Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

Perspectives on State Revenues

As always, a key determinant of California's current budget outlook is the strength of state revenues. These revenues will be affected by the performance of the state's economy, decisions by investors regarding their stock options and capital gains, numerous policy actions taken in past years, and proposals included in the Governor's current budget. In this Part, we provide background information relating to the revenue outlook, discuss recent revenue developments, summarize the budget's revenue projections, and present our own revenue forecast.

The Budget's Forecast for Total State Revenues

The 2004-05 Governor's Budget projects that California's state government will receive over $97 billion in revenues during 2004-05, a $4.3 billion (1.3 percent) increase from the current year. These revenues are deposited into either the General Fund or a variety of special funds. Figure 1 shows that:

• General Fund Revenues. About 79 percent of total state revenues are deposited into the General Fund. These revenues are then allocated through the annual budget process for such programs as education, health, social services, and criminal justice.
• Special Funds Revenues. The remaining 21 percent of revenues are received by special funds and are primarily earmarked for specific purposes, such as transportation, local governments, and targeted health and social services programs.

As the figure shows, some revenues, such as sales and tobacco taxes, support both the General Fund and special funds.

Sources of General Fund Revenues. Figure 1 indicates that about 91 percent of total General Fund receipts are attributable to the state's "big three" taxes—the personal income tax (PIT), the sales and use tax (SUT), and the corporation tax (CT). The remainder comes from a variety of smaller taxes (including insurance, estate, tobacco, and alcoholic beverage taxes), as well as investment earnings and various loans and transfers from special funds. 

Recent and Proposed Tax-Related Changes

Figure 2 shows the effects of policy changes and other special factors on tax revenues for 2002-03 through 2004-05. This table does not include numerous other special factors involving nontax revenues, such as loans, transfers, asset sales, or tribal gaming revenues. (These latter factors are discussed below in the "Other Revenues and Transfers" section of this Part.) The figure shows:

• In 2002-03, major tax revenues were increased by $2.1 billion, primarily as a result of withholding increases on stock options and real estate sales, a two-year suspension of net operating loss (NOL) "carryforward" provisions, and a variety of other tax compliance and acceleration measures. 
• In 2003-04, the net revenue impact of special factors is a $849 million increase. Most of this gain relates to the second year of the NOL suspension adopted in 2002-03 and modest gains related to tax compliance.
• In 2004-05, in contrast, the net revenue impact of special factors is only a marginal $10 million increase. This effect is the net result of revenue gains related to the expiration of the manufacturers' investment tax credit and tax compliance proposals, offset by revenue losses from the resumption and expansion of NOL carryforward deductions per the 2002-03 legislation.

Changes in Underlying Revenues

Figure 3 provides an indication of the trend in "underlying" General Fund revenues—that is, revenues excluding all of the previously adopted and currently proposed policy-related changes and other special factors. These include the tax-related changes shown in Figure 2, as well as numerous other loans, transfers, asset sales, and fee increases adopted in past years or proposed in the current budget. This underlying trend isolates how the state's basic tax structure has been affected primarily by changes in the economy and stock market in the recent past, and how we anticipate it to respond to economic changes in the future. It shows that: 

• Revenues boomed in the late 1990s, reflecting healthy economic growth and an unprecedented run-up in stock market-related revenues from stock options and capital gains.
• However, receipts dropped by over 15 percent in 2001-02, due to the stock market plunge and the economic recession.
• Revenues then stabilized in 2002-03 and are projected to grow moderately, roughly in line with statewide personal income, in 2003-04 through 2005-06.

The Budget's General Fund Revenue Outlook

Figure 4 shows the budget's revised estimate of General Fund revenues for the prior year and current year, as well as its forecast for 2004-05. (The revenue totals shown in this Part do not include the $12.3 billion in proceeds from the economic recovery bonds. In "Part I," we display these proceeds separately in our estimates of the General Fund budget condition).

Prior-Year Estimate. The budget estimates that 2002-03 General Fund revenues and transfers totaled $71.3 billion, a $470 million increase from the level assumed in the 2003-04 budget (and included in our November report). This increase is largely related to year-end accrual adjustments recently made by the State Controller totaling roughly $270 million for the PIT and about $100 million each for the SUT and CT.

Current-Year Estimate. The January mid-year forecast for 2003-04 assumes that General Fund revenues and transfers will be $74.6 billion, a $3.3 billion (4.6 percent) increase from the prior year. This is up by $1.3 billion from the estimate in the 2003-04 Budget Act. The revision is the net result of three main factors:

• First, the new forecast of revenues from the major taxes is up $2 billion, primarily reflecting stronger-than-anticipated economic growth and higher tax receipts during the first half of the fiscal year.
• Second, the forecast includes about $800 million in newly proposed revenues, loans, and transfers, primarily from transportation-related special funds.
• Third, and partially offsetting the first two factors, the revised forecast excludes $1.6 billion in revenues that had been assumed in the 2003-04 budget. These are related to (1) a pension bond sale which has been invalidated by a Superior Court and is currently being appealed by the state, and (2) new or renegotiated tribal gaming compacts, which have so far yielded no significant new revenues. (The administration is assuming smaller amounts from both of these sources in 2004-05).

2004-05 Forecast. The budget forecasts that General Fund revenues and transfers will be $76.4 billion in the budget year, a $1.8 billion (2.4 percent) increase from the current year. Major taxes are forecast to increase about 6 percent, roughly in line with growth in statewide personal income. In contrast, nontax revenues and transfers are projected to fall by roughly 44 percent, due to smaller amounts of one-time loans and transfers from special funds. 

The LAO's General Fund Revenue Outlook

Figure 5 presents our General Fund revenue outlook for 2003-04, 2004-05, and 2005-06. Our projections are based on our economic and demographic forecasts presented in "Part II" previously, and reflect the impacts of the Governor's major revenue-related policy proposals.

LAO Forecast Down Modestly From Budget

Our current forecast is generally similar to the budget forecast. For example, we agree with the administration's assumption that economic growth will result in a strengthening of the state's revenue picture this year and in 2004-05. Our one significant departure from the administration (and from our own November revenue projection as well) is that we have reduced our estimate of PIT liabilities in the 2003 "base year" to reflect recently revised historical information on wages and withholdings (please see discussion in box on page 55). This reduction results in a lower revenue trend, which in turn affects both our current-year and budget-year revenue forecasts. Specifically:

• 2003-04 Forecast. We forecast that General Fund revenues and transfers will total $74.1 billion in the current year, a $2.8 billion (3.9 percent) increase from 2002-03. This is down $491 million from the budget forecast, of which $477 million is related to our lower estimate of PIT revenues.
• 2004-05 Forecast. We forecast that revenues and transfers will total $75.9 billion in 2004-05, a $1.7 billion (2.4 percent) increase from the current year. This is down about $525 million from the new budget's projection, primarily reflecting the ongoing effects of the current-year reduction in PIT receipts.

2005-06 Outlook. We forecast that total revenues and transfers will increase from the current year by about $2.5 billion (3.3 percent) in 2005-06, to $78.4 billion. Excluding the impact of the Governor's policy proposals on the 2004-05 and 2005-06 revenue totals, the underlying increase would be a more robust 5.7 percent. This increase is consistent with our assumption that the economic rebound will continue in 2005, boosting revenues from the state's main taxes during the year.

The LAO's Forecast for Major Revenue Sources

As indicated above, the great majority of General Fund revenues are attributable to the state's three major taxes—the PIT, SUT, and CT. Thus, the performance of these taxes will dominate the overall revenue outlook. In the following sections, we discuss in more detail recent developments and the outlook for each of these three revenue sources. 

Personal Income Tax

Background

We project that the PIT will account for just under 50 percent of total General Fund revenues in 2004-05. Although this share has fallen significantly from its peak in 2000-01, the PIT remains by far the largest source of state General Fund revenues. In general, the PIT is patterned after federal law with respect to reportable types of income, deductions, exemptions, exclusions, and credits. Under the PIT, taxable income is subject to marginal rates ranging from 1 percent to 9.3 percent, with the top rate applying to taxable income in excess of $78,266 for joint returns in 2003 (and one-half of that in the case of single taxpayers).

PIT Liabilities

Our forecast of PIT liabilities is shown in Figure 6. After soaring in the late 1990s, PIT liabilities plunged in 2001 by nearly $10 billion (over 20 percent) from their unsustainable peak reached in 2000, and by another $1.5 billion in 2002. Liabilities then experienced a modest partial recovery in 2003. We expect them to grow at a stronger pace in both 2004 and 2005, reflecting healthy gains from most major income sources. Specifically:

• Ordinary wages (that is, wages excluding bonuses and stock options) are forecast to increase by roughly 4.5 percent in 2004 and 5.5 percent in 2005, reflecting an upturn in jobs and moderate growth in wage rates.
• Capital gains and stock options are forecast to increase by roughly 10 percent in both 2004 and 2005. These increases reflect the healthy gains in stock market values that have already occurred, and our expectation that growth in output, sales, and profits will push stock prices moderately higher in 2004 and 2005. Such stock market gains, if sustained, eventually will result in significant growth in taxable capital gains. However, the up-side revenue potential in the near term from this is somewhat limited by the large amount of related prior-year losses which are available to offset gains accruing in 2004 and 2005.
• Business-related income is also forecast to grow by nearly 10 percent in both 2004 and 2005, reflecting healthy increases in sales, output, and productivity in the economy. The outlook for business earnings is becoming an increasingly important factor in the PIT outlook. This is due to the ever-increasing number of companies filing as S-corporations and limited liability corporations (whose income is largely taxable under the PIT—as opposed to under the CT, as is the case for taxpayers filing as regular corporations).

PIT Revenue Forecast

Based on our estimated changes in PIT liabilities, we forecast that fiscal-year PIT receipts will total $34.6 billion in 2003-04, and then expand to $37.4 billion in 2004-05 and $40.1 billion in 2005-06. Compared to the budget forecast, our current projection of PIT revenues is down by $477 million in the current year and by $613 million in 2004-05—or $1.1 billion for the two years combined. As noted earlier and discussed further in the nearby shaded box, our lower PIT estimates primarily reflect our reassessment of historical withholding and wage data for 2003, which suggests that PIT liabilities are less than assumed in the budget forecast.

Sales and Use Tax

Background

The SUT is the General Fund's second largest revenue source, accounting for about one-third of total revenues in 2004-05. The main SUT component is the sales tax, which is imposed on retail sales of tangible goods sold in California. Some examples of sales tax transactions include spending on clothing, furniture, computers, electronics, appliances, automobiles, and motor vehicle fuel. Purchases of building materials that go into the construction of homes and buildings are also subject to the sales tax, as are purchases of computers and other equipment used by businesses. Roughly 70 percent of the SUT is remitted by retailers, while the remaining 30 percent is directly paid by businesses who themselves consume or use the products being taxed. The largest exemption from the sales tax is for most food items consumed at home. The great majority of services are not subject to the sales tax.

The second component of the SUT—the use tax—is imposed on products bought from out-of-state firms by California residents and businesses for use in this state. With the exception of automobile purchases (which must be registered), out-of-state purchases are difficult to monitor, and the state is prohibited under current federal law from requiring most out-of-state sellers to collect the use tax for California. As a result, use tax receipts account for only a small portion of total SUT revenues.

SUT Rates

The total SUT rate levied in California is a combination of several different individual rates imposed by the state and various local governments. These include:

• State Rates. The current overall state SUT rate is 6 percent. The largest single component is the 5 percent state General Fund rate. Also included in the overall state rate are two half-cent rates, whose proceeds are respectively deposited into (1) the Local Revenue Fund, which supports health and social services program costs associated with the 1991 state-local realignment legislation; and (2) the Local Public Safety Fund, which was approved by the voters in 1993 for the support of local criminal justice activities.
• Uniform Local Rate. This is a uniform local tax rate of 1.25 percent levied by all counties (the so-called Bradley-Burns rate). Of this total, 0.25 percent is deposited into county transportation funds, while the remaining 1 percent is allocated to city and county governments for their general purposes.
• Optional Local Rates. The final overall SUT rate component involves optional local tax rates, which local governments are authorized to levy for any purpose. These taxes, which require local voter approval, are normally levied on a countywide basis—primarily for transportation-related purposes. They can be levied in 0.25 percent or 0.5 percent increments and cannot exceed 1.5 percent in total (except in San Francisco and San Mateo Counties).

Impact of Proposition 57 on the Sales Tax Allocation. The budget assumes the approval of Proposition 57 on the March 2004 ballot. This measure authorizes up to $15 billion in bond sales to eliminate the state's 2002-03 General Fund budget deficit and address other obligations. This bond would be repaid through a multiple step process involving the diversion of a one-quarter cent portion of the Bradley-Burns local sales tax to a state special fund created for the purpose of making annual debt-service payments on the bonds. (Local governments would then be reimbursed for their SUT losses through a shift in property taxes to them from schools, which in turn would be reimbursed through added General Fund payments to them.) The diversion of SUT revenues would remain in effect until the bonds are paid off.

Combined SUT Rates. The combined state and local SUT rate varies significantly across California due to differences in the local optional rates that are levied. As depicted in Figure 8, the combined SUT rate currently ranges from 7.25 percent (for those counties with no optional rates) up to 8.5 percent (for the City and County of San Francisco). No county currently imposes the maximum allowable SUT rate of 8.75 percent. 

Taxable Sales Improved in 2003

The key determinant of sales tax receipts is the performance of consumer and business spending on taxable items. After falling in both 2001 and 2002, taxable sales increased about 3 percent in the first half of 2003 and by slightly over 4.5 percent during the second half of the year. While we have yet to receive industry detail on the sources of the improvement, we believe that the 2003 increases were primarily related to a revival in business investment spending in the second half of the year (which as noted above accounts for about 30 percent of total taxable sales). Other positive factors included a strong housing market—which boosted sales of building materials, appliances, and home furnishings—and a reasonably healthy holiday shopping season.

Outlook—Continued Growth in 2004 and 2005. We forecast that taxable sales will continue to strengthen, increasing by 5.9 percent in 2004 and 5.8 percent 2005 (see Figure 9). The main positive forces will continue to be healthy business investment and home construction. Consumer spending is forecast to grow moderately, roughly in line with personal income. As with the rest of the country, we believe that household spending in California will be somewhat restrained by high levels of consumer debt. 

SUT Revenue Forecast

Based on our forecast of taxable sales, we project that SUT receipts will total $23.7 billion in 2003-04, $25.1 billion in 2004-05, and $26.5 billion in 2005-06. The great majority of the year-to-year changes in these amounts are related to underlying growth in the economy and taxable sales. In contrast, SUT-related law changes play a relatively minor role in the overall revenue totals. Our SUT revenue estimate is similar to the budget forecast—the current-year estimate is down by just $24 million and our budget-year forecast is up by $68 million.

Corporation Tax

Background

The CT is levied at a general tax rate of 8.84 percent on California taxable profits. Banks and other financial institutions subject to the CT pay an additional 2 percent tax, which is in lieu of most other state and local levies. Corporations that qualify for California Subchapter "S" status are subject to a reduced 1.5 percent corporate rate. In exchange, the income and losses from these corporations are "passed through" to their shareholders where they are subject to the PIT.

Approximately two-thirds of all CT revenues come from multistate and multinational corporations. These companies have their consolidated U.S. income apportioned to California based on a formula involving the share of their combined property, payroll, and sales that is attributable to this state. California's CT allows for a variety of exclusions, exemptions, deductions, and credits, many of which are similar or identical to those provided under the federal corporate profits tax. Major examples include the research and development tax credit and net operating loss carryforward provisions, whereby companies can use a portion of their operating losses incurred in one year as a deduction against earnings in subsequent years Under legislation enacted in 2002, due to the state's tight budgetary situation, corporations were not able to use these losses to offset their income during 2002 and 2003. However, such deductions will be allowed once again in 2004, and the percentage of losses which may be carried forward has been increased in accordance with the above-noted 2002 legislation.

Profits Rebounding

The key determinant of CT receipts is the strength of corporate profits reported on California tax returns by businesses. After falling in 2001 and most of 2002, California earnings rebounded in 2003 (see Figure 10). This turn-around is partly related to the intensive cost-cutting efforts undertaken during the prior two years and the related productivity gains that materialized in 2003. Looking ahead, we forecast that taxable California corporate profits will increase by another 12 percent in 2004 and by 9.5 percent in 2005. While productivity growth will continue to play a key role, the majority of the anticipated profit growth during the next two years is related to expanded sales both at home and abroad.

Corporation Tax Revenue Forecast

We forecast that CT receipts will be $7.5 billion 2003-04, a 9.5 percent increase from the prior year, and $7.6 billion in 2004-05, an increase of 1.5 percent. The relatively small budget-year increase primarily reflects the conclusion of the two-year suspension of the net operating loss deduction after 2003. Absent this and other special factors shown earlier in Figure 2, the underlying increase in CT collections would be over 10 percent, or more in line with the underlying growth in California taxable profits. It also should be noted that our estimates do not include the significant potential negative effects on corporate tax revenues of the Farmer Bros. Co. legal challenge (see nearby shaded box). Our CT forecast is similar to budget forecast in both 2003-04 and 2004-05.

Other Revenues and Transfers

The remaining 9 percent of total 2004-05 General Fund revenues and transfers consists primarily of taxes on insurance premiums, estates, alcoholic beverages, and tobacco products. It also includes interest income and a large number of fees, loans, and transfers. We forecast that combined revenues from all of these other sources will fall from $9.4 billion in 2002-03 to $8.4 billion in 2003-04, and then further to $5.8 billion in 2004-05. About $4 billion of the annual totals are related to ongoing taxes and fees, which we expect will grow modestly over time. The remainder is related to new proposals and numerous one-time factors. For example:

• 2002-03. The prior-year total in this category includes $2.5 billion from a bond sale related to the securitization of tobacco settlement receipts, and about $2.8 billion in one-time loans and transfers from special funds. Nearly one-half of the special fund loans and transfers are related to transportation funds.
• 2003-04. The current-year total includes an additional $2.3 billion related to tobacco securitization bond sale proceeds, and an additional $1.5 billion in one-time loans and transfers, mostly from transportation special funds.
• 2004-05. The budget-year forecast includes $577 million associated with proceeds from the pension obligation bond (with the balance of the savings from the bond—$353 million—counted as an expenditure reduction), $300 million from a proposed Medi-Cal quality assessment fee, $500 million from tribal gaming revenues, and $220 million in one-time loans and transfers from special funds.

Estate Tax Phase-Out Continuing. Our forecast includes the impact on the state of a provision included in the federal tax reduction package enacted in the spring of 2001 which is resulting in the phase-out of revenues from California's "pick-up" estate tax. We specifically estimate that revenues from this tax will fall from $647 million in 2002-03 to $400 million this year, to $175 million in 2004-05, and to $100 million in 2005-06.

The Budget's Forecast for Special Funds Revenues

As shown in Figure 11, the Governor's budget assumes that special funds revenues will total $18.3 billion in 2003-04 and $20.8 billion in 2004-05. About one-third of the budget-year total is related to motor vehicle-related taxes and fees. These include the vehicle license fee, which is in-lieu of the property tax and whose proceeds are distributed to local governments, mostly for their general purposes. They also include fuel taxes and registration fees, which support transportation-related spending. The increases in registration fee revenues in 2003-04 and 2004-05 are related to rate increases enacted with the 2003-04 budget.