May 13, 2023
Summary. The present economic picture is particularly muddy. Some measures point to continued strength, while others suggest weakening. Many are asking whether we are heading toward a recession. This uncertainty poses a challenge for our revenue forecast. Whether or not the economy technically enters a recession, however, is not directly relevant to our revenue forecast. Instead, our exercise seeks to determine what current economic and revenue data can tell us about future revenues. That information currently is telling us to expect revenues to come in even weaker than the May Revision anticipates during the budget window.
Present Economic Picture Is Muddy. By some measures, the economy is booming. Unemployment is at record lows and wages continue to grow at a strong pace. From other vantage points, however, the economy seems to be on less sound footing. Housing clearly is in a slump, manufacturing and trade sectors have slowed, and a number of regional banks recently have failed. Overall, the broadest measure of economic activity (inflation-adjusted gross domestic product [real GDP]) continues to grow, albeit at a below-average pace.
Leading Indicators Continue to Offer Warning for Economic Outlook. We cannot say for sure if and when current weaknesses in parts of the economy could spread more broadly. In Outlooks last May and November, however, we discussed how certain economic indicators offered a warning that a broader slowdown could be on the horizon. Thus far, such a slowdown has not materialized. Nonetheless, these indicators continue to signal a looming downturn. Consistent with this, the consensus among economic forecasters has deteriorated recently. For example, forecasters responding to the Survey of Professional Forecasters and Blue Chip Economic Indicators anticipate real GDP to decline in the third quarter of 2023 (something which rarely occurs outside of recessions). This risk continues to weigh on our outlook for state revenues and the economy over the next couple of years.
Regardless of Broader Economic Picture, State Revenues Are Clearly in a Downturn. Regardless of the mixed economic picture, it is now fairly clear that state revenues are in a downturn. For example, “core” taxable sales (a seasonally adjusted measure that omits fuel and certain online sales) has declined for two straight quarters. In the last 30 years, comparable two-quarter declines have occurred only around the Dot-Com Recession and the Great Recession. Similarly, income tax withholding (the largest component of income tax collections) has declined 5 percent so far this year, a stark departure from the double digit growth of the preceding two years. As we’ve discussed previously, the state’s revenue downturn can, in part, be attributed to particular weakness in the technology sector and a decline in investment in California businesses, both of which drag down compensation to higher income taxpayers.
LAO Revenue Outlook: Drop in the Current Year, Flat in the Budget Year. The table below summarizes our forecast for total revenues from the state’s three largest taxes (the “big three”). Consistent with recent deterioration in tax collections, our forecast anticipates big three revenues will decline 11 percent in 2022-23. The bulk of this decline is attributable to the personal income tax. For 2023-24, our forecast anticipates big three revenues will remain flat, with weakness shifting from the personal income tax to sales and corporation taxes. This shift reflects the risk of a broader economic slowdown which could weigh down consumer spending and corporate earnings.
Downside Risk to Administration’s May Revision Revenues. Across 2021-22 to 2023-24, our estimates of big three revenues are $11 billion lower than the administration’s May Revision estimates. As such, while we consider the May Revision revenues plausible, adopting them would present considerable downside risk.
Wide Range of Possible Outcomes. Revenue collections ultimately will depend on the future path of the economy, which is highly uncertain. Lacking certainty on the future of the economy, our revenue forecast instead draws on historical relationships between current economic conditions and future revenues. While these relationships help us gauge the potential path of revenues, they are imperfect and our revenue estimates will be wrong to some extent. For example, our weak revenue forecast over the next couple years largely is based on the historical observation that when economic conditions are similar to today there is a strong chance of a slowdown in the near future. This historical observation, however, is not a guarantee. There is a good possibility that rising interest rates and tightening credit soon will push the economy into a broader slowdown, leading to further revenue declines. It is also possible that today’s economy could prove more resilient than prior episodes—perhaps due to unprecedentedly high demand for workers.
This uncertainty means revenues could end up considerably higher or lower than our estimates. The figure below shows how historical experience suggests revenue could differ from our forecast. As shown on the figure, by the end of our forecast in 2026-27, it is entirely plausible that revenues could end up $50 billion above or below our forecast.
How Much Have Tax Filing Delays Impacted Our Forecast? Earlier this year, the IRS extended into October several tax filing deadlines that typically fall between January and September of this year. Among other things, this means that our forecast was not able to incorporate information we typically have about tax filings in March and April. While this information would be helpful, we still can get a relatively good sense of the current revenue situation by looking at other tax data. In particular, payroll withholding for the personal income tax has been unaffected by the deadline delays. Withholding historically has had a strong relationship with overall income tax collections. For instance, as shown on the figure below, a simple rule of thumb of doubling annual changes in withholding has been a relatively accurate predictor of overall income tax changes in the current year. Because of this, by combining recent data showing a decline withholding with various other economic data, we are able to arrive at our forecast of a 13 percent decline in income tax revenues in the current year.