November 2005

California's Fiscal Outlook

LAO Projections 2005-06 Through 2010-11

Foreword

This report provides our projections of General Fund revenues and expenditures for 2005-06 through 2010-11. 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 primarily 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 eleventh 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.

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

Budgetary Outlook Has Improved . . .

The budget outlook for 2006-07 and beyond has improved considerably over the past year. In last year’s California’s Fiscal Outlook, we projected that the state faced ongoing structural shortfalls peaking at nearly $10 billion in 2006-07. Since that time, California’s budget outlook has benefited from both a major increase in revenues and a significant amount of savings adopted in the 2005-06 spending plan. As a result of these developments, our current forecast indicates that:

• The current year will end with a reserve of about $5.2 billion, up by nearly $4 billion from the 2005-06 Budget Act estimate.

• This large carryover reserve will be more than sufficient to keep the state’s budget in balance in 2006-07 without any new program reductions or added revenues-even though current-law projected expenditures exceed projected revenues by $4 billion during that year.

. . .But State Still Not Out of the Woods

While the improved fiscal outlook is clearly very good news, the state still faces major challenges in achieving an ongoing balance between revenues and expenditures and getting its fiscal house in order. Even assuming continued steady economic growth, we project that multibillion-dollar operating deficits (that is, annual shortfalls between revenues and expenditures) will persist throughout most of the forecast period. Eliminating these shortfalls will require significant actions. Beyond this, an economic downturn or even sharp slowdown sometime in the next several years would add several billions of dollars to the projected shortfalls, and while this is not our baseline forecast, it could always occur. For these reasons, it will be important for the Legislature to continue to take actions to minimize operating shortfalls, match any new or increased program funding with offsetting savings or revenues, avoid using the remaining deficit-financing bonds in 2006-07, and build up budgetary reserves.

Update on the 2005-06 Budget

The Budget as Adopted

The 2005-06 budget adopted last July included two key features which significantly improved the state’s longer-term fiscal picture. First, it contained well over $2 billion in ongoing budgetary savings, mainly in the areas of Proposition 98 and social services. Second, lawmakers allocated most of the unexpectedly strong revenues received last spring to prepay outstanding loans from local governments and eliminate the planned sale of additional deficit-financing bonds.

Under the signed budget, the state was expected to close 2005-06 with a reserve of $1.3 billion. We also projected that-as a result of improving revenues and actions taken in the 2005-06 spending plan-the operating shortfall in 2006-07 would be reduced to $6 billion, absent further corrective actions.

What Has Happened Since July?

Key changes in our fiscal estimates since the 2005-06 Budget Act was adopted are shown in Figure 1. These changes include the following:

Revenues Up Sharply. We estimate that General Fund revenues exceeded the budget estimate by over $1 billion in 2004-05 and prior years combined, and will exceed the budget estimate by $2.8 billion in 2005-06. This combined $3.9 billion increase is primarily related to the personal income tax, but also reflects a significant gain in the corporation tax (CT) and a modest increase in the sales and use tax.

Expenditures Down Modestly. We also estimate that net General Fund expenditures for 2004-05 and 2005-06 will fall below the 2005-06 Budget Act estimate by $80 million. The largest changes consist of lower spending for Proposition 98 education partly offset by increases in state retirement costs (stemming from an assumed one-year delay in the sale of pension obligation bonds).

Result-Major Increase in Year-End Reserve. Taking into account both the sharply higher revenues and slightly lower net costs, we estimate that the 2005-06 year-end reserve will increase from the $1.3 billion assumed in the 2005-06 Budget Act to our revised estimate of $5.2 billion. As noted below, much of this reserve will be needed to maintain a balanced budget in 2006-07.

2006-07 Outlook

Budget Projected to Balance. Figure 2 shows our updated projection of the General Fund condition through 2006-07, using the assumptions outlined in the nearby box. We forecast that revenues will climb to $91.1 billion and that expenditures will total $95.1 billion, resulting in a $4 billion operating shortfall. After taking into account the $5.2 billion reserve available carried into 2006-07 from 2005-06, the $4 billion operating shortfall in 2006-07 would leave the state with a year-end General Fund reserve of just over $1.2 billion.

The large operating deficit in 2006-07 reflects factors affecting both the revenue and expenditure sides of the budget. Specifically:

• On the revenue side, collections are forecast to grow by just 4.4 percent, due to (1) a large transfer of sales taxes on gasoline from the General Fund to transportation special funds (so-called “spillover funds”), (2) a resumption of the teachers’ tax credit, and (3) slow growth in CT revenues, partly related to amnesty-related refunds expected to go out in the budget year.

• On the expenditure side, General Fund spending on Proposition 98 will increase due to (1) the end of the two-year diversion of property taxes from local governments to schools and (2) the triggering of additional spending on after school programs required by Proposition 49. Other factors include an increase in California Work Opportunity and Responsibility to Kids costs related to a court ruling affecting grant levels, and the payment of past non-education mandate claims.

What if Higher Proposition 98 Appropriations Occurred? Our estimates assume that Proposition 98 is funded at the minimum guarantee in 2006-07 (including the added spending required by Proposition 49) and all subsequent years. While over the long term the guarantee grows significantly faster than enrollment and inflation, this is not the case in 2006-07. This is because of an unusually small increase in the “Test 2” growth factor for the guarantee and an unusually large increase in the statutory cost-of-living adjustment (COLA) for K-12 apportionments. As a result of these factors, the minimum guarantee will rise by $731 million less than the amount needed to fully fund enrollment and COLAs for K-14 education programs in 2006-07.

In Chapter 4, we discuss several options for covering this shortfall in order to maintain the current-services level of funding. One of these options would be to appropriate above the guarantee. If the Legislature were to choose this option, total Proposition 98 spending in 2006-07 would be $731 million higher than otherwise, and the resulting year-end General Fund budgetary reserve would be reduced by a like amount, to $470 million.

Longer-Term Forecast

Our longer-term revenue and expenditure forecasts through 2010-11 are detailed in Chapters 3 and 4, respectively. Figure 3 shows the effects of these projections on the state’s operating balance-that is, annual revenues minus annual expenditures.

Operating Shortfalls to Persist but Shrink Over Time

The figure shows that the state would continue to face significant operating shortfalls over the forecast period, peaking at $4.3 billion in 2007-08, before declining to $3 billion in 2008-09, $1.7 billion by 2009-10, and $600 million in 2010-11. The operating shortfalls in 2007-08 and 2008-09 each include well over $1 billion in scheduled repayments of loans from transportation and other special funds. Thus, by the end of the forecast period the state would have just about grown its way out of its structural shortfalls. In the meantime, however, the state would have to take corrective actions to address its yearly shortfalls.

BSA Transfers Not Included in Our Estimates. In March 2004, the voters approved Proposition 58, which among other things requires annual transfers of revenues to a newly created reserve fund called the Budget Stabilization Account (BSA). These transfers are equal to 1 percent of General Fund revenues in 2006-07 ($910 million), 2 percent of revenues in 2007-08 ($1.9 billion), and 3 percent of revenues in 2008-09 ($2.9 billion) and annually thereafter until the balance of the BSA reaches $8 billion or 5 percent, whichever is greater. The Governor may suspend the transfers to this fund through executive order.

We have not included these transfers in calculating our estimates of operating balances. Inclusion of these transfers would add to the operating deficits we are projecting for the out years of our forecast period.

Implications of Our Projections for The Legislature

While the improved near-term and long-term outlooks are clearly positive news, the state is still not out of the woods with respect to its longer-term structural budget problem. Consequently, in approaching the upcoming budget, it will be important for the Legislature to get a head start on addressing its out-year shortfalls by achieving as large a reserve as possible by the close of 2006-07. It will also be important to match any significant new commitments with offsetting revenues or budgetary savings. Finally, we believe that the state should avoid using the remaining $3.7 billion in authorized deficit-financing bonds at this time. Along with reserves, these bonds would be valuable to keep available as an option for helping the state deal with the still large budgetary shortfalls projected for 2007-08 and 2008-09, and to provide a cushion against a steeper-than-projected slowdown in economic activity sometime within the next two years, should one materialize.

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 calendar years 2005 through 2011, which will affect California’s budgetary condition during fiscal years 2005-06 through 2010-11.

The Economic Outlook

Overview of the Economic Forecast

Recent Growth Has Been Good. The U.S. economy has grown at a solid pace over the past year, despite facing soaring energy costs, rising interest rates, and three major hurricanes in the Gulf region of the country. Real gross domestic product (GDP) for the U.S. increased at an average annual rate of over 3.5 percent during the first three quarters of 2005, representing only a slight deceleration from the healthy pace experienced in 2004. The nation’s positive trends are clearly evident in California, which has experienced solid growth in employment, personal income, and housing-related activity for most of this year.

Some Near-Term Slowing Expected. Although the economic expansion has shown surprising resilience so far, we expect growth to moderate in late 2005 and early 2006, as the higher energy and interest costs being experienced take their toll on consumer confidence and discretionary incomes. An added concern in California is the state’s housing market, which-after several years of record sales and soaring prices-is vulnerable to adverse changes in interest rates or the strength of the economy.

Growth to Remain Moderate. After a period of slowing in 2006, our outlook calls for moderate economic 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 the major factors underlying our forecasts.

U.S. Economy

First Three Quarters of 2005 Were Better Than Expected

The national economy has defied expectations by continuing to grow at a healthy pace through the first three quarters of 2005. The preliminary estimate for the third quarter’s GDP was a real (that is, adjusting for the effects of inflation) annual rate of growth of 3.8 percent. This healthy increase occurred despite the negative impacts of major hurricanes, rising interest rates, and over $3 per gallon gasoline prices. The overall increase in economic output was well-balanced, with consumer spending, housing, business investment, and exports all expanding at healthy rates during the quarter.

Profits Have Been Particularly Strong. Business earnings have continued to grow rapidly in 2005, despite higher energy and health insurance costs during the year. As shown in Figure 2, U.S. after-tax profits increased by 12 percent in 2004, and are expected to grow by another 30-plus percent in 2005. A significant portion of the recent gains in profits is due to dramatic increases in the profits of oil-related companies. The recent change in the tax treatment of foreign earnings of multinational companies that are being transferred (or repatriated) back to the U.S., may also be contributing to the healthy earnings growth this year. Beyond these special factors, however, profit growth appears to be widespread, occurring in most industry sectors.

These healthy gains in profits are very important in the context of our fiscal outlook. This is because they are boosting taxable earnings subject to either the state’s personal or corporate income taxes. These earnings are also providing companies with large amounts of cash to invest in new facilities and equipment, which we believe will be the leading source of economic growth next year. The large profit margins are also enabling businesses to absorb rising energy costs, rather than passing them along in the form of higher product prices to consumers that would otherwise reduce demand and hurt the economy.

Inflation and Interest Rates Climbing

After several years of price stability, inflation accelerated significantly in 2005, with consumer prices increasing at an annual rate of 5 percent and producer prices jumping by 8 percent in the third quarter of the year. The majority of the acceleration is related to higher gasoline prices, but costs for a variety of other subcomponents of spending (such as for food, rents, and medical services) are also increasing significantly.

Partly in response to the higher inflation, the Federal Reserve has consistently increased interest rates in 2005. The federal funds rate (that is, the rate that banks charge on overnight loans to one another) has increased from 1.4 percent in the summer of 2004 to 4 percent as of late October 2005. We expect that short-term interest rates will continue to rise until the inflation subsides and economic growth slows.

Fourth Quarter Set to Slow

Although economic growth so far has outpaced expectations, there are signs that the pace of the expansion will slow late this year. For example, recent surveys of consumer confidence have shown major declines. These surveys, which are often harbingers of future consumer spending, suggest that retail spending during the holiday shopping season will be less robust than in recent years. Other signs of slowing growth include sharp declines in payroll employment in September (only part of which is attributable to the hurricanes), slowing growth in real disposable incomes (which are being eroded by sharply rising inflation), and the recent softening in monthly car sales-particularly of low gas mileage sport utility vehicles and light trucks.

The Nation’s Outlook-Slower but Still Moderate Growth in 2006

Our forecast assumes that U.S. economic growth will slow some over the next year. The anticipated slowdown is primarily due to a softening in consumer spending and home construction, which will be only partly offset by improvements in business spending and foreign exports. As indicated in Figure 3, we project that annual real GDP growth will subside from 3.7 percent in 2005, to 3.3 percent in 2006, and further to 3 percent in 2007.

Our national outlook also assumes that:

• Consumer spending growth will slow from 3.4 percent in 2005 to 2.8 percent in 2006, before partially rebounding to an average annual pace of around 3 percent during the balance of the forecast period.

• Business investment will accelerate from 8.5 percent growth in 2005 to over 11 percent in 2006, before moderating to about 5 percent in subsequent years of the forecast. These relatively healthy increases are related to continued strong growth in business spending on computer equipment and software. The continued strength in this type of spending is positive for California, which has a large number of firms which design and produce computer and software products.

• Gasoline prices will fall slowly from current levels, reflecting an easing of U.S. demand in response to higher prices, as well as improving supply conditions occurring as refineries damaged by the hurricanes come back on line. (See box below regarding recent gas price developments.) However, continued strong worldwide gasoline demand and the lack of new U.S. refinery capacity are expected to keep prices from falling dramatically in the next several years. We specifically forecast that U.S. average gasoline prices will retreat to below $2.40 by the end of 2005, but remain above $2.00 through the end of the forecast period.

• Inflation will remain high through the first quarter of 2006 (reflecting rising heating costs) but then subside beginning next spring. On an annual average basis, we forecast that the U.S. Consumer Price Index (CPI) will increase by 3.5 percent in 2005 and 2.6 percent in 2006. Factors leading to this anticipated slowing of inflation include the projected declines in energy prices, intense worldwide competition for a variety of products and services, and ongoing worker productivity gains. Over the longer term, inflation is expected to remain moderate, with the CPI averaging a projected 2.3 percent yearly increase between 2007 and 2011.

• Interest rates will continue to rise through early 2006, but then stabilize as a result of slowing U.S. economic growth and lower inflation. The average interest yield on one-year Treasury Bills is projected to increase from 4.3 percent in the fourth quarter of 2005 to 4.8 percent by the fourth quarter of 2006.

• Productivity growth will average around 2.5 percent annually through the forecast period. While this is down from the over 3.7 percent rate for the 2002-through-2004 period, it is still well above the rates historically achieved, particularly after the initial stages of economic expansions.

California’s Economy

In many respects, California’s economic performance has mirrored the rest of the nation during the past year. During this period, the state has experienced healthy growth in output, sales, home construction, personal income, and corporate profits-despite historically high energy prices and rising interest rates. Looking ahead, we expect that California will continue to grow roughly in line with the U.S. economy, with slowdowns in consumer spending and housing activity being partly offset by healthy gains in investment spending and exports.

Housing Set to Ease

Home sales and prices have soared in California over the past several years. The volume of sales reached an all-time high in 2004, and will remain near record levels this year. As shown in Figure 4, the median price of existing home sales has jumped by over 100 percent in the past four years, and now stands at about $550,000. This is more than double the national median of $220,000.

These extraordinary developments have contributed to major increases in sales and income in the state’s real estate and financial sectors. The “wealth effect” associated with rising home values has also contributed to retail spending in the state.

However, after several years of sustained increases, home prices are now at all-time records, making California’s housing market vulnerable to setbacks related to rising interest rates or slowing economic growth. Under our baseline forecast, which anticipates modest increases in interest rates, we expect home prices to fall modestly, and that sales volumes, new construction, and mortgage refinancings will ease in 2006.

Larger increases in interest rates would result in correspondingly larger declines in real estate and mortgage refinancing activity. They would also result in rising mortgage costs for many recent home buyers who have financed expensive home purchases with variable rate mortgages and other loans that must be refinanced after a specified time period. These higher housing-related costs could further squeeze household discretionary incomes, and further depress consumer spending in this state.

High Tech on Rebound

After several soft years, California’s high-tech industries are expanding once again. The increases being experienced are partly due to the national increases in business spending on high-tech goods discussed above. They also reflect a major new cycle of product innovations in the areas of Internet sales and applications. These improvements are resulting in large increases in sales and earnings of major California high-tech firms such as Apple, EBay, Yahoo, and Google. They are also resulting in significant increases in new hiring for the first time since 2000.

The Outlook-Slowing but Still Solid Growth

We project that California’s economy will grow by slightly less than the nation in 2006 and early 2007, before accelerating to a pace which is slightly higher than the national average in 2008 and beyond. Part of the reason for California’s slightly below-average growth rate next year is that post-hurricane rebuilding-which will boost U.S. economic growth by roughly 0.3 percent in 2006-will be concentrated in the southern region of the nation. Specifically, we forecast that:

• Personal income growth will slow from 6.3 percent in 2005 to 5.7 percent in 2006, and further to 5.5 percent in 2007, before rebounding to roughly 6 percent per year during the balance of the forecast period (see Figure 5). Most of the anticipated modest slowdown in income growth during the next two years is related to tapering activity in the construction and finance-related sectors.

• Wage and salary employment growth will slow slightly from 1.4 percent in 2005 to 1.3 percent in 2006, before returning to 1.4 percent in 2007 and remaining in that general range through the forecast period.

• Taxable sales growth will slow from 6.1 percent in 2005 to 5.2 percent in 2006, before partly rebounding to 5.6 percent in 2007. The 2006 slowdown reflects easing of gasoline prices, more modest gains in consumer spending, and declines in residential construction activity (which will adversely affect the taxable sales of building materials).

• Permits for new construction are projected to decline from 214,000 this year to 185,000 in 2006, and further to 175,000 by 2008. This slowing is expected to be primarily concentrated in the single-family segment, and is due to the negative impact of projected rising interest rates on home affordability.

Key Risk-Still Higher Energy Costs

The main risk to the U.S. and California economic forecasts continues to be energy prices. Renewed growth in crude and refined energy costs would put more upward pressures on output prices and interest rates, and would further dampen consumer confidence and spending in the months ahead. Such a development would lead to slower near-term growth, particularly in interest-sensitive sectors such as housing. The effects would be especially acute in California, where high housing costs make this state’s real estate and construction industries particularly vulnerable.

The Demographic Outlook

California’s population currently totals over 37 million persons and reflects a diverse ethnic and racial mix (see Figure 6). Figure 7 shows that the state’s population growth is projected to average about 1.4 percent annually over the forecast period. In terms of numbers of people, this annual growth translates into over one-half million people and is roughly equivalent to adding a new city close to the size of Long Beach to California each year. As a result, California will add more than 3.2 million people over the forecast interval and reach over 40 million by 2011.

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 1.7 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 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 over 315,000 new Californians annually over the forecast period. This net natural gain reflects an annual average of around 570,000 births partially offset by about 255,000 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 2011. 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 yearly natural-increase component will grow slightly during the forecast period.

Net In-Migration. We project that combined domestic and foreign net in-migration will average a bit over 220,000 annually over the next six years. This is weaker than during the end of the 1990s and early 2000s when annual net in-migration averaged about 260,000. It also is considerably less than the projected average 315,000 natural-increase component noted above. Regarding this in-migration:

• Foreign In-Migration. 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 2011, averaging about 210,000 annually.

• Domestic In-Migration. Regarding domestic net in-migration, preliminary data suggest that this has been modestly negative in 2005 (that is, about 20,000 more people are leaving California this year for other states than flowed in from them). In large part, this is attributable to the lingering impacts of California’s recent recession and such factors as its continued modest job market strength and high housing prices. Given our outlook for moderate expansion of California’s economy, we do not foresee a return to net positive interstate population in-flows until 2007. At that time, net domestic in-flows should total several thousand and rise modestly thereafter, reaching the general range of 20,000 annually by the end of the forecast period.

Growth to Vary Significantly By Age Group

Figure 8 shows our population growth projections by broad age categories, including both numerical and percentage growth. Of special note are the following:

• Baby Boomers Swelling. The 45-64 age group (largely, the so-called “baby boomers”) continues to be the fastest growing single segment of the population, both in percentage and numerical terms. This group is projected to expand by nearly 1.6 million people over the forecast period, or an average rate of 2.9 percent annually.

• Negligible Growth for School-Age Children. Towards the other extreme, slow growth is anticipated for the K-12 school-age population. This reflects a variety of factors, including the lower rates of recent net domestic in-migration of families with school-age children, reduced birth rates during the late 1990s and early 2000s, and the increasing movement of baby boomers’ children into the college-age category.

• Above-Average Growth for the Elderly and College-Age Individuals. Reflecting both the aging of the older baby boomers themselves and the maturing of baby boomers’ children, both of these segments are expected to grow at a faster-than-average pace-2.6 percent and 1.9 percent, respectively.

These various age-group demographic projections can have significant implications for the state’s fiscal outlook, due to their impacts in such areas as school enrollments, health care needs, and the size and characteristics of the labor force.

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 Situation

Revenue collections in early 2005-06 are significantly outperforming the estimates contained in the 2005-06 Budget Act. Total General Fund cash receipts through the first four months of this fiscal year are up by over $1.5 billion (6 percent), due to particularly large increases in PIT and CT receipts. We believe that this solid performance will continue through the balance of 2005-06 and into the budget year.

Recent Revenue Trends Strong

In Chapter 2, we indicated that the U.S. and California economies have experienced healthy and broad-based growth in 2005, characterized by robust gains in business earnings. The effects of these developments are evident in the state’s recent revenue trends. Specifically, General Fund cash receipts from each of the major taxes are up significantly from the prior year. The largest increases are related to quarterly estimated payments made by taxpayers filing under the CT and the PIT.

Corporate Estimated Payments-Doing Extremely Well. As indicated in Figure 1, quarterly estimated tax payments made by companies filing under the CT were up by nearly 30 percent from one year earlier in the third quarter of this year. These payments are attributable to companies in a wide variety of industries, but they particularly involve oil refining, utilities, telecommunications, financial services, and manufacturing.

PIT Estimated Payments-Also Strong. The growth in PIT quarterly payments was up a similar amount during the most recent quarter. While we do not have any detailed payment information for these PIT receipts, we believe that much of the growth in this source is also due to robust gains in business earnings subject to the PIT. This includes the profits of business entities that themselves are directly taxed under the PIT (such as partnerships, sole proprietorships, and certain limited liability companies). It also includes the profits from corporations that are taxed directly under the CT but that also flow through to be taxed under the PIT, such as distributions to shareholders and the pass-through income of Subchapter S corporations.

Other Tax Payments-Healthy Too. Tax receipts other than PIT and CT estimated payments are growing at a more moderate, but still healthy, rate in 2005. As indicated in Figure 2, withholding payments, which are related to the wages, bonuses, and stock options received by individuals, have experienced fluctuating growth rates in recent quarters, but nevertheless are growing in the general range of 7 percent in 2005. Likewise, SUT receipts have been growing in the range of 6 percent to 7 percent during the same period.

The LAO Revenue Forecast

Figure 3 and Figure 4 present our updated revenue projections for the period 2004-05 through 2010-11. Figure 3 shows our revenue estimates for the prior year (2004-05) and current year (2005-06), and compares them to the projections assumed when the 2005-06 budget was adopted this past summer. Figure 4 shows our revenue projections for the entire forecast period, ending in 2010-11.

Prior-Year Revenues-Up $1 Billion. Based on preliminary agency revenue reports for 2004-05, we estimate that revenues and transfers totaled $81 billion during the year. As Figure 3 shows, this is up $1 billion from the estimate assumed in the 2005-06 Budget Act. Of this gain, PIT revenues were up $824 million, SUT was up $262 million, and all other sources combined were down $63 million. The large increase in prior-year receipts reflects a variety of factors, including the accrual of stronger-than-expected cash payments received early this fiscal year back to 2004-05. A second factor is an upward adjustment to the expected amount of audit collections during the 2005-06 fiscal year, which under California’s accounting system, will be accrued back to 2004-05.

2005-06 Revenues-Up $2.8 Billion. We project that revenues and transfers will total $87.3 billion in 2005-06, a 7.8 percent increase from 2004-05. Our revised estimate is up $2.8 billion from the estimate contained in the 2005-06 Budget Act. As Figure 3 shows, this difference consists of a $2.1 billion increase in the PIT, a slightly under $600 million increase in CT, a nearly $200 million increase in SUT, and more modest upward adjustments to interest earnings and other sources. A partially offsetting factor in 2005-06 concerns the sale assumed in the budget of pension obligation bonds. Specifically, due to legal delays, we have assumed the sale is delayed by one year. This shift will result in a $252 million reduction in revenues in 2005-06 and a corresponding increase in
2006-07 revenues.

2006-07 Revenues-Modest Growth. As shown in Figure 4, we forecast that total revenues and transfers will be $91.1 billion in 2006-07, a 4.4 percent increase from the current year. This relatively modest growth rate reflects the projected economic slowdown in 2006 as well as several other factors. For example, our estimate assumes a resumption in certain sales tax transfers (so-called “spillover payments”) from the General Fund to the Public Transportation Account (PTA). This transfer was suspended in the current year but a portion will again occur in 2006-07 and reduce General Fund SUT revenues by slightly over $300 million in that year. Other factors include: (1) the resumption of the teachers’ tax credit, which will lower PITs by about $200 million, and (2) a drop in nontax-related revenues of $500 million. The decline in such nontax revenue