Revenue Estimating: Can’t We All Get Along?

May 13, 2019

By John Hicks

Executive Director of the National Association of Budget Officers (NASBO)

For state government budgets, better revenue conditions have finally arrived over the past 18 months – after two previous fiscal years of muted growth in tax receipts. Many states ended fiscal year 2018 with unexpected revenue surpluses and most of them have increased their revenue estimates for the current year, fiscal year 2019, since they passed them. Early reports on April’s tax returns portend further good news.

A reasonably accurate process of coming up with the revenue estimates upon which budgets are based is critical to reaching agreement and fiscal stability. This has been less of a problem in the past two years, as surprisingly strong revenues have left states with more, not less money to be spent. But in a time when some observers believe that a recession is coming our way at some point, overexuberant revenue estimates can lead to shortfalls in the dollars necessary to pay for promised services.

Despite the method of organizing a revenue estimate, all forecasts will have some error. There is simply no known way to guarantee perfectly accurate estimates. Large errors and especially overestimation can trigger significant actions, like spending cuts, to ensure a balanced budget at year’s end.

Most states update their revenue estimates after the governor has submitted the budget to the legislature. States track actual revenue collections throughout the year. Nearly half of the states break down the revenue estimates into monthly or quarterly increments to closely monitor actual results which allows governors and legislatures to prepare timely reactions.

Determining a revenue estimate in more than half the states is assigned to a consensus revenue forecasting group or an executive branch actor, where the estimate is usually adhered to by both the governor and the legislature. In other states there are dueling or competing revenue estimates between the executive and legislative branches.

But there is one event that can be even more troublesome than an inaccurate estimate, and that’s a government that doesn’t come up with one generally accepted number. When various branches of government start their budgetary work using different revenue predictions for the coming year or biennium, the budget can find itself hostage to politics, more than reliant on good estimating practices.

The so-called consensus approach, used by just over half of the states can be  key to a well-oiled budgeting process. It is defined as the participation and acceptance by the two main political budget actors of a revenue estimate, the governor and the legislature. In addition, the group often also includes advisory experts, such as a council of economic advisers, to agree on the state’s underlying economic assumptions.

On the other side of the crystal ball, about one-fourth of the states do not follow such a path and competing revenue forecasts can become the subject of controversy, politics, and sometimes rancor. The legislative branch which holds the “power of the purse” ultimately decides.

Reviews of revenue forecast accuracy studies have concluded there is very little relationship between the use of consensus forecasting and forecast accuracy. The primary reasons often cited as the primary factors for forecast errors include unexpected recessions, economies which are based on a slim number of industries, revenue volatility, tax types (property taxes, for example are far more predictable than income taxes) are mentioned as the primary causes of forecast errors. Whatever the complexity of the state’s tax system, these are factors that can be very difficult to consider.

But if accuracy isn’t necessarily an achievable goal, the single number produced by an effective consensus process enables a far smoother budgeting process, and one that helps immunize a city or state from internecine warfare, when the numbers go awry.

Establishing the amount of money to be budgeted is a linchpin to the state budget process. Tax administration and forecasting are complex and difficult, with a lot riding on them. The professional staff and outside advisors that carry out much of this work provide states with a strongly rational, empirical process.

The next step, of course, is figuring out what to do when estimates are off. Revenue surpluses from last year are often  moved into states’ rainy day funds, used for nonrecurring purposes, or left to be decided on in the next budget cycle. Caution should be exercised to avoid putting that money into new, ongoing programs, which then must rely on good times for years to come.