Betting on the Future with a Cloudy Crystal Ball: Revenue Forecasting, Financial Theory, and Budgets - An Expanded Treatment

Abstract

Accurately predicting revenue growth is nearly impossible. Predicting the peaks and valleys of the business cycle is even more hopeless. This matters because tax revenues are largely driven by economic growth. Volatile, unpredictable revenue growth causes all sorts of unpleasant responses on the part of governments, most commonly manic-depressive patterns of spending and taxing. Fortunately, modern financial economics gives us a set of tools that can be used to manage volatility. These tools include tax portfolio analyses, hedging and buffering strategies, and, in the context of present-value balance, consumption smoothing based on sustainable spending rules. These tools are based on mean-variance analysis, analysis of covariance, the use of stochastic processes to model movements in financial variables, and optimal control theory to formulate solutions to those processes. This article shows how these tools can be used to inform fiscal decision-making. Our focus is on state governments, but our analysis applies to all jurisdictions that face a hard budget constraint and must therefore balance spending increases against revenue growth.

Keywords: fiscal sustainability, revenue forecasting, volatility, mean-variance analysis, tax-portfolios, covariance, martingales

JEL Classification: C53, D73, D80, D23, E6, E34, G11, H61, H63, H7