July | August 2017

Forecasting future state tax revenues is difficult, yet state governments have no choice but to do so. How else will they know how much money will be coming in to state coffers?
State officials base their one- or two-year budgets on an estimate of how much money is available to spend, and that includes estimates about how much tax money they expect to see from income, sales and corporate taxes, as well as other revenue sources like lotteries. As is true in all areas of life, forecasting the future can be exceptionally hard. As a result, the process for revenue forecasting in states involves using the best economic information they can find.
States use economic forecasts from national economic forecasting groups and federal government sources like the Federal Reserve. They supplement that national economic information with the best data and information they can find about their region and state. Often, economics professors at universities are an important part of the process. For example, the state economist of Minnesota has for years held a joint appointment with the university there. Business leaders, with their pulse on the economy of the state and surrounding region, are also relied upon for informing the state revenue estimation process.
The processes by which states estimate the future tax revenue have evolved over the years and are based on economic data, rather than a choice made by political whims. State officials learned long ago they don’t want the revenue estimate based on wishful thinking, since the consequences are significant. If estimates are not met—states have to cut programs quickly or raise taxes.
State officials experienced that when the Great Recession hit in 2008–09. State forecasters had predicted a downturn, but not one as dramatic as what actually occurred. State revenue began crashing quickly. With less money coming in than predicted, state budgets immediately initiated significant cuts to almost all state programs. This explains why, for the most part, state revenue forecasts are usually very cautious, so when tax revenue rises or falls rapidly, the forecasts are less able to capture a quick change.
We’re seeing that now with the economy getting better; tax revenue is actually coming in higher than forecast in most states. Fortunately, when swings in the economy—and thus revenue—are less dramatic and volatile, forecasts tend to be more accurate.
How do states approach this difficult task of predicting the future? The official estimate of how much tax money will come in is, in most states, done as a “consensus forecast,” usually involving finance officials on both the executive and legislative side. This helps to avoid the executive and legislative branches from choosing opposing forecasts or ending up with wildly inaccurate forecasts.
With a consensus forecast, the two branches making budget decisions—the governor and legislators—can at least agree on how much they think will come in as tax revenue and then argue over how to spend the money, not how much is coming in. For example, in Louisiana the governor, Senate president, House speaker and a university expert meet as a revenue estimating conference and four times a year develop a forecast of revenue coming into the state.
Many states have somewhat similar processes in which elected officials and experts participate. Many states have elaborate processes for picking the revenue estimate. In Virginia, two advisory committees—one composed of economists and the other of business leaders—provide input into the revenue estimating process and the governor includes the forecast in the proposed budget.
During the legislative process, the estimate can be changed, but usually just based on new economic and tax data. In some states, like Missouri, a de facto consensus process exists even though a consensus forecast is not required by law.
Although movies on a sci-fi channel might suggest otherwise, truly knowing the future is impossible. State revenue forecasts can be wrong. They are most often wrong when the economy is quickly taking a turn for the worse or is improving rapidly, since such changes—and their magnitude—are harder to predict.