Tax Revenue Forecasting John King Tax Policy Division Fiscal Affairs Department

July 28, 2003Public Finance Course The Role of Revenue Forecasts Budget preparation –Providing the budget “envelope” –Determining the expected deficit Management of the revenue departments –Benchmarks for monitoring performance –Targets to stimulate effort

July 28, 2003Public Finance Course Revenue And Expenditure Budgeting Revenue forecasting is a technical matter: what will happen, given –Current law –State of tax administration –Expected economic conditions Expenditure allocations are mostly political (permissions to spend) Some exceptions....

July 28, 2003Public Finance Course Desirable Characteristics Of Revenue Forecasts Accuracy: –Unbiased –As close to the mark as possible Consistency with expenditure projections Authoritative and professional

July 28, 2003Public Finance Course Bias In Revenue Forecasts Would some bias be desirable? –Overestimating the deficit for prudential reasons –Overestimating revenues to encourage collection effort What biases occur in practice? –Revenue departments usually prefer to underestimate –Ministries of Finance may be biased in either direction

July 28, 2003Public Finance Course The Form of Revenue Forecasts For an MoF, what matters is the “bottom line”: –detailed forecasts for different taxes may not be useful For a revenue department, details are needed –By tax, district and month

July 28, 2003Public Finance Course Responsibility For Revenue Forecasts “Top down” and “bottom up” approaches Primary responsibility may lie with –Budget department in MoF –Revenue department(s) –A “neutral” third party –Some combination of these approaches

July 28, 2003Public Finance Course Choosing The Best Organization “Conditional” forecasts (depend on macro forecasts) vs. “unconditional” forecasts The need to bring to bear: –Relevant information and knowledge –Relevant technical expertise Coping with biases Ensuring acceptance of the forecasts

July 28, 2003Public Finance Course The Revenue Forecasting Cycle Initial revenue forecasts Revision and finalization for the budget In-year monitoring In-year updating Review after end of budget year

July 28, 2003Public Finance Course Measuring Forecasting Accuracy Simple measures: mean absolute percentage error (MAPE) More complicated measures: root mean square error (RMSE), etc Other tests: –How well do the forecasts predict turning points? –Are they better than naïve (no change) forecasts? Assessing conditional and unconditional forecasts

July 28, 2003Public Finance Course Revenue Forecasting Predicting receipts over the budget period On the basis of current law (or law proposed in the budget) Usually, made on the basis of a broader macroeconomic forecast Both macro and revenue forecasts may be updated during the year

July 28, 2003Public Finance Course Revenue “Estimating” The term used in the USA for predicting changes in tax receipts that will result from changes in tax law Budget revenue forecasts often incorporate revenue estimates But revenue estimates may be needed at any time during the year –In the USA, over 1,000 revenue estimates now prepared each year

July 28, 2003Public Finance Course The “Baseline” Revenue estimates are made relative to some “baseline” forecast of revenues Usually this is the “unchanged policy” forecast for the budget period –But there may be exceptions Hence, revenue estimates assume that macroeconomic conditions are fixed –e.g., that a change in tax law will not affect the level of GDP

July 28, 2003Public Finance Course Revenue Effects of a Change In Tax X Liabilities to X change Subsequent change to –Assessments of X –Collections of X If X is included in the base of another tax (Y): –Liabilities, assessments, and collections of Y change Those liable to X (and Y) may “shift” the change onto others Payers of X may change their behavior as a result of the new “tax price” –This will have implications for revenues from X (and Y) Revenues from these (and other) taxes will alter as a result of macoeconomic “feedback” effects

July 28, 2003Public Finance Course Which Effects To Include In A Revenue Estimate? The answer depends on the context However if macro feedback effects will be incorporated into a new macro forecast, including them in a revenue estimate will entail double counting Hence, the general convention in OECD countries: –Revenue estimates take account of behavioral effects –But not macro feedback effects In the USA, this is now rather controversial

July 28, 2003Public Finance Course Taking Account Of Behavioral Effects Income taxes: –theoretically, behavioral effects of changes are indeterminate –little evidence that individuals respond to changes within the relevant timescale Broad-based consumption taxes (e.g. the VAT): likewise Hence, revenue estimates for these taxes do not usually include any behavioral effects But for changes to some other taxes (e.g. excise taxes) behavioral effects may be important and revenue estimates need to take account of them

July 28, 2003Public Finance Course “Offsets” in Revenue Effects Implications of holding constant a baseline macro forecast

July 28, 2003Public Finance Course A Final Warning Revenue estimation is very difficult But mistakes will not usually be found out –because nobody will know what revenues would have been if the tax change had not been made Occasional exceptions –e.g. the introduction of PIT in Bhutan

Tax Expenditure Budgets

July 28, 2003Public Finance Course Alternative Forms of Financial Assistance Direct grants or subsidies Loans at below-market rates Reduction in tax liability, through –Tax exemptions –Investment tax credits or allowances –Accelerated depreciation deductions –Reduced tax rates or tax holidays

July 28, 2003Public Finance Course Tax Expenditures Spending programs implemented through the tax system Concept developed in the USA in the 1960s Over half of OECD countries now have some form of TE budget –Useful way to avoid bias in ways of spending government money –Recommended in the IMF Manual on Fiscal Transparency

July 28, 2003Public Finance Course Identifying Tax Expenditures TE = difference between revenue from a “standard” tax and revenue from a tax with the particular preferential provision Problems in defining the standard tax: e.g. in a PIT: –Is an allowance for a dependent spouse a TE? Provisions considered TEs in some countries may not be considered TEs in others So some countries avoid the term “TE”

July 28, 2003Public Finance Course Measuring Tax Expenditures 3 alternatives measures: “Revenue gain” (how much revenue would result if this TE were abolished?) –Same as the revenue estimation concept “Revenue forgone” ex post from the existence of the TE: –Takes no account of behavioral effects “Outlay equivalents”: –What direct expenditure would be needed to give the same benefit? Most countries use revenue forgone