Legislative Analyst's Office, November 20, 1997

California's Fiscal Forecast
The LAO's Economic and Revenue Projections 1997-98 Through 1999-00

Chapter 3: Revenue Projections

We expect that California's ongoing economic expansion will result in moderate General Fund revenue growth through 1999-00.

Current-Year Revenues. As indicated in Figure 1, we estimate that revenues and transfers in the current year will total $53 billion, a 7.5 percent increase from 1996-97. Our current estimate is up $507 million from the 1997-98 Budget Act estimate.

Figure 1
LAO General Fund Revenue Projections
(Dollars in Millions)
Revenue Source 1996-97 1997-98 1998-99 1999-00
Personal income tax $23,400 $26,150 $27,700 $28,900
Sales and use tax 16,480 17,450 18,430 19,410
Bank and corporation taxes 5,840 5,950 6,300 6,600
All other sources 3,605 3,488 3,339 3,446
Totals, revenues and transfers $49,325 $53,038 $55,769 $58,356
Annual percent change 6.5% 7.5% 5.1% 4.6%

Revenues in the Budget Year and 1999-00. Figure 1 also shows that we project revenues to increase to $55.8 billion in 1998-99 and $58.4 billion in 1999-00. Overall, we project that revenues will increase at an average annual rate of 5.8 percent between 1996-97 and 1999-00. Our estimates take into account our updated economic projections, as well as the estimated impacts of (1) the recent federal income tax rate reduction on capital gains and (2) California's tax reduction package adopted in September, which phases in beginning in 1997-98.

Recent Cash-Revenue Trends

Total General Fund revenue receipts during the July through October period were down by $210 million from the budget estimate, primarily due to lower-than-expected quarterly estimated payments toward personal and corporate 1997 income tax liabilities.

At this point, we are assuming that most of the softness from these sources is due to the normal volatility in the month-to-month timing pattern of estimated payments, as opposed to any unexpected, fundamental weakness in investment income or business earnings that underlie such payments. The main reasons for this view are (1) the documented strength of the economy and (2) the fact that withholding and sales tax payments--which normally are good indicators of current economic activity--exceeded the budget estimate during the first four months of this fiscal year.

Underlying Revenue Growth Forecast To Remain Healthy

To provide a picture of the underlying revenue trend, Figure 2 shows the year-to-year change in revenues adjusted to remove the impacts of legislation passed since 1990, including the tax reduction package passed in September. It shows that the state's overall revenue performance has closely followed the changes in California's economy. After declining during the early 1990s' recession, revenues bounced back in line with California's economic recovery. Consistent with our economic outlook, we project that underlying revenue growth will continue at a healthy though moderating pace over the next three years.



California's 1997 Tax Reduction Package

In September, the Governor signed legislation that reduces individual and corporate income taxes by a combined total of $189 million in 1997-98, $593 million in 1998-99, and $1.1 billion in 1999-00 (when its provisions are fully phased in). As indicated in Figure 3, the majority of the ongoing fiscal impact from this tax package is related to an increase in the dependent exemption credit claimable on personal income tax returns. Specifically, the per-dependent exemption credit will rise from $68 in 1997 to $120 in 1998 and to $222 in 1999.

Figure 3
Fiscal Effects of 1997 Tax Relief Package
(In Millions)
1997-98 1998-99 1999-00
Increase in PIT dependent exemption credit -$15 -$295 -$780
Change in calculation of research & development credit -63 -58 -48
Capital gains exclusion on sales of principal residences -25 -110 -70
Alternative Minimum Tax (AMT) exemption increase and indexing -44 -74 -85
Subchapter S corporation conformity to federal law -18 -21 -22
Other provisionsa -24 -35 -81
Total -$189 -$593 -$1,086
aIncludes conformity to federal law regarding Roth Individual Retirement Accounts (IRAs) and Education IRAs, corporate prepayment rules, and various amortization rules.

The provisions of the tax package are described more fully in California Spending Plan for 1997-98, which our office released in October 1997.

MAJOR REVENUE SOURCES

As indicated in Figure 1, the majority of General Fund revenues are from the personal income, sales and use, and bank and corporation taxes. These three sources are estimated to account for about 93 percent of total revenues in 1997-98.

Personal Income Tax

The personal income tax (PIT) is California's single largest state General Fund revenue source, accounting for 49 percent of total estimated receipts in 1997-98. This tax has marginal tax rates ranging from 1 percent to 9.3 percent, depending on a taxpayer's income level.

PIT Liabilities. As indicated in Figure 4, PIT liabilities have increased by an average of 11.9 percent during the past three years. These gains partly reflect the general increases in employment and personal income that have occurred in California, but also are due to rapid increases in capital gains, dividend income, bonuses, and business receipts. These forms of income accrue primarily to high-income taxpayers, who are subject to the highest marginal income tax rates.



We forecast that PIT liabilities over the next couple of years will continue to grow, although at a pace which is more in line with the growth we project for California personal income generally. Our expectation of a somewhat reduced rate of liability growth is partly related to the outlook for a mild slowdown in annual personal income gains. It also reflects our assumption that a relatively smaller share of the income gains will be from above-average increases in bonuses, capital gains, and other forms of income subject to high marginal income tax rates.

Revenue Forecast. Based primarily on our forecast of PIT liabilities, we currently estimate that fiscal-year PIT collections will total $26.1 billion in 1997-98, an 11.8 percent increase from 1996-97. Our current projection is up $628 million from the 1997-98 Budget Act forecast. We further project that PIT revenues will expand to $27.7 billion in 1998-99, and to $28.9 billion in 1999-00. The revenue estimates for 1997-98 through 1999-00 reflect the impact of the recently enacted tax reduction package discussed above, as well as the impact of the recent federal tax rate reduction on capital gains, which we estimate will increase state PIT revenues by $450 million in 1997-98 and by $250 million annually through the remainder of the forecast period.

Sales and Use Taxes

Sales and use taxes represent the second largest General Fund revenue source, accounting for about 33 percent of total estimated revenues in 1997-98. (When state special fund and local sales tax receipts are counted, the sales and use tax is California's largest overall revenue source.)

The state sales and use tax rate is a combined 6 percent, which includes a 5 percent General Fund rate and a 1 percent rate allocated to special funds. Additional local rates ranging from 1.25 percent to 2.5 percent are imposed by cities, counties, and transportation districts, bringing the combined state-local tax rate to between 7.25 percent and 8.5 percent, depending on the county involved.

The key factor determining the level of sales and use tax receipts is the strength of taxable spending by consumers and businesses in California. As shown in Figure 5, taxable sales fell sharply during the early 1990s' recession, but have recovered during the subsequent economic expansion. We forecast that taxable sales will continue to expand over the forecast period, increasing by 5.6 percent per year during both 1997 and 1998, before moderating slightly to 5.5 percent in 1999 and 5.2 percent in 2000.



Despite the taxable sales gains projected for the next three years, the share of total personal income devoted to taxable spending is expected to fall slightly over the next three years. The declining share reflects the ongoing shift in share of total consumption away from commodities and toward services (which are not generally taxable).

Revenue Forecast. Based on our projections for taxable sales, we estimate that General Fund sales and use tax receipts will total $17.5 billion in the current year, representing a 5.9 percent increase from 1996-97. This estimate is $120 million above the 1997-98 Budget Act fore-cast, reflecting slightly stronger economic growth in late 1997 and early 1998 than was previously assumed. We project that sales and use tax receipts will grow to $18.4 billion in 1998-99, and further to $19.4 billion in 1999-00.

Bank and Corporation Taxes

Bank and corporation taxes are the General Fund's third largest revenue source, accounting for about 11 percent of total receipts in the current year. The current tax rate applied to the net income of corporations is 8.84 percent. Banks and other financial institutions are subject to an add-on tax rate of 2 percent, which is in lieu of certain local taxes.

The key determinant of bank and corporation tax revenues is California taxable profits. (We note, however, that tax receipts in recent years have been significantly influenced by a number of other factors, including large audit-related collections and certain tax law changes.)

California taxable earnings fell sharply in the recession, but bounced back during the early stages of the current economic expansion, growing by as much as 19 percent in 1995. Over the past year, profit growth has subsided some. Although underlying business sales and earnings appear to have been strong, total earnings were affected by one-time charges against earnings related to restructurings in the state's finance and utility industries. As a result, profits grew by an estimated 8 percent in 1996, or about one-half the rate of the prior year. We expect profit growth to continue to moderate over the next three years, increasing at an average annual rate of 5.5 percent between 1997 and 2000.

Revenue Forecast. We project that bank and corporation tax revenues will total $6 billion in 1997-98, a 1.9 percent increase from the prior year. Our current estimate is $78 million below the 1997-98 Budget Act estimate. The small gain from the prior year reflects the impact of both the tax-rate reduction that took effect in January 1997, and the tax package enacted in September of this year. We project that bank and corporation tax receipts will continue to grow in the following two years, reaching $6.3 billion in 1998-99 and $6.6 billion in 1999-00.

Other Revenues

We estimate that revenues from all other sources, including insurance premiums taxes, estate taxes, tobacco and alcohol-related taxes, interest earnings, and a variety of fees, will decline slightly--from $3.6 billion in 1996-97 to $3.3 billion by 1998-99--before turning upward in 1999-00. The main reason for the decline between 1996-97 and 1998-99 is the reallocation of trial court revenues from the General Fund to a trust fund, beginning in the current year. The shift will lower both General Fund revenues and expenditures by over $300 million when fully phased in during 1998-99.

Alternative Outlooks

There are three main factors that could cause revenues to differ significantly from our forecasts for 1997-98 through 1999-00. The first is the economy's performance. As discussed in Chapter 2, we are assuming that the state's economy will continue to expand over the next few years, although at a slightly moderating pace in 1999 and 2000. Should the economy fail to grow as we expect, revenues could come in significantly weaker than our forecast. For example, under a mild economic slowdown, the revenue drop-off could be several hundred million dollars. Under a severe slowdown or recession the drop-off would be much larger, possibly in the billions of dollars.

A second uncertainty relates to taxpayer responses to recent federal law changes relating to capital gains. Specifically, our forecast assumes that the reduction in the maximum federal tax rate on such gains from 28 percent to 20 percent will result in a moderate increase in capital gains realizations in 1997 and beyond. Our estimates assume that the increased level of these realizations will translate into a $450 million increase in PIT receipts in 1997-98 and approximately $250 million annually through the remainder of the forecast period. These assumptions are somewhat conservative relative to those used by federal revenue estimators in preparing fiscal estimates of the federal implications of the rate reduction. If the increase in realizations turns out to be more in line with the federal assumptions, 1997-98 revenues would be $250 million more than our estimate.

A third, and more general, uncertainty relates to the compositional characteristics of recent and projected taxable income growth in California. As indicated above, much of the extraordinary increases in the PIT during the past two years has been related to major increases in capital gains, investment earnings, and bonuses. Unexpected strength or weakness in these extremely volatile taxable income components could cause revenues to be several hundred millions of dollars higher or lower than our projections--even if our overall estimates of economic growth turn out to be correct.

Continue to Chapter 4: Expenditure Projections

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