Unprecedented economic forecast revision will frame special session

Heard the joke about the three economists who went hunting together? When they saw a deer, the first fired his shotgun and missed a foot to the left, while the second aimed and missed a foot to the right.

The third economist didn’t shoot. Instead, he shouted in triumph, "We got it!"

With the help of outside economists, Indiana government goes through a similar exercise every other year—a process that’s taken on increased importance this spring, as Gov. Mitch Daniels and the Legislature attempt to craft a two-year budget amid the deepest recession since the early 1980s.

"If the forecast is off, we’ve got problems. We can’t pay our bills," said state Rep. Jeff Espich, R-Uniondale and a member of the State Budget Committee. "We live and die by that forecast and hope it’s correct. And historically, it’s been so."

An IBJ analysis of the state forecasts going back to 1990 found they are frequently close to the mark, though they tend to underestimate revenue in good times and overestimate it during downturns.

The pattern held for both the recession in the early 1990s and the milder one earlier this decade—a finding that suggests tougher times may lie ahead than many lawmakers expect.

More art than science

The first step in crafting a biennium budget is establishing expectations for future revenue.

Every year, the state updates its forecast in December. But it’s the April forecast, issued only in budget years just before the Legislature adjourns, that has the most impact on spending.

Coming up with the projections is never easy, but in this recession it’s a nightmare, economists say, since the meltdown has taken the nation and state into nearly uncharted territory.

Economists have to look back to the Great Depression for comparisons to the banking crisis that broadened the recession into a global phenomenon.

So it’s perhaps not surprising that recent projections are proving wildly off the mark.

Back in April 2007, legislators received the final forecast they used to establish the 2008-2009 biennium budget.

At that time, they expected to receive $12.8 billion in taxes the first fiscal year and $13.4 billion the second. Actual revenue for the first year, which closed June 30, 2008, was $12.9 billion, or nearly 1 percent above the forecast.

There are two months left in the current fiscal year. Actual revenue for fiscal 2009 so far: just $9.9 billion.

In December, the state released its first forecast for the 2010-2011 biennium. That forecast had similar projections for fiscal 2009: $13.5 billion. But it included massive new revenue from Indiana’s 1-percent sales tax hike, enacted to offset property tax caps.

State Sen. Luke Kenley, R-Noblesville and co-chairman of the State Budget Committee, said it was immediately clear a "significant reduction" in spending was necessary.

"The governor was prompt in cutting about $750 million in state spending, which was very beneficial to the current budget process," Kenley said. "Those cuts set the stage for this year’s budget negotiations. If we had that much more of a hole to deal with, it would be even harder."

In April, legislators received what’s traditionally their final forecast before passing a new budget. It quickly became clear real-world results weren’t matching up.

In his April 2009 monthly revenue report, State Budget Director Chris Ruhl pointed out that, in that month alone, actual collections missed the April forecast by $255 million—five times the expected shortfall for April, May and June together.

Ruhl warned in his report that $1 billion in revenue projected in the April forecast was highly unlikely to materialize.

"Total tax collections dramatically missed the most recent revenue forecast—a forecast that is less than three weeks old. The skepticism noted by Gov. Daniels and numerous fiscal leaders over the forecast’s prediction of a sudden near improvement in revenue collections has proven correct."

Unnerved by the inaccurate projections, Daniels in early May ordered an unprecedented forecast revision. Released May 27, it shaved nearly $1.1 billion off the previous version. The new forecast will frame the General Assembly’s special session, which is expected to start in mid-June. Lawmakers expect to have to implement steep cuts in government services over the next two years.

Other states are experiencing similar pain, said Stacey Mazer, senior staff associate at the Washington, D.C.-based National Association of State Budget Officers.

"Many states’ estimates have come in below what they thought they would be," Mazer said. "Unfortunately, what Indiana’s experiencing, we’re seeing across a lot of the states."

Over and under

While Indiana’s forecast has a solid track record for accuracy, it’s far from perfect.

In eight of the last 20 years, April forecasts were more than 3-percent off the mark compared with subsequent annual revenue reports.

From 1992 to 1999, the forecast underpredicted revenue every year. Its worst performance was in 1995, when projections were 9.2-percent below reality. As a result, Indiana collected $597 million more than expected that year. Underpredictions for the entire period total $2 billion.

During the last recession, the forecast overpredicted revenue by 4.9 percent in 2001 and 8.8 percent in 2002. As a result, Indiana took in $481 million less than expected in 2001. The second year was even worse, with $837 million less than expected in 2002.

Economists say the volatility of capital gains taxes helps explain why past projects have tended to underestimate tax revenue when the economy is doing well but overestimate it during periods when it falters.

After the recession early this decade, the accuracy of the forecasts improved. They were consistently within 2.6 percent of actual collections. But the forecast process was blindsided by the current recession, and its extent.

"Forecasting the economy’s turning point is not for the timid," said former Ball State University economist Pat Barkey. He’s now at the University of Montana. Until two years ago, he helped craft Indiana’s forecast. "It’s a tough business."

Nonpartisan projections

For generations, Indiana has followed the same forecasting process, one carried out at arm’s length from the Legislature.

It starts with top economists who make their best guess about the state’s macroeconomic direction. Then a team of tax experts applies technical formulas to estimate how much revenue Indiana should expect to collect.

For 29 years, Gary Baxter, president of locally based Baxter Capital Management, led a group of half a dozen volunteer economists who crafted the forecast.

His predecessor was the chief economist at Indiana National Bank. Baxter remembers the process as a robust one in which the group would gather in his office.

Each shared his model of the economy’s direction. Whoever was furthest from the median forecast then would justify his position. Sometimes it would sway the group. Other times, the group would change his opinion.

"We’d spend the day going back and forth about why we had differences in our forecasts and then eventually, we had to come to a consensus," Baxter said. "It was always fun. I think we all looked forward to it."

When Baxter presented every new forecast, he always began by warning that the process is fragile and imprecise. He then explained the errors in the previous one.

"The forecast, it’s looking into the future and taking some educated guesses. That’s all it is," Baxter said. "And it’s intrinsically saying the future will look like the past, which isn’t always true. We’re going to continue to miss turning points, as any forecaster will. That’s why the Rainy Day Fund is so important."

Last year, Baxter retired from the state forecast for a simple reason: Indiana ran out of economists to fill out his group. The local banks and utility headquarters that once employed them are long gone.

So Indiana hired Lexington, Mass.-based IHS Global Insight to take the local volunteer economists’ place. With 700 employees—half of them economists, researchers and analysts—IHS bills itself as "the global leader in economic and financial analysis, forecasting and market intelligence."

To produce its part of Indiana’s forecast, IHS Global Insight relies on views from its chief U.S. economist, Nigel Gault, who has economics degrees from Cambridge and Harvard universities, and from Group Managing Director James Diffley, who has his doctorate from the State University of New York at Stony Brook.

Indiana economists say the state will need all the expertise IHS Global Insight can muster.

"We haven’t seen anything like the magnitude or scope we have now since before World War II," said Indiana University economist Bill Witte, who formerly served on Indiana’s forecast committee.

Economists also haven’t seen this much government intervention since President Franklin Roosevelt created the Works Progress Administration in 1935.

They base their predictions on analysis of current conditions. But right now, it’s hard to separate the federal stimulus from the underlying real economy. Indiana’s share of the stimulus is expected to be $4.3 billion.

"It’s something like a patient being really sick, going into the hospital and being on life support," Baxter said. "The gauges show the heart rate and respiration are OK, but the patient may not be OK. The question is, how will the patient look when you take him off life support?"

Such factors make it exceedingly difficult to project the conditions for Indiana’s next biennium. Some economists worry that, when the stimulus runs out, the nation will endure a "double-dip" recession. Others say it could be five years or more before the economy fully recovers.

Baxter said that if he were still leading the state’s forecast, he’d estimate a 45-percent chance that a recovery will begin in the second half of this year, a 45-percent chance the recovery begins in early 2010, and an outside chance the recovery doesn’t come at all.

"This is a good time not to be forecasting," he said, laughing.

Challenging session

Legislators will spend the special session debating just how conservative the budget ought to be. Some, like state Rep. Dennis Avery, D-Evansville, favor taping all $1.3 billion in state reserves available to avoid sharp cuts in services.

"The Rainy Day account … is meant to be used in a rainy day. Right now, if ever in our recent history, it’s raining," said Avery, a member of the state budget committee. Another member of the committee, state Sen. John Broden, D-South Bend, is bullish on an impending upturn.

"Indiana is poised and ready to take advantage of the economic upturn when it comes, and I think it’s going to come sooner rather than later," he said. "I don’t want to be Pollyannaish … but I do think in the next two years, we are going to see a recovery and Indiana is situated such that we’re going to be leading the curve."

But economists formerly involved with Indiana’s forecast worry that whatever recovery arrives, it won’t be robust.

They see no obvious engine for growth. And with most consumers’ home values and retirement accounts devastated, they’ll be in saving mode for years to come.

"We see a recovery that is a little sluggish. Things will be better, but output won’t get back to pre-recession levels until the end of 2011 and employment won’t be back until 2012," Witte said. "It’ll be a recovery, but it won’t have people dancing in the streets."