Legislative Analyst's Office, November 14, 2003

California's Fiscal Outlook

LAO Projections 2003-04 Through 2008-09

Foreword

This report provides our projections of General Fund revenues and expenditures for 2003-04 through 2008-09. 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 ninth 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 1

Chapter 2: Economic and Demographic Projections 11

Chapter 3: Revenue Projections 21

Chapter 4: Expenditure Projections 27

Chapter 1

The Budget Outlook

Summary

Major Budget Problem Still Confronts State

As was the case last year, California's policymakers will face a substantial challenge in crafting next year's General Fund budget. According to our updated projections, the state is facing a year-end shortfall of $10.2 billion in 2004-05 assuming the vehicle license fee (VLF) rate increase remains in effect, and substantially more if the rate is rolled back and the state resumes backfill payments to localities. Over the longer term, absent corrective actions, the state faces annual current-law operating deficits (that is, excesses of expenditures over revenues) that remain over $9 billion through the end of the forecast period—and $14 billion if the VLF rate is rolled back.

Actions Now Can Eliminate The Structural Problem

The persistent nature of the out-year operating shortfalls—even in the face of an improving economy—indicates that the state will not be able to "grow its way out" of its budget problems on the natural. The "good news," though, is that the projected operating shortfalls do start to narrow over time. This means that once the basic gap between annual expenditures and revenues is closed by ongoing solutions, we would expect future revenue growth to be sufficient to cover program costs over the forecast period.

In the paragraphs below, we (1) briefly review the 2003-04 budget signed by the Governor in August, (2) discuss the subsequent budget-related developments that have occurred, and (3) present our updated budget projections for 2003-04 through 2008-09.

Review of the 2003-04 Budget Plan

In confronting the 2003-04 budget, policymakers faced an enormous fiscal shortfall that the administration estimated was as high as $38 billion. This shortfall was the product of three years' worth of major imbalances between revenues and expenditures, which first opened up when revenues plunged during the 2001 economic downturn and stock market decline.

As Figure 1 shows, the majority of the 2003-04 budget solutions were clearly one-time in nature, consisting of borrowing, deferrals, funding shifts, and revenue accelerations. The budget plan did include ongoing savings from various program reductions and a VLF rate increase (the latter triggered by the "insufficient funds" provision in current law).

Ongoing Operating Shortfalls Not Fully Addressed. Assuming that all of the budgetary savings and borrowing actions included in the 2003-04 budget plan would be realized, that plan estimated that the huge 2003-04 shortfall would be closed and the state would end the year with a reserve of about $2.2 billion. However, since so much of the adopted 2003-04 budget solution involved borrowing, deferrals, and other one-time actions, it also was acknowledged that the disappearance of such solutions the next year would leave a large "budget hole" and thus a major operating shortfall of roughly $10 billion would automatically reemerge in 2004-05. The added debt-service costs associated with repayment of the deficit financing and pension bonds that the budget plan authorized also contributed to the projected shortfall in 2004-05. Taking into account the carryover $2.2 billion reserve projected for the end of 2003-04, the year-end 2004-05 budget shortfall was expected to be about $8 billion, absent further corrective actions.

What's Happened Since the Budget's Enactment?

As Figure 2 shows, there have been both positive and negative developments on the budget front since the summer that we have taken into account in updating our fiscal projections.

Economy and Tax Revenues Are Up . . .

On the positive side, recent economic developments and cash receipts trends have been more favorable than expected. These positive developments, which are discussed in Chapter 2, include (1) a sharp improvement in business investment spending documented in the third quarter's gross domestic product report, which should benefit California firms; (2) healthy business earnings reports; and (3) higher state tax collections from withholding and quarterly estimated income tax payments during the first four months of 2003-04. As a result of these and other developments, we have revised upward our projections of major tax revenues by modestly over $2 billion in both 2003-04 and 2004-05.

. . . But So Are Budget-Related Expenses

On the negative side, however, the added revenues from these positive developments have been more than offset by added costs in the state budget. These include the effects on pension-related costs of an adverse court ruling involving the planned pension obligation bond sale, various costs related to the Southern California fires, higher Proposition 98 spending (triggered by the gains in revenues), and budget deficiencies in corrections, Medi-Cal, and state operations. In addition to these costs, we expect tribal gaming revenues to be considerably less than previously assumed.

Bottom Line—State Still Faces Formidable Challenge

Taking into account both the positive economic and revenue developments and the more-than-offsetting cost increases, the budget outlook is modestly worse than previously thought for 2003-04 and 2004-05 although modestly better over the longer term. Despite these recent developments, however, the key point for policymakers is the same as before—namely, the state faces a major mismatch between revenues and expenditures, and this will ultimately need to be addressed through spending reductions and/or revenue enhancements if the state is to regain fiscal balance.

Specific General Fund Budget Estimates

Figure 3 presents our updated estimates of the General Fund's condition for 2002-03 through 2004-05. These estimates take into account our revised projections of current-law revenues and expenditures discussed in Chapter 3 and Chapter 4, respectively. The basis for our estimates, including their underlying methodology and assumptions, is summarized in the accompanying box (see page 7). The estimates shown in Figure 3 assume that the VLF rate increase (effective October 1, 2003) remains in effect in both 2003-04 and 2004-05, as provided for in current law. Our projections indicate the following.

 

Vehicle License Fee (VLF) Background The state law enacting a VLF rate reduction beginning in 1999 included three accompanying provisions which are of significance to the current fiscal outlook: (1) it required that the state backfill local governments for their revenue losses resulting from the lowered rates, (2) it required that the VLF rate be increased whenever there were insufficient moneys in the General Fund to pay for the backfill, and (3) it stated that, from 2000-01 through 2003-04, California Work Opportunity and Responsibility to Kids (CalWORKs) cost-of-living adjustments (COLAs) would be granted only in fiscal years in which VLF tax relief is granted. Several VLF-related actions were taken in conjunction with the 2003-04 budget which are having an impact on General Fund expenditures. In June 2003, the Director of Finance made the determination that there were insufficient moneys in the General Fund for the backfill, thereby terminating backfill payments and triggering a rate increase (from 0.65 percent to 2 percent) for VLF payments due on or after October 1, 2003. Backfill payments to local governments (with a few minor exceptions) ceased after June 20, 2003, saving the General Fund about $4 billion in 2003-04. The revenue loss to local governments during the time period between when the backfill ceased and additional revenues from the rate increase started flowing is being treated as a loan. The loan is scheduled to be repaid by mid-2006. The 2003-04 budget included language which sets the VLF backfill at $1,000 for 2003-04, regardless of the tax rate's level. Presumably, this language would hold the backfill to $1,000, absent legislative action, even if the tax rate were rolled back this year. Also, because tax relief was eliminated, the CalWORKs COLA for 2003-04 was suspended. Our VLF Expenditure Forecast Given the large operating shortfalls that we are projecting through 2008-09, we are assuming that the "insufficient moneys" provision holds through the forecast period, and the higher VLF rate therefore remains in effect as provided for in current law. Thus, our estimates include no VLF backfill payments other than a loan repayment in 2006-07. We also include no 2003-04 COLA for CalWORKs recipients, again reflective of current law. What Happens if New Administration Rolls Back the VLF Rate? The Governor-elect has stated his intent to roll back the VLF tax rate once he takes office. The fiscal impact of this rollback, particularly in 2003-04, would depend on exactly how such a reduction were implemented. Figure 4 shows the potential effects in 2003-04 under three alternative scenarios regarding the timing of the rollback and which governmental level—the state or localities—bears the revenues losses from the rollback. In Scenario A, the rate is rolled back effective February 1, 2004, but legislation is not passed which restores the backfill to local governments. Under this scenario, local governments would shoulder the full cost of the rate reduction in 2003-04—$1.8 billion. In Scenario B, the rate reduction is also effective February 1, 2004 but legislation is passed restoring the backfill. Under this scenario, the State General Fund would bear the costs of the tax reduction. In Scenario C, the rate reduction would apply retroactively to everyone that paid the higher rate in 2003-04, through a rebate mechanism. Assuming that the backfill is also restored, the 2003-04 cost to the General Fund would be about $3.2 billion.   Figure 4 Potential Impacts of VLF Rate Rollback in 2003-04a (In Billions)   Vehicle Owner Savings Governmental Cost State General Fund Localb Scenario A—Rate reduction effective February 1, 2004 but no backfill in 2003-04. $1.8 — $1.8 Scenario B—Rate reduction effective February 1, 2004 and backfill restored through legislation. 1.8 $1.8 — Scenario C—Rate reduction made retroactive to October 1, 2003 and backfill restored through legislation. 3.2 3.2 —   a  Fiscal effects in subsequent years are identical for all scenarios at $4.2 billion in 2004-05, $4.4 billion in 2005-06, $4.6 billion in 2006-07, $4.8 billion in 2007-08, and $5 billion in 2008-09. b  The cost shown is in addition to the $960 million reduction in backfill payments already being experienced by local governments.   In all three scenarios, the out-year costs of a VLF rollback would be identical, as current law would again require backfill payments to local governments beginning on July 1, 2004. These backfill payments would be about $4.2 billion in 2004-05, increasing modestly in subsequent years. Impact on CalWORKs Costs. The rollback of the VLF rate would have no impact on General Fund expenditures on CalWORKs in 2003-04. The additional costs would be covered from federal reserve funds. However, there would be costs of roughly $223 million in 2004-05 and about $130 million in subsequent years, as the federal reserves are depleted and the added CalWORKs costs are borne by the General Fund.

Revised 2003-04 Outlook

Based on our updated projections, 2003-04 General Fund revenues will total $74.2 billion, expenditures will be $73.7 billion, and the year will end with a positive reserve balance of $601 million. This compares to the $2.2 billion reserve that was anticipated when the 2003-04 budget was enacted. If the VLF rate were rolled back and refunds were provided to motorists that have paid the higher rate since it went back into effect, current-year expenditures would be $3.2 billion higher than the baseline, and the year would end with a deficit of $2.6 billion, absent corrective actions. Please see nearby box for a discussion of the VLF situation and its potential fiscal impacts.

2004-05 Outlook

For 2004-05, revenues are projected to be $75 billion, or $10.7 billion less than the projected expenditure total of $85.7 billion. As a result of the reemergence of the mismatch between revenues and expenditures, the budget faces a year-end deficit of $10.2 billion, absent corrective actions. If the VLF rate increase were rolled back and the backfill resumed beginning this year (2003-04), the cumulative impact on the 2004-05 reserve would be a $7.4 billion deterioration—the $3.2 billion noted above for the current year and another $4.2 billion in 2004-05. (This assumes no other offsetting savings were achieved.) In addition, California Work Opportunity and Responsibility to Kids (CalWORKs) cost-of-living adjustment (COLA) costs would increase by $223 million. Thus, the rollback would increase the projected cumulative year-end shortfall for 2004-05 to $17.8 billion.

Longer-Term Forecast—Shortfalls Persist

Figure 5 presents our revenue and expenditure forecasts through 2008-09, both with and without a rollback in the VLF rate. It indicates that, for example, assuming no rollback, the operating deficit grows to a peak of $12.3 billion in 2005-06. This primarily reflects the large scheduled repayment of a transportation loan and the resumption of local mandate reimbursements in that year. In the following three years, the gap narrows somewhat, as ongoing revenue growth modestly outpaces ongoing growth in program expenditures. As of 2008-09, however, the gap would still remain in the range of $10 billion assuming the VLF increase remains in place, and $15 billion if it is rolled back (the difference due to the amount of the backfill).

Approaching the Budget Problem

This is the third consecutive year that we have projected in our fiscal forecast a persistent current-law budget shortfall extending throughout the forecast period. This indicates that the state has not yet met the fundamental challenge of getting expenditures and revenues in line. In the preceding two reports, we also identified a group of budget-balancing principles, strategies, and tools that we again offer, as summarized in Figure 6 (see next page). Although the specific numbers in this year's report differ from those provided previously, we believe that these items still merit the Legislature's attention. This is because the state's basic budget problem is still essentially the same—namely, current-law expenditures exceed current-law revenues.

Among other things, we recommend that the Legislature:

• Take Current-Year Actions. Undertaking mid-year actions that produce budgetary benefits will not only improve the General Fund's projected balance at the end of 2003-04 that carries forward into 2004-05, it would also reduce the out-year problem as well. In addition, because implementation of some budget solutions takes time, acting early will help the state maximize the budget-year benefits that can be realized from them.
• Put Everything on the Table. In order to get the budget back into balance on an ongoing basis, we believe it makes sense to consider all types of actions—including spending reductions, fund shifts, revenue augmentations, and improved tax collections and compliance activities. The Legislature may of course find that some of these alternatives deserve more attention than do others, and the potential benefits in some areas may already have been largely exhausted due to actions already taken. However, potential savings and budgetary benefits can still be achieved in most program areas, and we recommend that the Legislature consider the largest possible "menu" in addressing the budget problem.
• Be Cautious About Additional Borrowing. Although the 2003-04 budget relied extensively on borrowing as a solution to close the fiscal shortfall, we believe that additional use of this tool should be limited given the future costs it imposes and its failure to address the budget's underlying problem (see accompanying box).
• Take Significant Ongoing Actions. The Legislature has extensively relied on one-time solutions in crafting both its 2002-03 and 2003-04 budget packages. Prudent use of one-time solutions could also help address the current problem. However, to the extent that one-time solutions are used to temporarily deal with ongoing problems, they generally end up creating a "budget hole" that needs to be filled with yet another action the next year. Given the persistent current-law operating shortfalls we foresee over the forecast period, the current budget problem for the most part represents an ongoing imbalance between revenues and spending. As such, it is important that the Legislature also adopt major ongoing solutions—spending reductions and/or revenue augmentations.

In the coming months, our office will be assisting the Legislature in developing possible budget-balancing expenditure and revenue strategies and options to help address both the large projected 2004-05 shortfall and the ongoing operating imbalances projected for future years.

 

Basis for Our Estimates As noted in past reports, our revenue and expenditure forecasts are based primarily on the requirements of current law, including constitutional and statutory funding requirements (such as the Proposition 98 funding guarantee). Our estimates also reflect projected changes in caseloads, federal reimbursements, and other factors affecting program costs. For the current forecast, we have also taken into account language included in the 2003-04 budget plan stating the Legislature's intent that the administration not include certain funding adjustments in developing the 2004-05 budget. These include funding for: (1) University of California (UC) and California State University (CSU) salary increases and enrollment growth; (2) discretionary price adjustments to state, UC, and CSU operations; (3) local mandate reimbursements; (4) direct appropriations for capital outlay in excess of $50 million; and (5) Proposition 98 spending above the minimum guarantee. Our basic estimates included in Figure 3 assume that the VLF rate increase, triggered by the insufficient funds provision of current law, remains in place through the forecast. Because the Governor-elect has stated his intent to roll back the increase, we discuss the incremental impact of that change separately. Our out-year estimates also include scheduled loan repayments to special funds as well as payments to cover accumulated local government mandate claims. Projections, Not Predictions. Our estimates 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.

Borrowing and the Budget Shortfall

How Much Budget-Related Borrowing Have We Done?

As indicated earlier, the 2003-04 budget relied on a variety of different types of borrowing-related actions to help close the budget gap. Among others, these included the use of deficit financing and pension bonds, direct loans from special funds, deferrals of spending obligations such as for transportation and local mandates, tobacco bonds to accelerate the state's receipt of future revenues, and refinancing of existing general obligation bond principal repayments. Altogether, we estimate that there was close to $20 billion of these and other different types of borrowing incorporated in the adopted 2003-04 budget plan. This budget-related borrowing is in addition to the more traditional types of borrowing that use general obligation and lease-revenue bonds to finance the state's outlays for infrastructure and other capital needs, as well as the internal and external borrowing needed for cash-flow purposes.

The Impact of Budget-Related Borrowing on the General Fund's Condition

Budget-related borrowing of course helps the General Fund's condition in the years when it is undertaken. However, it generally is a one-time savings, and thus creates a "budgetary hole" to fill the next year. In addition, the effect of borrowing eventually becomes a drag on the budget, because debt service expenses for past spending will interfere with providing current public services.

A significant portion of the General Fund operating shortfalls that we project for 2004-05 and beyond is associated with such debt repayments. For example, in 2005-06, debt service on the deficit financing bond and the scheduled payment of the transportation loan totals about $3.9 billion, or one-third of the projected operating shortfall for that year.

Is More Budgetary Borrowing the Way Out?

There is no "hard and fast rule" to identify what amount of borrowing is "right" for the Legislature to use in addressing budget shortfalls. As a general policy, however, we believe that budget-related borrowing—particularly from private markets—should be relied on only as a last resort. Actions to bring spending and revenues into line should be the top priority.

This is not to say that there are no instances where some borrowing makes sense. Examples might be when the size of a deficit is simply too large to handle all at once, or when a budget shortfall will likely be quickly eliminated by a strongly rebounding economy. We do not believe that either of these situations currently exists. Engaging in budget-related borrowing to avoid spending cuts and tax increases, or to finance additional spending and tax cuts—is a slippery slope.

Given the large amount of budget-related borrowing already authorized, we caution against the state engaging in new borrowing—particularly from private markets—to cover the projected 2004-05 operating shortfall.

Chapter 2

Economic and Demographic Projections

Economic and demographic developments are typically two of the most important determinants of California's fiscal condition through their impacts on both tax revenues and state expenditures. This chapter presents our economic and demographic projections for 2003 through 2009, which will affect California's fiscal condition during fiscal years 2003-04 through 2008-09.

The Economic Outlook

Overview of the Economic Forecast

We believe that California, like the nation, has "turned the corner" economically and is now embarking on a period of faster and more-balanced expansion as 2003 comes to a close. This acceleration is due to (1) a long-awaited improvement in business investment in computers, software, and other high-tech goods produced and designed in this state; and (2) ongoing strength in home construction and consumer spending. A key assumption in our outlook is that this faster economic expansion will finally result in an improvement in the jobs outlook, which has lagged thus far during the current rebound.

Our forecast assumes that the massive October fires in Southern California, while having tragic personal and economic consequences for those directly affected, will not have a major net adverse impact on the overall state economy. We anticipate that the loss in wealth and income in the regions affected will be roughly balanced by a surge in rebuilding financed by federal funds and private insurance payments. Figure 1 (see next page) summarizes the details of our economic forecast. In subsequent sections, we discuss in more detail major factors underlying our projections.

Recent National Economic Developments

Although the recession officially concluded in late 2001, the ensuing recovery was weak and unbalanced through 2002 and into early 2003. Low interest rates and federal tax reductions kept consumer spending and housing activity on an upward track. However, business spending and hiring remained soft during this period, reflecting chronic overcapacity in many key industries, weak foreign demand, and a loss of confidence by corporate executives who make investment decisions.

The improvement in business spending finally materialized in the third quarter of this year (see Figure 2). This increase, coupled with sharp gains in consumer spending and strong housing construction, boosted real gross domestic product (GDP) by a 7.2 percent annual rate in the July-through-September period. Of particular importance to California was the jump experienced in spending on computers and software, as the business sector began to upgrade systems that had not been replaced since 1999.

Recent California Developments

Gross domestic product data on consumption and business investment are not available at the state level, so it is not possible to directly determine how the recent national improvement in GDP growth has affected our state. However, various industry and tax-related data suggest that California's economy clearly is participating in the national recovery. For example:

• Company Reports. Business revenues and profits reported by California companies on their financial reports are up sharply in 2003. According to a recent survey of 167 public companies in Silicon Valley, for example, combined sales rose 12 percent between the third quarter of 2002 and the third quarter of 2003, while combined net income jumped from a $4.4 billion loss to a $1.7 billion profit during the same period.
• Tax Receipts. As discussed later in
• Chapter 3, personal income tax withholding, taxable sales, and corporate tax payments are up significantly in 2003 from last year, suggesting significant improvements in both spending and income.
• Foreign Trade. After falling sharply in 2001 and 2002, exports of goods produced in California stabilized in the second quarter of 2003, and more current monthly data from the state's major ports suggest that shipments abroad are starting to turn upward.
• Housing. Demand for housing remains surprisingly strong in California despite record home price levels and some recent increases in interest rates. According to the California Association of Realtors, the median home price in the state has jumped by 20 percent from the prior year and is now over $400,000. Housing supply is also expanding, as permits for new construction are on track to reach 188,000 units in 2003—the strongest level since 1989.

While these gains are encouraging, an important uncertainty concerning the durability of the current expansion—both at the national and state levels—is whether the recent improvements in spending and output will translate into more jobs in the months ahead. The jobs outlook is particularly clouded by the differing trends in employment data that the two main information sources are exhibiting, with the "household survey" showing growth but the "payroll survey" showing continued declines (see box on page 15). We examine California's job picture in more detail below, comparing its current performance to that of past recession/recovery periods and to the nation as a whole.

Job Losses From 2001 Recession—Mild but Prolonged

California Relative to the Nation. The job losses experienced in California since early 2001 (when the most recent recession began) are not out of line with the rest of the nation. As shown in Figure 3, the cumulative job loss over the past 30 months is about 2.2 percent in California, compared to 2 percent for the nation as a whole. Within California, the percentage reduction in the San Francisco Bay Area has been considerably greater than for the nation, but losses in Southern California and the Central Valley regions of the state have been proportionally less.

Current Performance Compared to Past Recessions. As indicated in Figure 4, the cumulative job losses associated with the 2001 recession and its aftermath are roughly on a par with those of the early 1980s' recession, but considerably less severe than the early 1990s' downturn. In terms of duration, however, job declines in the current period have been prolonged compared to the 1980s' experience. For example, the cumulative 2 percent decline in jobs during the 30 months following the start of the 2001 recession compares unfavorably to the 4 percent net gain in jobs that had occurred 30 months after the beginning of the 1981 recession. In this regard, the current downturn is more similar to the 1990s' recession.

Thus, while many indicators are pointing toward improved sales, production, and income in the state, the lack of job growth thus far remains a key concern regarding the durability of the expansion.

 

So—What's the True Picture Regarding Employment Strength? There are two surveys used to measure employment performance at the national and state levels. The first is the household survey, which is drawn each month from interviews with members of a selected sample of households. The resulting data are then used to develop detailed estimates of the employment and unemployment characteristics of individuals in the labor force. The second source is the payroll survey, which is based on information collected from employers that file withholding and unemployment insurance reports. These latter data are used primarily for estimates of aggregate employment totals and job performance within various industry categories, and indeed are what we are referring to in our discussion of current employment trends. Historically, the above two employment series have usually moved in concert with one another over economic cycles, although the household series has shown more month-to-month variation due to its smaller sample size. As shown in Figure 5, however, the two series have significantly diverged from one another in 2003, with the payroll survey showing year-to-year declines averaging about 0.5 percent, and the household survey showing year-to-year increases averaging about 1.2 percent. A similar discrepancy is evident at the national level.     The payroll survey is traditionally considered to be a more reliable indicator of employment trends due to its more extensive coverage and greater detail. However, at the present time, the household survey seems to be more consistent with the more upbeat data on spending and production in the economy. One of the possible explanations for the current difference between the two surveys' results may be an increase in the use of contract workers by employers that are reluctant to add to their permanent workforce. These contract workers would show up in the household survey as employed but may be excluded from the industry survey, which is based on actual company payrolls. While the contract jobs are more likely to be part time and have less pay and fringe benefits than traditional jobs, the growth in this sector provides some positive evidence that businesses are taking the first step toward renewed hiring.

The Economic Outlook

National Outlook

Our updated forecast assumes that U.S. economic growth will pick up somewhat and expand at a very healthy pace through 2004, before settling into a somewhat more moderate though sustainable pace in subsequent years. During the next year, the economy is expected to benefit from continued improvements in business investment and foreign trade, as well as ongoing expansion in consumer spending. Overall, we forecast that growth in U.S. GDP will accelerate from 3 percent in 2003 to 4.2 percent in 2004, before moderating some in subsequent years. The unemployment rate is projected to slowly decline from the current level of around 6.1 percent down to 5.6 percent by 2008.

What About Large Budget Deficits? Clearly, the large U.S. budget deficits that federal officials project for the future imply that the borrowing needs of the federal government will be substantial in the years ahead. At present, U.S. government borrowing is being easily accommodated in the credit markets, due to the large amount of liquidity in the financial system and the fact that businesses have large amounts of cash on hand to finance new investments. However, the large federal budget deficits will likely put upward pressure on interest rates once private demand for borrowing picks up. This will push interest rates slowly upward over the forecast period, and these higher rates will eventually work to moderate economic performance in such areas as business investment, consumer spending, and housing activity.

California Outlook

We forecast that California's economy will grow in line with the national economy over the next several years, reflecting the positive effects of improving business investment and foreign trade on our manufacturing and high-tech service industries. After falling for most of 2003, we expect that wage and salary employment will stabilize late in the year and grow modestly in 2004 and thereafter. On an average annual basis, we forecast that jobs will fall by 0.4 percent in 2003 before expanding by 1.3 percent in 2004 and 2.6 percent in 2005.

Reflecting the improvement in jobs, wages, and business earnings, we project that personal income will accelerate from 4.2 percent this year to 5.9 percent in 2004 and 6.3 percent in 2005. Finally, we forecast that taxable sales will accelerate from 2.4 percent this year to 5.9 percent in 2004 and 6.3 percent in 2005. These projected strong taxable sales gains are in part reflective of the expected improvement in the roughly one-third of taxable sales that are related to business spending.

We expect that housing construction will remain near current levels through the forecast period. While this is well above the rates achieved over the past decade, our projected pace of residential building construction remains below what many economists consider the amount needed to fully accommodate the state's ever-expanding population. The shortfall between the available supply and demand for housing, which is partly related to the limited availability of developable land in key areas of the state, will continue to put upward pressure on home prices in future years.

Risks to the Forecast

We see two primary risks to the near-term economic outlook. These involve:

Lack of Job Growth. While our forecast assumes that the recent growth in business spending and output will translate into added jobs in the U.S. and California economies, we have yet to see firm evidence that this is occurring. On the one hand, the fact that businesses have been able to increase output and sales without adding to the workforce suggests that productivity gains in the economy are even better than anticipated. This, by itself, has positive implications for the long-term achievable growth in output, income, and wealth in the nation and state. However, persistent softness on the job front poses a significant near-term risk, in that the lack of job creation may undermine consumer confidence and spending, and in turn undercut the economic expansion. The lack of job growth is an especially significant risk in California, where concerns about business costs could translate into more out-of-state outsourcing and less expansion in the state than would normally be expected during a growth period.

Potential Home Price Bubble. A second key risk to California's outlook involves the pattern of extraordinary increases in home prices. Following four years of uninterrupted increases, the median home price statewide is now over $400,000, with many major metropolitan areas being above $500,000. The key question this raises is whether the state faces a home price "bubble" that will deflate or even burst in the near future. Many economists and real estate analysts currently believe that the price jumps being experienced are not due primarily to speculative excesses. Rather, they attribute them as largely reflective of limited housing supply in many regional markets and ongoing growth in the state's population. However, there is no doubt that the recent price increases make the housing market more vulnerable to adverse economic developments than otherwise, such as a significant upturn in interest rates. To the extent that the increased household wealth associated with home price increases has been a positive factor underlying consumer spending during the past two years, a sharp reversal in home prices could have a significant negative effect in the future.

The Demographic Outlook

California's population currently totals slightly over 36 million. During the six-year forecast period covered in this report, the state's population is projected to grow annually by about 1.3 percent, or close to half a million persons yearly. (This is roughly equivalent to a city the size of Long Beach.) Thus, California will add roughly 2.9 million people over the forecast interval and reach almost 39 million by 2009.

The population growth rate we are projecting is somewhat slower than that experienced in the latter part of the 1990s, when growth was averaging about 1.6 percent. This reflects both the dampening effects of the slower economy of recent years on in-migration, plus 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 California for out-of-state destinations). On average, these two components have tended to contribute about equally over time to the state's population growth. However, their relative shares can vary significantly from one year to the next depending largely on the strength of the net in-migration component—by far the most volatile element.

Natural Increase. We project that the natural-increase component will average about 275,000 new Californians annually over the forecast period. This amount is slightly less than in the late 1990s and early 2000s, when it averaged about 295,000. This softening reflects 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 during the latter half of the forecast period. This is 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 nearly 215,000 annually over the next six years. This is weaker than during the latter half of the 1990s and early 2000s when annual net in-migration averaged about 260,000. It also is considerably less than the projected natural-increase component. As shown in Figure 6 (see next page), this reflects a projected drop in domestic net in-migration that we believe will follow California's period of economic softness. 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 Significantly By Age Group

Figure 7 (see next page) shows our population growth projections by broad age categories, including both numerical and percentage growth.

Ranks of Baby Boomers to Dramatically Swell. The 45-to-64 age group (largely the "baby boomers") continues to be by far the fastest growing segment of the population. Over 1.7 million new people are expected to move into this age category over the next six years. At the other extreme, slow growth is anticipated for preschoolers and the K-12 school-age population. This reflects several factors. One is the movement of children of the "baby boom" generation beyond the upper-end of the 5-to-17 age group. Other factors include the slower rate of net in-migration, and the decline in birth rates in recent years that has reduced the number of children moving into the preschool and school-age categories.

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.

Other Variations

In addition to age, projected population growth will also differ markedly along other dimensions. For example:

• Geographic Variation. Rates of growth will be above-average for the state's Central Valley, Inland Empire, and foothills areas. This will occur as the availability of land allows population to "fill in" and attracts intrastate