Legislative Analyst's Office, November 14, 2001

California's Fiscal Outlook

LAO Projections, 2001-02 Through 2006-07

Chapter 3

Revenue Projections

The revenues that finance California's state General Fund budget come from a number of different sources, including various taxes, fees, licenses, earnings on investments, loan repayments, and transfers from other funds. Of these, taxes are by far the most significant, typically accounting for over 90 percent of all revenues. This chapter summarizes our projections for General Fund revenues over the forecast period.

Recent Revenue Developments

California's revenue outlook has deteriorated substantially since the 2001-02 budget was enacted last summer. The budget had already assumed that revenues in 2001-02 would fall by about 3.7 percent from last year's level, reflecting a slowdown in economic activity, and a decline in stock options and capital gains. Since the time of the budget's enactment, however, the economy and stock market have deteriorated more sharply than anticipated, and state revenue receipts have consequently fallen well short of earlier expectations.

Cash Shortfall Already Exceeds $1 Billion

Total cash receipts between May and September were down about $1 billion from the 2001-02 Budget Act forecast, reflecting across-the-board softness in all major revenue sources. What is particularly disturbing is that most of the weakness so far has been related to economic activity prior to September 11, and thus, does not reflect the full effects of the slowdown in sales and income that occurred following the terrorist attacks.

A key indicator of the revenue slowdown is the slide in personal income tax (PIT) withholding. The month-to-month performance of revenues from this source is a very significant indicator of emerging fiscal trends, since the PIT is the state's largest revenue source and monthly PIT receipts reflect current trends in jobs, wages, and stock-option income. As shown in Figure 1 (see page 16), year-over-year growth in this key indicator was running above 20 percent during the peak of California's economic boom in early 2000, but had slid to a minus 6 percent as of the third quarter of this year. Other state tax receipts—including sales taxes as well as quarterly income tax prepayments from individuals and corporations—also have exhibited a similar adverse pattern—booming in 2000 but sharply weakening throughout 2001.

The LAO's Revised Forecast

Dramatic Deterioration Foreseen

Reflecting the recent extremely negative revenue developments and our projected downturn for the state's economy, our updated forecast foresees a dramatic revenue deterioration in the near term. Moreover, although revenues will begin recovering once the economic recovery starts, we do not expect revenues to climb back to their 2000-01 level until 2003-04. Our revenue forecast, presented in Figure 2, is as follows:

• Prior Year. Revenues in 2000-01 totaled $77.7 billion, about $318 million below the budget act forecast. This shortfall reflected revenue losses from each of the state's major taxes in May and June.
• Current Year. Revenues are projected to total $68.3 billion in 2001-02, a 12 percent decline from the prior year. This amount is $6.8 billion below the 2001-02 Budget Act estimate, reflecting a dramatic $5.5 billion downward revision to the outlook for PIT receipts, as well as more-moderate declines from the sales and use tax (SUT) and bank and corporation tax (BCT).
• Budget Year and Beyond. We forecast that General Fund revenues will partially rebound from this year's very depressed level in 2002-03, with receipts increasing to $74.6 billion in the budget year. Over the longer term, we project that continued economic growth will boost receipts by roughly 10 percent in 2003-04, and by an average of roughly 7.5 percent in the subsequent three years.

Revenue-Related Legislation

Our forecast reflects the fiscal effects of revenue-related measures that were enacted both in conjunction with the 2001-02 budget and during the summer. These measures included an agricultural and rural tax assistance tax package that exempted from the SUT purchases of farm and forestry equipment, diesel fuel used in farming and food processing, and certain purchases of liquefied petroleum gas. Taken together, these exemptions will reduce General Fund revenues by approximately $40 million annually beginning in 2001-02. Our estimates also incorporate the fiscal effects of legislation signed following adoption of the budget. These measures include
SB 17xx, which provides a credit for the installation of solar systems for the production of electricity. The measure will reduce combined PIT and BCT revenues by $20 million in 2001-02 and $35 million in 2002-03. As discussed below, our forecast assumes that the one-quarter cent SUT trigger reduction will be in effect for 2001, but not thereafter.

Individual Revenue Sources

Personal Income Taxes

After steadily increasing from $16.3 billion in 1994-95 to $44.8 billion in 2000-01, we estimate that PIT revenues will decline to $36.7 billion in
2001-02—a drop of over 18 percent. This current-year decline is, by far, the steepest in the past three decades. We expect that PIT revenues will partially rebound to $41.7 billion in 2002-03. Over the longer term, we project that PIT receipts will increase at an average annual rate of 9.3 percent from 2003-04 through 2006-07, reaching $59.5 billion by the end of the forecast period.

Key Forecast Factors

The single largest factor behind the drop in PIT receipts in the current year is the dramatic decline in capital gains and stock options. As shown in Figure 3, income related to these sources soared from $25 billion in 1994 to over $200 billion in 2000. At their peak, these sources accounted for over $17 billion in PIT revenues in 2000-01, which was over 22 percent of total General Fund revenues during that year.

Based on recent stock market and revenue trends, however, it appears that capital gains and stock options have plummeted in 2001. We are currently assuming that the decline will be about 60 percent this year, with revenues attributable to these sources dropping to about $7 billion in 2001-02.

Why the Sharp Decline? The sharp drop in stock options and capital gains is related to the general drop in stock market valuations over the past year, and in particular, the dramatic drop in share values of California's high-tech companies (which have accounted for the majority of stock-option income in recent years). As shown in Figure 4, the stock prices of some of the largest of these companies currently are down by over 75 percent from their early 2000 peaks, and in many cases, options granted in recent years are "under water." This means that their current value is less than when they were granted, and thus, there is currently no income associated with them to tax.

A second factor behind the decline is that a larger-than-normal proportion of stocks were sold in 2000, as investors and employees attempted to "lock in" gains that had accrued in previous years. This increased taxable income associated with capital gains and stock options in 2000, but also reduced dollar-for-dollar the amount of "stored up" gains potentially available for realization in 2001 and beyond.

Outlook for 2002 and Beyond

One of the key factors affecting the state's long-term revenue outlook is what the strength and timing of the recovery in stock market-related income will be. We forecast that stock prices will partially rebound beginning in 2002, leading to projected 15 percent increases in capital gains and options in both 2002 and 2003. Even with these increases, however, revenues from gains and options are expected to remain well below their 2000-01 peak through the forecast period.

Sales and Use Taxes

Following an increase of 11.5 percent in 1999-00, General Fund revenues from this source remained flat in 2000-01 and are expected to decline slightly in 2001-02. We project that revenues will rebound by 9.2 percent in 2002-03, increasing to $23.1 billion during the year. Over the longer term, we project that sales tax receipts will increase at an average annual rate of 6.8 percent from 2003-04 to 2006-07, reaching $30.1 billion by the final year of the forecast.

Key Forecast Factors

Both policy- and economics-related factors are involved in our SUT projections through 2006-07.

Policy-Related Factors. Three key factors are involved here:

• Collections in 2000-01 were reduced due to a diversion to a special transportation fund of $500 million in SUT receipts from gasoline sales.
• Revenues in both 2000-01 and 2001-02 are affected by the one-quarter cent "trigger" reduction in the SUT rate that occurred for calendar year 2001. This reduction lowered revenues by about $500 million in 2000-01 and $600 million in 2001-02.
• Finally, as noted earlier, SUT receipts in 2001-02 and beyond will be reduced by roughly $40 million annually due to passage of the rural tax relief package in conjunction with the 2001-02 budget.

Due to these factors, total taxable sales growth slowed from 10.9 percent in 2000, to a marginal 1.5 percent during the first half of 2001. Recent monthly data suggest that the softness continued in the third quarter of the year, partly due to the negative effects of the September 11 terrorists attacks on consumer and business spending.

Outlook for 2002 and Beyond

Looking ahead, we project that taxable sales will continue to slide in the fourth quarter, before stabilizing in early 2002, and then turning upward beginning next spring. On an average annual basis, we forecast that taxable sales will decline by 2 percent in 2001, before rebounding by 3.9 percent in 2002 and 7.9 percent in 2003. Over the longer term, we project that taxable sales will increase slightly more slowly than state personal income, averaging 6.5 percent annually over the final three years of the forecast period. Sales and use tax revenues will follow this general pattern.

Bank and Corporation Taxes

We estimate that BCT revenues will fall sharply from $6.4 billion in 2000-01 to $5.2 billion in
2001-02, before partly rebounding to $5.9 billion in 2002-03. Over the longer term, we project that revenues from this source will increase at an average annual rate of 8.4 percent from 2003-04 through 2006-07, reaching $8.1 billion by the end of the forecast period.

Key Forecast Factors

The current economic downturn is having a dramatic adverse impact on corporate profits. Based on BCT prepayments through September, we estimate that California taxable profits are down by over 18 percent in 2001 relative to the prior year (see Figure 5). Company earnings reports suggest that profits throughout the nation are being squeezed by idle capacity, sluggish sales in both in the U.S. and abroad, falling product prices, heavy debt loads, and high costs for employee health care. The slump in information technology (IT)-related spending is having a particularly negative effect on California's economy and profits. This is because, as noted previously, California accounts for roughly 20 percent of the nation's IT industry.

Looking beyond 2001, we expect that corporate profits will slowly recover beginning next year, accelerate in 2003, and continue to expand at a moderate pace through the balance of the forecast period.

Other Revenues and Transfers

We forecast that revenues and transfers from the General Fund's remaining sources of income will be about $5.3 billion in the current year, or roughly the same level as in 2000-01. We then expect receipts from these sources to fall to about $3.9 billion in 2002-03, and remain in the range of from $3.5 billion to $3.8 billion in the subsequent four years.

Key Forecast Factors

Current-year revenues in the "other" category are being affected by a variety of offsetting factors, including the diversion of tobacco settlement receipts to special funds, and an increase in one-time transfers—a minus $16 million in 2000-01 to over $1 billion this year. Similarly, the revenue decline between the current year and the budget year is related to the assumed reduction in one-time transfers to $100 million. Over the balance of the forecast period, we assume that revenues from most nonmajor tax sources will increase at a moderate rate. The one key exception involves the estate tax. Revenues from this source will decline from $1.1 billion in the current year to near zero by 2005-06, due to federal law changes enacted last spring that will result in the phase-out of California's estate tax over the next four years.

 

Capital Gains and Stock Options The dramatic decline in capital gains and stock options is the single most significant factor in the unprecedented drop in General Fund revenues estimated for 2001-02. What Are Gains and Options? Capital gains are a form of income recognized on PIT and BCT tax returns that arises from the sale of assets that have increased in value over time. We estimate that roughly two-thirds of total capital gains in California are related to company stocks, with the remainder related to transactions involving bonds, real estate, and other physical assets. In contrast, employee stock options are legal contracts entitling an employee to purchase a fixed number of shares of the employer's stock at a predetermined price (usually the market price on the day the option is granted) for a specified period of time (usually ten years). Example of How an Option Works As a simple illustration of how a stock option works, assume that in a given year, an option is granted to an employee to purchase 1,000 shares of the company's stock at its then-market price of $10 per share. Assume further that after a three or four year "vesting period" (that is, a predetermined time period between when the option is granted and when the employee is first eligible to actually exercise the option and purchase the stock), the market price of the company's stock has increased to $30 per share. The tax treatment of this option will depend on whether it is a "nonqualified" or "qualified" option. For a nonqualified option, the employee must report as ordinary income subject to PIT taxation the "paper gain" on the stock at such time as the option is exercised and the stock is purchased, even if it is not subsequently resold and no actual capital gain has been realized. Thus, in our example, the employee would report upon exercising the option, a gain of $20,000 (1,000 shares times the increased stock price per share of $20). If, in contrast, it is a qualified option, the employee only has to report the gain realized when the stock is resold. In addition, if the stock is held for at least one year, a reduced federal preferential capital gains tax rate applies as opposed to the regular tax rate. Thus, qualified options can benefit both from having the taxes on their gains deferred and being taxed at a lower rate. (Qualified options are, however, subject to the federal Alternative Minimum Tax when they are exercised.)