SOURCES OF ERROR IN STATE REVENUE FORECASTS OR
HOW CAN THE FORECAST POSSIBLY BE SO FAR OFF
Thomas F. Stinson*
ABSTRACT. Recently state and federal revenues have fallen well short of
projections. While revenues normally turn down in a recession, current revenue
shortfalls have been much greater than would have been expected given how
mild the 2001 recession turned out to be. This paper examines some of the
reasons for the large forecast variances observed in recent years using specific
examples from forecasts made for the state of Minnesota. Key factors identified
include inaccurate forecast for U.S. economic growth, inadequate, untimely and
inaccurate data; imperfect models; and unrecognized changes in the structure of
the economy. These factors came together and reinforced each other, ultimately
producing a larger reduction in state revenues than could have been anticipated
in advance.
INTRODUCTION
On December 4, 2002, Minnesota’s Department of Finance
announced the state faced a $4.5 billion budget deficit. The $300 million
deficit forecast for the 2002-03 biennium would have to be resolved
quickly since Minnesota’s constitution prohibits borrowing across
biennia for operating expenditures and less than 9 months remained
before the biennium closed. But, the outlook for the 2004-05 biennium
posed a more serious problem. There, a $4.2 billion gap between
revenues and current law expenditures was now projected (Minnesota
Department of Finance, 2002c, p. 1).1 A sizeable budget deficit had been
widely anticipated, but few expected the projected shortfall would reach
an amount equal to more than $900 per Minnesota resident.
-------------------* Thomas F. Stinson, Ph.D., is an Associate Professor, Department of Applied
Economics, University of Minnesota. Since 1987 he has also served as the
Minnesota state economist where his duties include supervising preparation of
the state’s revenue forecast.
Minnesota was not alone in facing fiscal problems. Ray Schapack,
executive director of the National Governor’s Association characterized
the financial situation facing state government as the most severe since
World War II. Somehow state revenues had not only failed to meet
expectations, they had declined dramatically. The drop in revenue was
particularly hard to accept and deal with because the shortfall had
occurred following a period of what seemed like almost magical revenue
growth. State policy makers had grown used to finding substantial
surpluses each time the budget outlook was updated. Some efforts had
been made to build up reserves and rainy day funds, and some money
had been put away in “hidden reserves” to provide flexibility for dealing
with an economic slowdown that was becoming evident. But, no one
had prepared for budget problems of the magnitude that ultimately
appeared.
It is convenient to assume that state and federal revenue estimators
should have used more sophisticated forecasting techniques, and that,
had more complex modeling approaches been used, the eventual
shortfalls would have been more modest. And, it is true that alternative
approaches to revenue forecasting might have produced some marginal
reduction in projected shortfalls. But it is unlikely that substantial
shortfalls could have been avoided. Revenue forecasting models used in
most states are quite sophisticated and much of the error in forecast
comes from institutional factors outside the control of the forecaster and
unrelated to the sophistication of the forecasting models used.
Each state, of course, had different experiences and the sources of
their budget problems were not all the same. Still, the forecasts of most
states, and of the federal government, were adversely affected by many
of the same forces, and understanding them will help policymakers better
understand the need for risk management strategies including reserves
and longer-term structural balance. Recent revenue shortfalls are a notso-gentle reminder that the economy is continuously changing, and that
even the best economic forecasting models have great difficulty
forecasting turning points or changes in regime.
This paper describes sources of the budget deficit projected in
Minnesota for the 2004-05 biennium. It begins with a short discussion of
Minnesota’s forecast process. Then the evolution of the 2004-05 budget
outlook is traced, beginning with legislative decisions made in June
2001. Key factors contributing to the widening gap between forecast and
actual receipts are described in some detail. Those factors include the
overly optimistic forecasts of economic growth and stock market growth
provided by the state’s national forecasting service; inadequate, untimely
and inaccurate data; imperfect models; and unrecognized changes in the
structure of the economy. Each played a substantial role in Minnesota’s
revenue shortfall. And like the “perfect storm” when these factors joined
together they reinforced each other, ultimately producing a change in
state revenues that was much larger than could possibly have been
anticipated.
FORECASTING AND BUDGETING IN MINNESOTA
Minnesota is a biennial budget state with general fund expenditures
totaling about $27 billion in the 2002-03 biennium (Minnesota
Department of Finance, 2003, p. 66). Budgets are prepared on a
biennial basis, and the Finance Department produces official planning
estimates for the following biennium as well. Those planning estimates,
while not legally binding, provide budget discipline, helping to forestall
passage of programs with minimal costs in the current biennium, but
with budget busting potential in following years. Although there is no
explicit requirement that the budget be balanced in the out-years it is
generally accepted that structural balance, defined as revenues equal to
or exceeding on-going expenditures in the final year of the out-biennium,
is consistent with good financial practice.
Revenue and expenditure forecasts are prepared twice yearly, in
November and February.2 The November forecast in even numbered
years is the basis for the governor’s biennial budget. The forecast
released the following February updates the revenue outlook,
establishing the current law deficit or shortfall against which proposed
future spending and tax changes are measured, and triggering budget
action in the legislature. Forecasts the following November and
February update the outlook, indicating whether there is likely to be a
surplus or deficit at the end of the current biennium.
The forecast prepared by the state’s Department of Finance is the
basis for Minnesota’s general fund budget. The state does not have a
consensus forecast process, there is no forecast council that passes on the
final revenue estimates, and no competing forecasts are prepared by
legislative staff. By law forecast results must be made public at the time
they are revealed to the Governor. The state’s forecasts have the
reputation of being professional and independent from political
considerations. To help insulate the forecast from political pressures the
state’s Finance Department contracts with the University of Minnesota
for half time of a tenured faculty member to supervise the forecast’s
preparation. The four-person revenue forecasting staff is very
experienced, averaging more than 20 years of forecasting experience. In
2000, Minnesota held AAA bond ratings from all three rating services.
Today, despite its recent financial problems, Minnesota retains AAA
ratings from two rating agencies and is rated AA1 by the third.
The income and sales taxes are the largest sources of revenue,
generating 43 percent and 30 percent of general fund revenues
respectively. The corporate franchise tax and a statewide property tax on
commercial, industrial, and seasonal recreational property and the motor
vehicle sales tax provide less than 5 percent each. Other revenue
sources, including revenue from the state’s tobacco settlement made up
about 16 percent of Minnesota’s general fund revenues (Minnesota
Department of Finance, 2003, p.37).
Minnesota’s income tax uses federal taxable income as its base.
Capital gains are taxed at the same rate as ordinary income; they receive
no special treatment. In 2000, wages were more than 71 percent of
federal adjusted gross income (FAGI) for Minnesota taxpayers (see
Table 1). Capital gains were 7.8 percent of FAGI in 2000. Minnesota
applies a sales tax at a rate of 6.5 percent to purchases of household and
business items. Major items excluded from the sales tax base include
food, clothing, and prescription drugs. Purchases of business capital
equipment are subject to tax, but eligible for a sales tax refund. The
narrow coverage of the sales tax makes receipts more volatile than those
from broader based sales taxes levied in a number of states.
TABLE 1
Components of Minnesota Adjusted Gross Income, Tax Years 2000,
2001
2000
FAGI
Wages
Interest/Dividend
Business
Capital Gain
Pensions/IRA
Taxable Income
120.028
85.588
5.737
3.602
9.403
7.530
84.932
% of
FAGI
71.3
4.8
3.0
7.8
6.3
70.8
2001
116.938
88.096
5.097
3.573
4.502
7.739
80.616
Source: Statistics of Income Bulletin (2002; 2003).
% of
FAGI
75.3
4.4
3.1
3.8
6.6
68.9
%
Change
-2.5
2.9
-11.2
-0.8
-52.1
2.8
-5.1
THE EVOLUTION OF THE 2004-05 DEFICIT
The Prelude, 2000-2001
When the Finance Department released its preliminary forecast of
revenues and expenditures for fiscal 2002-03 and its first planning
estimates for FY 2004-05 the state had an embarrassment of riches. An
ending balance of $924 million was projected for the end of the current
(2000-01) biennium. State law required that balance be rebated to
taxpayers. (Minnesota Department of Finance, 2000, p. 1) A balance of
nearly $2.1 billion (in addition to the $924 million projected for fiscal
2001) was projected for the 2002-03 biennium, and the first planning
estimates for the 2004-05 biennium showed total revenues of nearly
$31.3 billion, with a structural balance of $1.5 billion in fiscal 2005.
The forecast report contained a note of caution, however. It warned
that “After several years of forecasts more cautious than most, (the
state’s national forecasting service’s) new national model projects
stronger than consensus growth through 2003”(Minnesota Department of
Finance, 2000, p. 5). The baseline forecast for the current year called for
national real GDP growth of 3.6 percent, only modestly stronger than the
3.4 percent growth anticipated by the November’s Blue Chip Consensus.
In future years, though, the gap was larger. Minnesota’s national
forecasting service expected the U.S. economy to grow at a real rate of
4.3 percent in 2002 and 4.8 percent in 2003. Those growth rates were
well above the Blue Chip panel’s, 3.3 percent and 3.2 percent (p. 5). The
Congressional Budget Office (2001) forecast, released the following
January, was built on real growth rates of 3.4 percent and 3.1 percent for
2002 and 2003.
Because forecasting services are generally believed to be hesitant to
forecast the start of a recession and because even good forecasting
models can occasionally produce projections that are decidedly too
optimistic (or too pessimistic) Minnesota’s Finance Department uses a
panel of local economists to help assess whether the national forecast
provided by the state’s forecasting service is reasonable.3 That Council
of Economic Advisors’ review, which is summarized in each forecast
report, noted that “for the first time since February, 1995, the Council
formally considered replacing the (national baseline) forecast with a
more conservative forecast.” But, “after a lengthy discussion a majority
of the Council recommended that the Department of Finance base its
November revenue forecast on the (national baseline forecast provided
by the contractor)” (Minnesota Department of Finance, 2000, p. 14) The
summary of the Council meeting was filled with cautions noting that “the
optimistic nature of this forecast greatly increases the risk that revenues
will fall short of forecast at some point during the 2002-03 biennium”
(November Forecast, 2000, p. 15).
Three months later, when the February 2001 revenue forecast was
released, economic conditions had deteriorated slightly, but only slightly.
The forecast service’s U.S. baseline had been cut back modestly, Council
members while in general agreement about the outlook for 2001 were
again less optimistic than the forecast service for 2002 and 2003. The
state’s national economic consultant saw additional risk, raising the
probability of an early recession to 40 percent from November’s
probability of 25 percent (Minnesota Department of Finance, 2001a, p.
1). Projected real GDP growth rates for 2001 and 2002 had been
reduced, but the baseline forecast still anticipated 4.8 percent growth in
2003. The inflation outlook remained low, with the consumer price
index projected to grow at just a 1.8 percent rate in 2002 and a 1.6
percent rate in 2003 (Minnesota Department of Finance, 2001a, p. 56).
The nominal (current dollar) growth rate used in the forecast for 2002
was 6.4 percent, still noticeably above the 5.1 percent CBO amount used
by CBO.
The Council requested Finance Department economists construct and
run several alternative national scenarios that assumed slower
productivity growth rates in 2002 and 2003. Real growth rates slowed,
but nominal (current dollar) growth rates changed little. Since Council
members typically expected higher inflation than the forecasting service
projected, and since revenue forecasts are driven by nominal growth
rates, the lower inflation rate provided a slight conservative offset to the
more optimistic real growth rate projection. Following another extended
discussion among Council members, it was agreed to use the U.S.
forecast provided by the forecasting service as the foundation for the
state’s February revenue forecast (Minnesota Department of Finance,
2001a, p. 10).
When completed, the February 2001 forecast showed the expected
ending balance for the 2000-01 biennium had fallen by $67 million, to
$856 million (Minnesota Department of Finance, 2001a, p. 1). The
projected surplus for fiscal 2002-03 had shrunk by nearly $600 million,
to $1.5 billion, but remained nearly 5 percent of the existing budget. The
2005 the structural balance had fallen only slightly to $1.4 billion.
Legislative deadlock over how much of the projected 2002-03
surplus should go for tax cuts and how much for increased spending
forced a special legislative session in June 2001. By the time the special
session was convened, the weakening of the national economy was
visible and state revenues were under-performing the forecast. The
Finance Commissioner and the state economist held a press conference
to warn that the economy appeared weaker than projected and that state
revenues were unlikely to meet February’s forecast. The official forecast
remained in place, but the legislature acceded to the Governor Ventura’s
demand that additional funds be added to the reserve. As further
insurance against lower revenues, an ending balance of $253 million was
left at the end of the biennium. Other actions taken to improve future
financial flexibility included both recognizing and paying for some
future costs and buying back some shifts in payment timing that had been
made in prior years. (Minnesota Department of Finance, 2001c)
At the end of the 2001 special legislative session, Minnesota policy
makers had reason to believe that they had positioned the state’s finances
well for a weakening economy. Revenues would likely be below
forecast when the next forecast was released in November, but the state
had reserves of $1 billion, and a structural balance of $242 million in
fiscal 2005. Events to follow, though, would soon make apparent that
the coming problem would dwarf those attempts to provide for financial
stability.
The Shock --The Economic Aftermath of September 11
On September 11, 2001, everything changed. Admittedly, the
economic outlook had deteriorated markedly before the terrorist attack.
The September U.S. baseline forecast was substantially below that used
to drive February’s revenue forecast. But, by October the outlook was
for a recession in 2001 and no real GDP growth in fiscal 2002
(Minnesota Department of Finance, 2001b). The economy was expected
to recover in fiscal 2003, but the 3.6 percent growth rate now projected
while historically healthy was well below the 4.7 percent growth
assumed when February’s revenue forecast was prepared. And, that
growth would come from a lower base level of economic activity.
Minnesota’s receipts during the first quarter of fiscal 2002 were equally
troubling. Revenues were down $100 million (3.5 percent) from
forecast. Large declines in the individual income tax – off $70 million
(5 percent)-- and the corporate franchise tax – off $47 million (24
percent) were only partially offset by smaller than expected tax rebate
payments and increased miscellaneous revenues.
November’s forecast provided a more complete picture of the grim
news. For the 2002-03 biennium the projected $253 million balance at
the end of the legislative session had disappeared and the Finance
Department now was now projecting a biennial budget deficit of nearly
$2 billion dollars (Minnesota Department of Finance, 2001c). And, as
would be expected, the outlook for the 2004-05 biennium was equally
dreadful with a deficit of more than $2.5 billion projected. The $242
million structural balance for fiscal 2005 was no more. In its place was a
structural deficit of $1.234 billion.
Many hoped February’s revenue forecast would bring better news,
but it did not. The projected deficit for 2002-03 grew by more than $300
million to nearly $2.3 billion, and the planning estimates for the 2004-05
biennium showed a projected shortfall of $3.2 billion (Minnesota
Department of Finance, 2002a). The outlook for the U.S. economy had
improved slightly from November to February, but revenues were even
failing to keep pace with the lower projections made in November. Net
non-dedicated revenues were now expected to be down $2.4 billion,
almost 9 percent below levels forecast a year earlier, after adjusting for
legislative action.
Legislative Action – A Solution for FY 2002-03, But FY 2004-05 Left
Unresolved
The Governor submitted a set of revised budget recommendations
that balanced the 2002-03 budget and made a start toward addressing the
emerging, longer-term structural budget problem, but his
recommendations were too austere to receive legislative approval in an
election year. Instead, the legislature quickly approved a set of shortterm measures including drawing down the state’s budget reserve and
shifting some payments to the next fiscal year to solve the projected
deficit for the current biennium. Some of those actions reduced
projected expenditures slightly for 2004 and 2005 as well, but most
changes affected only the current biennium. The Governor vetoed that
measure, the legislature overrode the veto, and the legislative session
ended with a projected ending budget balance of zero for the 2002-03
biennium, and an official budget shortfall for the 2004-05 biennium of
$1.65 billion (Minnesota Department of Finance, 2002c).
The official projected shortfall for 2004-05 was substantially lower
than had been projected in February’s planning estimates. But, the
decline was not due to an improvement in the economic outlook or
ongoing spending reductions. Instead, it reflected a new law prohibiting
the Finance Department from adjusting expenditure estimates in the outyears for inflation, except where specifically required by law (Minnesota
Department of Finance, 2002c). If expenditures had been fully adjusted
for inflation the projected shortfall would have been in excess of $2.1
billion.
Over the summer of 2002, the economic and revenue outlook
continued to worsen. The Finance Department (2002b) noted that while
total revenues were currently on forecast for 2002-03, there were some
very troubling signs. After analyzing data on tax year 2001 individual
income tax final payments and refunds (due April 15, 2002), tax year
2001 individual income tax liability appeared substantially less than had
been forecast. The lower final payments and refunds were reflected in
the fiscal year 2002 closing balance, but the longer-term impacts were
not. Lowering the base liability for the income tax affects not only the
year in which receipts were lower; it affects all future years as well, since
the base from which all future projections are made is lower as well. By
itself that lower base liability level for the individual income tax would
reduce expected revenues for the 2004-05 biennium by more than $800
million, bringing the expected deficit for the 2004-05 biennium to more
than $2.1 billion, with no inflation adjustment, even with no change in
the economic outlook. And, as noted in the Update, the short-term
economic outlook had also weakened.
The Finance Department’s November 2002 revenue and expenditure
forecast made clear to everyone the size of the state’s unresolved budget
problem. In the absence of legislative action Minnesota’s would have a
$4.56 billion deficit by the close of the 2005 fiscal year. In less than two
years the outlook for the 2004-2005 biennium had gone from one
showing a substantial surplus and a healthy structural balance in 2005, to
a situation where major changes would be necessary if the state’s
finances were to be put back in order.
SOURCES OF MINNESOTA’S $4.56 BILLION DEFICIT
Not all of Minnesota’s budget deficit came from lower than expected
revenues. Spending increases triggered by the weakened economy also
contributed.
November’s expenditure forecast projected biennial
spending at $30.975 billion; under current law with no inflation factored
in, the increase of $975 million from end-of-session estimates was 21
percent of the total projected budget deficit. While revenue shortfalls
were clearly the major source of the huge projected budget deficit,
expenditure projections had also been unduly optimistic. Even though
most state expenditures are limited to the amount appropriated, and thus
capped at a known level until the next budget is approved, entitlement
expenditures proved to be a major source of state budget instability.
These expenditures, primarily on health care and income maintenance,
tend to amplify state financial problems since caseloads increase
substantially when the economy weakens and revenues turn down.
Changes to the forecast for state health care costs for needy families
alone accounted for $541 million of Minnesota’s $4.5 billion projected
deficit for fiscal 2005-05 (Minnesota Department of Finance, 2002c).
Lower state revenues were the major cause of the projected deficit,
however. Projected individual income tax revenues for fiscal 2004-05
were down $1.333 billion from levels expected at the end of the 2002
legislative session, and total revenues were down $1.673 billion. More
dramatically, expected revenues for fiscal 2004 and 2005 had fallen by
more than $4.8 billion dollars, or more than15 percent from the level
anticipated when the 2001 legislature was making its budget plans.
Projected individual income tax revenues alone were down by $2.8
billion, and sales tax revenues by more than $1 billion. The United
States economy had entered a recession, there had been a terrorist attack,
and the United States was on the brink of war with Iraq. But, even given
those largely unforecastable events, the decline in state revenues seemed
surprisingly large and out of proportion to the shock to the national
economy. Several institutional factors contributed to the large revenue
shortfalls observed. Each is discussed in turn below.
Overly Optimistic Forecasts of U.S. Economic Growth.
State revenues vary with the outlook for the local economy, but each
state’s economic outlook depends heavily on the national economy’s
performance. Minnesota and many other states contract with national
forecasting firms for the national projections needed to drive their state
economic models.4 Relying on a national forecasting firm for the
national outlook has obvious benefits. It is cost efficient, providing
access to forecasts for a larger number of elements of the economy than
would be possible if an internally generated forecast were used. More
important though, use of a national forecasting firm lends credibility to
the revenue forecast since it ensures that key assumptions driving the
revenue forecast are based on outside professional judgement and not
local politics or decisions by state employees.
Minnesota’s first revenue projections for the 2004-05 biennium, the
out year revenue planning estimates, were prepared when economic
euphoria was at its peak. The economy’s performance had been
surprising even optimistic forecasters, with real GDP growing at an
average annual rate of 4.3 percent between 1996 and 1999. Late in 2000,
it appeared the economy was on track for a year of more than 5 percent
growth. That would make it the first time since the early 1960s that real
GDP growth rates had exceeded 4 percent for four consecutive years.
Unemployment was holding below 5 percent, and yet there were no
noticeable inflationary pressures. And, after a two decade long slump,
productivity was booming, hinting that further good economic news was
likely in the future. There was even media talk of a “new” economy in
which the business cycle was obsolete. Every forecaster was saying that
this was the best economy our generation would see. And, while no one
expected that the extremely strong economic growth would continue
forever, there were no obvious signs that it was quickly coming to an
end.
Now, with the benefit of hindsight, it is clear that the November
2000 national baseline forecast provided by Minnesota’s economic
consultant was far too optimistic. Projected real GDP growth rates for
2001, 2002, and particularly 2003, anticipated an economy that was
going to continue to grow at an extremely rapid pace for at least an
additional three years. The national economy was already in the longest
expansion in postwar U.S. history, and the forecast called for three more
years of extremely strong growth, without even a pause for consumers to
catch their breath. Real GDP in 2003 was projected to grow at an annual
rate of 4.8 percent, the strongest growth rate since 1984, and that was to
come after four years of four plus percent annual growth followed by the
already healthy 3.6 percent and 4.3 percent growth expected in 2001 and
2002. Those growth rates were well above the 2.5 percent growth rate
that most economists had previously thought possible on a sustainable
basis. Three years of stronger than expected productivity were beginning
to convince forecasters that economic growth rates in excess of the 2.5 to
3 percent range could be sustainable without triggering inflation, but
there was no reason to suspect that the economy’s sustainable real
growth rate had jumped to more than 4 percent, nor was there any pentup demand to drive GDP growth higher.
The national economic consulting firm serving Minnesota appears to
have bought in to the productivity turn-around story, and made
significant adjustments to their forecast in the second half of 2000. Their
longer term forecast contained growth rates nearly 50 percent higher than
had been projected just a few months earlier. And, for 2003, more than
24 months into the future, the November baseline called for growth at
nearly twice the rate that had been thought to be the maximum
sustainable rate just a few years earlier.
In the forecasting service’s defense, productivity had skyrocketed
and the economy had grown faster than anyone had thought possible
during the past few years. Still, as the state’s economic advisors and
Finance Department economists noted, even though it was not
impossible for the economy to continue to grow at an extremely strong
pace through 2003 and beyond, a slightly more conservative forecast for
two and three years in the future would not have been considered
pessimistic.
Inaccurate national economic forecasts are an easy target when one
is searching for reasons why revenue forecasts miss their mark.
Forecasters admit their failings, and no responsible forecaster will claim
that his model will successfully identify turning points in the economy.
One has only to look at the Wall Street Journal’s semi-annual listing of
their forecasting panel’s projections for economic growth during the
coming year to see the substantial differences in projections among
forecasters, and a quick review of the two-year history of the Blue Chip
panel’s consensus forecast illustrates how wide the swings in the general
outlook can be.5 Unfortunately, Minnesota’s first set of projections for
the 2004-05 biennium was produced at the time when forecasters were
feeling the most optimistic about the national economy’s future
prospects. By February 2001, the U.S. baseline forecast was slightly
more subdued, with projected real GDP growth rates of 2.1, 4.0, and 4.8
percent growth for 2001 through 2003 (Minnesota Department of
Finance, 2001a, p. 56). But that forecast was still overly optimistic and
by early September 2001 the economic outlook had weakened
sufficiently, Minnesota would have faced budget difficulties, even had
there been no terrorist attacks.
The actions taken during the 2001 special session to cushion the
state’s finances against potential revenue shortfalls might have been
sufficient to deal with the losses brought on revenue by the weakening
economy pre-September 11. But the revenue losses coming from
layering the terrorist attacks and subsequent events on top of an already
struggling economy overwhelmed Minnesota’s earlier efforts to provide
for the possibility of weaker than projected revenue growth.
Econometricians know that even well constructed economic
forecasting models have random errors that will lead to differences
between projected values and actual results. They also know that while
the mean forecast error of a particular model may be zero, in any
particular year the observed error can be substantial, and even the best
model can over-forecast or under-forecast for several years in a row. But
even with those caveats, the national economic forecasts provided clients
during late 2000 and early 2001 appear to have been overly optimistic,
particularly for 2002 and 2003. It appears national economic forecasters
all began to believe existing structural relationships in the economy,
particularly with respect to productivity, had changed dramatically, and
that that change would affect real GDP growth rates far into the future.
From the point of view of state revenue forecasts, a more circumspect set
of expectations about future growth would have been desirable.
The optimistic national economic forecasts were accompanied by
equally optimistic stock market forecasts. Everyone knows it is
impossible to consistently predict the stock market’s performance. But,
historical data on the stock market is often useful in constructing models
explaining economic activity and growth in many sectors of the
economy. Because their clients use stock market data in their own
internal forecasts, many national forecast services include a stock market
forecast with their economic forecast. In Minnesota the state’s model of
capital gains realizations makes use of a stock market forecast. And, as
noted earlier, capital gains realizations are an important part of taxable
income, so the stock market forecast affects the revenue forecast.
Through the late 1990s the stock market forecast of Minnesota’s
national economic consultant had been quite conservative. The valuation
model used did not come close to matching the performance of the
market during the late 1990s. We now know that the market peaked in
March of 2000, but in November 2000, it appears the forecasting service
had given up on their former stock market model. The S&P 500 stock
index was projected to average 2051 in 2005, up from 1457 in 2000. The
implied compound growth rate of just over 7 percent was not
unreasonable, had it not been coming from what now in retrospect is
surely a classic market bubble. Unfortunately the market bubble had
already begun to collapse and stock market gains were to be turned into
losses over the next three years. In late June, 2004 the S&P 500 index
stood at just over 1140, or about 78 percent of the level observed in
2000.
Forecasters know there will always be unexpected shocks that will
accelerate or slow economic growth temporarily. Because the number
and timing of those shocks are unknown, and because those shocks can
bring bad news as well as good news, revenue forecasters are
uncomfortable when the three to five year forecast calls for growth rates
averaging near the top of the sustainable range. Implicitly such forecasts
are building in all potential good news, and dismissing the possibility of
bad news for an extended period. Still, when a respected national
forecasting service is making those projections and there has been a
series of surpluses in the past, choosing to use lower projections is not
feasible without damaging the credibility of the revenue forecast. The
optimistic national forecast may come true, but should the economy
under perform projections early in the forecast horizon, relatively small
changes in the economic growth rates in year one or year two can easily
compound into large declines in projected revenues by year five. The
arithmetic is similar to the well-known effects of changes in base year
spending on future spending. More conservative forecasts for years four
and five can limit some of the damage done by a rosy scenario early in
the forecast horizon, but seldom can they fully offset the revenue losses
caused by an overly optimistic forecast for early years of the forecast
horizon.
Optimistic economic and stock market forecasts were major factors
in the change in the revenue outlook, but they are not the whole
explanation by any means. As recessions go, the recession of 2001 was
not particularly severe, and its impact on state revenues was far out of
proportion to the decline in the national economy. Revenue losses were
intensified by the substantial declines in the stock market (stock market
gains and losses are not included in GDP), but even with that taken into
account the revenue losses seem excessive. More conservative national
economic and stock market outlooks certainly would have reduced the
difference between forecast and actual receipts, but other factors
contributed to the revenue loss as well.
Inadequate, Untimely, Incomplete, and Inaccurate Data
Much of the responsibility for recent state and federal revenue
shortfalls should be assigned to the unduly optimistic national economic
projections underpinning the revenue forecasts. But, while it is easy to
criticize the results generated by forecasting models, the problems faced
by revenue forecasters go much deeper. Without good contemporaneous
data, not even the best model will yield timely, accurate forecasts. The
national economic data produced by U.S. statistical agencies is the best
and most complete in the world, but that data is still inadequate and
untimely. Eventually, after data has been released, revised, re- revised,
and benchmarked, a reasonably complete picture of what has gone on in
the economy is available. But, that refining process takes years. It is
important to have an accurate historical record of the economy’s
performance, but by the time good data is finally available the turning
point is long past and forecasters are searching for data releases for signs
of the next decline.
Individuals unfamiliar with the national income accounts may be
surprised by how much the official estimates of the economy for any
particular time period change. For example, in November 2000 when
Minnesota first prepared estimates for 2004-05 revenues, real GDP for
the recently completed the third quarter of 2000, was officially reported
to be $9.382 trillion, an increase of 2.7 percent at an annual rate over the
level observed in the second quarter of 2000. By February 2001 real
GDP for that same quarter had been revised to $9.369 trillion, a growth
of 2.2 percent at an annual rate over the second quarter. The June 2001
revisions showed even lower real GDP growth, just 1.3 percent. And
today, after benchmark revisions, real GDP in the third quarter of 2000 is
reported to have actually declined by 0.5 percent. Had forecasters
known in late 2000 that the economy not only had not grown at an
annual rate of 2.7 percent during the previous quarter, but actually
declined, their late 2000 and early 2001 forecasts would almost certainly
have been less optimistic.
Forecasters know they work with flawed data, and that future
revisions coming next month or next year may change their view of how
well the economy is faring. Policy makers and the public, however,
seldom appreciate how much the recent history upon which forecasts are
based can change. Because they lack that background, they are not fully
aware of the risk to the forecast.
Some data series are reported relatively quickly, but most economic
data are available only after lags of a month or more. Almost all key
series are subject to substantial and sizeable revisions, and the most
contemporaneous data is often, as would be suspected, the most heavily
revised. The data series relied on most heavily by short-term forecasters
is the monthly payroll employment report. This report offers an
important clue about the economy’s recent performance, and it is
available with less than a one-month lag. Unfortunately, that data is
revised twice more, often to a significant degree, before a final monthly
number is available. And, that final estimate is again only temporary,
since it is also readjusted in an annual benchmark revision.
Random revisions, while troubling, can be dealt with more easily by
forecasters and modelers than can systematic biases. Unfortunately,
revisions to the payroll employment estimates around turning points in
the economy are pro-cyclical. Because the original data are obtained
from a sample of existing firms, jobs created by new firms go uncounted
since by definition those firms are not in the survey’s sample frame.
That bias can easily be adjusted for when the economy is performing at
its normal rate, but when growth slows, the number of new firms creating
jobs also slows and when the economy booms, the number of new firms
surges as well. Calibrating a bias adjustment to various phases of the
economic cycle would be possible if it were known where in the cycle
we were, but since this data is the first indicator of how the economy is
performing, the bias adjustment often misses the mark and yield
misleading results.
The flawed bias adjustment means that when the economy is
weakening, initial estimates of payroll employment tend to overstate the
growth in the economy, and when the economy is showing signs of
strength, later revisions will add to the employment estimates. While the
biases in the data are known, they remain barriers to rapid recognition of
changes in the economy’s progress. For example, initial Department of
Labor reports showed payroll employment increasing slightly in each
month between February and July of 2002, reinforcing the general
impression that the economy was coming out of recession. Now the
official data shows a loss of employment in four of the first seven
months of 2002, with total payroll employment shrinking by 364,000
jobs. Forecasters using that set of information, rather than the
information available at the time, would almost certainly have been less
optimistic in their expectations for both 2002 and 2003.
Corporate profit estimates are another example of delayed and
inadequate data. Corporate profits affect revenues directly in most states
through the corporate profits tax. They also have an indirect impact by
shaping perceptions about the health of the national economy. Historical
data on before tax corporate profits are available in the national income
accounts with just over a one-quarter lag, but those estimates are subject
to substantial revisions.
Ultimately corporate profits can only be determined from tax filings,
and most firms file well after the close of the year in question. Estimated
tax bills are paid on a timely basis, but many corporations request and
receive extensions to the deadline for submitting the actual tax forms to
the IRS. This means that forms containing the data necessary to
establish corporate income and profits are not available to the IRS for 10
months or more after the close of the firm’s fiscal year. It is only after
two or more years that the national income accounts data on corporate
profits reflect actual corporate earnings. Again, at turning points in a
business cycle the differences between estimates and actual results can
be dramatic. In February 2001, before-tax corporate profits for 2000
were reported to be $929 billion, up 13 percent from 1999. Current
estimates are that corporate before-tax profits were $773 billion in 2000,
down 0.3 percent from 1999.
There are also important lags in the availability of state tax data,
particularly individual income tax data. Individual income tax forms are
due on April 15 of the year following the tax year under consideration.
Many taxpayers take advantage of provisions allowing an automatic
extension and delay filing until mid August.
Some taxpayers,
particularly those with large complicated returns, are allowed further
extensions. It is not until the end of the calendar year following the tax
year in question that the total tax liability for the prior year, as well as the
actual levels of wage income and other non-wage income can be
accurately estimated. Thus, in February of 2001, when the forecast
actually used for setting budgets for the 2002-03 biennium was made,
state income tax liability and the composition of taxable income for tax
year 2000 was unknown, and could not be known for almost another
year. For those sources of income that had been showing rapid growth,
such as capital gains and pension incomes, more current data would
certainly have been welcome and could conceivably have improved the
forecast. But the nature of income tax filing makes that impossible.
Imperfect Models
Forecasts come from econometric models, systems of statistically
estimated equations that describe economic relationships identified from
historical data. Those models then have to be driven with a set of
assumptions about future values for key variables. For national
economic forecasts those assumptions are part of a scenario specified by
the forecasting service. Each scenario typically includes assumptions
about items influencing the economy such as Federal Reserve policy,
global economic growth rates, federal budget activity, oil prices and the
underlying rate of productivity growth. State economic models typically
rely on the national economic projections provided by their forecasting
service for future values of needed variables, and state revenue models
use results from the state economic forecast.
Typically the standard error of an equation is used to measure the
variation of output, and results within two standard errors of the expected
value are seen to be within the range of the model. Obviously, the larger
the standard error, the larger the potential variation in results, so when
evaluating forecasting equations one seeks to have as small a standard
error as possible. Unfortunately, some components of the tax system
simply cannot be forecast with the same precision as other items. And,
some of the income types with large standard errors are important
components of the individual income tax base. Sometimes a large error
in one component of income can be cancelled by offsetting errors in
another source of income, but when errors are reinforcing and not
offsetting, large swings in projected revenues can occur. The better the
model, the more limited the likely range of outcomes, but even with
good, well specified models, actual results often differ substantially from
projections, particularly with sources of individual income and corporate
income tax receipts.
Capital gains – profits from the sales of assets – illustrate some of the
problems in modeling income tax receipts. Capital gains were an
important and growing item of income in the late 1990s, with net
realizations reaching $644 billion nationally in 2000, more than 250
percent above the 1995 level (Congressional Budget Office, 2004, p. 82).
In Minnesota growth had been similar and for tax year 2000 net taxable
capital gains realizations of Minnesota residents reached just over $9
billion (Minnesota Department of Finance, 2002c, p. 11).6
In February 2001 revenue forecasters did not know the level of
capital gains realizations for tax year 2000. The most recent data
available was for tax year 1999. From that base they would have to
make projections for capital gains realizations for the just completed tax
year 2000, as well as tax years 2001, 2002, and 2003. To produce that
forecast Minnesota analysts rely on a single equation model based on an
underlying assumption that there is a normal, desired relationship
between the level of unrealized capital gain and the total stock of capital
assets. That desired ratio of unrealized gains to household equity
holdings varies with changes in economic and tax policy variables.
Realizations in any single year are an attempt to re-establish that ratio,
although like other models of this form only part of the necessary
adjustment is done in any particular year.
The model has reasonable statistical characteristics and its results are
relatively robust, but there are some major problems.7 The model
requires a forecast of the total value of household holdings of corporate
equities in future years and, equally difficult, an estimate of the level of
unrealized capital gains. The combination of a relatively high standard
error for the estimating equation, and highly uncertain forecasts for the
driving variables creates a situation where there can easily be substantial
differences between actual and forecast revenues. Slightly different
models are used in other states, and by the Congressional Budget Office,
but all face similar problems.
Because economists lack both knowledge of the factors influencing
taxpayers’ decisions to realize gains and good data on the variables
affecting the realization decision, capital gains forecasts will continue to
be one of the most problematic portions of state and federal revenue
forecasts. And, because capital gains had been increasing as a share of
taxable income, revenue forecasts had become increasingly sensitive to
changes in the outlook for capital gains.
During the late 1990s the incredibly large growth in capital gains
realizations (45 percent in tax year 1996, 40 percent in 1997, 25 percent
in 1998 and 22 percent in 1999) was largely unanticipated. In Minnesota
that growth led to large surpluses, and led policy makers to expect future
surpluses. Even though conservative forecasting assumptions were used,
when stock market conditions changed, no one was ready for the sudden
drop in capital gains revenue that followed. Minnesota’s February 2001
forecast called for no growth in capital gains realizations in 2001. By
February 2002, taking advantage of a an additional year’s information
and the refitting of the model to just released revisions to the household
balance sheet as reported in the Federal Reserve’s Flow of Funds
Accounts, net realizations of capital gains were projected in Minnesota to
decline by more than 33 percent (Figure 1)
FIGURE 1
Minnesota Wage Growth: 1959-2003 [Please reduce the size of the
table to fit the size of the journal (L/R Margins = 2”]
Ann Pct Chg
4 Qtrs Apart
18
15
12
9
6
3
0
1959
1963
1967
1971
Source: U.S. Department of Commerce, (year?
1975
1979
1983
1987
1991
1995
1999
2003
Legislative leaders greeted the forecast of a decline in capital gains
realizations with substantial skepticism. Almost all doubted that capital
gains realizations could fall that precipitously. Unfortunately, the
forecast turned out to be too optimistic, with capital gains realizations
falling by more than 46 percent nationally. The loss in tax base in
Minnesota was substantial. Net capital gains realizations by Minnesota
resident tax payers fell from $9 billion in tax year 2000 to just over $4
billion in 2001, a decline of more than 55 percent. And, it is important to
note that the revenue lost is not just limited to one year. All future
changes in projected capital gains realizations will come from that lower
base. Assuming no changes in future growth rates, that means that all
future forecasts would have $5 billion less in capital gains realizations as
well. Over the entire forecast cycle from fiscal 2001 through fiscal 2005,
the reduction in capital gains realizations would amount to a reduction of
more than $20 billion in taxable income.
The stock market bubble and its subsequent bursting created two
quite different challenges for modeling. Since economic models are
estimated using historical relationships between the variable of concern
(in this instance realizations and other variables driving the amount of
unrealized gain) when those values go outside the range of the historical
data the predictive power of the model is less certain. During the upward
turn of the bubble, the growth in unrealized gains was exceeding the
range of prior observations, so there was no suitable reference point to
compare against. Then, once the bubble burst, there was an equally
difficult problem to model: How much of the paper losses accumulating
would be realized immediately, and how much would be left to ride out
the slump. Since only $3000 of long term capital losses can be applied
against ordinary income (but an unlimited amount can be used to offset
long term capital gains) the existence of these sizeable capital losses,
realized or not, will allow much of the population to offset all of their
capital gains, plus a small amount of ordinary income for several years
into the future, reducing future taxable income by a substantial, if
unknown amount.
Changes in the Structure of the Economy
During the late 1990s forecasters noticed that withholding receipts
were growing rapidly, indicating unusually large increases in nominal
wages. With the low inflation rates of the time that meant real wages of
workers were growing substantially as well. That was taken as just one
more sign that a “new” economy was in place, one where the benefits
from productivity increases were being shared with workers.
Some of that was true: hourly wages of production workers did
increase, but that was not sufficient to explain all the wage growth that
occurred. In retrospect it is clear that the use of performance-based
compensation, principally bonuses and options, was increasing, and
growing more rapidly than base salary. That change had important
implications for state revenues, but it went largely unnoticed.
There had been an indication of the importance of options and
bonuses in late 1992, when there were reports that high income taxpayers
expecting a top bracket tax rate increase were seeking to minimize their
tax liability by shifting bonus payments into 1992 from early 1993, and
exercising in the money stock options. That activity produced an unusual
spike in wages in the fourth quarter of 1992, followed by a steep decline
in the first quarter of 1993, providing some of the first evidence of the
amount of income received through end-of-year bonuses and the exercise
of options.
By the late 1990s corporate America’s desires to tie compensation
more closely to productivity, coupled with the financial advantages
options offered to both the firm and the employee, appears to have led to
an even greater percentage of compensation being tied to performance
based measures. Wage growth rates of more than 8 percent were seen in
some quarters, a surprising event given that employment growth and
inflation were much more modest.
Revenue forecasters now know that much of that wage growth came
from bonuses and the exercise of options and bonuses, not by growth in
base salaries. The money generated was real, but as was proven in 2001,
it was not permanent and it was not something that long term spending
plans could be based on. When the economy weakened, nominal wage
growth slowed dramatically. Nationally, the growth rate for nominal
wages, four quarters apart, has been less than 2 percent just 20 times
since 1960, 10 of those times have occurred since the third quarter of
2001.
In Minnesota the results were even more dramatic. Since 1960
nominal wage growth four quarters apart fell below 3 percent only once
between 1960 and the third quarter of 2001 (Figure 2) Since then,
nominal wage growth four quarters apart has not risen above 3 percent.
The increased importance of performance based compensation,
something that had gone largely unrecognized, created an unexpected
break in the structure of wage estimates. That break in structure, caused
wage forecasts to be overly optimistic, and contributed greatly to the
negative revenue variances observed during the period. Wages, of
course, are the single largest component of the income tax base,
accounting for more than 75 percent of adjusted gross income for
Minnesota resident taxpayers in 2001. Minnesota forecasters recognized
this problem in late 2001 and by February of 2001 they were
incorporating performance based compensation estimates in the forecast.
But the damage was already done since spending plans for 2002-03 had
been based on the outlook before the precarious nature of the changes in
wages had been recognized.
There is every reason to believe that the performance based
compensation proportion of total compensation will continue to grow. It
is popular with firms because it provides wage flexibility and ties
compensation to the firm’s performance. For workers, the increased
volatility in pay is offset by the possibility of substantial boosts in
compensation when times are good. For revenue forecasters and policy
makers, however, this is not good news since it increases the volatility of
the revenue stream – increasing revenues even more when times are
good, and depressing them when the economy turns down.
FIGURE 2
Minnesota Wage Growth: 1959-2003 [Please reduce the size of the
table to fit the size of the journal (L/R Margins = 2”]
[Table 1 and 2 are the same. Please check]
Ann Pct Chg
4 Qtrs Apart
18
15
12
9
6
3
0
1959
1963
1967
1971
1975
1979
1983
1987
1991
Source: U.S. Department of Commerce (year)
CONCLUSIONS
Minnesota and other states have faced significant budget challenges
after revenues failed to meet expectations following the 2001 recession.
An overly optimistic national economic forecast was responsible for
much of the revenue shortfall, but policy makers cannot realistically
expect future economic forecasts to be sufficiently accurate, or so
conservative that similar shortfalls will not occur in the future. Revenue
forecasting is imprecise under the best of circumstances. National
economic projections are often flawed, the data delayed and subject to
1995
1999
2003
substantial revisions, and economists understanding of factors underlying
household behavior is often insufficient to produce models with small
margins of error. When the possibility of undetected structural changes
in the economy is added in, the confidence interval surrounding
estimates in any particular revenue forecast expands further. Substantial
reserves will not prevent the next budget deficit. But, if used
responsibly, they will ease the adjustments necessary until revenues
recover again.
NOTES
1. All of the Finance Department’s forecast reports cited are available
at www.finance.state.mn.us.
2. A more complete description of Minnesota’s forecast process is
available in Stinson, 2002. Each of the Department of Finance’s
forecast releases also contains a brief section, “Forecast
Fundamentals” which describes forecast procedures.
3. A more complete description of the role Minnesota’s Council of
Economic Advisors plays is provided in Stinson, 2002.
4. Typically state economic models are used to adjust the externally
provided national economic forecast to reflect the specific structure
of the state’s economy and the way employment and income in
particular sectors have historically responded to national economic
growth. For example, GDP growth driven by expanded oil and gas
production would have little impact in Minnesota because Minnesota
has no oil exploration and production activity. And, the number of
individuals employed in the production of non-electrical machinery
may be less volatile in Minnesota than nationally due to differences
in the nature of contracts and productivity for Minnesota firms.
5. The Blue Chip Consensus Forecast for 2001 in January 2000 called
for 3.0 percent real GDP growth. The panel grew more optimistic as
2000 went on and by October real GDP growth at an annual rate of
3.5 percent was projected. By January 2001, the consensus forecast
had fallen to 2.6 percent, and by October 2001, 1.1 percent. (Blue
Chip Economic Indicators, 2001, p. 4) The U.S. Department of
Commerce now is reporting that the actual growth rate for real GDP
in calendar 2001 was 0.5 percent.
6. The Minnesota capital gains data reported below differs slightly from
the SOI data reported in Table 1. This data comes from a sample of
Minnesota resident tax filers used to calibrate Minnesota’s income
tax micro-simulation model. The SOI data includes income from
part-year Minnesota residents whose filing address is in Minnesota.
7. Minnesota’s capital gains model is outlined in November Forecast
1997, pp 27-29.
REFERENCES
Blue Chip Economic Indicators (2001, October). Kansas City, MO:
Aspen Publishing.
Congressional Budget Office (2001, January). The Budget and Economic
Outlook: Fiscal Years 2002-2011. Washington, DC: Author.
Congressional Budget Office (2004, January). The Budget and Economic
Outlook: Fiscal Years 2005-20141. Washington, DC: Author.
Department of Commerce (year). Title of publication as cited in Figures
1 & 2.
Minnesota Department of Finance (1977) November Forecast, Name of
City, MN: Author.
Minnesota Department of Finance (2000, November). November
Forecast. Name of City, MN: Author.
Minnesota Department of Finance (2001a, February). February
Forecast. Name of City, MN: Author.
Minnesota Department of Finance (2001b, October). Economic Update.
Name of City, MN: Author.
Minnesota Department of Finance (2001c, November). Fund Balance,
General Fund. Name of City, MN: Author.
Minnesota Department of Finance (2002a, February). February
Forecast. Name of City, MN: Author.
Minnesota Department of Finance (2002b, October). Economic Update.
Name of City, MN: Author.
Minnesota Department of Finance (2002c, November). November
Forecast. Name of City, MN: Author.
Minnesota Department of Finance, 2003 [Cited in text]
Statistics of Income Bulletin (2002; 2003). [Cited in text. Need full
references here]
Stinson, T. F. (2002, June). “State Revenue Forecasting: An Institutional
Framework.” Government Finance Review, Vol # (Issue #): 12-15.