Speaking uncertainty to power: risk-aware forecasting and budgeting.

AuthorKavanagh, Shayne

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This article is adapted from the upcoming GFOA publication, Informed Decision-Making through Forecasting: A Practitioners Guide to Government Revenue Analysis, by Shayne Kavanagh.

Budget forecasts are almost always wrong; it is just a question of by how much, and in which direction. The ways in which finance officers handle the risk of a forecast being wrong can have a real impact on their credibility and the quality of the budgetary decisions made by the chief executive officer and/or governing board.

Two variables affect the accuracy of a forecast: the inherent uncertainty of tax (or other) revenues, and the extent to which that uncertainty is taken into account by decision makers. Many people think good forecasting is simply a matter of accuracy--that is, making precise predictions that are used to inform the development of a given budget. But in practice, good forecasting also involves an element of education. The likelihood of different scenarios should be conveyed, and the consequences of budgeting mistakes should be transparent.

TRADITIONAL FORECASTING: FLAWS AND CHALLENGES

Forecasts are the starting point for budgeting. Forecasts are typically presented as a single-number "point" estimate. This not only obscures the range of possible revenue outcomes that really exist, but also leads to systematic errors that do not average out in the long run. This is commonly known as the Flaw of Averages (also known as Jensen's Inequality). The single-point forecast also fixates the audience on a single potential outcome, so they may not plan adequately for alternative futures when developing a budget. There are negative consequences if actual revenues miss the point estimate on either side. Therefore, even if your forecasts are right on average, you will be systematically exposed to negative budgetary consequences.

The consequences of underestimating revenues are typically less severe than those of overestimating revenues--if revenues are overestimated, the government may have to cancel spending plans, and, in the worst case, lay off staff.

Conservative Forecasts. Because revenue overestimates have the potential to create a budget shortfall and the need for mid-year spending cuts, many finance officers pursue a strategy of conservative revenue estimating--but this conservative forecasting strategy is not without consequence. If revenues are underestimated, the government will have foregone the opportunity to budget for a potentially valuable public service. For instance, a school district might have been able to fund reading help for a greater number of struggling students, or a city might have been able to put more police officers on the streets. Revenue underestimates might also cause unnecessary stress during budget development as decision makers struggle to make trade-offs that are unnecessary.

A conservative forecasting strategy might also have consequences for the finance officer's credibility, hurting his or her ability to provide financial leadership. GFOA's research shows that the strategy can work if policymakers are in agreement with it; otherwise, it can backfire. For example, a city that GFOA studied had a city council that expected revenue forecasts to represent the most objective approximation of what actual revenues would be. Consistent underestimates led the council to accuse the finance officer of "playing games" with the budget.

Best Estimates. Imagine that instead of a conservative forecast, the finance officer provides a "best estimate" of revenues --the single number that the finance officer believes has the best chance of matching actual revenues. This will lead to a smaller error on average, but a greater risk of an actual budget shortfall during the year. Certainly, an actual shortfall won't help the finance officer's credibility either. Furthermore, the finance officer's best estimate will never be 100 percent accurate. When the forecast is presented as single-point estimate, the audience may not plan adequately for futures that differ from that estimate.

Conservative and best-estimate forecasting strategies put the finance officer in a lose-lose situation. Both strategies can also lead to less than optimal resource allocation decisions. A conservative approach is more likely to lead to lost opportunities, whereas the best estimate creates greater exposure to financial stress. When either approach is presented as a single-point forecast, it will not lead the audience to plan adequately for an uncertain future. What can be done?

This article will show how several cities are using spreadsheets to bring sophisticated risk awareness to municipal finance. They demonstrate that finance officers don't need to choose between giving budget decision makers a conservative forecast and a best estimate. Instead, by explicitly recognizing the uncertainty in forecasts, finance officers can improve their dialog with decision makers and arrive at a budget that makes the best use of all available resources, while mitigating the risk posed by revenue shortfalls.

RISK-AWARE FORECASTING

As a result of the Great Recession, the City of Colorado Springs...

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