Washington has strong budget sustainability practices and a tradition of transparent and independent revenue forecasting. There is always room to improve, however. A pair of national reports (from June and last November) have recommendations on revenue forecasting and sustainable budgeting.

The Tax Policy Center (TPC) looks at state revenue forecast accuracy (specifically forecasts of personal income, corporate income, and sales taxes). The TPC finds, “In their forecasting practices, state revenue forecasters generally adopt a conservative approach, prioritizing the avoidance of overestimates due to their belief that the repercussions of overestimating are more severe than those of underestimating.”

Nationwide, revenue forecast errors in 2021, 2022, and (to a lesser extent) 2023 were much higher than any time since 1990, “due to the unprecedented nature of the pandemic and the extraordinary federal fiscal stimulus, which led to an unexpected revenue surge and substantial underestimation of revenues by most states.”

Additionally, revenue volatility contributes to forecast errors. The TPC emphasizes the impact of capital gains taxes on this volatility: “Increases in forecasting errors in the past decade were also driven by increases in revenue volatility, largely driven by greater reliance on increasingly volatile capital gains.”

According to the report,

In general, states with the largest revenue volatility are those dependent on severance taxes and income taxes from high-income earners. This volatility is primarily driven by fluctuations in oil prices, affecting severance tax revenues and stock market volatility, which impacts the income of wealthy taxpayers. Consequently, these states face greater fiscal unpredictability, directly tied to the volatile nature of oil and financial markets.

Here are the TPC report’s recommendations:

• Depoliticize the revenue forecasting process. Washington is one of 28 states with a consensus forecast (i.e., it isn’t prepared by solely the executive or legislative branch). Further, Washington is one of three states in which the executive branch doesn’t have a role in producing the forecast—our Economic and Revenue Forecast Council is an independent agency.
• Extend the forecast horizon. Many states only forecast the next fiscal year. The report lists Washington as forecasting the next FY plus three, like 10 other states. That’s not quite correct. Washington’s September and November forecasts estimate revenues for the current FY plus three and the February and June forecasts estimate revenues for the current FY plus five. According to the report, four states have forecast periods of the next FY plus five or more.
• Regularly update revenue forecasts. Washington is one of four states with four revenue forecasts a year. Two states have five forecasts. Eleven states have just one forecast a year.
• Incorporate a broad range of economic indicators. This includes, for example, employment, personal income, wages, and inflation. The report notes, “States also factor in unique elements relevant to their economic context and tax structure.”
• Enhance transparency and public engagement. Apparently some states do not make forecast updates available to the public. The report notes, “States can make their revenue forecasting processes more transparent by publishing detailed information on the methodologies, assumptions, and data sources used.”
• Strengthen fiscal reserves and rainy day funds. “States employ various strategies to manage tax revenue unpredictability, with rainy day funds being crucial for mitigating revenue volatility and forecasting errors.”

Regarding rainy day funds, the TPC report finds,

It might be expected that states with highly volatile and unpredictable tax revenues would have larger rainy day funds as a buffer against shortfalls. However, . . .  there is a weak correlation between the size of a state’s rainy day fund before the pandemic and the median forecast errors previously encountered.

What is the right target for the size of the rainy day fund? Washington’s revenues have been relatively stable. (The capital gains tax will make our revenues more volatile over time.) Our state treasurer recommends that reserves be 10% of revenues, in order to maintain strong credit ratings. Additionally, 10% is a good target given the state constitution: As we discussed in a report on reserves earlier this year, if the budget stabilization account (BSA, the rainy day fund) balance exceeds 10% of general state revenues, a majority of the Legislature may choose to use the excess for school construction.

However, the 10% figure is not tailored to Washington’s specific fiscal and budgetary needs at a given time. To more precisely set a target for state reserves, the state could conduct formal stress tests.

Indeed, Pew recommends that states conduct long-term budget assessments and budget stress tests “to regularly measure risks, anticipate potential shortfalls, and identify ways to address impending challenges.”

Long-term budget assessments “project revenue and spending several years into the future to show whether and why states may face chronic budget deficits.” Budget stress tests “estimate the size of temporary budget shortfalls that would result from recessions or other economic events and gauge whether states are prepared for these events.” Stress tests can thus indicate the adequacy of a state’s reserves.

Pew recommends that states publish the results of these analyses, draw conclusions from them about sustainability, and include spending.

According to Pew, Washington has not done budget stress tests or long-term budget assessments. Washington and 14 other states do “project revenues and spending at least three years into the future but do not use those projections to assess sustainability.” Further, Pew notes, “Oregon and Washington state analyze how recessions would adversely affect their budgets, but they do not take the final crucial step for a stress test: comparing those effects to the available contingencies.”