Legislative Analyst's Office, November 14, 2001

California's Fiscal Outlook

LAO Projections, 2001-02 Through 2006-07

Chapter 2

Economic and Demographic Projections

Economic and demographic developments in California have important effects on the state's fiscal condition through their impacts on both tax receipts and state expenditures. This chapter presents our economic and demographic projections for 2001 through 2007, which will affect California's fiscal condition during fiscal years 2001-02 through 2006-07.

The Economic Outlook

After nearly eight years of economic expansion, California—along with the rest of the nation—entered a recession in the second half of 2001. At this time, we are projecting that the downturn will be relatively modest in terms of employment losses—especially when compared to the prolonged downturn of the early 1990s. However, the recession will have a more pronounced adverse effect on personal income and state revenues than on employment, largely due to the impacts of recent stock market declines on stock options and capital gains.

There also is considerable uncertainty surrounding the current outlook. This relates to such factors as (1) the ongoing effects of the recent terrorist attacks, (2) the dramatic decline this year in stock market wealth, and (3) the uncertain timing of any improvement in U.S. investment spending, particularly on high-tech goods and services. These factors could, individually or collectively, deepen and prolong the recession.

Recent Developments

The National Economy

Before September 11. Even before September 11, the U.S. economy was teetering on the brink of recession. Business spending had been soft all year, and consumer spending also was moderating. While the consensus outlook in early September was that the U.S. economy would narrowly avoid a full-blown recession, most projections put the risk of a downturn at nearly 50 percent. Recent reports on the condition of the U.S. economy immediately before September 11 suggest the economy may have already been in decline.

After September 11. The terrorist attacks pushed the U.S. economy "over the edge" into recession by accelerating the slowdown noted above. Consumer and business spending collapsed in the weeks immediately following September 11, and while there are positive signs that consumer spending has subsequently experienced a partial rebound, most indicators of business confidence and spending remain extremely weak. New orders for manufacturing goods dropped 8.5 percent to a five-year low in September, as businesses cancelled or postponed commitments for aircraft, telecommunications equipment, computers, and other equipment. Layoffs were announced by firms throughout the economy, with particularly large job cuts instituted by companies in the airline, travel, and aircraft manufacturing sectors. Between September and October, the U.S. economy lost 415,000 jobs and the unemployment rate jumped from 4.9 percent to 5.4 percent.

In response to the economy's weakness, the Federal Reserve moved aggressively to lower interest rates, and the President and Congress are considering tax and spending measures aimed at stimulating future economic growth. The timing of any economic rebound, however, remains uncertain.

California's Economy

Before September 11. California's situation prior to September 11 was similar to the rest of the nation. While the state's economy held up well early in the year, private sector employment has been declining in recent months. Prior to September 11, however, the weakness was mainly concentrated in high-tech industries. For example:

• Figure 1 shows that significant job losses were experienced in the manufacturing and business services sectors since the start of the year, which were primarily related to cutbacks in computer and software industries.
• Figure 2 shows that unemployment nearly tripled in the tech-heavy Santa Clara County area during the past year.

After September 11. As with the nation, the economic slowdown in California appears to have broadened and deepened in the weeks following the September 11 attacks. A recent survey by the San Francisco Federal Reserve of economic conditions in the western states indicates that all sectors in the region slowed sharply immediately after
September 11, with the most severe declines reported in the travel-related industries. While some survey respondents reported that business activity subsequently rebounded, many others indicated that sales remained soft. Other signs of continuing economic weakness include softness in withholding payments, industry reports of extremely low hotel occupancy rates, drops in help wanted advertising, and sharp increases in new claims for unemployment.

The National Outlook

Near-Term Forecast (2001 Through 2003). Our forecast, which is consistent with the consensus of most public and private economists as of late October, is that the U.S. economy will remain in recession through early 2002, but that a rebound will emerge beginning next spring. The main assumptions behind this forecast are that (1) the chilling effects of the September 11 attacks on consumer and business activity will slowly subside, (2) the stimulative effects of federal monetary and fiscal policies will bolster income and spending next year, and (3) businesses will step up spending in 2002 in the information technology (IT) area. As shown in Figure 3 (see page 10), we project that growth in real gross domestic product (GDP) will accelerate from a marginal 0.8 percent next year (reflecting sluggish conditions in the first half and improvement in the second half) to 4 percent in 2003. The unemployment rate, which stood at 5.4 percent in October, is expected to peak at about 6.5 percent in mid-2002, before dropping back to 5.3 percent by the end of 2003. Inflation is expected to subside over the next two years, reflecting the economy's current large amount of unused productive capacity, lessening wage pressures, and stable oil prices.

Longer-Term Forecast (2004 Through 2007). Our longer-term forecast assumes that real GDP will increase at a trend rate of just under 3 percent per year through the end of the forecast period. This average annual growth rate is about three-quarters of what our longer-term outlook assumed last November, reflecting recent downward revisions to productivity gains in the late 1990s. These revisions have in turn caused many economists to reassess downward the prospects for growth in potential output in future years. We also assume that inflation will remain subdued, with the Consumer Price Index increasing at an average annual rate of 2.7 percent in the latter four years of our forecast.

California's Outlook

Near-Term Forecast (2001 Through 2003). We expect that the economic downturn in California will continue through early 2002, consistent with the national economy's performance. Factors contributing to the slide include ongoing weakness in high-tech spending, the adverse effects of the September 11 attacks on the state's travel and tourism-related industries, and the negative impact of recent stock market declines on wealth, income, and spending in the state.

Although both employment and income will experience declines, Figure 4 shows that income will be the hardest hit:

• The downturn in employment is projected to be relatively modest by historical standards, with job losses totaling about 140,000 between mid-2001 and early 2002. This is about one-third the job losses experienced in the early 1990s' recession.
• In contrast, we expect the income declines to be substantial in this downturn. As shown in Figure 4, the year-over-year growth in real personal income is projected to fall from a peak of 8.8 percent in early 2000 to a minus 5.2 percent in late 2001. This sharp slowdown is partly due to the reductions in jobs and stock options in the high-paying IT-related sectors of the economy.

Longer-Term Outlook (2004 to 2007). Our longer-term forecast assumes that after rebounding in 2002 and 2003, the California economy will expand at more moderate—but still healthy—rates in the subsequent three years. We expect that growth in jobs and income will outpace the nation during those years, reflecting California's favorable mix of fast-growing industries and above-average rate of population increases.

Risks to the Outlook

There always are a variety of uncertainties associated with making economic forecasts, including what future inflation will be, the likely course of interest rates, and how foreign economies will perform. However, the current forecast faces additional uncertainties that go well beyond those normally encountered. These are in three major areas:

• Effects of Terrorism. The main uncertainty here relates to the ongoing effects of the September 11 attacks. The forecast assumes that consumer and business spending will slowly recover to pre-September levels. While there are tentative signs that consumers are being enticed to spend more by price cuts and low-interest loans, businesses currently remain very cautious. Further business cutbacks in employment, production, and investment could undermine the chance for a recovery during the first half of 2002. In addition, further adverse effects could occur to the extent that additional terrorist-related disruptions take place, such as the current problems being experienced with mail delivery.
• Timing of IT Spending Recovery. A second and related risk involves the timing of an upturn in business investment spending involving IT-related goods and services. The forecast assumes that technologically driven investment in these areas will pick up next year. A delay in this recovery would have negative implications—especially for California, which accounts for about 20 percent of the nation's high-tech industry sector.
• Stock Market's Effects. Given the increased importance in recent years that the stock market has played in terms of generating wealth and income in California, the future performance of the market will be a key factor in the timing and strength of California's economic recovery. Our forecast assumes that stock market valuations will increase moderately beginning next year, in turn bolstering the wealth and incomes of Californians from their current levels. Given this, a stagnation or further decline in share values would have a restraining effect on the projected economic recovery.

The Demographic Outlook

The results of the 2000 Census indicate that California's population totaled around 34 million as the new millennium began. The state's population is projected to grow at an average rate of about 1.5 percent annually over the next six years. This growth is slightly slower than that experienced in the latter part of the 1990s, reflecting both the dampening effects of a slowing economy on net in-migration, as well as a continued decline in birth rates.

Population Growth Components

California's population growth can be broken down into two major components—natural increase (the excess of births over deaths) and net in-migration (persons moving into California from other states and countries, minus people leaving the state for other destinations). As indicated by Figure 5, the population growth associated with natural increase accounts for roughly one-half of California's projected annual growth over the forecast period, and is assumed to be fairly stable. Net in-migration accounts for the other half of the growth over the period, but varies with California's economic cycle.

Natural Increase. We project that the natural-increase component will contribute around 270,000 new Californians annually over the forecast period. This amount is slightly less than in the late 1990s due to the ongoing decline of birth rates being experienced by all ethnic groups. Despite declining birth rates, the natural-increase component grows slightly due to significant growth in the female population of child-bearing age groups in faster-growing segments of the population, including Hispanic and Asian women.

Net In-Migration. We project that net in-migration will average roughly 285,000 annually over the next six years, which is just slightly more than the natural-increase component. As indicated by Figure 5, the population growth associated with net in-migration is projected to decline in the near term due to the slowing of the California economy. However, a modest rebound is forecast in 2004 reflecting the state's projected economic recovery.

Nearly 85 percent of the net in-migration is associated with foreign in-migration. Foreign in-migration has remained relatively steady over the past decade and we expect similar levels in the near future, although some decline should result from the economic slowdown.

Regarding net domestic in-migration, this has historically fluctuated with California's economy. For example, California's early 1990s' recession resulted in negative net domestic in-migration, as more people were leaving the state than were moving in from other states. Similarly, we project that the current slowdown of the state's economy again will result in a decline in net domestic in-migration, especially in the very near term. However, domestic migration should rebound somewhat in response to the economy's recovery, before tapering off to its projected long-term level.

Growth to Vary by Age Group

Figure 6 shows our population growth projections by broad age categories, including both numerical and percentage growth. The 45-to-64 age group (baby boomers) continues to be the fastest growing segment of the population. Nearly 1.8 million new people are expected to move into this age category over the next six years.

These various age-group demographic projections can have significant implications for the state's revenue and expenditure outlook. For example, strong growth of the 45 to 64 age group generally benefits tax revenues since this is the age category that routinely earns the highest wages and salaries. Likewise, the growth in the young adult population affects college enrollments, while that for the
0-to-4 and 5-to-17 age groups drives K-12 enrollment growth over the forecast period.