Testing the Rationality of State Revenue Forecasts

In recent months, the governors of several states have suffered major political embarrassments because actual revenues fell, substantially short of the predictions in their respective budgets. Such episodes focus attention on the question of whether states do a "good" job of forecasting revenues. In modern economics, forecasts are evaluated on the basis of whether or not they are "rational" -- do the forecasts optimally incorporate all information that is available at the tune they are made? This paper develops a method for testing the rationality of state revenue forecasts, and applies it to the analysis of data from New Jersey, Massachusetts, arid Maryland. One of our main findings is that in all three states, the forecasts of own revenues are systematically biased downward.