Legislative Analyst's Office, November 14, 2001

California's Fiscal Outlook

LAO Projections, 2001-02 Through 2006-07

Forward

This report provides our projections of General Fund revenues and expenditures for 2001-02 through 2006-07 It includes our independent assessment of the outlook for California's economy, demographics, revenues, and expenditures.

Chapter 1 contains our principal findings and conclusions. Chapter 2 presents our economic and demographic projections, Chapter 3 our revenue forecasts, and Chapter 4 our expenditure projections.

Our fiscal projections reflect current-law spending requirements and tax provisions. They are not predictions of future policy decisions by the Legislature, nor are they our recommendations as to what spending and revenue levels should be.

This year marks the 60th anniversary of the Legislative Analyst's Office which was the first of its kind in the nation. This report, in its seventh year of publication, reflects the historical mission of the office to assist the Legislature with its fiscal planning by assessing the revenues and expenditures of the state. The report is part of an ongoing series and is updated periodically.

Table of Contentse of Contents

Chapter 1: The Budget Outlook

Chapter 2: Economic and Demographic Projections 

Chapter 3: Revenue Projections

Chapter 4: Expenditure Projections

Chapter 1

The Budget Outlook

Summary

The current recession and declining stock market values are having devastating impacts on California's budget outlook, largely due to shortfalls in revenues. Figure 1 tells the story in a nutshell. It shows that after increasing 22 percent in 1999-00, revenues decelerated to 8 percent growth in 2000-01, and are projected to fall 12 percent in 2001-02—the deepest one-year decline in the post-World War II period. This abrupt revenue fall-off is pushing the state into a major deficit for the first time since the early 1990s. Specifically, we estimate that:

• California will end 2001-02 with a deficit of $4.5 billion, compared to the $2.6 billion reserve assumed in the 2001-02 Budget Act.
• The 2002-03 budget year faces a shortfall of $12.4 billion and potentially even more if the recovery we are assuming for next spring is delayed.
• Annual budget shortfalls will persist well beyond 2002-03 absent corrective actions. As a result, it will be necessary to adopt substantial ongoing expenditure cuts and/or revenue augmentations in order to bring the budget back into balance.

Key Forecast Assumptions

Economic Outlook

Economy Soft Prior to September 11

The U.S. and California economies were on the brink of recession even before the September 11 terrorist attacks, with economic measures such as employment, personal income, and taxable sales having been on a slowing trend since the beginning of 2001. Key factors behind California's slowdown were the national weakness in business investment—particularly in high-tech goods and services—as well as reduced wealth and income related to declining stock market values.

Weakness Intensified Following Attacks

As with the rest of the nation, California's economic downturn accelerated in the weeks following the September 11 attacks. The most severe adverse developments have been in travel-related industries, where, for example, hotel occupancy rates in November remain well below year-ago levels. However, softness is also being experienced in a wide variety of other industry sectors, including manufacturing, real estate, retail sales, and entertainment.

Outlook—Recession That Ends in Spring 2002

Our forecast assumes that the national and state economies are currently in a recession that will last until spring of 2002. The downturn is forecast to be relatively mild in terms of job losses, although the adverse impacts on personal income will be much more pronounced than on employment. This is due to the sharp reduction in stock options-related earnings estimated for 2001 and early 2002. Our forecast is similar to the consensus view that the national and state economies will emerge from the downturn next spring, and that economic growth will accelerate through 2003. We specifically project that California personal income growth will fall dramatically from 9.8 percent in 2000 to 1.7 percent in 2001, before rebounding to 4.2 percent in 2002.

Revenue Outlook

Sharp Falloff Due to Soft Economy and Stock Market Decline

Total revenues are projected to decline from $77.7 billion in 2000-01 to $68.3 billion in 2001-02, a drop of 12.1 percent. Our updated current-year revenue forecast is $6.8 billion below the 2001-02 Budget Act forecast, reflecting the softening economy and a sharp drop in capital gains and stock options-related revenue. We then expect that the economic rebound will boost revenues by 9.2 percent in
2002-03. Despite this upturn, however, revenues will not regain their 2000-01 level until 2003-04. Over the longer term, we forecast that revenues will grow another 10 percent in 2003-04, then settle into annual increases of about 7.5 percent thereafter.

Delay in Economic Recovery Would Further Depress Revenues

Our forecast is for a relatively short-lived recession. However, there are a number of factors that could deepen and prolong the downturn. These include the ongoing effects of terrorism on spending by consumers, the uncertain timing of the recovery in business investment, and the depressing effects of the stock market's losses on wealth and spending. Given the considerable sensitivity of state revenues to changes in the strength of the economy, a delay in the economic recovery would further hurt the budget's outlook. As an illustration, we estimate that a six-month delay in the recovery—from spring 2002 to fall 2002—would reduce budget-year revenues by $3 billion to $4 billion below our forecast.

General Fund Condition

Figure 2 presents our updated estimates of the General Fund condition for 2000-01 through
2002-03. These estimates take into account our forecasts for state revenues and expenditures that are discussed in detail in Chapter 3 and Chapter 4, respectively. They include our estimated impacts of the Governor's recent executive orders that impose a hiring freeze and reduce procurement spending, as well as legislation enacted this summer. In addition, as discussed in the accompanying box, they assume that the $6-plus billion in General Fund loans used to purchase electricity this past year will eventually be repaid, and thus have no direct impact on the General Fund's condition.

Budget Outlook For 2001-02

The 2001-02 budget enacted in July assumed that the current fiscal year would end with a reserve of $2.6 billion. However, the $6.8 billion decline in revenues relative to the 2001-02 Budget Act estimate will eliminate the planned reserve and push the state into a deficit of $4.5 billion.

As noted in Figure 2 and illustrated in Figure 3, our forecast for revenues, at $68.3 billion, is more than $10 billion below the estimated expenditure total of $78.7 billion for the year. Aside from its impact on the current-year budget situation, this large operating deficit has serious negative implications for the budget outlook in 2002-03 and beyond. The fact that ongoing expenditures are running $10 billion above ongoing revenues means that—even with healthy revenue increases—large annual excesses of expenditures over revenues will likely persist in future years, absent corrective actions.

Outlook for 2002-03 and Beyond

Basis for Our Estimates. Our revenue and expenditure forecasts for 2002-03 and beyond are based primarily on the provisions of current law. For example, we have adjusted the current-year spending plan for constitutional and statutory funding requirements (such as the Proposition 98 minimum funding guarantee for K-14 education), as well as for projected changes in caseloads, cost-of-living indexes, price levels, federal reimbursement rates, and other factors affecting program costs. We have also adjusted the budget for any one-time spending in the current 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 should 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. By using this approach, we believe that our forecast provides a meaningful starting point for legislative deliberations involving the state's budget.

The 2002-03 Outlook. As shown in Figure 2, we estimate that:

• Revenues will increase from $68.3 billion in the current year to $74.6 billion in 2002-03, an increase of 9.2 percent.
• Expenditures will grow from $78.7 billion in the current year to $82.6 billion in the budget year, an increase of 4.9 percent.
• Given the faster increase in revenues than in expenditures, we anticipate that the annual operating deficit (that is, revenues minus expenditures) will shrink modestly from $10.4 billion in the current year to $8 billion in 2002-03.
• When combined with the current-year deficit of $4.5 billion, next year's operating shortfall will push the year-end budget shortfall up to $12.4 billion.

A key factor restraining expenditure growth over the longer term is slowing enrollment in K-12 education, which limits growth in the Proposition 98 guarantee. In other areas, we project above-average increases in Medi-Cal expenditures, reflecting continued rising medical costs and utilization, moderate increases in combined spending on social services programs, and somewhat below-average increases in criminal justice and other state programs. Our out-year estimates include the resumption of $1 billion in General Fund outlays for transportation programs in 2003-04, consistent with legislation enacted in 2001.

Basic Strategies for Addressing the Deficit

As indicated above, the state faces a cumulative shortfall of $12.4 billion in next year's budget. While the annual shortfalls between revenues and expenditures are projected to shrink some over time, they will remain quite large, absent corrective actions.

Given the persistence of large annual shortfalls into the future, any comprehensive solution to the budget problem would ideally include substantial ongoing adjustments to revenues and/or expenditures. Ongoing solutions (that is, revenue or expenditure adjustments enacted in one year that would automatically repeat themselves in future years) could include reductions or elimination of inflation adjustments for programs, permanent reductions in program service levels (such as by reducing caseloads or limiting benefits), or permanent increases in fees or tax rates. As one example, a 2 percent reduction in spending growth during each of the next two years (for example, the restriction of inflation adjustments or service reductions) would lower expenditures from our estimates by about $1.5 billion in 2002-03 and $3 billion in 2003-04 and thereafter.

To the extent that ongoing solutions are adopted that cover most of the projected operating shortfalls, the Legislature could use a variety of strategies to address the balance of next year's shortfall—including one-time adjustments to revenues or expenditures. Examples of one-time adjustments include temporary service reductions, temporary fee increases, or deferrals in scheduled cost-of-living adjustments.

Given the magnitude of the adjustments that will be necessary to address next year's budget problem, it will be important for the Legislature to consider a wide range of different spending and revenue-related strategies. As was the case in the early 1990s, when an equally large budgetary shortfall existed, the budget-balancing strategies fall into several broad categories. These are summarized in Figure 4.

In the coming months, our office will be assisting the Legislature with possible expenditure and revenue options for addressing the projected budget shortfall.