skepticism about the budget process. Such skepticism, in turn, may make it even harder to build the coalitions needed to reduce large budget gaps.”

The report looks at state estimates for three major revenue sources—income, sales and corporate taxes—comprising 72 percent of states' total tax revenues. The research covers the period from 1987 to 2009, a 23-year span that takes in three recessions and three stretches of economic growth. The study is the first to determine the size of forecast errors using data for multiple taxes in all 50 states.

No one expects perfection in forecasting, even when the economy is stable and behaving predictably. 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—and the Pew-Rockefeller Institute study does not attempt to address them all or compare states directly. Rather, this study examined the trends in revenue estimating errors over time—in particular, over the business cycle—and what steps states could take to manage the unexpected shortfalls or surpluses.

Over two decades, half of all states' revenue estimates were off by more than 3.5 percent, or $25 billion in 2009 dollars. What is notable is that these larger errors occurred more frequently in the past 10 years.

Among the report's key findings:

• Estimates grew progressively worse during the last three economic downturns. During the 1990-92 revenue crisis, 25 percent of all state forecasts fell short by 5 percent or more. During the 2001-03 downturn, 45 percent of all state forecasts were off by 5 percent or more. In 2009, 70 percent of all forecasts overestimated revenues by 5 percent or more. In New York, for instance, officials had to revise their fiscal year 2011 estimate five times in 2009. Even Indiana, whose estimates were off by less than 1 percent over the length of this study, erred in its forecasts for 17 straight months until the streak ended in March 2010. Arizona, New Hampshire, North Carolina and Oregon are among the states that had the most difficult time estimating revenues in 2009, with error rates greater than 25 percent.
• The Great Recession also was notable because revenue forecasters were confounded by major declines in all three of the major state taxes to a much greater extent than before. States overestimated personal income taxes by 9.7 percent in 2009, corporate income taxes by 19 percent and sales taxes by 7.6 percent. 
• State revenue estimates more often produce surpluses than shortfalls. In fact, in 16 of the 23 years covered by this study, the typical state underestimated revenue—leading to a median error of 1.5 percent, or $10 billion in surpluses in 2009 dollars. And in a handful of states, the underestimates were even larger: Connecticut, Massachusetts, Oregon and Vermont were among the six states with surpluses of more than twice the median, or 3 percent, over the study period. Facing an unexpected surplus, legislators may cut taxes, expand existing services or add new programs, but without the benefit of the planning time that would have been available with a more accurate forecast.

The study also highlights promising approaches for states to improve their estimating processes and better manage the effects of the volatility of their revenue streams:

• About half the states use a “consensus revenue estimate” in which a single forecast is put together with advice from the executive and legislative branches as well as academic and business interests. The Pew-Rockefeller Institute data do not show a clear link between consensus forecasting and accuracy, but consensus forecasting does bring other benefits.
• Several states have refined economic assumptions, even during the budget year, to adjust for the uncertain economy. Michigan is in the process of refining its economic assumptions around a smaller auto industry. Others have increased the frequency of their estimates, especially during downturns, to respond quickly to sudden swings. Florida offers a good example; it revises its revenue forecasts three times a year. Several other states, including Vermont and West Virginia, added forecasts during the Great Recession.
• Many states have taken steps to remove politics from the estimating process as much as possible to limit lawmakers' attempts, especially in election years, to present an unrealistically optimistic view of revenues. For example, Connecticut recently passed a bill to settle political disputes in its revenue estimating process, giving the final say to the state comptroller when the executive and legislative branches cannot agree on a revenue forecast. And some states are casting a wide net for expert economic analysis.
• Fiscal tools such as rainy day funds, limiting reliance on certain highly volatile taxes and capping spending below expected revenues are options that policy makers may wish to consider to make state budgets less vulnerable to economic downturns.

The Pew-Rockefeller Institute report relied on data from the Fall Fiscal Survey of the States published by the National Association of State Budget Officers and the National Governors Association.

Pew Center on the States
The Pew Center on the States is a division of The Pew Charitable Trusts that identifies and advances effective solutions to critical issues facing states. Pew is a nonprofit organization that applies a rigorous, analytical approach to improve public policy, inform the public and stimulate civic life.  www.pewcenteronthestates.org

Rockefeller Institute of Government
The Nelson A. Rockefeller Institute of Government, at the University at Albany, is the public policy research arm of the State University of New York. The Institute conducts fiscal and programmatic research on American state and local governments. www.rockinst.org.