Better budget forecasting using simulation.

• Author: Joffe, Marc

The debate over the fiscal cliff has once again put the spotlight on budget forecasting. The Congressional Budget Office and other forecasters were asked to predict revenues, expenditures, and deficits under various policy scenarios, but these projections have attracted criticism--despite the tremendous effort expended in producing them.

Since we can't predict the macroeconomic future, what are our options? Abandoning forecasting is not one of them; we need some kind of projections to assess policy alternatives as well as the risks inherent in maintaining the status quo. Instead, forecasters need to change their approach, creating forecasts with a number of possible outcomes instead of just one scenario.

FORECASTING FAILURES

Alan Auerbach, director of the Robert D. Burch Center for Tax Policy and Public Finance at the University of California, Berkeley, (1) found large errors in a comparison of federal budget results to Congressional Budget Office and Office of Management and Budget forecasts, but did not find evidence of bias; the forecast errors were sometimes positive and sometimes negative. Richard Boylan, professor of economics at Rice University, (2) found that state general fund revenue forecasts for fiscal years 1982 through 2005 understated actual revenue by 3 percent, on average. He also found that revenue forecasts were significantly more optimistic relative to actual revenue in election years.

The most infamous case of budget forecasting error occurred in 2001. At the time, the CBO anticipated $5.6 trillion in surpluses over the next 10 years. The projection was used to justify $1.6 trillion in tax cuts. While those reductions were supposed to leave the country with $4 trillion in surpluses over the fiscal 2002-2011 period, the actual result was a cumulative deficit of $6.1 trillion.

Some have used this outcome to condemn the CBO, but such criticism is ill-founded. Those familiar with the task of budget forecasting recognize that the CBO strives for quality and objectivity--and succeeds to a remarkable extent. Unfortunately, CBO analysts can't do the impossible, which is to accurately forecast economic growth, inflation, interest rates, and policy changes over a 10-year window.

FORECASTING OPTIONS

Instead of a single budget projection, forecasters should generate a budget forecast distribution using a large number of randomly selected macroeconomic values chosen from within reasonable ranges. This will produce an array of possible outcomes, as opposed to the traditional "point forecast," which shows only one scenario. The results will give policymakers and the public a full range of plausible outcomes. This technique is known broadly as simulation. Exhibit 1 shows a fan chart produced by a CBO federal budget simulation in 2007. (3)

The basic premise of simulation is ably described by Sam Savage, author of The Flaw of Averages (Wiley, 2012). Savage gives the...