If policy makers are not certain how much revenue their states will have coming in, it is tougher for them to make thoughtful decisions about where to spend and where to cut. A report from the Pew Center on the States and the Nelson A. Rockefeller Institute of Government finds that when states' revenue estimates are substantially off—in 2009 alone half the states overestimated revenues by at least 10 percent—the consequences can be significant.
States' Revenue Estimating: Cracks in the Crystal Ball examines state estimates for three major revenue sources—income taxes, sales taxes and corporate taxes—that comprise 72 percent of states' total tax revenues. The report shows that the volatility of these revenue streams has been a significant cause of inaccurate forecasting, more so than states' estimating processes, methods and techniques.
This research covers the period from 1987 to 2009, a 23-year span that takes in three recessions and three stretches of economic growth.
- Errors in revenue estimates have worsened progressively during the fiscal crises that have followed the past three economic downturns. Between 1990 and 1992, a quarter of the states had errors of 5 percent or more. In 2001 and 2003, nearly half the states were off by 5 percent or more. In 2009, almost three in four states missed the mark by 5 percent or more.
- 2009, the first full fiscal year of the Great Recession, ended with the largest overestimates in revenue forecasting of any year studied. This translated to a roughly $50 billion shortfall that states had to cover.
- Unique among past downturns, the Great Recession was also notable for major declines in all three major state taxes.
Revenue estimating is a vital component of the budget process. Before governors and state legislators can make strategic decisions about how much money to invest in certain programs—or whether to increase or reduce taxes—they need to know how much revenue they have to work with.
Inaccurate estimates do not have to be large to add up to a significant amount of money. In Montana, a 1 percent error translated to a $36 million revenue swing in a two-year budget. In New York, a 1 percent error translated to $527 million in general fund revenues—nearly half of what the state spends on public assistance.
Missouri and Arizona illustrate the challenges states can face when they overestimate—and underestimate—revenue.
On the eve of the 2010 legislative session, Governor Jay Nixon and the state legislature had agreed that revenue for the 2011 fiscal year would be $7.2 billion. Eight weeks later, the governor announced that the revenue estimate was revised downward by about $200 million. Lawmakers thought they had resolved the crisis by cutting $484 million from the governor's budget before they adjourned in May. Weeks later, the revenue projection weakened again, and Governor Nixon said he would have to trim an additional $301 million. In all, the 2010 and 2011 budgets had to be slashed six times.
Missourians have been affected by nearly $2 billion in cuts over two years. College scholarships have been reduced for low- and middle-income families. School bus transportation has been eliminated on many routes. About 2,500 state workers have been laid off. Mental health, developmental disability and drug and alcohol addiction services have been diminished. Fewer hot meals and rides to doctors and grocery stores are available for seniors. The list of budget cuts goes on.
For fiscal year 2006, Arizona had an unanticipated $530 million surplus. Arizona's phenomenal rates of growth in 2005 and 2006, coupled with the surplus, led lawmakers to cut taxes and increase spending.
The 21st Century Research Fund, an effort designed to invigorate Arizona's energy and biotechnology initiatives, was one of the programs that received increased funding. Then, as budget surpluses turned to deficits, the legislature killed the program. The about-face led Science Foundation Arizona to sue the state. The nonprofit group had helped solicit matching funds for the state money and provided state-funded grants to startup companies and university researchers. The foundation won its case, but a county court said there was no way to force the state to pay up. In the end, the state government made good on its commitment for 2008 but not beyond that.
Revenue forecasting cannot be perfect. But states can find ways to improve their accuracy better and manage the volatility of their revenue streams. Interviews with dozens of budget experts uncovered some promising practices from a number of states.
States' Revenue Estimating: Cracks in the Crystal Ball provides an in-depth review of these practices, including:
- Analyzing errors and refining assumptions
- Making frequent estimates
- Ensuring independence from the political process
- Adding expertise
- Building rainy day funds
- Implementing fiscal devices for limiting reliance on volatile taxes
- Setting spending rules