Vlatility and Revenue Frecast Errrs Vlatility and Revenue Frecast Errrs Last mnth, the Pew Center n the States tgether with the Rckefeller lnstitute f Gvernment issued a reprt n trends in revenue frecasting, in which Oregn and its kicker law played a central rle ("States' Revenue Estimating: Cracks in the Crystal Ball": http://rvrvw.pewtrusts.rg/unladedfiles/wwwpewtrustsrglreprts/state plicv/st ates Revenue Estimating.ndn. Despite several references t ur state, it wuld be dangerus t base any plicy prescriptins fr Oregn's tax structure r frecasting prcesses n the study results, given the reprt's cursry nature. The study des very little t cntrlfr differences in state ecnmies r revenue systems when cmparing frecast methds and errrs. In particula ri "T exmine the methds in greater detil, we wuld need mre cmplete data n them, and we wuld need t cntrl fr the vltility f the revenue stream". This statement frm the study des nt g nearly far enugh. In rder t have a meaningful discussin f frecast errrs at all, ne wuld need t cntrl fr bth the size f a given state's revenue stream (as Pew des), as well as hw much its revenues bunce arund frm year t year. The size f the target, and the degree t which the target mves arund, are bth primary determinants f frecast errrs. The Pew study asserts that revenues have becme mre vlatile ver time, and frecast errrs mre prnunced, in part because states have becme mre dependent n taxes derived frm vlatile nnwage surces f incme such as capital gains. Althugh this is a key finding f the study, n quantitative analysis f revenue vlatility is presented. Instead, the authrs include a nte n revenue vlatility as the last f seven caveats abut the limits f the study befre stating: "Given these limitatins... we re unable t reliably cmpqre r rank ne stte against nther. Rather, this analysis is intended as n explrtin f brad trends in revenue estimting". Having issued this disclaimer, the authrs prceed t shw a table with interstate cmparisns f revenue frecasting errrs, and tie the data t a series f recent anecdtes abut the successes and failures f the frecasting methds emplyed by individual state budget fficers. It nly takes a quick lk at the estimates f frecast errrs prduced in the study t cnfirm that vlatility f revenue streams is a majr determinant f interstate REVENUE & TRANSPORATION INTERIM COMMITTEE DECEMBER 8-9, 2011 December 8, Exhibit z
differences in frecast accuracy. All f the states fr which the median abslute percentage frecast errr was fund t be ver 3/ in the Pe{Rckefeller study have revenue streams that are far mre vlatile than that f the typical state. Fr example, majr revenue streams bunce arund twice as much in Califrnia and Oregn as they d in New Yrk and lllinis. 910 14 5 612 II J 5 10 r8? -/A 'E IE '54?t F2!t g.s0 a Less than 1/ 1/ t 2/ 2/ t 3% Median P e Frecast Errr" Over 3/ Surces: Sfafes'Revenue Estimatirry; Cracks in the Crystalfull, Pew/Rckefeller. Census Bureau Surces f Vlatility Lking at the vlatility f revenue streams acrss states highlights tw primary causes f the fluctuatins: 1) the severity f ecnmic cycles and 2) expsure t incme taies.
s f l- L ul {:, (s L. lt +, I J 6.cl F-.g tt = 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 OMA VT }MT NV.lD NM *' '.b1-:;" Jlqi'f K.., CT A 57 Standard Deviatin f Revenue Grwth O^'.,R -'-'+ AK (64.2, 10.5) 11 Surces: "Sfafes' Revenue Estimating: Cracks in the Crystal Balf, PedRckefeller. Gensus Bureau Many f the states where majr revenue streams display the least vlatility (and the smallest frecast errrs) are farm states r ld-line manufacturing hubs in the Plains r Midwest regins (la, ll, ln, MN, MO, NE, OH, SD & Wl). These reginal ecnmies have seen less prnunced recent business cycles than has the typical state since these areas have had relatively less expsure t recent macrecnmic imbalances (e.g. the technlgy, husing and energy bms). Similarly, traditinal ecnmies in the rural Suth (AL, AR, GA, KY, M5, NC & TN) have als seen smaller revenue swings than has the average state. In additin t the severity f ecnmic cycles, the structure f the tax system als plays a rle in the vlatility f revenue streams. lncme tax-dependent states are ften amng thse with the mst vlatile and hard-t-predict revenue streams (CA, CT, MA & OR), as are states that depend heavily n energy and mining industries (AK, LA, MT, ND, NM, OK & WY). The unique tax systems f NV and DE als display a lt f vlatility, hwever, their revenue frecast errrs are nt captured well by the Pew study's
methdlgy, which fcuses n the big three revenue surces fr states (i.e. sales, persnal incme and crprate incme taxes). ln additin t the rle f vlatility, states with biennial budgets are als likely t see relatively large frecast errrs given their lnger frecast hrizn. This appears t be supprted by the Pew errr estimates. After adjusting fr vlatility, amng the nine states with biennial budgets and legislatures, nly Wiscnsin and Maine exhibit belw average frecast errrs. What Can We D Abut Vlatility? Vlatility f revenue streams increases uncertainty and leads t frecast errrs. ln a wrld where balanced budget requirements have teeth, frecast errrs ften lead t inefficiencies in the level f prgram funding. Oregn's plicymakers have been made painfully aware f the real wrld csts assciated with the state's vlatile ecnmy and revenue streams. As a result, a wide range f plicy measures are being prmted t better manage this vlatility, including the expansin f ending balances and ther budget reserves, lng-range budgeting, and kicker refrm. In additin t better managing budgets in light f large revenue swings, vlatility can als be reduced via refrms t the tax cde that diversiry the revenue base r shift tax burdens t mre stable elements f the ecnmy. Hwever, reducing vlatility and related frecasting errrs are nt the nly factrs that plicymakers must cnsider when designing revenue systems and frecasting prcesses. In particular, state plicymakers must weigh bth risk and return when determining their tax structures. Shuld Alaska scrap its il-related revenues simply because they are very vlatile and difficult t predict? A central bservatin in the PewlRckefeller study is that revenue vlatility and revenue frecasting errrs have increased ver time as taxes have becme mre sensitive t business cycle cnditins. lt is asserted that revenues have becme mre clsely linked t asset markets, crprate prfits and ther cmpnents f ecnrnic activity that are ften subject t wide cyclical swings. Why has this transfrmatin ccurred? Expsure f revenue systems t vlatile cmpnents f the ecnmy has risen largely because these vlatile cmpnents f the ecnmy have grwn faster than ther parts f the ecnmy in the average year. This
trend willcntinue ging frward. As the baby-bm ppulatin chrt ages, many wrkers will leave the labr market, putting dwnward pressure n taxable earnings. Als, husehlds will make fewer purchases f auts, hme furnishings and the ther big-ticket gds that drive sales tax cllectins. Overall ecnmic grwth will be led by trade, business investment, and the drawing dwn f retiree wealth. This is a departure frm recent business cycles that have been led by gains in cnsumer spending and the size f the labr frce. This evlutin cmplicates the debate n tax refrm. As the nature f ecnmic grwth changes, taxes n the riskiest cmpnents f the ecnmy such as prfits and capital gains are likely t cntinue t yield the highest returns. Further cmplicating any tax refrm is the fact that Oregn's ecnmy is an pen ne, and tax rates must be set with an eye tward the tax systems f ther states. Oregn is in cmpetitin with ther states t attract and retain mbile husehlds and firms. lf taxes n rapidly expanding elements f the ecnmy are set t high, the state risks biting the hand that feeds it. Oregn's plicymakers face a difficult, but necessary, task as they refrm their revenue system and budgeting prcesses t better weather cyclical dwnturns and t reflect the evlutin f the reginal ecnmy ver the extended hrizn. T succeed at this task, plicymakers must rigrusly analyze the effectiveness, efficiency and fairness f Oregn's tax instruments, and nt base their decisins n simple measures and statistics that are geared t grab headlines, such as thse cntained in the Pew/Rckefeller reprt.