The track record of a 20-year history of density forecasts of state tax revenue in Iowa is studied, and potential improvements sought through a search for better-performing 'priors' similar to that conducted three decades ago for point forecasts by Doan, Litterman and Sims (Econometric Reviews, 1984). Comparisons of the point and density forecasts produced under the flat prior are made to those produced by the traditional (mixed estimation) 'Bayesian VAR' methods of Doan, Litterman and Sims, as well as to fully Bayesian 'Minnesota Prior' forecasts. The actual record and, to a somewhat lesser extent, the record of the alternative procedures studied in pseudo-real-time forecasting experiments, share a characteristic: subsequently realized revenues are in the lower tails of the predicted distributions 'too often'. An alternative empirically based prior is found by working directly on the probability distribution for the vector autoregression parameters - the goal being to discover a better-performing entropically tilted prior that minimizes out-of-sample mean squared error subject to a Kullback-Leibler divergence constraint that the new prior not differ 'too much' from the original. We also study the closely related topic of robust prediction appropriate for situations of ambiguity. Robust 'priors' are competitive in out-of-sample forecasting; despite the freedom afforded the entropically tilted prior, it does not perform better than the simple alternatives.
All Science Journal Classification (ASJC) codes
- Modeling and Simulation
- Computer Science Applications
- Strategy and Management
- Statistics, Probability and Uncertainty
- Management Science and Operations Research