Revenue Estimates: A Critical Step in the Budget Process

By John Hicks posted 19 days ago

  

Budget offices in 33 states are preparing their fiscal year 2021 governor’s budget recommendations for consideration during the upcoming 2020 state legislative sessions (the other 17 states already enacted their 2021 budgets through a biennial budget process). Three states with biennial budgets are also preparing their fiscal year 2022 budgets. One overriding constraint on those budgets is the amount of revenues available to cover the spending decisions.

For state budgets, better revenue conditions have finally arrived over the past two fiscal years – after two previous fiscal years of muted growth in tax receipts. Many states ended fiscal year 2018 and 2019 with unexpected revenue surpluses.

A reasonably accurate process of coming up with the revenue estimates upon which budgets are based is critical to reaching agreement between the governor and legislature and fiscal stability. But in a time when many economists believe that an economic downturn is on the horizon, overexuberant revenue estimates can lead to shortfalls in the dollars necessary to pay for promised services. States have incorporated various structures to ensure an empirical, rational process of setting revenue estimates.

All forecasts will have some error. There is simply no known way to guarantee perfectly accurate estimates. But, revenue estimates for budgeting purposes have to be a “point estimate”, usually with an equal probability of underestimation and overestimation. The conclusion may come from a range of estimates, but budget decision-makers must have a single number to work toward. Governors and legislatures both understand that the consequences of an overestimate are more severe than an underestimate. A handful of states have chosen to make appropriations that are less than the total revenue estimate to provide a cushion for an overestimate.

State Variations of the Responsibility of Setting Revenue Estimates

In about half of the states the job of determining a revenue estimate is assigned to a consensus revenue estimating group, where the estimate is usually adhered to by both the governor and the legislature. Only six of those states have political actors as members of the group, the governor or legislators. About one-fourth of states grant the sole authority to set the revenue estimate to an executive branch actor, while another fourth of states work with competing revenue forecasts between the executive and legislative branches.

The consensus approach is defined as the participation and acceptance by the two main political budget actors of a revenue estimate, the governor and the legislature. A consensus estimating entity includes members from both the executive and legislative branches (elected members or assigned staff) or members appointed by both branches. In addition, the process often involves other experts, such as a council of economic advisers, to agree on the state’s underlying economic assumptions. 

There is one event that can be as troublesome as an inaccurate estimate, and that is when there is disagreement between the executive and legislative branches on a revenue estimate. A disagreement on the revenue estimate adds to the already difficult set of spending tradeoff decisions and can further complicate getting to final budget agreement.

Revenue Forecast Accuracy

Reviews of revenue estimate accuracy studies have concluded there is very little relationship between the use of consensus estimating and forecast accuracy. The reasons often cited as the primary factors for errors include unexpected recessions, economies which are based on a slim number of industries, revenue volatility, and tax types (property taxes, for example are far more predictable than income taxes). These conditions exist no matter the type of revenue estimating group. NASBO’s Spring 2019 Fiscal Survey of States reported that over the last eight years, post-Great recession, revenue estimating errors in excess of one-half percent have occurred 107 times, or an average of about 13 states per year. While one-half percent may seem small, it can lead to a budget gap of millions of dollars. During the two fiscal years of 2016 and 2017, half of the states had revenue shortfalls in excess of one-half percent.

Vigilance and Continuous Monitoring

States keep a close eye on revenue estimates throughout the budget development and budget execution processes. Most states update their revenue estimates during the legislative session after the governor has submitted the budget and make modifications based on any legislative changes to tax and revenue policy. States also track actual revenue collections closely 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 time to prepare budget balancing responses.

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