Updated "Big Three" Revenue Outlook

Surging Income Tax Collections Boosting Revenues. Recent income tax collections have been decidely strong. Over the last 12 months, total income tax collections have grown at an annual rate of nearly 20 percent, while withholding has grown over 10 percent. Reflecting this trend, our outlook for revenues during the budget window (2023-24 to 2025-26) continues to improve. Our latest forecast now suggests there is upside potential relative to the revenues assumed in the Governor’s Budget. Despite this, and consistent with our recent guidance to policy makers on how to make the best use of our forecasts, we continue to view the Governor's Budget revenues as a reasonable baseline for budget deliberations. 

Stock Market Continues to Underpin Income Tax Growth. Surging income tax collections do not seem to be tied to a clear improvement in the state’s economy. Both the job market and taxable consumer spending remain stagnant. Instead, the surge appears linked to the strength of the stock market. The S&P 500, for example, has grown over 50 percent in the last two years. This has boosted the earnings of high-income Californians and, in turn, income tax collections.

Is the Stock Market Rally Sustainable? Whether the stock market surge is sustainable is impossible to say, but several hallmarks of prior unsustainable stock market booms appear present today. The boom seems to be driven by a narrative, in this case optimism about advances in artificial intelligence, that has a basis in truth, but also a potential for overreaction. Measures of how “expensive” stocks are have reached historically high levels. And investors are going into increasing amounts of debt to buy stocks. These signs are worrying, but do not necessarily mean a stock market reversal is imminent. Even if a reversal is on the horizon, it may not come for some time. Similar observations could have been made in 1998, but the stock market and the state continued to experience a boom for two more years. A similar dynamic is possible today. The stock market very well could continue to boost state revenues into the budget year. At the same time, it is important to remember that booms very often carry with them the risk of a future bust.

Inflation Could Become a Complication. Stubbornly elevated inflation further complicates this picture. Inflation gradually declined after peaking in 2022, but seems recently to have plateaued at a rate higher than historic norms. While this development is worrying in its own right, it also poses a risk for the continued strength of the stock market. As stock prices and optimism have risen recently, financial conditions have loosened, making it easier for businesses, investors, and consumers to access financing. This has boosted economic activity and put upward pressure on prices. Should the stock market rally continue, this dynamic could keep inflation high. Eventually, the Federal Reserve may feel compelled to take additional steps to slow inflation by cooling the economy and financial markets. Such actions from the Federal Reserve could halt the stock market rally, just as they did in 2022.