Long-Term Financial Forecasting
Exhibit 1: Factors that Influence Revenue
Revenue Source,Type           Influence Factors
Property Tax              Impact f...
Exhibit 3:Trend Analysis

   method relies on simple trend analysis       allows for “what-if” testing of various      ...
Exhibit 4: Correlation Analysis

trend analysis. While historical trends     percentage of total revenue indices pro-  ...
Exhibit 5: Sensitivity Analysis, Baseline Scenario

      Exhibit 6: Sensitivity Analysis, Unfavorable Scenario

64 ...
Exhibit 7: Expenditure Forecast, Restrained Spending Scenario

increases, and as confidence decreases,       vency. Orga...
Alternative expenditure forecasts can   CONCLUSION                                                help organizations analy...
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Long-Term Financial Forecasting for Local Governments


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Long-Term Financial Forecasting for Local Governments

  1. 1. SOLUTIONS Long-Term Financial Forecasting for Local Governments By Christopher J. Swanson C ities, counties, and other local stituents about an organization’s pres- government agencies are ent and potential financial capabilities. Too many jurisdictions increasingly adopting long-term In particular, forecast models that financial forecasting as a critical com- include well-designed charts and tables have found out ponent of their financial management can be used as visual aids in public pre- practices. Too many governments have sentations about the organization’s the hard way what found out the hard way what can hap- finances, helping elected officials, citi- pen in the absence of a realistic fore- zens, and other stakeholders gain a bet- can happen in the cast model, one that projects and quan- ter understanding of financial issues. absence of a realistic tifies the impact of potential revenue shortfalls and increased liabilities well FORECASTING TECHNIQUES forecast model. into the future.Forecasts can be used to Baseline forecasts are based on create a strategic context for evaluating recurring revenues and expenditures, the annual budget, to establish a base- projected at least five years into the line for measuring the long-term effects future. It is recommended they be pro- of decisions, to test the economic jected much further out, as far as 20 effects of best-case and worst-case years, depending on known commit- funding scenarios, and to establish a ments and liabilities such as employee baseline projection of revenues, expen- benefit and debt obligations. Proposed ditures, and future cash flows and fund new revenues and expenditures that balances. the organization has not committed to An effective forecast model is not a can be included in the forecast model budget, nor is it a Soviet-style “5-year as “optional” variables, the future effects plan” that remains static and sits on a of which can be measured against the shelf. It is also not an absolute predic- baseline forecast. tion of the future. Instead, a forecast Local governments typically use one model projects a range of possible out- or a mixture of three techniques for comes, based on a set of known vari- forecasting revenues and expenditures: ables and assumptions.As with a weath- expert judgment and analysis, deter- er forecast,a financial forecast is always ministic forecasting, and econometric subject to revision based on new infor- modeling. The methods used depend mation, and an effective budgeting and on the type of revenue being forecasted planning process provides a consistent and the availability of historical and routine for updating the forecast. If pre- current economic data, along with pared and managed properly, a forecast other factors that drive the revenue. can also help public officials evaluate the financial effects of proposed initia- Expert judgment and analysis can be tives, and it can help educate con- used when data are limited. This 60 Government Finance Review | October 2008
  2. 2. Exhibit 1: Factors that Influence Revenue Revenue Source,Type Influence Factors Property Tax Impact from housing market, home sales,foreclosure activity, assessed valuation trend, population, personal income, unemployment rate Property Transfer Tax See Property Tax Sales Tax Retail/commercial activity, consumer trends, impact of housing market, population growth, impact of regional economic forces, planned developments, personal income, unemployment rate Franchise Tax Population change, general demand, new development, per unit usage, potential rate increases (external providers and city rates) Transient Occupancy Tax Hotel/motel development, occupancy rate trends, travel & tourism trends Other Tax Impact factors affecting other taxes Intergovernmental—Federal Availability of federal grants and reimbursements, legislative and budget actions Intergovernmental—State For vehicle in lieu fees, similar to factors that affect property and sales taxes; availability of state grants and reimbursements, legislative and budget actions Licenses & Permits Similar factors as property and sales taxes Fines & Forfeitures Fines and penalty rates; similar to factors that affect property and sales taxes Charges for Service Similar to factors that affect taxes, cost of providing services, and rate schedule for cost recovery Exhibit 2: Baseline Assumption October 2008 | Government Finance Review 61
  3. 3. Exhibit 3:Trend Analysis method relies on simple trend analysis allows for “what-if” testing of various Commercial and residential develop- and requires alternative scenarios to assumptions and outcomes, and their ment, along with local economic con- measure the broadest range of proba- likely impact on the organization’s ditions, will affect permit and planning ble outcomes.For example,a forecast of finances. Quantifying unfavorable sce- fees, franchise income, and sales taxes. fines and forfeitures might be based on narios, in particular, allows a local gov- These forecast techniques require not historical trends but modified to ernment or agency to make contin- only availability of historical data but account for expected inflation — gency plans that can be implemented an understanding of the relationship assuming fines are adjusted according earlier and more thoughtfully than the among myriad variables such as popu- to the Consumer Price Index (CPI) — reactionary measures that would likely lation, inflation, local economic activity, and population growth. be put in place after the day of revenue- tax rates, consumption patterns and shortfall reckoning occurs. consumer trends, property values, con- An organization should develop alter- struction activity, and so on. Exhibit 1 native favorable and unfavorable (or Deterministic and econometric fore- shows examples of key revenue types best- and worst-case) scenarios in a casts are based on one or more corre- and associated forecasting factors. way that represents the broadest range lated underlying factors that directly of possible forecast outcomes. The pri- affect revenues and, to a lesser case, PREPARING THE mary purpose for creating alternative expenditures. For instance, changes in BASELINE FORECAST scenarios is to support sensitivity analy- assessed property values and millage sis,which attempts to identify what area rates, or the amount per $1,000 that is The first step in establishing the base- of uncertainty makes the most differ- used to calculate property taxes, will line forecast for a recurring revenue ence in the forecast. Sensitivity analysis directly affect property tax revenues. type is to collect historical data for 62 Government Finance Review | October 2008
  4. 4. Exhibit 4: Correlation Analysis trend analysis. While historical trends percentage of total revenue indices pro- shown in Exhibit 4. Both examples are are not necessarily predictive, they do vide further understanding of real based on the sales tax revenue data establish a base for future projections. growth rates and help identify recurring from Exhibit 2. The correlation analysis In Exhibit 2, historic sales tax receipts and non-recurring elements that can be shows that while Springfield’s receipts for the fictional city of Springfield are factored into the forecast. (See Exhibit are relatively flat between fiscal 2007 broken out by business category, allow- 3 for a per capital trend analysis.) and 2008, they in fact are falling when ing for greater insight into revenue Correlation analysis can be used to ana- compared with CPI inflation growth for sources and trends. In this case, while lyze relationships among major rev- the same period. overall sales tax receipts are on a down- enue sources such as property and ward trend, certain components such sales taxes, in comparison with residen- ALTERNATIVE SCENARIOS as service stations and food stores con- tial and commercial development, eco- Once the baseline forecast is estab- tinue to show positive growth. nomic cycles, population growth, infla- lished, alternative scenarios can be pre- tion, and so forth (see Exhibit 4). pared that depict favorable and unfavor- TREND AND CORRELATION able variations on the baseline scenario. In Exhibit 3, Springfield’s sales tax ANALYSIS The degree to which the baseline and revenues are illustrated in nominal and Once historical data have been gath- per capita values. Once per capita alternative scenario differ will depend ered, they can be further analyzed by trends are established, those numbers on how much the revenue type tends to using trend and correlation analysis. In can then be compared with inflation to vary, historically, and the organization’s trend analysis, metrics such as per capi- provide a clearer understanding of real degree of confidence that the baseline ta, percentage of annual growth, and growth versus nominal growth rates, as forecast is accurate. As variability October 2008 | Government Finance Review 63
  5. 5. Exhibit 5: Sensitivity Analysis, Baseline Scenario Exhibit 6: Sensitivity Analysis, Unfavorable Scenario 64 Government Finance Review | October 2008
  6. 6. Exhibit 7: Expenditure Forecast, Restrained Spending Scenario increases, and as confidence decreases, vency. Organizations also need to ana- are not. Common expense types the distance between baseline and alter- lyze historical trends in their fund bal- include: salaries and wages, employee native positive and negative scenarios ances, using measures such as unre- benefits, materials and supplies, profes- should increase to capture the full range served fund balance as a percentage of sional and contract services,minor cap- of probable outcomes. annual appropriations, and compare ital (office equipment),capital projects, historical and projected balances with debt, and other operating expenses. The baseline scenario shown in the organization’s minimum policy Exhibit 5 illustrates a positive gap The baseline forecast should be requirements.The unreserved fund bal- between revenues and expenditures, based on existing and recurring staff ance,or fund balance available,is a crit- resulting in an increasing fund balance levels, operating expenditures, and ical benchmark for evaluating an orga- over time. This scenario was construct- other expenses the government or nization’s ability to meet unexpected ed using an interactive forecasting agency has already committed to, funding shortfalls and is often used as model, which allows various assump- including capital programs, debt, and one way of measuring solvency. tions and budget options to be activat- contractual commitments such as ed, instantaneously demonstrating posi- employee compensation and benefits. EXPENDITURE FORECASTING tive or negative impacts on projected The latter example illustrates the need fund balances, as shown in Exhibit 6. Expenditure forecasting is similar to for longer-term forecasting to measure revenue forecasting.To create the base- In the interactive forecasting model future impact, as employee retirement line expenditure forecast, first identify illustrated in this article, the projected recurring expense types, and then ana- and health-care benefits are the fastest- fund balance is used as a proxy for the lyze historical trends for expenditures growing components of most govern- organization’s financial health and sol- that are related to labor and those that ment budgets. October 2008 | Government Finance Review 65
  7. 7. Alternative expenditure forecasts can CONCLUSION help organizations analyze trends and reflect spending levels that mirror Long-term financial forecasts are not identify possible future financial states, potential increased department mis- absolute predictions of the future, but but they also help communicate finan- sions (i.e.,“augmented”scenarios based projections of possible future states cial issues to key constituents. ❙ on what departments might spend if based on known assumptions.The best additional resources were available). forecasts are based on a solid under- They can also reflect restrained or con- standing of historical trends combined CHRISTOPHER J. SWANSON is the founder tingent spending plans that could be with a range of future scenarios derived of Government Finance Research Group implemented in response to reduced from a detailed analysis of known fac- (GFRG), a financial management consulting resources. Exhibit 7 shows the way a tors that can affect revenues and spend- firm specializing in financial planning, cost restrained spending plan improves the ing. Longer forecasting horizons can analysis, econometric modeling, benchmark- impact on fund balance from the unfa- reveal structural imbalances that are ing, and optimization modeling for local gov- vorable revenue scenario from Exhibit not yet apparent, giving an organization ernments throughout the United States. 6.This forecast model can also factor in time to take corrective action in a GFRG designed and developed the itemized spending options, in addition proactive way, thus optimizing the use MuniCast interactive financial forecasting to or in place of an organization-wide of public funds over the long term. model. Swanson can be contacted at 949- expenditure scenario. Interactive forecasting models not only 412-6078 or An Elected Official’s Guide: Tax Increment Financing by Nicholas Greifer This booklet introduces the fundamentals of tax increment financing (TIF). It reviews how gov- ernments establish and manage TIF districts, common techniques for financing TIF projects, and the pros and cons associated with TIF usage. It also discusses the risks and risk management- tools for helping to ensure successful TIF outcomes. The entire Elected Official’s series provides practical and easy-to-understand explanations — in plain language — on a variety of public finance topics. These booklets are ideal for distribution to newly elected officials, news reporters, government employees, citizen and taxpayer groups, and others interested in local government finance. To learn more and to purchase one book, a bundle, or the entire series, visit us online at Order online Government Finance Officers Association 66 Government Finance Review | October 2008