The 2019-20 May Revision

LAO Revenue Outlook

This post details our General Fund revenue outlook for 2017‑18 through 2022‑23. Our estimates of General Fund revenues and transfers for the “budget window”—2017‑18 through 2019‑20—are $774 million (0.2 percent) above the administration’s May 2019 revenue forecast.

Figure 1 displays our General Fund revenue outlook through 2022‑23. Our revenue outlook is based on a consensus national economic forecast compiled by Moody’s Analytics. As such, our revenue estimates are premised on the continuation of moderate economic growth through 2023. If economic conditions vary from those assumed in this scenario, General Fund revenues could vary substantially from our estimates. See our post “LAO Economic Outlook” for more information concerning our economic assumptions.

All of our revenue estimates use the administration’s assumptions for the effects of conforming to certain federal tax law changes and expanding the Earned Income Tax Credit.

Personal Income Tax (PIT)

PIT Growth Remains Steady. While wage growth was somewhat lower in 2018 than we had anticipated in November, it remained above the long-term historical average. Under our updated economic outlook, we expect total wages and salaries to continue to grow steadily in 2019 and 2020 in part due to a historically high number of initial public offerings (IPOs) by California-based companies in 2019. This effect is one time, however, and we expect wage growth to slow in the out years consistent with slowing economic growth nationally.

IPO-Related Revenue. As noted above, our PIT estimates account for the significantly higher IPO activity in 2019. A typical IPO year for California-based companies is roughly $30 billion of market capitalization. So far this year, California-based company IPOs have had almost $150 billion of market capitalization ($82 billion of which was from the recent Uber IPO). While IPOs can ultimately increase capital gains, the primary observable effect of IPOs is in withholding. Specifically, the state receives withholding from newly public companies due to the vesting of California-based employees’ restricted stock units (which are a common form of deferred compensation), which become taxable at the offering. The effect of this activity is one time in 2018‑19 and 2019‑20.

Capital Gains Spike in 2018‑19. Franchise Tax Board data show that net capital gains increased from $110 billion in 2016 to $140 billion in 2017. Based on 2018 revenue collections to date, we estimate net capital gains to increase to $155 billion in 2018. We expect capital gains to decline somewhat in 2019 and 2020, lowering to $123 billion by 2023 due to relatively slow growth in the stock market.

Corporation Tax (CT)

CT Collections Surged in the Current Year. With two collection months remaining in the fiscal year, we expect that CT revenues will exceed the administration’s January estimate by well over 10 percent. We believe this increase in revenues likely is a one-time event in response to federal tax changes in 2017. Specifically, the 2017 federal tax changes created an incentive for corporations to shift profits from 2017 into 2018 due to the new, lower tax rates. This boosted corporate profits on a one-time basis in 2018. Moreover, as we explained previously, the federal tax changes included a one-time tax on profits held overseas. Now, corporations may bring back those profits at any time without facing additional federal taxes. With this lower-barrier to “repatriating” profits, we believe a portion of the surge in recent state collections likely is due to corporations bringing this cash back to the United States and paying the applicable state taxes on those profits.

Higher One-Time Collections Lower Growth Rate in 2019‑20. While the consensus forecast expects corporate profits to grow 4 percent in 2019 and 6 percent in 2020, we expect CT collections to decline somewhat from 2018‑19 to 2019‑20. This is due to the significant one-time increases in collections in 2018‑19. Because those events are unlikely to recur, the underlying growth in corporate profits is not sufficient to offset those one-time effects.

Sales and Use Tax (SUT)

Solid Growth in the Current Year. So far, 2018‑19 SUT revenue is running very close to the administration’s January projections. Based primarily on revenues received to date, our revenue outlook includes roughly $26.2 billion of SUT in 2018‑19—4.7 percent higher than the prior year, but slightly below the January Governor’s budget.

Projected 2019‑20 Growth Strengthened by Wayfair . . . In our outlook, SUT is $27.5 billion in 2019‑20—a growth rate of 4.9 percent. This projection is due in large part to the state’s response to the recent U.S. Supreme Court ruling in South Dakota v. Wayfair, Inc., which gives states new opportunities to improve compliance with the use tax on Internet sales.

. . . But Softened by Economic Factors. Our SUT projections are based, in part, on several parts of our economic outlook—particularly our projections for California personal income. Without Wayfair, these economic conditions would suggest weak growth in SUT.

Comparing LAO Outlook to Administration’s Forecast

Figure 2 shows the administration’s forecast of General Fund revenues through 2022‑23. Figure 3 compares our revenue outlook with that of the administration. As shown in Figure 3, our estimates of General Fund revenues and transfers are $774 million above the administration over the budget window—2017‑18, 2018‑19, and 2019‑20 combined. The largest difference is in PIT, where we are $753 million higher than the administration over the three fiscal years combined.

Higher 2018‑19 PIT Estimates Compared to Administration. As seen in Figure 3, our PIT estimate is somewhat higher than the administration’s in 2018‑19. This may be due in part to additional information available at the time of our analysis. Specifically, collections at the end of April and beginning of May were higher than anticipated, which increased our projection for the rest of the year. In addition, we took a different approach than the administration on estimating the effects of IPOs (as described above).

Budget Stabilization Account (BSA) Transfer Significantly Higher in 2018‑19 Due to Lower Proposition 98 Increment. As is the case in the Department of Finance’s estimates, our 2018‑19 BSA transfer estimate is up significantly compared to January. Under the rules of Proposition 2, the Proposition 98 minimum guarantee is calculated with and without excess capital gains. The difference between these two levels of the guarantee is the Proposition 98 increment. The increment lowers the ultimate required BSA transfer. Consequently, a lower increment means the BSA transfer goes up.

Higher Growth in the Out Years Compared to the Administration. The greatest difference between our outlook and the administration’s forecast in the out years is in PIT. This difference is driven by different assumptions about how wages will grow across different segments of the income distribution. Since 1990, high-income Californians’ wages have grown faster than lower-income Californians’ wages. Under our outlook, we assume that this trend continues—specifically, higher earners’ wages will continue to grow faster than lower earners’ wages. In contrast, the administration assumes all earners see relatively similar rates of wage growth.

Key Uncertainties

Our estimates of revenue growth in the budget window are driven by particularly volatile revenue sources—capital gains and corporation taxes. In addition, the ultimate effect of IPOs this year is yet to be known. As noted above, we also used the administration’s assumptions for the revenue effects of conforming to federal tax law. These estimates are highly uncertain both in the budget window and in the out years.