The Post-Pandemic Puzzle: Forecasting State Revenues Accurately
State revenue forecasting has always been a complex task. Given these challenges, state forecasters tend to underestimate rather than overestimate revenues to avoid potentially severe consequences of overestimation on state budgets and fiscal planning.
But the COVID-19 pandemic and its aftermath introduced unprecedented challenges for state fiscal planners. In a new report, I use state revenue forecasts, actual revenue collections, and a survey of state revenue forecasting officials to examine how state revenue forecasts fared during the pandemic and draw lessons for the future.
Revenue Forecast Errors
Forecast error is the difference between actual revenues and forecasted figures. A positive error indicates that actual revenue exceeded the forecast (an underestimate), while a negative error signifies that actual revenue fell short of the forecast (an overestimate).
Typically, recessions and their immediate aftermath exhibit revenue overestimation. But the post-COVID period saw massive underestimations (Figure 1). This was due to a combination of factors including extraordinary federal fiscal stimulus, heightened inflation, a robust stock market performance throughout 2021, a surge in initial public offerings, and changes in consumer behavior.
The Pandemic’s Impact on Revenue Forecasting Accuracy
Revenue forecasting is inherently complicated. My survey of state forecasts suggests it became even more challenging with the COVID-19 pandemic because of:
- Economic volatility: Rapid changes in economic conditions can significantly impact tax revenues.
- Policy changes: Federal and state policy shifts can alter revenue forecasts unexpectedly.
- Technological disruption: E-commerce and other innovations are reshaping the economic landscape.
- Changing consumer behavior: Shifts in spending patterns affect sales tax revenues.
- Demographic trends: An aging population, declining birth rates, and migration patterns influence the tax base.
- Market volatility: Fluctuations in stock and energy markets impact state revenues.
- External shocks: Geopolitical crises, health emergencies, and natural disasters create uncertainty.
- Political dynamics: Federal and state leadership changes can affect economic perceptions and behaviors.
- Seasonal factors: Both regular and irregular seasonality through any given year complicate forecasting efforts.
Furthermore, large forecast errors in economic indicators, such as GDP growth and unemployment rates, muddied state revenue forecasts. As a result, state revenue forecast errors were also unusually large during the post-pandemic period.
The Challenge of Volatile Revenue Sources
Certain revenue sources are particularly difficult to forecast accurately. Corporate income taxes showed the highest volatility and largest forecast errors from 2013 to 2023, while capital gains and severance taxes were also major sources of revenue forecast error. This was particularly true for states with high reliance on personal income taxes from high-income earners and for resource-rich states dependent on severance taxes tied to commodity prices like oil and gas.
States can solve the post-pandemic forecasting puzzle
Accurate revenue forecasting is essential for effective fiscal planning and policymaking. My research suggests states can improve their forecasting accuracy and better manage fiscal risks by implementing more sophisticated, adaptable, collaborative, and transparent forecasting practices as described below.
Enhance forecasting models and methods:
- Incorporate a broader range of indicators, including state-specific factors like demographic shifts and industry trends.
- Leverage advanced forecasting methods, including artificial intelligence.
- Update revenue forecasts regularly, at least semi-annually.
Enhance collaborative decision-making:
- Depoliticize the revenue forecasting process.
- Adopt or strengthen consensus forecasting practices involving both executive and legislative branches.
Improve transparency and stakeholder engagement:
- Make forecasting processes more transparent by publishing detailed information on methodologies and data sources.
- Engage a diverse group of stakeholders in the forecasting process.
Adapt to structural and policy-related challenges:
- Review and adjust tax structures to create more stable revenue streams.
- Diversify revenue sources, especially for states heavily reliant on volatile taxes.
- Prepare for demographic and technological changes.
Strengthen fiscal reserves and manage revenue volatility:
- Maintain robust rainy day funds to cushion against revenue shortfalls.
- Establish clear rules for fund deposits and withdrawals linked to revenue volatility.
Above all, navigating the post-pandemic economic landscape requires states to be adaptable to changing conditions. Revenue forecasting will always be challenging given ongoing economic uncertainties, demographic shifts, and technological changes. But states can learn from their pandemic-era experiences and build more resilient fiscal systems for the future.
