Testing the Rationality of State Revenue Forecasts

Abstract

Recent revenue shortfalls in several states focus attention on the question of whether states do a good job of forecasting revenues. In modem economics, forecasts are eval- uated on the basis of whether or not they are rational-do the forecasts optimally incorporate all available information? This paper develops a method for testing the rationality of state revenue forecasts, and applies it to the analysis of data from New Jersey, Massachusetts, and Maryland. One of our main findings is that in all three states, the forecasts of own revenues are systematically biased downward. tN 1985, the 50 states raised $349 billion in revenues from their own sources, and received $84 billion in grants from the federal government. (U.S. Bureau of the Census (1987, p. 266).) State governments are clearly important players in the U.S. system of public finance, and the efficiency with .which they conduct their financial affairs has an important impact on consumer welfare. One important determinant of a state's ability to con- duct reasonable fiscal policies is the quality of its revenue forecasts. Sensible deliberations about ex- penditures cannot be made in the absence of good forecasts. Indeed, in the presence of con- stitutional or statutory provisions for balanced budgets, unanticipated changes in revenues can wreak havoc not only on proposals that are sched- uled for funding, but on plans that have already been put into effect as well. In recent months, two powerful governors, Michael Dukakis of Massachusetts and Mario Cuomo of New York, have suffered major politi- cal embarrassments because actual revenues fell substantially short of the predictions in their re- spective states. Such episodes focus attention on the question of whether states do a good job of forecasting revenues. In modem economics, fore- casts are evaluated on the basis of whether or not they are rational-do the forecasts optimally incorporate all information that is available at the time they are made? Although there is a large literature on state revenue forecasting methods, that literature focuses mostly on state budgetary institutions. Forecasts themselves are evaluated only in an informal fashion.1 Although the theory and econometric methods of rational expectations have been used to evaluate forecasts made by households and businesses,2 these powerful tools have not been applied to state government fore- casts. This paper applies these methods to the problem of state revenue forecasting, and as an example, uses them to analyze data from New Jersey, Massachusetts, and Maryland. The results cast light not only on the question of rationality per se, but on issues such as the impact of political factors on forecasts. Section II presents the conceptual framework for testing rational expectations. The relevant in- stitutional issues and data are described in section III. The results are discussed in section IV. We find that in all three states forecasts of own rev- enues are systematically biased downward. Section V concludes with a summary.