State Forecasting Errors Driven by Increasing Volatility in Their Tax Revenues

WASHINGTON — States are having trouble forecasting tax revenue mostly because of increasing volatility in their revenues, according to a report released by the Nelson A. Rockefeller Institute of Government Tuesday.

States overestimated tax revenues by more than 10% in fiscal year 2009 -- the largest error since 1987, the earliest year for which data were available. It's usually more difficult for states to make forecasts during and after economic recessions, the Institute said.  The errors near the 2001 and 2007 recessions were much bigger, compared to earlier data around the recession in the 1990s, which suggests increasing volatility in states' tax revenue, it said.

The report examined how revenue forecasting errors have changed in response to the tax revenue volatility, timing and frequency of forecasts, and forecasting institutions and processes. It focused on income, sales and corporate taxes, the three major sources of tax revenue, which represent three quarters of total state revenues. Data in a 27-year span were collected from 1987 to 2013, including both economic recessions and expansions.

The Rockefeller Institute found that the increase in forecasting errors were mostly attributed to growth in tax revenue volatility, which was driven by increased reliance on increasingly volatile capital gains. Among the three major sources of tax revenues, corporate income taxes appeared to have the largest forecast errors, followed by personal income taxes and sales taxes.

Errors also were found to be particularly large during and after economic recessions. At the same time, variations in errors across the states also increased. While states returned to normal forecasting levels at the end of the recession, errors during the 2001 and 2007 recessions were much worse than those during the early 1990s, suggesting an increase in revenue volatility.

Smaller states with less diverse economy structures, such as Alaska, Montana, Nevada, New Hampshire and North Dakota, were reported to have larger errors, which might be attributed to the volatility in their economics and tax bases. States also tended to under-forecast revenue when it became particularly difficult to do forecasting, according to the analysis.

Many options to improve revenue forecasts, including increasing forecast frequency, were suggested by the report. "States should maintain larger rainy day funds in order to manage the effects of volatility," the report concluded.

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