Updated "Big Three" Revenue Outlook

Revenues Presently on a Path to Beat Budget Expectations. Our updated forecast anticipates revenues from the state’s three largest taxes (income, corporation, and sales) will come in above the level assumed in the recently adopted state budget. This upgraded outlook is entirely attributable to higher expectations for income tax collections. Income tax collections are being driven higher by enthusiasm around artificial intelligence (AI), which has pushed the stock market to record highs and boosted compensation among the state’s tech works. Given this, we suggest approaching the improved revenue outlook with guarded optimism. Further, the state was expected to enter the next budget cycle with a sizable operating deficit. This fact, combined with the state's complicated Constitutional budget rules, means revenue improvements are likely to translate to smaller deficits, rather than new budget capacity.

AI Enthusiasm Is the Story…The stock market (S&P 500) has risen 50 percent in the last two years. Most of these gains come from the meteoric rise in the value of a handful of tech companies that investors believe will be major beneficiaries of recent advances in generative AI. These companies have made big bets on AI. Microsoft, Amazon, Meta, and Google (Alphabet) have spent hundreds of billions on datacenters for AI and are expected to spend hundreds of billions more. These same companies are also offering extravagant pay packages to recruit AI researchers. This spending, coupled with sizable gains to investors and tech company employees via stock options is boosting state income tax receipts.

…But Risks Being Overdone. Recent advances in AI undoubtedly have been impressive, but their economic value remains a huge unknown. As put by a team of economic researchers that recently reviewed the evidence on AI, “Whether practical genAI applications will be consequential enough to raise aggregate productivity growth remains to be seen.” AI very well may bring about new era of innovation. Even still, history suggests there is some risk that the current enthusiasm is overdone, especially among investors. For California, the dot-com boom offers the most salient example. The internet has proven to be a transformative technology and, yet, the stock market’s initial reaction was clearly overly exuberant. Indeed, many signs of an overly exuberant stock market are present today: households are more invested in the stock market than they have been in at least 70 years, measures of how “expensive” stocks are historically high, and investors are taking on increasing amounts of debt to buy stocks. While far from assured, such unprecedented amounts of money flowing into the stock market raises the specter of a correction that triggers a reversal in state income tax collections. For as long as this run-up continues, however, income taxes are likely to continue outperforming the broader economy.

Rest of the Economy Appears Fragile. Should enthusiasm around AI wane, the rest of the economy does not appear poised to pick up the slack. The labor market at both the state and national level is stagnant. Consumers remain pessimistic about economic conditions, in large part due to concerns over rising inflation pressures. And the consensus expectation among economic forecasters, while improved somewhat since the spring, is for a slowdown in the near team. Taken together with signs of an overheated stock market, these observations suggest recent improvements in the revenue outlook—while a positive development—should be met with guarded optimism.