LAO 2006-07 Budget Analysis: Perspectives and Issues

Analysis of the 2006-07 Budget Bill

Legislative Analyst's Office
February 2006

Perspectives on the Economy and Demographics

Summary

Despite a slowdown in the final quarter of the year, the U.S. and California economies generally outperformed expectations in 2005, shrugging off soaring energy costs, rising interest rates, and the impacts of three major hurricanes on Gulf Coast states. Recent monthly data on spending, employment, and production suggest that the softness that occurred in late 2005 will be short-lived, and the economy will expand at a moderate pace in 2006 and 2007. This outlook is subject to significant downside risks, however, associated with the potential for further increases in energy prices and steeper-than-expected declines in the real estate market. The latter risk is of particular importance to California, where real estate markets showed some signs of weakening late last year.

Recent U.S. Developments

Solid Growth In 2005

Despite a marked slowdown in the final quarter of the year (when growth slowed to an annual rate of only 1.1 percent), real gross domestic product (GDP) still expanded by a solid 3.1 percent pace between the fourth quarter of 2004 and the fourth quarter of 2005. As indicated in Figure 1:

Slowdown in Fourth Quarter Likely to Be Short-Lived

Although 2005’s fourth quarter slowdown caught many economists by surprise, monthly indicators released in January and early February of 2006 suggest that the U.S. economy will regain momentum. Positive indicators include rebounding car sales, major drops in initial claims for unemployment, and rising new orders for manufactured goods. In addition, surveys of both consumers and businesses in January found high confidence levels, improving business conditions, and increased hiring. While these conditions could quickly change in response to, for example, renewed increases in energy prices, they suggest that the economy is on an upward growth track as of early 2006.

Energy Prices Soared …

World crude oil prices climbed sharply between late 2004 and summer 2005, pushed upward by supply disruptions and strong demand, particularly from China and other industrializing countries. Prices temporarily retreated in October and November of 2005, but then rebounded again in December of 2005 and January of 2006 when it was becoming apparent that consumption of oil was continuing to outpace new supplies.

High crude oil prices, coupled with the damage to U.S. refineries caused by hurricanes Katrina and Rita, resulted in record gasoline prices in the nation. As indicated in Figure 2, the national average per-gallon price for unleaded gasoline increased from $1.83 in January 2005 to a peak of $2.90 in September 2005 (with many regions seeing prices well above $3 per gallon during the latter month), before retreating late in the year. Prices of aviation fuel and diesel also increased sharply, raising operational costs for fuel-dependent industries such as airlines and trucking. Prices of home heating fuel and natural gas also rose sharply during the year, further stretching the budgets of households across the nation.

… But They Did Not Derail the Economy

Perhaps the most pleasant surprise in 2005 was that the higher energy costs did not have the more widespread adverse impacts that some analysts had feared. While there were some negative effects on automobile sales and inflation during the second half of 2005, the impacts on the broader economy were relatively mild compared to those that rising energy prices had on economic growth and inflation 25 years ago. Increases in energy-related price components temporarily pushed the year-over-year increase in the U.S. consumer price index (CPI) to 4.7 percent in September 2005, but the growth in the index subsequently slowed late in the year (see Figure 3). The so-called “core” inflation rate (that is, the CPI excluding food and energy costs) never exceeded 2.3 percent during the year, indicating that the jump in energy costs did not “spill over” broadly into other sectors of the economy. Similarly, while higher energy prices stretched household budgets and curtailed spending on light trucks and SUVs, consumer expenditures outside of the automotive sector remained on an upward track for most of 2005.

The relatively mild impact of higher energy prices appears to be related to two main factors:

While these factors have enabled the economy to avoid widespread problems so far, further energy-related price increases still pose a risk to future economic growth and inflation.

Job and Income Growth Moderate

Job growth continued at a moderate pace in 2005. Total nonfarm payroll employment rose by 1.6 percent nationally, reflecting a 1.8 percent increase in private jobs and 1.1 percent growth in the government sector. Personal income increased by a solid 5.4 percent during the year, reflecting moderate increases in wages, and above-average increase in business-related earnings.

Profits Jumped

U.S. after-tax corporate profits increased by an estimated 34 percent in 2005, reflecting major gains in a wide variety of industries. Profits were boosted by changes in federal laws that provided for a temporary tax reduction on foreign earnings that were “repatriated” back into the U.S. by multinational companies. Even when these repatriated earnings are subtracted out, however, remaining profits were still up by more than 20 percent during the year. These gains reflect major increases in oil-related profits, as well as the ongoing benefits of high productivity and robust sales growth on businesses’ bottom-line earnings. As noted in the Part III revenue section of this volume that follows, strong profit growth is clearly benefiting the state’s fiscal picture by boosting tax receipts from both corporate and personal income taxes.

California Trends

State Economic Performance Better Than Expected For Most of 2005 …

As with the rest of the nation, California’s economy grew at a solid pace in 2005. Its growth was led by high levels of real estate sales, construction, and financing activity, but many other industries experienced healthy growth as well during the year. Some key indicators of recent state economic performance include the following:

… Although Residential Real Estate Softened Late In the Year

While all sectors of the state’s economy experienced economic growth during 2004 and most of 2005, the leading sector for this period was real estate. However, this sector showed definite signs of softening in the final quarter of the last year. As shown in Figure 4, the median price for existing home sales more than doubled between 2001 and mid-2005, but then dropped back late in the year. Similarly, permits for new residential construction activity dropped from nearly 220,000 (annual rate) during the first three quarters of 2005 down to 180,000 in the final three months of the year, with December falling to just 160,000 units. Other indicators pointing to a slowdown include fewer loan applications, rising inventories of homes on the market, and a slower pace of new building permit activity.

The late-2005 decline may have been exaggerated by unusually harsh weather and building code changes (which accelerated some permits from the fourth into the third quarter of last year). Our forecast assumes that the underlying housing trend, though falling, is less negative than the late 2005 performance would suggest. However, if the fourth quarter experience is indicative of a more disturbing underlying downward trend, the negative effects in terms of losses in wealth, income, and employment could be much more pronounced than we are assuming.

Extent of Employment Growth Remains Uncertain

The discrepancy between two key surveys of employment that has been present through much of this decade widened markedly in 2005. As indicated in Figure 5:

Which Survey Is Correct? We believe that the “true” amount of job growth is probably closer to that portrayed by the household survey, for two reasons:

We would note that some of the self employed jobs included in the household survey may be of lesser quality in terms of wages earned, hours worked, and benefits received than similar-type jobs captured in the payroll survey. Despite this, however, we believe that the household survey is more consistent with other economic and revenue indicators suggesting that 2005 was generally a good year for California.

All Major Industries and Regions Expanded In 2005

Jobs Performance by Industry. Figure 6 shows the increase in jobs reported by the payroll survey by major industry sector between December 2004 and December 2005. It shows:

Jobs Performance by Region. Regionally, payroll employment growth was under 1.5 percent in both Southern California and the San Francisco Bay Area. It was a little stronger-over 2 percent-in the Central Valley and Central Coast regions. Regarding unemployment rates, these have declined across the state over the past two years, and now generally range from 4 percent to 5 percent in Southern California, the San Francisco Bay Area, and Sacramento. The rates are somewhat higher in the San Joaquin Valley counties, the Central Coast, and the rural areas of Northern California (due partly to the greater presence of seasonal jobs in agriculture in these areas). However, unemployment in these regions is also down significantly from prior-year levels.

Export Growth Slowed in 2005

Following a strong 21 percent gain in 2004, exports of goods produced by companies in California increased at a much more subdued rate of 6 percent in 2005. The slowing growth rate was largely due to a flattening in computers and electronics exports, which jumped 15 percent in 2004, but fell by 2 percent in 2005 (see Figure 7).

Although exports have jumped substantially over the past three years combined, they are still below the all-time peak of $120 billion reached in 2000. As shown in the figure, this is because the exports of computers and electronics products-which accounted for one-half of the total in 2000-fell sharply in 2001 and 2002, and have since only recovered a fraction of their losses. The drop in foreign shipments of computers and electronics is consistent with the decline in high-tech manufacturing activity that has taken place during the past several years. While the state remains a center for research, design, and development of information technology (IT) products, the production of such products has migrated to lower-cost locations both within the U.S. and abroad.

The Budget’s Economic Outlook

The budget’s economic forecast assumes that U.S. and California economic growth will subside but remain on track in 2006 and 2007, reflecting slowing consumer spending and less construction activity. Key elements of the administration’s forecast are displayed in Figure 8. The budget forecasts that real GDP growth will slow from 3.6 percent in 2005 to 3.2 percent in 2006, and further to 3 percent in 2007. The forecast assumes that inflation will retreat slightly from 3.5 percent in 2005, to 3.2 percent in 2006, and further to 2.4 percent in 2007. The inflation forecast assumes that energy-related prices will flatten in 2006 and drop slightly in 2007.

 

Figure 8

Summary of the Budget's Economic Outlook

 

 

Estimate 

 

Forecast

 

2004

2005

 

2006

2007

U.S. Forecast

 

 

 

 

 

  Percent change in:

 

 

 

 

 

    Real gross domestic product

4.2%

3.6%

 

3.2%

3.0%

    Personal income

5.9

5.7

 

6.4

5.8

    Wage and salary employment

1.1

1.6

 

1.5

1.3

    Consumer Price Index

2.7

3.5

 

3.2

2.4

  Unemployment rate (%)

5.5

5.1

 

4.9

5.0

  Housing starts (000)

1,950

2,060

 

1,830

1,780

California Forecast

 

 

 

 

 

  Percent change in:

 

 

 

 

 

    Personal income

6.6%

6.0%

 

5.8%

5.5%

    Employment:

 

 

 

 

 

        Payroll survey

0.9

1.4

 

1.3

1.3

        Household survey

1.5

2.4

 

1.5

1.4

    Taxable sales

8.5

5.3

 

4.9

5.0

    Consumer Price Index

2.6

3.9

 

3.6

3.0

  Unemployment rate (%)

6.2

5.3

 

5.1

5.2

  New housing permits (000)

213

219

 

197

183

 

The administration’s forecast assumes that California’s economy will generally grow in line with the rest of the nation. It projects that personal income-the broadest measure of state-level economic activity-will slow from a growth rate of 6 percent in 2005 to 5.8 percent in 2006, and further to 5.5 percent in 2007. The forecast assumes solid growth in a variety of services and trade industries, but a decline in construction activity.

LAO’s Economic Outlook

Our updated economic outlook is similar to both the administration’s January budget forecast and our November 2005 fiscal forecast. We continue to expect the national and state economies will expand through the forecast period.

National Outlook

As shown in Figure 9, we forecast that real GDP growth will ease from 3.5 percent in 2005 to 3.3 percent in 2006, and further to 2.9 percent in 2007. The slowdown reflects a slightly slower pace in consumer spending and housing activity, partly offset by a slightly accelerated pace of business investment. Specifically:

 

Figure 9

Summary of the LAO's Economic Outlook

 

Estimate 

 

Forecast

 

2005

 

2006

2007

2008

U.S. Forecast

 

 

 

 

 

  Percent change in:

 

 

 

 

 

    Real gross domestic product

3.5%

 

3.3%

2.9%

3.0%

    Personal income

6.3

 

5.7

5.5

5.9

    Wage and salary employment

1.6

 

1.5

1.4

1.2

    Consumer Price Index

3.4

 

2.6

2.2

2.4

  Unemployment rate (%)

5.1

 

4.8

4.9

5.0

  Housing starts (000)

2,077

 

1,984

1,808

1,760

California Forecast

 

 

 

 

 

  Percent change in:

 

 

 

 

 

    Personal income

6.3%

 

5.7%

5.5%

5.9%

    Employment:

 

 

 

 

 

        Payroll survey

1.6

 

1.5

1.5

1.6

       Household survey

2.5

 

2.1

2.0

1.8

    Taxable sales

6.5

 

5.3

5.4

5.6

    Consumer Price Index

4.0

 

2.8

2.1

2.6

  Unemployment rate

5.4

 

5.2

5.4

5.5

  New housing permits

208

 

190

181

178

 

Energy Costs to Stabilize

A key assumption in our economic forecast relates to energy prices. This is because, although recent increases have not substantially depressed economic activity so far, further increases could have that effect. We project that crude oil prices will average close to $60 per barrel in 2006, and then trend down slightly to $55 per barrel in the 2007-through-2009 period. Our outlook assumes that, while some of the recent price increases are driven by speculation, underlying market conditions will remain tight, as worldwide oil demand continues to grow and new supplies are slow to come on the market. We expect prices of gasoline to move in tandem with crude oil costs, with unleaded gasoline averaging $2.35 per gallon nationwide in 2006, and about $2.30 per gallon the following year.

Inflation to Ease

Based on our assumption that energy costs will stabilize and then fall modestly over the next several years, we are forecasting that overall inflation will subside from recent levels. For example, growth in the U.S. CPI is projected to slow from 3.4 percent in 2005 to 2.6 percent in 2006, and further to 2.2 percent in 2007, as energy costs start to decline and nonenergy-related inflation holds steady in the 2 percent to 3 percent range. Factors holding down inflation include continued business productivity growth, moderate wage increases, and intense international competition.

U.S. Budget Deficits to Remain Large

Our forecast for the nation assumes that large federal budget deficits will persist through the next decade despite sustained economic growth during the period. As shown in Figure 10, the federal budget moved from a surplus to deficit situation in 2002 following the stock market crash, economic downturn, tax reductions (which were aimed at boosting the economy out of the 2001 recession), spending related to Iraq, recent U.S. hurricanes, and expansions in the Medicare program. These deficits are projected to remain large throughout the next decade, despite ongoing economic expansion during the period. In the early years of this decade, the large deficits had a stimulative effect on the economy, as consumers and businesses spent their proceeds from the federal tax reductions. In the future, however, added financing costs associated with the federal debt will have some depressing effects on long-term economic growth.

 

California Outlook

We forecast that California’s economic growth will ease some in 2006 and 2007, but that the state’s economy will continue to expand during the next two years. A key assumption underlying our forecast is that the slowdown in real estate will not be dramatic, and that output and hiring in other industries will offset most of the softness in this sector. As shown earlier in Figure 9:

Key Forecast Risks

Key assumptions underlying our economic forecast are that (1) energy prices will hold near current levels, rather than rising significantly further in 2006 and 2007, and (2) California’s housing markets will experience only modest declines in sales, construction, and prices in 2006. Both of these assumptions are subject to risks.

Energy Costs

As indicated earlier, the energy markets remain extremely tight, with little excess capacity worldwide. While our forecast assumes that a delicate balance between supply and demand will result in prices staying near current levels, one forecast risk is that unanticipated supply disruptions or faster-than-expected growth in demand could quickly translate into another round of energy price increases. Such a development would depress consumer discretionary incomes, put upward pressure on general inflation and interest rates, and ultimately result in a more pronounced slowdown in economic activity during the next year.

Real Estate Activity

Our forecast assumes that the decline already underway in real estate will be orderly and limited in 2006, with sales rates, prices, and new construction activity falling by between 5 percent to 10 percent from 2005 levels. There is always the risk at such times, however, that rising mortgage rates and a tightening of lending standards will send the California housing markets into a steeper decline. Such a development would directly depress earnings and income in real estate-related industries, and indirectly affect many other areas of the economy, through the effects of lost wealth and income on sales, hiring, and confidence in the economy. Another type of risk involves the housing market sharply contracting to the extent that some of its past strength has reflected speculative behavior.

Illustration of Potential Downside Effects. As an indication of the potential reductions to our economic forecast that the above risks could produce, we have estimated the adverse impacts of a steeper-than-expected decline in the real estate sector using the following assumptions:

Under this alternative projection, we estimate that California personal income growth would fall from our baseline forecast by about 1.4 percentage points in 2006 (from 5.7 percent to 4.3 percent) and by about 2 percentage points in 2007 (from 5.5 percent to 3.5 percent). As discussed in Part III of this volume, reductions of this magnitude in our economic forecast would have substantial downward impacts on state General Fund revenues.

Comparison to Other Forecasts

Figure 11 compares our economic forecasts for the nation and California to our November 2005 forecasts, as well as to a variety of other economic projections made in recent months by other forecasters. These include the projections made by the University of California, Los Angeles (UCLA) Business Forecast Project in December 2005, the consensus forecast published in the Blue Chip Economic Indicators (January 2006), the consensus outlook forecast in the Western Blue Chip Economic Forecast (February 2006), and the 2006-07 Governor’s Budget forecast.

 

Figure 11

Comparisons of Recent Economic Forecastsa

(Percent Changes)

 

Forecast

 

2005

2006

2007

United States Real GDP:

 

 

 

  LAO November

3.7%

3.3%

3.0%

  UCLA December

3.6

2.8

2.5

  DOF January

3.6

3.2

3.0

  Blue Chip "Consensus"b January

3.6

3.4

3.1

  LAO February

3.5

3.3

2.9

California Payroll Jobs:

 

 

 

  LAO November

1.4%

1.3%

1.4%

  UCLA December

1.6

1.1

0.8

  DOF January

1.4

1.3

1.3

  Blue Chip Consensusc February

1.6

1.5

1.2

  LAO February

1.6

1.5

1.5

California Personal Income:

 

 

 

  LAO November

6.3%

5.7%

5.5%

  UCLA December

6.2

5.2

4.5

  DOF January

6.0

5.8

5.5

  Blue Chip Consensus c February

5.9

5.9

5.6

  LAO February

6.3

5.7

5.5

California Taxable Sales:

 

 

 

  LAO November

6.1%

5.2%

5.6%

  UCLA December

6.9

5.1

4.0

  DOF January

5.3

4.9

5.0

  Blue Chip Consensus c February

5.2

5.6

5.7

  LAO February

6.5

5.3

5.4

 

a  Acronyms used apply to Legislative Analyst's Office (LAO); University of California, Los Angeles (UCLA); and Department of Finance (DOF).

b  Average forecast of about 50 national firms surveyed in January by Blue Chip Economic Indicators.

c  Average forecast of organizations surveyed in February by Western Blue Chip Economic Forecast.

 

Our projections have not changed a great deal since November, and we are generally similar to those of the administration and most other forecasts shown in Figure 11. To varying degrees, all of the projections call for slowing growth over the next two years, with UCLA anticipating a bit more of a slowdown than other California forecasters.

The Demographic Outlook

California’s demographic trends both directly and indirectly affect the state’s economy, revenue collections, and expenditure levels. For example, they influence the size of the labor force, the demand for homes and automobiles, the volume of taxable sales, and the amount of income taxes paid. Similarly, the population and its age distribution affect school enrollments and public programs in many other areas, such as health care and social services. Consequently, the state’s demographic outlook is a key element both in estimating economic performance and in assessing and projecting the state’s budgetary situation.

State Population to Approach 38 Million in 2007

Figure 12 summarizes our updated state demographic forecast. We project that California’s total population will rise from an estimated 37.5 million in 2006 to 38 million in 2007, and 38.5 million in 2008. These population projections use as their starting point published 2000 Census data for California and incorporate developments since then regarding births, deaths, and migration flows.

 

Slight Slowing Projected. The state’s population is projected to grow at an average rate of somewhat above 1.3 percent annually over the next three years. This is down slightly from the 1.5 percent average for the 2002 through 2005 period. Birth rates are forecast to stabilize at historically low levels, and net in-migration is projected to turn upward after having fallen for the past several years.

In numeric terms, the number of new Californians being added each year-about 505,000 people over the forecast interval-is above the size of such cities as Long Beach, Fresno, and Sacramento, and very similar to such states as Wyoming.

 

Figure 12

Summary of the LAO’s California Demographic Forecast

(Population in Thousands)

 

2006

2007

2008

Total population (July 1 basis)

37,480

37,987

38,508

Changes in population:

 

 

 

  Natural change (births minus deaths)

306

306

307

  Net in-migration (in-flows minus out-flows)

182

202

214

  Total changes

488

508

521

Percent changes

1.3%

1.4%

1.4%

 

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 people leaving the state for other destinations). The population growth associated with natural increase accounts for about 60 percent of California’s projected annual growth over the forecast period and is assumed to be fairly stable. Net in-migration accounts for the other roughly 40 percent of the growth over the period, but has historically varied in response to changing economic conditions in the state.

Natural Increase. We project that the natural increase component will contribute an average of 307,000 new Californians annually over the forecast period. This reflects stable birth rates, but growth in the female population of child-bearing age groups.

Net In-Migration. This component dropped from 388,000 in 2001 to 179,000 in 2005, due mainly to a decline in net in-migration from other states. Specifically, net domestic in-migration from other states fell from a positive 97,000 in 2001 to a negative 29,000 in 2005, meaning that in 2005 more people left California for other states than moved into California from them. The decline in net domestic in-migration in recent years appears to reflect, to some degree, the impact of high home prices and a slower rate of hiring in California compared to past expansions. We expect net domestic in-migration to slowly turn positive during the next several years, but remain well below the levels realized in past economic expansions. Combined with our projections for steady rates of immigration from other countries, the slow increase in inflows from other states will result a modest rise in total in-migration over the next several years.

Growth to Vary by Age Group

The implications of demographic trends for the budget depend not only on the total number of Californians, but also on their characteristics. California is well known for having one of the world’s most dynamic and diverse populations, including an increasingly rich ethnic mix and a large number of in-migrants. The state’s age and ethnic mix are shown in Figure 13.

The age-related characteristics of California’s population growth are especially important from a budgetary perspective, given their implications for such program areas as education, health care, and social services. Figure 14 shows our forecasts for both the percentage and numeric changes in different population age groups. The 45-to-64 age group (largely representing baby boomers) continues to be the fastest growing segment of the population. About 843,000 new people are expected to move into this age category over the next three years, as the tail-end of the baby boom generation moves into its mid-40s. In contrast, the leading edge of the baby boomers will be only 62 years of age by the end of the forecast period, and thus still occupants of this age category.

Overall Budgetary Implications

California’s continued population growth-including its age, ethnic, and migratory characteristics-can be expected to have many implications for the state’s economy and public services in 2006-07 and beyond. For example, strong growth of the 45-to-64 age group generally benefits tax revenues since this is the age category in which people normally earn their highest wages and salaries. Alternatively, the lack of growth statewide in the 5-to-17 age group translates into significant declines in enrollment for many school districts.

More general examples of demographic influences include the following:


Return to Perspectives and Issues Table of Contents, 2006-07 Budget Analysis