Pew: Improved Rainy Day Funds Can Mitigate Revenue Forecasting Errors

Pew: Improved Rainy Day Funds Can Mitigate Revenue Forecasting Errors

WASHINGTON— The amount of money states collect is harder to predict than ever, according to a new report from The Pew Charitable Trusts and the Nelson A. Rockefeller Institute of Government. Managing Volatile Tax Collections in State Revenue Forecasts finds that rising volatility of tax collections has contributed to increases in the size and frequency of forecasting errors, and identifies specific steps that states can take to manage volatile revenue.

“Some level of forecasting error is inevitable, but the impact of this error can be mitigated by a mix of effective policy solutions,” said Brenna Erford, who manages Pew’s state budget policy research. ”States can adopt evidence-based rainy day fund policies to address budget shortfalls arising from unforeseeable economic and fiscal circumstances that make forecasting revenue increasingly difficult.”

According to the study, budget forecasting errors are generally larger when a long lag exists between a forecast and the adoption of the state budget, during and after recessions, in less populated states, in states that are heavily reliant on certain industries, and particularly when forecasting corporate income taxes.

“The increased volatility of tax collections compounds the difficulty of estimating revenue,” said Donald Boyd, senior fellow at the Rockefeller Institute of Government.

The research cautions that 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.

The study identifies three best practices to help state policymakers manage volatile revenue and use the best available data when forecasting revenue:

  • Design and implement an effective rainy day fund. As a buffer against unexpected shocks, a reserve fund can replace lost revenue from shortfalls triggered by downturns, natural disasters, the rise and fall of commodity prices, and other factors, helping states minimize cuts in services and tax increases. And because credit rating agencies view healthy reserve funds favorably, they can also help keep borrowing costs down. Thirteen states tie rainy day fund deposits in part to overall revenue volatility or a single unpredictable tax so that some revenue during unusually good times is automatically deposited into reserves.
  • Prepare and update revenue forecasts as close as possible to the start of the budget year, giving officials more timely information about income tax collections.
  • Regularly analyze forecast errors and sharpen revenue forecasting techniques and assumptions to reflect changing economic and fiscal conditions. Reasonable economic assumptions often change, and forecasters should factor those adjustments into their estimates.

The report, which updates and extends a 2011 analysis and includes findings from a new survey of state officials conducted by the Rockefeller Institute of Government, looked at state revenue forecasting errors by examining personal income, sales, and corporate income tax data from 1987 through 2013. It also draws from current research and interviews with government finance experts and elected officials.


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Managing Volatile Tax Collections in State Revenue Forecasts

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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.