Federal Aid About to Become Largest Portion of State Revenues

Published March 29, 2011

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.

“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 policymakers faced $63 billion in midyear shortfalls—on top of $47 billion they already had closed when crafting their budgets—this was a significant challenge.

Especially Volatile Income Tax
The study found the primary culprit driving more serious and frequent errors is not the states’ processes, methods, and techniques but instead the increasing volatility of the revenue streams. 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 policymakers 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.”

“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,” said Thomas L. Gais, director of the Rockefeller Institute of Government.

Long-Term Look
The report examines state estimates for three major revenue sources—income, sales and corporate taxes—comprising 72 percent of states’ total tax revenues. The research covers 1987 to 2009, a 23-year span that includes 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.

Several factors 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.

More Frequent Errors
Over two decades, half of all state revenue estimates were off by more than 3.5 percent, or $25 billion in 2009 dollars. 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.
•    The Great Recession 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.

•    Inaccurate state revenue estimates more often produce surpluses than shortfalls. In 16 of the 23 years covered by the study, the typical state underestimated revenue with a median error of 1.5 percent, or $10 billion in surpluses in 2009 dollars. In a handful of states, the underestimates were even larger.

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

•    Approximately 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 it says consensus forecasting does bring other benefits.

•    Several states have refined their economic assumptions to adjust for the uncertain economy. Michigan is doing so to account for the state’s shrinking auto industry. Others have increased the frequency of their estimates, especially during downturns, to respond quickly to sudden swings.

•    Many states have taken steps to limit lawmakers’ attempts, especially in election years, to present an unrealistically optimistic view of revenues. Connecticut, for example, 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 forecast.

•    Fiscal tools such as rainy day funds, limiting reliance on certain highly volatile taxes and capping spending below expected revenues are other options policymakers may wish to consider to make state budgets less vulnerable to economic downturns.

The 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.

Donald J. Boyd ([email protected]) is a senior fellow and Robert B. Ward ([email protected]) is deputy director at The Nelson A. Rockefeller Institute of Government.

Internet Info

“States’ Revenue Estimating: Cracks in the Crystal Ball,” The Nelson A. Rockefeller Institute of Government: http://www.budgetandtax-news.org/article/29585