November 2004

California's Fiscal Outlook

LAO Projections 2004-05 Through 2009-10

Foreword

This report provides our projections of General Fund revenues and expenditures for 2004-05 through 2009-10. 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 tenth 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 9

Chapter 3
Revenue Projections 19

Chapter 4
Expenditure Projections 27

Chapter 1

The Budget Outlook

Summary

Major Budget Challenges Loom

In approaching the 2005-06 budget, California's policymakers face a deceptively difficult challenge. On the one hand, the strengthening revenue picture, coupled with the availability of the remaining $3.5 billion in authorized deficit-financing bonds that have not yet been used, would enable the Legislature to balance the 2005-06 budget by making a relatively modest amount of hard choices to reduce spending and/or augment revenues.

This would only be a temporary fix, however, as the 2005-06 outlook masks a much more negative underlying budget picture. This is because the 2005-06 budget will be helped by a carry-over balance and various limited-term solutions enacted in the 2004-05 budget which will not be available in subsequent years. As a result, these solutions cannot be counted on to address the state's large and persistent ongoing structural budget shortfall. We project that this shortfall will reach nearly $10 billion in 2006-07 under current-law spending and revenue policies, absent corrective actions.

The size and persistence of this shortfall, even in the face of an expanding economy and strengthening revenues, underscores a critical point that we have made in the past—namely, it is unlikely that California will be able to simply "grow its way out" of this shortfall.

Ongoing Solutions Need Adoption

Given the above, we believe it is critical that the Legislature act now to address the large underlying structural budget imbalance. Every ongoing budget solution that is adopted this year will reduce the amount of actions that will be needed later. Conversely, postponing action will only make the state's fiscal matters worse in the future. Therefore, we recommend that the state adopt real and ongoing solutions to close the budget gap in 2005-06 and that it not sell the remaining $3.5 billion in deficit-financing bonds at this time. Such an approach will have the dual benefits of both (1) reducing the structural deficit in later years through adopting ongoing solutions, and (2) preserving the bonding authority for possible use in 2006-07 or thereafter, when the current-law structural shortfall gets much larger and harder to deal with.

Update on the 2004-05 Budget

Review of the 2004-05 Budget Plan

The 2004-05 budget adopted last summer addressed a roughly $15 billion budget shortfall. As shown in Figure 1, that budget plan contained a variety of budget-balancing actions, including substantial borrowing, a two-year diversion of property taxes, targeted revenue increases, funding shifts (including higher education student fee increases), and significant program savings in education and other areas of the budget.

Proposition 98 Suspension. The budget package included a suspension of Proposition 98 and language in Chapter 213, Statutes of 2004, that 2004-05 education spending be set at $2 billion less than the minimum guarantee. (This language, in effect, signals the Legislature's intent to provide more/less funding if the guarantee increases/decreases during the year—for example, due to changes in revenues or attendance.) The difference between this Chapter 213 "target" level and the actual amount appropriated by the budget—$302 million—is shown as a Proposition 98 reserve in the 2004-05 budget.

General Fund Condition. Under the budget plan, the 2004-05 fiscal year was estimated to conclude with a reserve balance of $768 million, of which $302 million was earmarked for Proposition 98 and the remaining $466 million was to be available for non-Proposition 98 purposes. Because of the budget's reliance on one-time or limited-term solutions, it was clear when the budget was adopted that the state would continue to face substantial budget shortfalls in the future, absent further corrective actions.

Recent Budgetary Developments

Since the 2004-05 budget was enacted, there have been various developments affecting the revenue and expenditure sides of the budget. Key changes in our fiscal estimates relative to the budget act are shown in Figure 2.

Revenues Up Sharply. We estimate that the major taxes will exceed the budget estimate by $2.4 billion over 2003-04 and 2004-05 combined, due to a sharp increase in the corporation tax and more moderate gains in both the personal income tax and the sales and use tax. Partly offsetting the increase in tax revenues is a $364 million decline in nontax revenues, due to lower-than-expected receipts from tribal gaming revenues and the sale of surplus property. The net increase in General Fund revenues is $2.1 billion.

Costs Are Also Up. Offsetting a significant portion of the revenue increase are higher state costs totaling about $860 million. The increases are occurring in a variety of areas, including corrections, Medi-Cal, trial court funding, and spending on state operations. In some instances, the higher costs are occurring because the amount of savings resulting from various budgetary solutions is falling short of earlier estimates.

Revised Reserve. Taking into account the higher revenues and higher costs, we estimate that the year-end reserve increases by about $1.2 billion, to just under $2 billion.

Proposition 98 Interaction. The increase in projected 2004-05 tax revenues increases the minimum Proposition 98 K-14 funding guarantee by about $1 billion compared to the budget plan. Consequently, if the Legislature funds Proposition 98 at the Chapter 213 target level (that is, $2 billion below the guarantee), it would require a $1 billion increase in school appropriations. In Figure 2, we have reflected this higher obligation as an increase in the Proposition 98 reserve from $302 million to $1.357 billion. This leaves $614 million of the total reserve available for non-Proposition 98 purposes, only a marginal increase from the $466 million estimated at the time the budget was enacted. Thus, the large increase we project in tax revenues is almost completely offset by increased spending due to the Proposition 98 interaction and higher costs in other program areas.

2005-06 Outlook

Figure 3 shows the General Fund condition through 2005-06, using the assumptions outlined in the accompanying box. We estimate that revenues will climb to $82.2 billion and expenditures will total $89.5 billion in 2005-06, resulting in a $7.3 billion operating shortfall (that is, the difference between annual revenues and annual expenditures). After taking into account the $614 million non-Proposition 98 reserve available from 2004-05, the 2005-06 year-end deficit would be $6.7 billion.

Year-End Condition if Proposition 98 Not Increased. If appropriations for Proposition 98 were not increased in the current year, spending in the current year and budget year each would be reduced by $1.4 billion. This would reduce the 2005-06 year-end shortfall from the $6.7 billion shown in Figure 3 down to $3.9 billion.

 

Basis for Our Estimates Our revenue and expenditure forecasts are based primarily on the requirements of current law, including constitutional and statutory funding requirements. Our estimates also reflect projected changes in caseloads, federal reimbursements, and other factors affecting program costs. Of special significance in the current forecast are our assumptions in the following three areas. Governor's Higher Education Compact. In the current forecast, we have not assumed the Governor's "compact" with higher education, as the Legislature has taken no statutory action to implement such an agreement. Rather, our estimates for higher education are based on projected enrollment and inflation-related increases. Fully funding the compact would require added annual expenditures beyond those we are projecting, reaching over $500 million by the final year of our forecast period. Future Proposition 58 Transfers to the Budget Stabilization Account. Proposition 58, approved by the voters in March 2004, created a Budget Stabilization Account (BSA) to cushion the state against budget-related shortfalls. The measure provided for annual transfers of General Fund revenues to the BSA, equaling 1 percent of General Fund revenues in 2006-07 (about $875 million), 2 percent in 2007-08 (about $1.9 billion), and 3 percent in 2008-09 (about $2.9 billion) and thereafter until the balance in the fund reaches $8 billion. The measure, however, allows the transfers to be suspended or reduced through a Governor's executive order. Given the major budget shortfalls we are already projecting in the out years, we have not included the added expenditures that would be needed to fund the annual transfers to the BSA in our estimates. Interaction of Proposition 98 With Revenue Increases. Our baseline estimates include the impacts of the current-year increase in revenues—and other factors—on the Proposition 98 spending levels. This is consistent with language in Chapter 213, which was enacted with this year's budget. However, given the increased General Fund shortfalls and increased pressures on non-Proposition 98 programs that would result from this use of revenues, we also show the outlook assuming no change in 2004-05 Proposition 98 appropriations. 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.

Longer-Term Forecast—Large Shortfalls Continue

Our longer-term revenue and expenditure forecasts through 2009-10 are detailed in Chapters 3 and 4, respectively. Figure 4 shows the effects of these projections on the state's operating deficit—annual revenues minus expenditures—under two scenarios:

• Assuming Proposition 98 Spending Is Increased to Chapter 213 Target. Under this scenario, the budget's operating shortfall jumps sharply in 2006-07 to nearly $10 billion, and remains at slightly below $9 billion until the final year of the forecast period, when the gap narrows to below $6 billion.
• Assuming No Change to Current Proposition 98 Appropriation Level. Under this scenario, the minimum guarantee would be lower throughout the forecast period. As a result, the projected operating shortfalls, while still substantial, would be reduced—peaking at about $8.3 billion in 2006-07 before falling to just over $4 billion by the end of the forecast period.

Reasons Behind the Structural Shortfalls

The state has been plagued with a large structural budget shortfall since 2001-02, when revenues plunged following the recession and the steep decline in the stock market. The annual gap between projected revenues and expenditures has been massive, reaching as much as one-quarter of annual General Fund spending. While the state has addressed the annual shortfalls in each of the past three budgets, many of the solutions have involved borrowing, spending deferrals, accounting shifts, and other one-time actions. As the benefits of these one-time solutions fell away in subsequent years, the large underlying structural shortfall reemerged.

The one-time and limited-term savings included in the 2004-05 budget are highlighted in Figure 5. They include savings from deficit-financing bonds, pension obligation bonds, Proposition 42 transportation loans, postponement of local mandate payments, and diversion of local property taxes.

These actions, along with substantial borrowing undertaken in previous budgets, are resulting in significant current and future General Fund costs. As indicated in the accompanying box, annual General Fund costs related to budget borrowing will peak at nearly $4 billion annually in 2006-07 through 2008-09, before trailing off somewhat in subsequent years.

Approaching the Budget Problem

As discussed above, our projections indicate that, absent corrective actions, the state will not resolve its structural imbalance. As a result, it is important that the Legislature take meaningful actions in 2005-06 to address this shortfall. In this regard, we believe that there are four basic "building-blocks" that should be considered in crafting a strategy for dealing with the budget shortfall in 2005-06:

• Avoid Using the Remaining $3.5 Billion in Deficit Bonds in 2005-06. The state is already benefiting from carry-over reserve funds and other one-time savings in 2005-06 that will not be available in subsequent years. By preserving these bond proceeds, the state can "even out" difficult budget actions and avoid much harsher adjustments that would otherwise be needed in 2006-07.
• Avoid Making Additional Deferred Spending or Revenue Commitments. As noted above, a significant portion of California's projected out-year structural imbalance is related to loans and spending deferrals included in recent budgets. The state should avoid adding to these types of commitments.
• Consider Maintaining 2004-05 Proposition 98 Appropriations at the Existing Level. Achieving the Chapter 213 spending target would result in $1.4 billion in additional current-year funds being directed to Proposition 98. Given the fiscal pressures confronting the General Fund, we believe the Legislature should seriously consider maintaining Proposition 98 spending at the current level. This would generate ongoing savings of roughly $1.4 billion per year, without any reductions in education services assumed in the 2004-05 budget package. In addition, under this scenario, there would still be sufficient growth in the guarantee over the forecast period to provide full growth and cost-of-living adjustments, retire existing obligations to schools, and expand educational programs.
• Adopt Other Ongoing Budget Solutions. As we have indicated in the past, we continue to believe that all budget options should be on the table, both those involving expenditures and revenues. Potential solutions include suspension or reduction of cost-of-living adjustments throughout the budget, reduction of General Fund support for transportation, the elimination of selected mandates, and the elimination of selected tax expenditures.

While it is tempting to use deficit-financing bonds to avoid the more painful budget choices in 2005-06, making real changes in the budget year would enable the state to make meaningful progress toward eliminating the structural problem that has plagued the state since 2001-02.

Chapter 2

Economic and Demographic Projections

Economic and demographic developments are important determinants of California's fiscal condition, mainly because of their impacts on state revenues and expenditures in such areas as education, health, social services, and transportation. This chapter presents our economic and demographic projections for 2004 through 2010, which will affect California's fiscal condition during fiscal years 2004-05 through 2009-10.

The Economic Outlook

Overview of the Economic Forecast

Despite sharply rising fuel prices and somewhat uneven job gains, both the national and state economies have experienced solid economic growth over the past year. The gains have been fueled by strong performances in interest-sensitive sectors such as housing, as well as healthy gains in business capital investment and continued strength in consumer spending.

Looking ahead, we expect economic growth to slow modestly in 2005 due to the constraining impacts on the economy of high household debt levels, the rise in energy costs, and mild increases in interest rates. In subsequent years, our outlook calls for moderate expansion at both the national and state levels. Figure 1 summarizes the details of our economic forecasts for the nation and state. In the subsequent sections, we discuss in more detail major factors underlying our forecasts.

U.S. Economy

Solid Growth Continues

The national economy has experienced broad-based economic growth over the past year. Although the third quarter's real (that is, inflation-adjusted) gross domestic product (GDP) growth—initially reported at a 3.7 percent annual rate—was modestly below expectations, the shortfall was mainly related to less-than-expected accumulation of business inventories, as opposed to a softening in consumer or business demand.

Monthly information for October and early November suggests that solid economic growth is continuing in the final quarter of 2004. After several months of sluggish gains, job growth rebounded sharply in October. Although some of the increase was due to post-hurricane rebuilding activity in the southeastern U.S., the October expansion was widespread, affecting most major industry sectors. Recent reports on retail sales, company profits, new orders for manufactured goods, and consumer confidence, also point toward healthy fourth-quarter economic growth. Finally, the stock market, after lagging for much of 2004, jumped in early November, reflecting optimism about future business sales and profits.

Key Areas of Concern

Although the near-term outlook is clearly positive, the U.S. economy faces at least two key challenges as of late 2004. These are high oil-related prices—which are boosting the costs of gasoline and heating oil—and the uneven job gains in 2004.

Oil Prices. As indicated in the accompanying box, world oil prices have jumped dramatically in 2004, having reached an all-time high of $55 per barrel in mid-October before sliding back to slightly below $50 as of early November. The oil price jump has had a major adverse impact on prices paid by American consumers for gasoline, diesel fuel, heating oil, and other oil-based commodities. It is also negatively affecting consumer confidence, and will likely have a modest negative impact on spending over the next year.

Jobs. Although the U.S. job report for October was bullish, the employment gains over the past year have been uneven, with businesses relying on added hours and productivity gains from their existing workforce rather than hiring additional employees. This strategy has worked so far, yielding major gains in business earnings, as well as higher wages for some workers. However, the lack of broad-based job growth remains a risk to the durability of the expansion, in that, if continued, it may undercut consumer confidence and spending throughout the economy.

 

Impact of High Oil Prices After several years of relative stability, oil prices have soared in 2004, reflecting the impacts of sharply rising worldwide demand, the lack of new production capacity, and numerous supply disruptions in the Gulf of Mexico and abroad. As shown in the accompanying figure, the per-barrel price of crude oil rose from $19 in early 2002 to $30 in early 2004, before soaring nearly to $50 in the final quarter of the year. The increase in crude oil prices has in turn boosted retail prices of gasoline—where the average per gallon price in late October surpassed $2 nationwide, and $2.40 in California—as well as heating oil and a variety of other oil-based products. The increases that have already occurred will have modest adverse effects on inflation and real economic growth over the next year. Indeed, the modest economic slowdown we are projecting in 2005 is partly related to the effects of higher energy costs on household confidence and discretionary incomes. We do not, however, expect the negative economic impacts to be anywhere near as dramatic as in the 1970s and early 1980s, when sharply rising oil prices sent the U.S. economy into two recessions. The main reason is that, while oil prices are at an all-time high, they are nowhere near the levels reached in 1980 in inflation-adjusted terms. As shown in the figure, in constant 2004 dollars, oil prices peaked at more than $80 per barrel in 1981. In addition, the consumption of oil-based products as a percentage of economic output and income is less today than a quarter century ago, meaning that the proportional impact of any given crude oil price increase is less today than in the past. A related factor is that the oil price increases do not appear to be having the same type of adverse "ripple" effects on other prices throughout the economy as they did in the 1970s and early 1980s. Businesses have thus far managed to "hold the line" on retail prices, due to offsetting savings related to, for example, worker productivity increases. Absent more broad-based increases in economy-wide inflation, it thus is unlikely that the oil price increases will have the dramatic negative impacts on interest rates and other elements of the economy that they did in the 1970s.

The Outlook—Tapering but Still-Solid Growth

Our forecast assumes that the U.S. economy will expand at a solid though moderating pace in 2005. As indicated in Figure 2, we forecast that year-over-year increases in inflation-adjusted GDP will subside from the current 4 percent pace to around 3 percent by mid 2005, before accelerating modestly in 2006. This outlook assumes continued healthy increases in business investment, but slowing growth in consumer spending.

Our national outlook assumes that:

• Consumer spending will slow from 3.6 percent growth in 2004 to 3 percent in 2005, before accelerating mildly to a trend pace of 3.2 percent in 2006 and beyond. The main factors behind the 2005 slowing are:(1) household debt levels, which remain at historically high levels; (2) rising interest rates, which will adversely impact monthly payments on variable rate loans and raise financing costs for big-ticket purchases such as cars; and (3) high energy costs, which will cut into household budgets.
• Business investment will slow from 10.6 percent in 2004 to a still-healthy 8.5 percent in 2005, and an average rate of 6 percent during the subsequent five years. The main source of growth in this sector will be spending on high-tech and productivity-enhancing equipment and software. However, we also expect investment in new facilities to grow in 2005, as businesses seek to modernize and expand their operations.
• Wage and salary employment will accelerate from 1 percent growth in 2004 to 1.6 percent in 2005, followed by annual increases averaging 1 percent in the 2006-through-2010 period. This outlook reflects the expectation of continued increases in sales, output, and corporate earnings, as well as the results of recent surveys suggesting that businesses intend to step-up hiring in 2005.
• Inflation will rise modestly over the next several months, boosted by high costs for energy, lumber, steel, and other raw materials, before subsiding in the second half of 2005. On an annual average basis, we forecast that the U.S. Consumer Price Index (CPI) will increase by 2.7 percent per year in both 2004 and 2005. Over the longer term, slightly slower inflation is expected, with the CPI averaging a projected 2.1 percent between 2006 and 2010.
• Oil prices will continue to fall from their recent peaks, and will settle in a range of $35-to-$40 per barrel—still well above recent historical norms. Although recent reports suggest that the crude oil inventories are rebounding from very low levels, we expect that strong worldwide demand, limited near-term increases in worldwide production capacity, and continued threats of supply disruptions will keep prices from falling dramatically in the foreseeable future.
• Interest rates also will rise, reflecting the impacts of Federal Reserve policies to boost short-term yields from recent historically low levels, and the prospects of large future federal budget deficits. The average yield on one-year Treasury Bills is projected to increase from 1.5 percent in 2004 to 2.5 percent in 2005, and to continue trending upward to over 4 percent by the end of the forecast period.
• Housing starts will subside from near-record levels of 1.9 million in 2004, to just below 1.8 million in 2005, and average about 1.6 million per year over the 2006-through-2010 forecast period. Our predicted slowdown is largely related to higher interest rates.

California's Economy

The California economy has experienced generally healthy growth since mid-2003. The state has faced challenges in many areas—most recently being the major increase in gasoline costs. However, most measures of statewide economic activity—such as taxable sales, personal income, permits for new construction, and company profit reports—suggest that the state's economy is clearly on an upward track as 2004 draws to a close.

Factors boosting economic growth over the past year have included:

• The strong national rebound in business investment, particularly in high-tech goods, computers, networks, and software systems produced and supported by California firms;
• The state's booming housing market, which has boosted income in the state's construction, finance, and various retail trade industries; and
• A sharp increase in international exports, which has boosted activities in the manufacturing and agriculture sectors.

The Outlook—Continued Growth

Similar to the national pattern, we expect that California's economic growth will continue in 2005, although at a more moderate pace than in 2004. As indicated earlier in Figure 1, personal income is forecast to slow from 5.9 percent in 2004 to 5.5 percent in 2005, but then average over 6 percent for the balance of the forecast period. On the positive side, the national outlook for continued strong business investment will boost many industries in this state. On the negative side, however, we expect that high energy costs and rising interest rates will take a significant toll on consumer spending and housing activity in the state.

Sector-by-Sector Prognosis

Employment Picture Mixed—Some Improvement Expected. Over the past year, the employment picture has been uneven. According to the monthly survey of employers, payroll jobs (which economists follow closely in gauging the strength of the job markets) have increased by just 110,000 between September 2003 and September 2004, a growth rate of just 0.8 percent. This is less than one-third the number of payroll jobs that would normally be expected at this stage of an expansion.

As we have indicated in previous forecasts, the separate survey of households (which is mainly used to calculate the unemployment rate) shows significantly more job growth. Using this alternative measure, the total number of jobs in California has increased by over 300,000 in the past year, a more respectable 2 percent growth. The discrepancy between the two job measures may reflect an increase in the number of individuals working as independent contractors. Such workers would be counted in the household survey but not necessarily included in the survey of employers. While the higher job growth totals in the household survey is encouraging, its exact implications for the economy are uncertain. This is because little is known from the household survey about the nature of the nonpayroll jobs—for example, whether they are full or part time, or their pay and benefit levels. In any event, the reluctance of employers to expand their permanent work force remains a concern in the outlook.

Looking ahead, we forecast that job growth will improve modestly, from 0.9 percent in 2004 to 1.4 percent in 2005 (an increase of 210,000 jobs), as businesses step up hiring to meet continued growth in output and sales. Over the 2006-through-2010 period, job growth is forecast to average 1.7 percent per year (about 240,000 jobs annually), a rate that is roughly consistent with projected adult population growth and thus labor force expansion.

Personal Income Growth Has Been More Positive. While California's job performance has been disappointing, the recent rebound in personal income has been more positive. As shown in Figure 3, after falling sharply in the 2001 recession, real personal income growth jumped sharply to almost 4 percent in early 2004, due to healthy increases in wages and business earnings. Although we project a modest slowdown in personal income during 2005, growth should remain in the solid 3 percent to 4 percent range through the forecast period.

International Exports Finally Improving. Exports are an important element of California's economy. In 2003, international sales of California-produced goods totaled about $95 billion, directly accounting for about 7 percent of California's gross state product. Over one-half of California's exports related to high-tech goods, such as computers, electronics, and aerospace products. Other key export categories include paper, chemicals, and pharmaceuticals.

As shown in Figure 4, after lagging since 2001, international exports jumped to a quarterly level of over $27 billion (over 20 percent growth) in the first half of 2004. Key factors behind the growth are the declining value of the U.S. dollar (which makes U.S. goods more competitive in foreign markets), major growth in the economies of China and other developing nations on the Pacific Rim, and a long-awaited acceleration in Japan's economy. We expect export growth to continue in 2005 and 2006, although at a slower pace than in 2004.

A Key Factor In California's Outlook—Housing. California's housing market has been booming, as evidenced by record sales levels, dramatic price increases, and strong levels of new construction. As of September 2004, the median price of a detached single-family home in California was $465,000, up over 20 percent from the prior year. Home construction will likely exceed 200,000 units in 2004, the strongest level in 15 years.

Our forecast assumes that prices will level off and that sales and new construction will retreat modestly from 2004 levels. As shown in Figure 5, we assume that permits for new construction will fall slightly below 200,000 in 2005, and slide a bit further to around the 180,000-to-190,000 range for the remainder of the forecast period. Our forecast assumes that interest rates will increase only modestly, and that underlying population and income growth result in continued strong demand for new housing. This forecast is vulnerable, though, to a larger-than-expected climb in interest rates. Given that many recent home buyers are already financially stretched by large mortgages, rising rates on variable interest rate loans could further squeeze their household budgets. For prospective buyers, such higher rates would further reduce the affordability of new homes, resulting in fewer sales and downward pressure on home prices. These developments could depress construction activity, and potentially reduce levels of spending and income in other areas of the economy.

The Demographic Outlook

California's population currently totals over 36 million persons. During the six-year forecast period covered in this report, Figure 6 shows that the state's population growth is projected to average about 1.3 percent annually. In terms of numbers of people, this annual growth translates into about half-a-million people and is roughly equivalent to adding a new city the size of Long Beach to California each year. As a result, California will add roughly 3 million people over the forecast interval and reach over 39 million by 2010.

The population growth rate we are projecting is somewhat slower than that experienced in the late 1990s and early 2000s, 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 in the past 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 close to 300,000 new Californians annually over the forecast period. This net natural gain reflects an annual average of around 550,000 births partially offset by about 250,000 deaths.

Our forecast incorporates the well-documented trend of declining birth rates that has been occurring for essentially all ethnic groups in recent years in California. Despite these declining birth rates, however, the number of new births in our forecast actually trends up a bit through 2010. This is due to significant growth in the female population of child-bearing age groups in the faster-growing segments of California's population, including Hispanic and Asian women. As a result, even after accounting for growth in the number of deaths occurring annually in California, we project that the natural increase component will grow slightly during the latter half of the forecast period.

Net In-Migration. We project that combined domestic and foreign net in-migration will average roughly 206,000 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 300,000 natural-increase component noted above.

• Most of the net in-migration we are projecting reflects foreign net in-migration from other nations. This component has been relatively stable over the past decade and has proved to be less sensitive to the economy than domestic population flows between states. We forecast that net foreign in-migration will be fairly constant through 2010, averaging about 195,000 annually.
• Regarding domestic net in-migration, preliminary data suggest that this was slightly negative in 2004 (that is, more people left California for other states than flowed in from them). In large part, this is attributable to California's recent recession and continued sluggish job market. Given our outlook for moderate expansion of California's economy and continued concerns about job growth, we do not foresee a return to net positive interstate population in-flows for a couple of years. Starting in 2007, we project modest net domestic in-flows of 20,000 annually.

Growth to Vary Significantly By Age Group

Figure 7 shows our population growth projections by broad age categories, including both numerical and percentage growth.

Baby Boomers Swelling 45-64 Age Group. The 45-to-64 age group (largely the "baby boomers") continues to be by far the fastest growing segment of the population. Nearly 1.6 million additional people are expected in this age category over the next six years.

Slow Growth for Children. 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, which partially explains the above-average growth in the 18-24 age category. 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.

Chapter 3

Revenue Projections

The revenues that finance California's state General Fund budget come from numerous sources, including taxes, fees, licenses, interest earnings, loans, and transfers. However, over 90 percent of the total is attributable to the state's "big three" taxes—the personal income tax (PIT), the sales and use tax (SUT), and the corporation tax (CT). In this chapter, we summarize our updated General Fund revenue projections and provide detail behind our key revenue-related assumptions.

Current Revenue Trends

Before presenting our revenue forecast, it is first useful to review where things currently stand in terms of recent revenue-related trends that serve as the "springboard" to our revenue projections.

Revenues Continue to Strengthen

Total cash receipts from major taxes during the first four months of this fiscal year have exceeded the 2004-05 budget projection by over $900 million, largely reflecting much-stronger-than-expected CT receipts. Despite the mild slowdown in overall economic activity that we are projecting for 2005, we believe that the stronger revenue trend will hold through the remainder of this fiscal year, and that total revenues through June 30, 2005, will exceed the budget estimate by slightly over $2 billion. About $430 million of this increase is attributable to final returns for 2003 tax liabilities, and thus will be accrued back to 2003-04. The balance will be reflected as higher revenues in the current year.

Business-Related Receipts Booming

Figure 1 shows that estimated tax payments under the CT were up from the prior year by 28 percent in the third quarter of calendar-year 2004. These higher payments were primarily attributable to large increases by firms in the petroleum, finance, and high-tech manufacturing industries. The figure also indicates that PIT-related estimated tax payments were up by over 15 percent in the third quarter from the same time in the prior year. We believe that this increase was likewise due to strong business payments—in this case, those related to earnings of the subset of businesses that file under the PIT (such as S-corporations, partnerships, and sole proprietorships).

Other Sources—Somewhat Subdued But Still Healthy

Revenue collections from other sources have been growing at a more subdued, but still healthy, rate in 2004. For example, Figure 2 shows that after a strong performance in late 2003 and early 2004, the growth in PIT-related withholding payments—which are attributable to employee wages, salaries, stock options, and bonuses—moderated to about 6 percent as of the third quarter of 2004. These recent increases are generally consistent with solid wage gains but relatively subdued employment gains over the past year. We believe that some of the recent slowdown is related to a slackening of stock option-related activity since the stock market peaked in early 2004.

The LAO Revenue Forecast

Figure 3 presents our updated revenue projections for the period 2003-04 through 2009-10.