The 2018-19 May Revision

LAO Revenue Outlook

This post details our General Fund revenue outlook for 2016-17 through 2021-22. Our estimates of General Fund revenues and transfers for the “budget window”—2016-17 through 2018-19—are $2.6 billion above the administration’s May 2018 revenue forecast.

Figure 1 displays our General Fund revenue outlook through 2021-22. Our revenue outlook is based on a consensus national economic forecast compiled by Moody’s Analytics. As such, our revenue estimates are premised on two key assumptions: the continuation of the current economic expansion through 2022, and a moderate stock market decline in 2019 followed by a gradual rebound. If economic and financial conditions vary from those assumed in this scenario, General Fund revenues could vary substantially from our estimates. See this post for more information concerning our economic assumptions.

Personal Income Tax (PIT)

Healthy Growth in Wages and Salaries Drive PIT Growth. Our PIT outlook reflects anticipated tightening in labor markets, which puts upward pressure on wages. Accordingly, we estimate that taxable wages and salaries will increase by 7.5 percent in 2018 and 6.6 percent in 2019 before fading to 3.5 percent growth in 2021. As wages and salaries make up about two-thirds of income (as seen in the tax guide on page 6), this growth is a key driver of our outlook for the PIT.

Capital Gains Spike in 2017-18 and 2018-19. Preliminary Franchise Tax Board data show that net capital gains in 2016 totaled $110 billion. We estimate that net capital gains increase to $150 billion in 2017 and $162 billion in 2018, driven primarily by recent increases in stock market values. Under our economic scenario, the S&P 500 drops by about 8 percent in 2019. Accordingly, estimated net capital gains decrease to about $135 billion in 2019 and remain around that level through 2022.

Corporation Tax (CT)

Revenues Up Significantly in 2017-18. We expect CT revenues in 2017-18 to be almost 9 percent higher than 2016-17. This increase primarily reflects two factors: (1) steady long-term growth in corporate profits, and (2) a reduction in the use of credits and net operating losses. As the economy is in an extended economic expansion, previously accumulated tax credits and net operating losses from the last economic recession (which may be deducted from current profits) are being depleted. As a result, over the coming years, corporations may pay somewhat more in taxes relative to their state net income. Under our moderate economic growth scenario, we expect corporate profits to continue to grow at roughly 4 percent annually. Consequently, we expect corporate tax revenues to increase steadily over the next few years.

Major Effects of Federal Tax Changes on California Revenues. Among the changes Congress made to the federal CT in 2017 was a one-time tax on corporate profits held overseas. (Corporations previously avoided paying federal tax on these profits by holding them overseas.) Once this one-time tax is paid, corporations may bring these profits back to the U.S. any time (without paying any additional federal taxes). Consequently, some corporations will elect to bring some of this cash back to the U.S. We estimate that corporations bring back $1 trillion in overseas profits. Depending on corporations’ tax status in California, a portion of this returning cash will be taxed by the state. Specifically, the state taxes corporate profits based on the business’ share of sales generated in California (which is roughly 7 percent on average). Many of these corporations can reduce their taxes by using tax credits, such as research and development credits. As a result, we estimate increased CT revenues on a one-time basis by a few hundred million dollars over the next two to three years. Ongoing, we expect this change will permanently increase the amount of overseas profits that corporations opt to bring back now that the incentive to hold cash overseas is eliminated. We estimate this amount to be in the low tens of millions of dollars in additional CT revenue annually.

Near-Term LAO Outlook Significantly Higher Than Administration Forecast

Figure 2 shows the administration’s forecast of General Fund revenues through 2021-22. Figure 3 compares our revenue outlook with that of the administration. As shown in Figure 3, our estimates of General Fund revenues and transfers are $2.6 billion above those of the administration over the budget window—2016-17, 2017-18, and 2018-19 combined. Most of the variance is explained by the PIT, where we are $3.7 billion higher than the administration over the three fiscal years combined. Most of that difference appears to be in capital gains and wages. The difference on PIT is offset by lower estimates of the sales and use tax ($757 million) and CT ($88 million).