Betting on the Future with a Cloudy Crystal Ball

[Sapphire Capital]

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

FRED THOMPSON
Willamette University - Atkinson Graduate School of Management
BRUCE GATES
Willamette University - Atkinson Graduate School of Management
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Public Administration Review, Vol. 67, No. 5, pp. 48-66, September/October 2007


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.

papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1123736_code249171.pdf?abstractid=1123736&mirid=4

[Sapphire Capital]

Response to Comments on Betting on the Future with a Cloudy Crystal Ball: Revenue Forecasting, Financial Theory, and Budgets

FRED THOMPSON
Willamette University - Atkinson Graduate School of Management
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Public Administration Review (online version), Vol. 67, No. 5, pp. 88-93, September/October 2007


Abstract:
Budget policymakers should focus on expected revenue growth (average growth over history) and on the risk or volatility around that average. It makes sense to think about this risk as having two components purely random risk unrelated to the economy and risk associated with an economy that is hard to predict. Budget policymakers should reduce random (unsystematic) risk by building a diversified revenue portfolio within the constraints of practical tax policy objectives. They should use hedging, reserve funds, and other strategies to offset risk that cannot be diversified away the risk associated with the underlying economy and unsystematic risk that is not practical to diversify away. And, they should adopt spending rules that will balance the budget over the long run while allowing it to be unbalanced in any given year. They can do this by balancing the present value of revenues against the present value of spending over the long run or, second best, by balancing over the business cycle.

papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1123737_code249171.pdf?abstractid=1123737&mirid=2