Legislative Analyst's Office, November 14, 2002

California's Fiscal Outlook

LAO Projections, 2002-03 Through 2007-08

Foreword

This report provides our projections of General Fund revenues and expenditures for 2002-03 through 2007-08 It includes our independent assessment of the outlook for California's economy, demographics, revenues, and expenditures.

Chapter 1 contains our principal findings and conclusions. Chapter 2 presents our economic and demographic projections, Chapter 3 our revenue forecasts, and Chapter 4 our expenditure projections.

Our fiscal projections reflect current-law spending requirements and tax provisions. They are not predictions of future policy decisions by the Legislature, nor are they our recommendations as to what spending and revenue levels should be.

This report, in its eighth year of publication, reflects the historical mission of the Legislative Analyst's Office to assist the Legislature with its fiscal planning by assessing the revenues and expenditures of the state. The report is part of an ongoing series and is updated periodically.

Table of Contents

Chapter 1: The Budget Outlook 

Chapter 2: Economic and Demographic Projections 

Chapter 3: Revenue Projections 

Chapter 4: Expenditure Projections 

Chapter 1

The Budget Outlook

Summary

California policymakers will be facing an enormous challenge in crafting the 2003-04 General Fund budget. For the second year in a row, the state faces a budget problem in excess of $20 billion. Specifically, our updated forecast indicates the following:

• Current Year. California will end the 2002-03 fiscal year with a General Fund deficit of $6.1 billion, compared to the $1 billion positive reserve balance assumed when the 2002-03 Budget Act was adopted.
• Budget Year. The 2003-04 budget faces a cumulative year-end deficit of $21.1 billion, absent corrective actions. However, if California's economic performance continues to lag and fails to experience the accelerating growth that we are expecting in the latter half of 2003, the shortfall could easily be several billion dollars higher.
• Beyond the Budget Year. Over the longer term, the state will face annual operating deficits (that is, excesses of expenditures over revenues) of between roughly $12 billion and $16 billion per year, again absent corrective actions. These shortfalls average about 14 percent of the state's annual General Fund budgets over the period.

What Is Behind Huge Budget Problem?

Given that the General Fund budget enacted for 2002-03 only a few months ago was balanced with a $1 billion reserve, a natural question to ask is: How could such an enormous problem for 2003-04 develop so fast? As discussed below, two main factors are responsible:

•  First, the budget enacted for 2002-03, while at the time balanced, did not address the large underlying mismatch between current-law expenditures and revenues.
•  Second, due largely to soft economic performance, fiscal conditions—especially the outlook for revenues—have deteriorated substantially.

Underlying Operating Shortfall Not Addressed In 2002-03 Budget

About one-half of the projected 2003-04 budget problem relates to an underlying operating shortfall in California's General Fund budget that would have existed even without the recent deterioration in the economic and revenue outlook.

Stock Market Collapse a Key Factor. As we have indicated in previous reports, the state has faced a large and ongoing imbalance between revenues and expenditures since the stock market bubble burst and tax revenues fell by over $10 billion in 2001-02. The dramatic impact of the stock market decline is depicted in Figure 1, which shows the amount of personal income taxes attributable to stock options and capital gains. It indicates that these tax revenues peaked at $17 billion in 2000-01, but fell abruptly following the stock market decline—to under $6 billion in 2001-02. This unprecedented 66 percent decline is the key factor behind the $10-plus billion annual mismatch between revenues and expenditures that began in 2001-02.

One-Time Solutions Provided Only Temporary Relief. In dealing with the cumulative $23.6 billion budget shortfall facing the state in 2002-03, the Governor and Legislature relied primarily on one-time actions to close the gap. While these actions addressed the cumulative shortfall in the 2002-03 budget itself, they did not eliminate the underlying current-law gap between revenues and expenditures. Thus, the expenditure-revenue mismatch was destined to reappear. Consequently, even if all of the assumptions embedded in the 2002-03 budget had held up, the state would have still faced an operating shortfall of over $10 billion in 2003-04.

Further Deterioration in Revenue and Expenditures

The other roughly half of the projected $21 billion cumulative shortfall in 2003-04 largely relates to the recent deterioration in the revenue outlook resulting from near-stagnant economic conditions in past months. This factor has caused us to reduce our General Fund revenue forecasts relative to our earlier projections by $777 million in 2001-02, $4.1 billion in 2002-03, and $6.5 billion for 2003-04—or a total of $11.4 billion for the three years combined.

Our updated estimate of the 2003-04 shortfall also includes the impacts of revised assumptions about new federal funds, retirement incentives, Medi-Cal fraud detection, and state operations reductions—as well as savings related to lower Proposition 98 spending in 2003-04. On balance, these expenditure revisions have worsened the budget's bottom-line condition, although not to the same extent as have revenues.

Key Forecast Assumptions

Economic Outlook

Recent Trends Have Been Weak. Although the national and state economic downturns appear to have bottomed out in late 2001, the economic expansion has been extremely sluggish in 2002. At the national level, consumer spending has increased over the past year, but business spending and net exports have been soft. These trends have also been evident in California, where growth has been extremely limited in recent months.

Modest Growth Expected. Our updated forecast assumes that the national and state economies will continue to expand at subdued rates until mid-2003, when improvements in business spending and export sales start to boost overall economic growth. Specifically, we forecast that U.S. gross domestic product will increase by about 2.5 percent this year and 2.6 percent in 2003, before accelerating to annual growth rates in the 3 percent to 4 percent range in subsequent years. In California, we forecast that, following a marginal gain of 1.2 percent in 2002, personal income growth will accelerate to 4 percent in 2003, slightly over 6 percent in 2004, and to between 6 percent and 7 percent in subsequent years.

Downside Risks Exist. Our forecast is subject to a significant downside risk that further delays in business hiring and spending, coupled with sagging consumer confidence and spending, will depress U.S. and California economic growth below our current forecast. Another risk involves the resolution of the current labor-management dispute involving workers at West Coast ports. A protracted economic slowdown could reduce state General Fund revenues by several billions of dollars below our baseline forecast in the current and budget years combined.

Revenue Outlook

We currently forecast that revenues will grow from $73.1 billion in 2001-02 to $75 billion in 2002-03, before declining to $70.2 billion in
2003-04. These totals are affected by a variety of special factors, which are discussed in Chapter 3. Absent these factors, underlying revenues fell by about 16 percent in 2001-02, and are expected to decline another 1 percent in 2002-03 before growing about 5.6 percent in 2003-04. Over the longer term, revenue growth is forecast to average roughly 7 percent per year.

Revenue Revisions. As indicated above, our revenue forecast is down from the 2002-03 Budget Act estimates by $777 million in 2001-02 and by $4.1 billion in 2002-03. In addition, our estimates for 2003-04 and beyond are below our previous estimates by about $6 billion annually. These substantial downward revisions are primarily associated with the personal income tax. Collections from this source are being adversely affected by (1) the continued reductions of jobs and income in high-paying manufacturing and software industries, and (2) continued declines in stock market values, which will result in reduced levels of taxable income from stock options and capital gains. To a lesser degree, sluggish economic growth is also depressing collections from the sales tax and corporation tax.

Projected General Fund Condition

Figure 2 presents our updated General Fund condition projections for 2001-02 through 2003-04. These estimates take into account our revised projections of current-law revenues and expenditures, discussed in Chapter 3 and Chapter 4, respectively.

Revised Outlook for 2002-03

Deficit to Exceed $6 Billion. The 2002-03 budget enacted in September assumed that the current fiscal year would end with a positive reserve of $1 billion. However, we estimate that the large combined $4.9 billion reduction in 2001-02 and 2002-03 revenues, coupled with $1.8 billion in added expenditures and a $410 million deterioration in the 2001-02 carry-in balance, will use up the reserve and push the state into a deficit of $6.1 billion in the current year. As discussed above, the decline in revenues reflects the deterioration in the near-term economic outlook. The increase in expenditures is due to our revised estimates related to new federal funds, the state retirement incentive program, state operations reductions, and Medi-Cal fraud detection.

Outlook for 2003-04 And Beyond

Basis for Our Estimates

Current Law Assumed. Our revenue and expenditure forecasts for 2003-04 and beyond are based primarily on the requirements of current law. For example, we have adjusted the current-year spending plan for constitutional and statutory funding requirements (such as the Proposition 98 minimum funding guarantee for K-14 education), as well as for projected changes in caseloads, cost-of-living adjustments (COLAs), federal reimbursements, and other factors affecting program costs. We have also adjusted the budget for one-time costs and savings in the current year.

Projections, Not Predictions. It is important to note that our fiscal projections are not predictions of what the Legislature and Governor will adopt as policies and funding levels in future budgets. Rather, our estimates are intended to be a reasonable "baseline" projection of what would happen if current-law policies were allowed to operate in the future. In this regard, we believe that our forecast provides a meaningful starting point for legislative deliberations involving the state's budget.

Treatment of Loan Repayments and Mandates. In preparing our estimates for 2003-04 and beyond, we needed to make assumptions about repayments of loans to the General Fund from special funds, as well as state payments to localities associated with mandates which were deferred in 2002-03. With regard to loan repayments, our estimates include the timely repayment of all loans which had specific repayment dates scheduled in the budget. We also assume that about one-half of the remaining loans are repaid evenly over the forecast period. With regard to state-imposed local mandates (excluding education), we assume that prior-year claims will be paid off over the forecast period.

2003-04 Outlook—Huge Problem Looming

Key Elements. As shown in Figure 2, we estimate that revenues will fall from $75 billion in
2002-03 to $70.2 billion in 2003-04. The decline reflects the large amount of one-time revenues, loans, and transfers that total $9.5 billion in 2002-03, but which are largely absent in 2003-04. At the same time, expenditures are projected to increase from $78.5 billion in the current year to $85.2 billion in 2003-04. The increase reflects a variety of factors, including new General Fund costs associated with health programs previously funded from the tobacco settlement special fund, the annualized costs of COLAs provided for the Supplemental Security Income/State Supplementary Program in June 2003, $1.2 billion in added funding for transportation spending (as mandated by Proposition 42), and additional costs for employer retirement contributions. General Fund Proposition 98 funding is projected to grow by only 2.4 percent in 2003-04, due to (1) a relatively small increase in the minimum funding guarantee and (2) a rapid increase in local property taxes, which reduces the General Fund share of total Proposition 98 funding.

$21 Billion Imbalance Projected. The combination of the expenditure increases and revenue reduction in 2003-04 will result in an operating deficit of nearly $15 billion in the budget year. Thus, when combined with the $6.1 billion deficit carry-in from 2002-03, the 2003-04 budget faces a cumulative shortfall of roughly $21 billion, absent corrective actions.

Longer Term Outlook—Continued Shortfalls

Figure 3 presents our revenue and expenditure forecasts through 2007-08. It indicates that current-law operating deficits are expected to persist over the entire period, absent corrective actions.

On the positive side, we do expect revenues to grow somewhat more rapidly than expenditures over these years, as evidenced in Figure 3 by the revenue line closing in a bit on the expenditure line over time. Our projected faster growth for revenues than for expenditures reflects our assumption that revenue growth will accelerate in 2004-05 as the economic expansion gains momentum. It also reflects relatively slow growth in General Fund Proposition 98 spending, due primarily to slowing growth in K-12 school enrollments. As a result of the above factors, our projected operating deficits do decline slightly over time.

Despite these favorable trends, however, projected revenues remain well below expenditures at all times over the forecast period. Specifically, as the figure indicates, we expect that annual operating deficits peak at $15.6 billion in 2004-05 before slowly declining to $12.3 billion by 2007-08. The persistence of these large mismatches between current-law revenues and expenditures indicates that the state has a large structural budgetary imbalance that it cannot simply "grow" its way out of on the natural. As a result, substantial budget-balancing actions will be needed.

Approaching the Problem

This Year Will Be Much Harder Than the Last

Last year, when the state faced a cumulative $23.6 billion budget problem, we identified for the Legislature a variety of principles, strategies, and tools for dealing with the shortfall (see, for example, our report entitled Addressing the State's Fiscal Problem, December 2002). The current budget shortfall is much more formidable and challenging than last year's. This is due both to the magnitude of the problem and because a number of the one-time solutions heavily relied on last year cannot be used again—such as the $4.5 billion raised from tobacco securitization, the $1.1 billion near-term savings from restructuring repayments of state general obligation bonds, and certain loans and tax accelerations. Given this, there is really no easy way out of the current predicament, and this makes it all the more important that the Legislature take advantage of the alternative budget-balancing approaches and options available to it.

Key Principles, Strategies, and Tools

Figure 4 summarizes in broad terms the various key budget-balancing principles, strategies, and tools that we have previously identified and that we believe merit the Legislature's attention again this year.

Of particular importance are:

• Take Current-Year Actions. In last year's budget process, the Governor and Legislature acted mid-year to make significant reductions in 2002-03 spending. We recommend that the Legislature again consider mid-year adjustments. This would not only reduce the projected year-end 2002-03 deficit, but could reduce the out-year problem as well.
• Put Everything on the Table. In order to bring the budget back in balance, it will be necessary to consider all types of solutions—spending reductions and deferrals, fund shifts, revenue increases, and improved tax compliance and collection. Or, put differently, we believe that nothing should be taken off the table when considering options. This doesn't mean that all program areas are of the same import. The Legislature, for instance, has made it clear that K-12 education is a high priority. However, there are potential efficiencies and savings that can be achieved in any area, and the Legislature will need the largest possible "menu" from which to choose in addressing the problem.
• Continue to Use One-Time Solutions, But Significant Ongoing Actions Needed. The Legislature relied extensively on onetime solutions in crafting its 2002-03 budget package. We believe one-time solutions should also play an important role in coming budget deliberations. Of the $21 billion problem that we have identified, roughly $6 billion is from the projected year-end 2002-03 deficit. This part of the problem could be appropriately addressed entirely with one-time solutions. The remaining $15 billion portion of the budget problem for the most part represents an ongoing imbalance between revenues and spending. Thus, it is important that the Legislature adopt major ongoing solutions—spending reductions and revenue increases —to address this portion of the gap.

Chapter 2

Economic and Demographic Projections

Economic and demographic developments in California have important effects on the state's fiscal condition through their impacts on both tax revenues and state expenditures. This chapter presents our economic and demographic projections for 2002 through 2008, which will affect California's fiscal condition during fiscal years 2002-03 through 2007-08.

The Economic Outlook

Overview of the Economic Forecast

California's economy has been hard hit by the slump in spending on high-tech goods and services, plunging exports, and the stock market's decline. These factors have combined to produce soft personal income growth in the state, and they continue to dampen economic performance as of late 2002. Looking ahead, we forecast that the economy will continue to "muddle along" until the second half of 2003, when a long-delayed improvement in business investment spending is anticipated to begin to boost California's overall job and income growth. From then on, moderate income and job gains are expected through the remainder of the forecast period.

Although our forecast reflects what we believe is the most likely future path for the economy, our forecast—like any—is subject to risks and uncertainties. In this regard, we believe that the main risk to our forecast is on the downside—namely, our economic projections are subject to the possibility that further declines in consumer confidence and spending could occur that, in turn, could result in prolonged economic weakness during the next year. In this event, both the economy and the state's fiscal condition would under-perform our expectations.

Figure 1 summarizes the details of our economic forecast, while the current state of the economy and the major components of our economic forecast are discussed below.

Recent National Economic Developments

Consumer Spending Keeping U.S. Economy on Upward Track . . .

After falling in 2001, the U.S. economy has experienced a modest rebound over the past year. For example, U.S. real gross domestic product (GDP) grew by 3 percent between the third quarter of 2001 and the third quarter of 2002. This output increase has occurred despite virtually no growth in employment and only modest gains in personal income, and thus is attributable primarily to increased productivity.

As shown in Figure 2, most of the recent growth in U.S. output has been related to consumer spending, which has remained surprisingly strong in view of the lack of job and income growth over the past year. A key force behind this continued spending growth has been low interest rates, which have boosted sales of automobiles and other interest-sensitive durable goods. Declining mortgage rates have also produced a boom in both new home sales and financings, as well as the refinancing of existing mortgages. The new home activity has directly added to output, and the refinancings have enabled individuals to reduce their home payments and/or "cash out" some of their previously built-up home equity—in both cases providing additional funds for spending.

. . . But Continued U.S. Growth Will Depend on Businesses

A very important question for the U.S. outlook is how much longer can consumer spending carry the economic expansion—especially in view of the recent lack of employment and personal income growth in the economy. In this regard, a key to future economic growth would appear to be increased business spending on capital equipment and labor.

Normally, continued growth in consumer spending would be matched by new investment and hiring by businesses. However, this has not been the case during the past year. For example, nonresidential investment, which includes spending by businesses on new plants and equipment, fell by over 4 percent between the third quarter of 2001 and the third quarter of 2002 (see Figure 2). The decline in business investment, coupled with cautious attitudes by employers generally, has contributed to a 190,000 drop in private sector jobs since the beginning of the year.

The lack of business spending on plants and equipment reflects the large amount of idle capacity that currently exists in the economy, which has partly resulted from past over-investment by many businesses in telecommunications and other high-tech areas. It also reflects pressures that businesses are facing from their shareholders and directors to control costs and improve their "bottom line" profit statements. These factors have translated into delays or cancellations of equipment and software upgrades, and sharp cutbacks in hiring.

The lack of job growth, coupled with declining stock market values and other uncertainties, is starting to take a toll on consumers. The Conference Board's consumer confidence survey plunged to a nine-year low in October, and preliminary reports suggest that retail sales softened in October. A slowdown in consumer spending would have major implications for the overall economic expansion, since consumer spending accounts for over two-thirds of economic output.

Given these factors, a key to the outlook is an improvement in business spending and hiring. Such an improvement would provide a welcome boost to income and jobs, which would in turn sustain gains in consumer spending and overall economic growth in the future.

California Developments

Employment and Income Both Have Been Weak

There are no current state-level gross domestic product data available to precisely measure output changes in California. However, the information that is available from such diverse sources as employment, personal income, withholding, taxable sales, new vehicle registrations, and building permit activity suggests that, like the nation, California's economy bottomed-out in late 2001, and has been on a weak growth path during the first ten months of 2002. The recovery has not been of sufficient magnitude to create new jobs and, in fact, California's private sector has experienced job losses during the past year. With regard to personal income, California has suffered a steeper slowdown than the rest of the nation, due to (1) a large amount of job losses in the state's high paying manufacturing sector, and (2) continued declines in stock-option income. Reflecting these factors, we estimate that the state's personal income will increase by just 1.2 percent in 2002, compared to 3.2 percent for the nation as a whole.

California's Manufacturing-Related Jobs Have Plunged

As indicated in Figure 3, total California manufacturing employment has fallen by over 230,000 jobs (12 percent) since its peak in late 2000. Although not as dramatic as in the early 1990s, when the state faced major restructuring of its defense industry, the manufacturing job downturn has nevertheless been one of the steepest two-year declines in the state's history.

Business Services Employment Also Has Suffered

A similarly large employment reduction has occurred in the state's business services job sector (which includes temporary hires by manufacturers as well as computer and software design jobs). After growing at an average rate of 8.4 percent per year between 1995 and 2000, this sector has lost 11 percent of its job base during the past two years. The losses of manufacturing and computer-related business services jobs are significant, since these are among the highest paying jobs in the state.

Forces Behind California Job Losses—Weak Business Spending and Exports

As with the nation generally, a key force behind the job losses in California's manufacturing and business services sectors has been the weakness in national business investment spending. The decline is important to California since so much of its high-tech goods and services are sold to businesses.

In addition to the decline in U.S. investment spending, manufacturers in this state are also coping with a plunge in foreign demand for their products. Total California-produced exports fell by 11 percent in 2001 and will decline by another 14 percent this year, due to soft economic conditions abroad. As shown in Figure 4, the export decline between the first half of 2001 and the first half of 2002 has been concentrated in computers, electronics, aerospace, and transportation products. The drop in exports is important since a significant share of California-produced high-tech goods are sold in other countries.

Main Positive Force in State—Low Interest Rates

Outside of the manufacturing and business services sectors, the California economy has recently managed to grow at a modest pace. The main positive forces have been low interest rates and continued California population growth. Like the rest of the nation, California's spending on automobiles has remained strong in 2002, buoyed by zero-interest financing promotions. Likewise, strong home sales and mortgage refinancings associated with low interest rates, along with continued growth in residential construction activity, are boosting employment in California's construction and finance-related industries. Nonbusiness services employment is also expanding modestly, reflecting gains in such diverse industries as health care, personal services, and auto repair.

Increases in interest-sensitive and population-driven industries have managed to keep California's economy on a slight upward track thus far in 2002. However, it is unlikely that they can continue to offset the negative effects of falling business spending and exports for much longer. Without improvement in these latter two areas, it is unlikely that California can sustain a meaningful expansion.

The Economic Outlook—Slow Improvement Beginning In Mid-2003

Our forecast assumes that both the national and state economies increase at a very subdued rate through the first half of 2003. At that point, we assume that business spending will finally begin to improve, providing a much-needed boost to overall economic growth. We expect business spending to eventually improve because, although the manufacturing sector currently has a considerable amount of unused capacity, businesses will eventually need to upgrade equipment and software to take advantage of new innovations in communications, web technology, and other areas.

National Outlook

As indicated previously in Figure 1, we forecast that U.S. GDP will increase by 2.5 percent and 2.6 percent in 2002 and 2003, respectively, before accelerating to 3.8 percent in 2004 and an average of about 3.3 percent over the balance of the forecast period. Over the longer term, growth in U.S. economic output will be aided by healthy gains in worker productivity, which we expect to rise by slightly over 2 percent per year.

The forecast assumes similarly modest accelerations in jobs and income. Inflation is expected to remain relatively low over the forecast period, with the Consumer Price Index forecast to increase by an average of less than 3 percent over the next six years.

California Outlook

As with the nation, we expect California's economy to grow at a very sluggish pace until the second half of 2003, with employment and income improving slowly in 2003 before accelerating in 2004 and 2005. The improvement is tied to an assumed rebound in manufacturing employment, which we expect to benefit from an eventual rebound in business spending and exports.

We specifically project that personal income will increase by 4 percent in 2003 and 6.1 percent in 2004, and that wage and salary employment will grow by 0.5 percent and 2.4 percent during the same two years. Continued population growth and low interest rates will result in growth in residential construction activity during the forecast period. Nonresidential construction is expected to decline through mid-2003, then slowly grow thereafter.

Risks to the Forecast

Our near-term forecasts for both the nation and California are below the consensus of estimates made by other economists in October 2002, particularly with regard to California personal income growth. However, given recent negative reports on employment, consumer confidence, and manufacturing activity, we believe that even our forecast is subject to considerable downside risk. The combination of a steeper slowdown in consumer spending, and further cutbacks in business investment and hiring, could further weaken near-term growth—or even produce a "double dip" recession early next year. Such a development would result in further job declines and another year of near-zero growth in personal income in 2003. It would also have substantial adverse effects on state tax revenues, and thus on the projected outlook for the General Fund's condition. Another risk involves the current labor management dispute at the West Coast ports. While our forecast assumes that current federally mediated negotiations will produce a successful resolution, a prolonged lockout or strike would disrupt commerce in California and elsewhere in the nation.

The Demographic Outlook

As of 2002, California's population totaled slightly over 35 million. During the six-year forecast period, the state's population is projected to grow annually by about 1.5 percent, or well over half a million persons yearly. Thus, California will add roughly 3.3 million people over the forecast interval and reach over 38 million by 2008.

The population growth rate we are projecting is somewhat slower than that experienced in the latter part of the 1990s. This reflects both the dampening effects of the slower economy on in-migration, and a continuing downward trend in birth rates.

Population Growth Components

California's population growth can be broken down into two major components—natural increase (the excess of births over deaths) and net in-migration (persons moving into California from other states and countries, minus those leaving for other destinations). On average, these two components tend to contribute about equally to the state's population growth, although their relative shares can vary significantly from one year to the next depending largely on the strength of net in-migration.

Natural Increase. We project that the natural-increase component will average about 285,000 new Californians annually over the forecast period. This amount is slightly less than in the late 1990s, due to the ongoing decline in birth rates being experienced by all ethnic groups. Despite these declining birth rates, however, the natural-increase component still will grow slightly due to significant growth in the female population of child-bearing age groups in faster-growing segments of the population, including Hispanic and Asian women.

Net In-Migration. We project that net in-migration will average roughly 265,000 annually over the next six years. This is weaker than during the latter half of the 1990s and somewhat less than the natural-increase component. As indicated by Figure 5, this reflects a projected drop in domestic net in-migration that we believe will accompany California's less-than-robust economic performance. In contrast, foreign net in-migration—which has been relatively stable over the past decade and has proved to be less sensitive to the economy—is projected to remain relatively flat.

Growth to Vary by Age Group

Figure 6 shows our population growth projections by broad age categories, including both numerical and percentage growth.

Ranks of Baby Boomers to Swell. The 45-to-64 age group (largely the "baby boomers") continues to be the fastest growing segment of the population. Over 1.6 million new people are expected to move into this age category over the next six years. At the other extreme, although continued in-migration will result in moderate growth for preschoolers, relatively slow growth is anticipated for the K-12 school-age population. This reflects the movement of children of the baby boom generation beyond the 5-to-17 age group. The decline in birth rates in recent years has also resulted in fewer children moving into the school-age category.

These various age-group demographic projections can have significant implications for the state's revenue and expenditure outlook. For example, strong growth of the 45-64 age group generally benefits tax revenues since this is the age category that routinely earns the highest wages and salaries. Likewise, the growth in the young adult population affects college enrollments, while that for the 0-to-4 and 5-to-17 age groups drives K-12 enrollment growth.

Chapter 3

Revenue Projections

The revenues that finance California's state General Fund budget come from a wide variety of different sources, including taxes, fees, licenses, interest earnings on investments, loans, and transfers. The great majority of General Fund revenues, though, is attributable to the state's three major taxes—the personal income tax (PIT), the sales and use tax (SUT), and the corporation tax (CT). In addition, however, actions taken in conjunction with the adoption of the 2002-03 budget have also resulted in a variety of significant one-time revenue increases in the current year related to loans and the securitization of tobacco receipts. In this section, we summarize our revenue projections and provide detail behind our key revenue-related forecast assumptions.

The LAO's Revenue Forecast

Major Downward Revisions To Outlook

The revenue outlook continues to deteriorate. Our updated revenue forecast, presented in Figure 1, is as follows:

• Prior-Year Revenues. We estimate that revenues in 2001-02 totaled $73.1 billion, about $777 million below what was assumed in the 2002-03 Budget Act. This shortfall is primarily due to lower-than-expected combined receipts from the PIT and SUT in May and June, as well as higher-than-expected CT refunds this fall (which we accrued back to 2001-02). The $12.8 billion shown in the figure for "other revenues and transfers" in 2001-02 includes $6.2 billion related to the repayment of the General Fund loan for electricity power purchases.
• Current-Year Revenues. Revenues are projected to total $75 billion in the current year, a 2.6 percent increase from 2001-02. The current-year amount includes about $9.5 billion in special factors included in the 2002-03 budget package. These include tobacco securitization, tax increases, and one-time loans and transfers. Absent these and related changes affecting revenues in the prior and current years, "underlying" revenues are down about 1 percent from 2001-02. Compared to the 2002-03 budget forecast, our revenue projection for the current year is down by about $4.1 billion, reflecting a particularly large PIT revision.
• Budget-Year Revenues. We forecast that General Fund revenues will be $70.2 billion in 2003-04, a 6.4 percent decline from the current year. This decline reflects the large amount of one-time revenues included in the current-year totals but missing for 2003-04. Absent these factors, underlying receipts would be up a modest 5.6 percent in 2003-04. Our updated forecast is down by about $6.5 billion from the long-term projections for the budget year that we made in summer 2002.
• Longer-Term Revenues. We forecast that improving economic conditions will result in accelerating General Fund revenue growth in 2004-05 and thereafter. Specifically, we forecast that revenues will increase by 7.2 percent in 2004-05 and 9.5 percent in 2005-06, before settling down into a more moderate pattern of growth rates during the final two years of the forecast.

Main Factors Behind the Downward Revenue Revisions

The major downward revisions to revenues in the current and budget years are primarily related to the continued softness in California's economy. This softness is taking a greater toll on personal income, taxable sales, and taxable profits than we had previously estimated would be the case. In addition, the continued deterioration in the stock market since last spring implies that personal income taxes from stock options and capital gains will be even less than assumed in spring 2002.

The impacts of continued softness in economic activity are evident in key California revenue indicators. As shown in Figure 2, although both personal income tax withholding and taxable sales have shown slight improvements since the beginning of 2002, both measures remain below last year's already-depressed levels.

Special Revenue-Related Factors

Our revenue forecast for 2002-03 and beyond includes the impacts of numerous actions taken in conjunction with the adoption of the 2002-03 budget. These include:

• Revenue Increases. The budget includes about $2.5 billion in new tax-related revenues during 2002-03. The main components are: (1) a two-year suspension of the business net operating loss (NOL) carry-forward deduction (which is coupled with future increases in the amounts that can be carried forward from 65 percent to 100 percent beginning in 2004); (2) higher withholding on stock options and certain real estate sales; and (3) the suspension of the teachers' tax credit.
•   Tobacco Securitization. About $4.5 billion in one-time revenue is anticipated in 2002-03 from the securitization of future tobacco settlement receipts. The state will raise these funds by selling its rights over the next 25 years or so to its tobacco settlement receipts, for $4.5 billion in up-front cash. This will be achieved through the sale of revenue bonds whose repayment is secured by the tobacco settlement payments the state receives beginning in 2002-03 until the bonds are paid off.
•   Special Fund Loans and Transfers. About $2.6 billion is involved in one-time loans and transfers from special funds. The single largest component involves a $1 billion loan from the Traffic Congestion Relief Fund, which is scheduled to be repaid over the subsequent three years. Our out-year revenue estimates include the repayment of this and other loans for which specific repayment dates have been established.

Combined Effect of Special Factors. Figure 3 shows the net impact of the above special factors on General Fund revenues during the forecast period. Taken together, special factors will increase General Fund revenues and transfers by about $9.5 billion in 2002-03. In 2003-04, the net impact of these factors will be relatively small—$188 million—as the second-year impact of the NOL suspension is partly offset by scheduled loan repayments. In subsequent years (2004-05 through 2007-08), the net impact will be annual losses ranging from $250 million to $1.2 billion. These losses are due to loan repayments and higher NOL deductions.

Individual Revenue Sources

Personal Income Tax

After its historic 25 percent plunge (from $44.6 billion to $33.4 billion) between 2000-01 and 2001-02, we project that PIT receipts will increase modestly to $34.5 billion in 2002-03 and further to $36.4 billion in 2003-04. Over the longer term, we forecast that PIT receipts will increase at an average annual rate of 9.6 percent between 2003-04 and 2007-08, reaching $52.5 billion by the end of the forecast period.

Key Forecast Factors

Much of the estimated PIT revenue gain between 2001-02 and 2002-03 is related to the $1 billion in PIT revenue increases adopted in conjunction with the 2002-03 budget. Absent these changes, the underlying growth in PIT receipts would be less than 1 percent. This small underlying increase is related to both continued economic sluggishness and the adverse impacts of further stock market declines on taxable income related to stock options and capital gains. We estimate that after plunging by nearly 66 percent in 2001, the income from gains and options will decline another 19 percent in 2002 before starting to rebound in 2003. In subsequent years, we project that the combination of an economic rebound and modest improvement in stock market-related income will boost PIT receipts.

Sales and Use Taxes

We estimate that SUT receipts will total $22.4 billion in 2002-03, a 5.3 percent increase from 2001-02. We forecast that these receipts will grow further to $23.5 billion in 2003-04. Over the longer term, we forecast that SUT receipts will increase at an average annual rate of 6.6 percent between 2003-04 and 2007-08, reaching $30.5 billion by the end of the forecast period. This growth in SUT receipts is projected to be slightly less than our projected growth for statewide personal income for the period, reflecting a slight decline in the portion of income that is spent on taxable commodities.

Key Forecast Factors

A key determinant of sales tax receipts is taxable sales. As indicted earlier in Figure 2, these sales fell sharply beginning in the second half of 2001, and have only partially recovered in the first three quarters of this year. On an average annual basis, taxable sales were down by 0.7 percent in 2001 (reflecting softness in the second half of year), and are expected to be down another 1.4 percent in 2002. As indicated in the shaded box, much of the recent softness appears to be due to weak business-related spending.

Looking ahead, we project that taxable sales will accelerate, increasing by 3.9 percent in 2003 and 6.2 percent in 2004. Over the longer term, our forecast assumes that taxable sales will increase slightly slower than personal income. These increases are somewhat subdued compared to what would normally be expected during a cyclical upturn. As indicated in Chapter 2 , consumer spending on automobiles and other durable goods has been strong during the recent economic downturn. Because of this, consumers at this point in time have less capacity to take on new debt and have less "pent up" demand than is normal for this stage of an economic cycle. This, in turn, will constrain taxable sales growth.

Corporation Taxes

We estimate that CT receipts will increase from $5.6 billion in 2001-02 to $6.8 billion in 2002-03, before falling to $6.7 billion in 2003-04 and $6.5 billion in 2004-05. In the subsequent three years, we project that revenues from this source will increase at an average annual rate of 6.6 percent, reaching $7.9 billion by the end of the forecast period.

Key Forecast Factors

Corporation tax receipts in 2002-03 and beyond will be affected both by changes in California taxable corporate profits and by law changes enacted along with the 2002-03 budget. Specifically:

• Taxable Profits. Figure 4 shows that, after growing by slightly over 3 percent in 2000, profits plunged by 13 percent in 2001. This reflected the dual impacts of falling sales and rising compensation costs on corporations' bottom-line profits. Despite major efforts by the business sector to control costs in 2002, we estimate that profits will continue to decline during the near term due to continued softness in manufacturing. We expect that profits will rebound beginning in 2003, reflecting the benefits realized from current cost-cutting measures and accelerating business sales anticipated for next year. Specifically, we forecast that California taxable profits will increase by 6 percent in 2003 and by roughly 10 percent in 2004 and 2005, before settling into annual rates of about 7 percent over the balance of the forecast period.