States Can Better Manage Revenue Volatility Through Redesigned Reserve Policies and Improved Forecast Timing

A new study by The Pew Charitable Trusts, Managing Uncertainty: How State Budgeting Can Smooth Revenue Volatility, offers several promising solutions to help policymakers navigate the ups and downs of state revenue collections. This variation leads to state budget shortfalls and surpluses and makes it harder for states to accurately forecast revenue and balance their budgets.

"Revenue fluctuations are unavoidable, but policymakers can strengthen the fiscal health of their states by adopting budget policies that work to smooth state finances over economic peaks and valleys," said Brenna Erford, who manages Pew's state budget policy research.

The report is the first in a series designed to provide strategies to policymakers to improve long-term state fiscal health, and examines patterns of state economic and revenue fluctuation over the past 20 years. The analysis reveals wide variation in the degree to which revenues change over time and identifies state economic characteristics and tax systems as factors influencing volatility. Pew's research also finds that, on average, state revenues vary more dramatically than do their underlying economies.

Several dynamics contribute to revenue fluctuations, including economic factors such as states' natural resources, industry mix, and demographic change. State tax policy also can magnify or moderate underlying economic sources of revenue variations.

The study identifies three promising practices that can help policymakers chart a clearer direction through the fiscal uncertainty caused by unforeseeable changes in revenue:

1. States should study the causes of volatility in their economies and their impact over time. These studies should be released on a regular schedule, examine which areas of the tax system and the economy are volatile and why, and include recommendations for fiscal policies to manage uncertainty. 
2. States should revise revenue forecasts as close to the final passage of the state budget as possible and plan for possible shortfalls or surpluses.  Although revenues can be inherently difficult to predict, states can develop their projections as close to key budget decisions as possible and have processes in place to better respond to forecasting errors. 
3. States should develop or refine budget policies that run counter to economic cycles and save money during growth periods for use in down times. States can create reserves, or rainy day funds, so that saving money during good times is a consistent, predictable practice based on specific drivers of revenue volatility.  

Pew analyzed the relationships between state-specific economic data from the Federal Reserve Bank of Philadelphia and state revenue collection data compiled by the Rockefeller Institute of Government for all 50 states and interviewed fiscal policymakers and independent analysts in 15 of them. The study includes two full business cycles from 1990 to 2012 and tax revenue collections from 1994 to 2012.

The Pew Charitable Trusts is driven by the power of knowledge to solve today's most challenging problems. Learn more at www.pewtrusts.org.