The Budget Outlook

California is in the midst of an extraordinary economic and revenue boom. Seven years into the current economic expansion, the state's economy continues to roar ahead, with such measures as personal income, taxable sales, and employment far outdistancing previous estimates. These economic gains, coupled with stock market-driven increases in capital gains, are translating into extraordinary increases in state revenues. As shown in Figure 1, underlying General Fund receipts increased by nearly 21 percent last year, and are projected to grow by another 12 percent in 2000-01. Eliminating the effects of inflation, the recent gains in General Fund receipts are the largest in recent history.

Looking ahead, we forecast that the national and state economies will slow some from their recent robust growth rates, but still remain in a solid expansionary mode. Thus, even with these slowdowns, our projections indicate that 2001-02 will be another very good year for state finances--and that, once again, substantial resources will be available for budget- and tax-related priorities.

As indicated in Figure 2 (see page 2), we project that 2000-01 will end with a reserve of nearly $6.9 billion--up sharply from the $1.8 billion assumed in June when the budget was adopted. In 2001-02, assuming current-law spending and tax policies, we forecast that revenues would exceed expenditures by $3.4 billion, bringing the cumulative reserve to $10.3 billion. In subsequent years, we forecast that revenues would exceed expenditures by well over $3 billion annually, again assuming current-law policies.

The details behind our "bottom line" are summarized below.

Key Features of the LAO Outlook

The Economy

The national, and particularly the California, economy are expanding at rapid rates--well above those envisioned in the 2000-01 Budget Act. These increases reflect widespread gains in consumer spending and technologically driven business investments. We estimate that California personal income and taxable sales will each increase by well over 11 percent this year--the fastest rates since 1984, and considerably stronger than the roughly 7 percent increases that had been assumed.

We forecast that economic growth will ease some in 2001 and beyond, but remain strong by historical standards. Our long-term forecast reflects further upward assessments regarding worker productivity, economic output, and personal income at both the national and state levels. For example, we now project that personal income will increase at an average annual rate of 7.3 percent during the 2000 through 2006 period. This compares to last year's projection of an average annual increase of 5.7 percent for the 1999 through 2005 period.

Revenues

The strong economy translates directly into a further improvement in the General Fund's revenue outlook.

Prior and Current Years. We estimate that General Fund revenues totaled $71.7 billion in 1999-00, a 22.3 percent increase from 1998-99. This estimate is $551 million above the total assumed last summer, reflecting stronger-than-expected 1999-00 receipts from personal income and sales taxes. We further estimate that revenues will reach $77.9 billion in the current year, an 8.7 percent increase from 1999-00. This estimate is about $4.1 billion above the budget act estimate, even after accounting for the quarter-cent sales tax reduction certified by the Director of the Department of Finance in October (see discussion in Chapter 3).

The positive revenue outlook reflects both the current strength in California's economy and extraordinary growth in monthly receipts from withholding and other key revenue sources. These receipts, in turn, are partly due to another major increase in capital gains and stock options in 2000. Specifically, we estimate that, after jumping by 50 percent in 1999, income from capital gains and stock options is increasing another 30 percent in 2000.

2001-02 and Beyond. We forecast that revenues will reach $81 billion in the budget year--a 4 percent increase from 2000-01. Most revenue sources are expected to experience moderate growth next year, in line with the state's overall economic expansion. However, we believe that capital gains and stock option-related income will drop 10 percent next year from this year's extraordinary level. This projected decline is due to the lagged effects of the recent drop in stock prices on stock options and capital gains in 2001. Thereafter, we forecast that revenues will increase in line with statewide personal income, reaching $106 billion by 2005-06.

It should be noted that our General Fund revenue estimates reflect a variety of recent policy-related factors. These include (1) the diversion of sales taxes for transportation purposes included in the 2000-01 Budget Act, (2) the certification of the quarter-cent sales tax reduction, and (3) the fiscal effects of targeted tax reductions enacted with this year's budget. The fiscal effects of these actions are discussed in Chapter 3.

The General Fund Condition For 2000-01

The 2000-01 budget signed by the Governor included a year-end reserve of $1.8 billion. We now project that the current year will end with a reserve of $6.9 billion, an increase of $5.1 billion. The improvement is largely due to our higher revenue estimates for the prior and current years, partly offset by additional spending related to legislation passed last summer following the budget's enactment.

Budgetary Outlook for 2001-02 And Beyond

Basis for Our Estimates. Our expenditure forecasts for 2001-02 and beyond are based primarily on the requirements of current law. Specifically, we have adjusted the underlying 2000-01 spending plan for constitutional and statutory funding requirements, as well as for projected changes in caseloads, federal reimbursement rates, and other factors affecting program costs. For example:

• Our forecast for K-14 education is determined by the changes in the Proposition 98 minimum funding guarantee.
• Spending for higher education is based on projected enrollments and inflation.
• Our projections for health and social services take into account caseloads, program service requirements, and cost-of-living adjustments required by current law.
• We have assumed annual employee compensation increases equal to projected inflation (slightly more than 3 percent per year).

It is important to note that our fiscal estimates are not predictions of what the Legislature and Governor will adopt as policies and funding levels in future budgets. Nor are they our recommendations of what tax and spending policies ought to be. Rather, they are intended to be a reasonable "baseline" projection of what would happen if current-law policies were allowed to operate in the future. We recognize that the Legislature is likely to make alternative policy choices, as it has in recent years. However, by using this approach, we believe that our forecast provides a meaningful starting point for the Legislatures's evaluation of the state's fiscal condition.

Quarter-Cent Sales Tax Reduction. Consistent with the certification, our revenue forecast assumes that the quarter-cent sales tax reduction will be in effect for calendar year 2001. For purposes of our long-term forecast, we have not assumed continuation of this quarter-cent reduction in subsequent years. The status of the trigger in these out years will depend in large part on policy decisions regarding the level of reserves included within future budgets.

The 2001-02 Outlook. As indicated in Figure 2, General Fund revenues are projected to exceed current-law expenditures by $3.4 billion next year, boosting the cumulative reserve to just over $10 billion. The $3.4 billion operating surplus in the budget year reflects the combination of (1) the modest 4 percent revenue growth discussed above and (2) a decline in expenditures of 1.6 percent during the year.

The small decline in expenditures projected for 2001-02 is primarily related to one-time funding of over $5 billion included in 2000-01. A second factor is relatively small increases in ongoing expenditures in such key programs as Proposition 98, California Work Opportunity and Responsibility to Kids (CalWORKs), and corrections programs.

Long-Term Projections. In subsequent years, our projections indicate that General Fund revenues will again exceed expenditures--by $3.4 billion in
2002-03 and increasing amounts thereafter. This positive outlook reflects our assumption that spending for most of the state's major program areas--including education, CalWORKs, Supplemental Security Income/State Supplementary Program, and corrections--will increase less rapidly than the roughly 7 percent average growth rate expected for General Fund revenues during the period. The one major exception to this trend of moderate expenditure growth is the Medi-Cal Program, where increased health care costs and utilization are expected to result in average annual increases of nearly 8 percent during the 2002-03 through 2005-06 period.

Implications of Our Estimates

Our estimates imply that there will be $10.3 billion in uncommitted resources available next year to address budget- and tax-related priorities. While this is a very substantial sum, it will continue to be important to keep in mind the out-year implications of any decisions made regarding the use of these funds. In this regard, we believe that--as in past years--it will make sense to divide the $10.3 billion into two major categories--namely, (1) funds that should be used predominately for one-time purposes and (2) funds that are available for ongoing commitments.

In the context of the current outlook, Figure 3 shows that the $6.9 billion reserve carried into the budget year from 2000-01 should be used primarily for one-time purposes, and the $3.4 billion annual operating surplus (that is, the excess of revenues over expenditures in 2001-02) can be used for ongoing purposes.

Uses of One-Time Funds

Within the one-time category, we believe that $2.5 billion--or about 3 percent of revenues--should be targeted for the 2001-02 budget reserve. This is a somewhat larger reserve than the Legislature has included in recent budgets. However, a 3 percent reserve has considerable merit in view of the current good economic times, and the ongoing uncertainty surrounding the future pace of growth in the state's revenue stream. As one indication, if continued declines in the stock market were to cause capital gains and stock options to fall 10 percent below our current estimate, total revenues would be about $1.5 billion less than the forecasted amount in 2001-02. Similarly, if employment and income growth in California were to fall just 1 percent below our forecast, the resulting reduction in revenues would be in the range of $1 billion.

After funding such a reserve, the remaining one-time funds--about $4.4 billion--would be available for such potential one-time commitments as tax reduction, infrastructure spending, and settlement of the long-standing special education mandate claim.

Uses of Ongoing Funds

Figure 3 shows that the excess of revenues over expenditures in 2001-02--about $3.4 billion--would be available for ongoing budget- and tax-reduction priorities. This reflects our assumption that the $3.4 billion annual operating surplus will be maintained--and in fact grow--in future years, assuming continued economic expansion and current-law policies.

Even though they are quite large, it is important to keep our projected annual operating surpluses in perspective. They assume, for example, that Proposition 98 funding will grow at a comparatively modest pace in 2001-02 (due to the interaction of the Proposition 98 guarantee with our revenue forecast). If, in contrast, the Legislature chose to fund Proposition 98 at $1 billion above the minimum guarantee next year (an amount that would result in continued growth in real per pupil funding in 2001-02), this would "use up" roughly one-third of the operating surplus. Similarly, a decision to make permanent the quarter-cent sales tax reduction (or provide an equivalent tax reduction through some other means) would reduce the annual surpluses by another $1.2 billion. Just these two actions would eliminate two-thirds of the annual surpluses we foresee in the next two years.

Thus, even in these extraordinarily positive fiscal circumstances, it will be important that decisions made regarding the 2001-02 budget be consistent with the maintenance of balanced budgets both next year and in the future.