Rainy day funds help mitigate volatile state tax collections.

• Position: News & Numbers

The amount of money states collect is harder to predict than ever, according to a new report from The Pew Charitable Trusts and the Nelson A. Rockefeller Institute of Government. The rising volatility of tax collections has contributed to increases in the size and frequency of forecasting errors. The report identifies specific steps that states can take to manage volatile revenue.

Some level of forecasting error is inevitable, but its impact can be mitigated by a mix of effective policy solutions, according to the report, Managing Volatile Tax Collections in State Revenue Forecasts. States can adopt evidence-based rainy day fund policies to address budget shortfalls arising from unforeseeable economic and fiscal circumstances that make forecasting revenue increasingly difficult.

According to the report, budget forecasting errors are generally larger when a long lag exists between a forecast and the adoption of the state budget. Errors also occur during and after recessions, in less populated states, in states that are heavily reliant on certain industries, and particularly in forecasts of corporate income taxes.

The research cautions that overly optimistic forecasts can prompt hurried, across-the-board spending cuts, tax increases, or borrowing when collections fall short. Alternately, forecasts that are too low can result in a onetime surplus, tempting lawmakers to cut taxes or commit to spending that is unsustainable over the long run.

The report identifies three best practices to help state policymakers manage volatile revenue and use the...