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2011

Other Budget Issues

Further Detail

(Note: A subsequent posting on this website provides an update to the sales and use tax forecast released below on February 15, 2011. That subsequent posting is accessible here.)

This note contains information on our office’s current General Fund revenue and economic forecast. Because of the need to prioritize budget subcommittee-related workload in recent weeks, we have focused below on a forecast of the state’s “Big Three” revenue sources (personal income, corporation, and sales and use taxes), and we have not completed an expenditure forecast. (We have no significant issues to raise concerning the administration's other General Fund tax forecasts at this time.)

Summary

The 2011-12 Governor’s Budget assumes $162.9 billion of Big Three General Fund revenues in 2010-11 and 2011-12 combined under current-law tax policies—$1.4 billion (0.8 percent) more than our office projected in our November 2010 forecast, after adjusting all of these figures to ensure consistent treatment of the 2010 “fuel tax swap” and the December 2010 federal tax legislation. As we described in our January 12 publication, Overview of the Governor’s Budget, our office’s near-term economic outlook is somewhat more optimistic than that of the administration, given the inability of the Department of Finance to incorporate the late-breaking news of the December 2010 federal tax package into the Governor’s forecast. Nevertheless, even while adopting a slightly more pessimistic economic forecast than ours for 2011, the administration projects revenues above those that we identified in November. We find that the administration’s revenue projections for 2010-11 and 2011-12 essentially already incorporate the results of the short-term economic boost that should result from the federal tax package. In total, including our estimates of the effects of the Governor’s proposed tax policy changes, our Big Three revenue forecast for 2010-11 and 2011-12 combined is just slightly below ($688 million) the administration’s. Our higher revenue forecast for sales and use taxes (SUT) is more than offset by a considerably lower projection for corporation tax (CT) revenues. The total difference between our projections and the administration's--$688 million over two fiscal years—is statistically insignificant.

Revenue and economic forecasts always prove to be incorrect, with a margin of error for state revenue forecasts of several billion dollars per fiscal year—both on the "upside" and the "downside." We caution policy makers that revenue forecasts are prone right now to an unusually large margin of error. Forecasting is—in part—dependent on observing past trends to predict future results. Because the recently-concluded economic recession and the state’s policy responses to it were unprecedented, there are many open questions about how the economy and state revenues will react in the coming years as the recovery progresses.

Economic Forecast

Figure 1 summarizes our office’s current national and state economic outlook.

Figure 1
LAO February 2011 Economic Forecast
(Percent Change Unless Otherwise Indicated)

Outlook for the Economy Somewhat Improved Since Last Fall. The outlook for the U.S. economy has improved since our last forecast in November 2010—a function of three months of generally good economic news and congressional passage of legislation in December that lowered taxes and boosted unemployment benefits temporarily. The biggest piece of good news was the fourth quarter gross domestic product (GDP) report, which boosted overall growth for 2010 to 2.9 percent (up from the 2.6 percent growth that we forecast in November) and showed a hefty increase in consumption. Various data show that consumers and businesses are becoming less apprehensive about the future of the economy. While California continues to experience higher joblessness than the rest of the country, the state’s economic fortunes otherwise are improving in line with the nation’s. We expect this to continue.

Effect of the December 2010 Federal Tax and Benefits Bill on the Forecast. Congress approved and the President signed the tax decrease and unemployment benefit bill in December 2010. In general, the legislation authorizes additional federal deficit spending, which will have the effect of stimulating the economy in the short run. As shown in Figure 1, we now forecast 5.0 percent personal income growth in California in 2011 and 3.3 percent growth in 2012. Were it not for the reduction in the federal payroll tax in the December 2010 legislation, our personal income growth forecast for California would have been 4.0 percent in 2011 and 4.2 percent in 2012. Similarly, the Governor’s budget forecast assumed 3.8 percent personal income growth in the state in 2011 and 4.0 percent in 2012.  All of these forecasts assume roughly the same level of economic activity over the two calendar years—with the federal tax changes essentially accelerating growth somewhat from 2012 to 2011.

“Big Three” Revenue Forecast—2010-11 and 2011-12

Governor’s Current-Law Forecast Higher Than Our November 2010 Projections. While the administration’s January 2011 economic forecast did not reflect the full effects of the December 2010 federal tax package, the Governor’s revenue projections did assume higher current-law General Fund revenues in 2010-11 and 2011-12 combined than did our office’s November 2010 forecast. As shown in Figure 2, after adjusting totals to ensure a reasonably consistent treatment of federal tax policy and the 2010 fuel tax swap, the administration has forecasted $1.4 billion more in current-law revenues in the two fiscal years combined than we did in November 2010. In particular, we note that our respective models for CT appear to be quite different at this point in time. Over the two fiscal years, the administration’s current-law CT revenue forecast is $1.6 billion (8 percent) higher than the similar forecast of our office three months ago. (Below, we discuss some of the key differences between our respective CT forecasts.)

Figure 2
Comparison of LAO November 2010 and Governor's January 2011 Current-Law Revenue Forecasts^a
("Big Three" General Fund Revenues, In Millions)

^aAssumes current-law revenue policies, including adoption of none of the Governor's January 2011 budget proposals.
^b Adjusts administration's January 2011 current-law personal income tax forecast to eliminate
   a timing shift in capital gains and related income related to the December 2010 federal tax package. This
   ensures a treatment of this timing shift that is equivalent to that of the November 2010 LAO forecast.
^c  Adjusts LAO's November 2010 sales and use tax forecast to ensure a treatment of the 2010 "fuel tax swap"
   that is equivalent to that in the January 2011 administration forecast.

Personal Income Tax (PIT) Forecast. Figure 3 shows our office’s current General Fund Big Three revenue forecasts assuming adoption of the Governor’s revenue proposals and our updated economic forecast. (In our projections, we have attempted to mirror the administration’s new accrual approach for its four tax proposals, as described in our recent publication, The Administration’s Revenue Accrual Approach.) For the PIT, the state’s largest revenue source, our forecast reflects slightly higher revenues than the administration’s forecast in 2010-11 and slightly lower revenues in 2011-12. For the two fiscal years combined, our PIT forecast is $104 million (0.1 percent) above that of the administration. While our office’s economic forecast assumes higher personal income growth for the state in 2011, we are concerned that “net final payments” (final PIT payments this spring, net of refunds) may be substantially lower than reflected in the administration’s current forecast. The administration’s forecast already assumes that the higher PIT withholding rates in 2010 will lead to more substantial refunds this spring, but our forecast indicates that these refunds will be even larger. As always, the level of capital gains to be reflected in each fiscal year’s PIT collections is a wild card, particularly given the large overhang of investment losses resulting from the stock market and housing market declines of recent years. 

Figure 3
"Big Three" General Fund Revenue Projections for 2010-11 and 2011-12^a
(In Millions)

^aAssumes adoption of Governor's January 2011 budget proposals.

SUT Forecast. As shown in Figure 3, our office projects higher SUT revenues than those indicated in the administration’s forecast in both 2010-11 and 2011-12. For the two fiscal years combined, we forecast $809 million (1.6 percent) more in SUT collections for the General Fund. To date in the 2010-11 fiscal year, SUT collections are running several hundred million dollars above the administration’s monthly estimates. Continuation of this trend will depend heavily on consumer confidence and the willingness of both consumers and businesses to resume spending more heavily on taxable tangible products. In recent months, there have been some indications of a rebound in auto sales, and continuation of this trend will be important for future SUT collections.

As noted in our recent update to the Legislature on January 2011 SUT collections, the administration has expressed concern that the Board of Equalization may have inaccurately attributed some revenue related to the fuel tax swap to the General Fund in recent months. Our forecast assumes that there was no such problem. Accordingly, if BOE determines that prior months’ SUT collections were overstated, our SUT forecast would need to be adjusted downward.

CT Forecast. Our office projects considerably lower CT revenues than those indicated in the administration’s forecast in both 2010-11 and 2011-12. For the two fiscal years combined, we forecast $1.6 billion (7.1 percent) less in CT collections. Our forecast assumes lower taxable corporate profits than the administration’s forecast in 2010 and 2012, but similar levels of profits in 2011. In addition, our forecasting model differs from that of the Department of Finance in its assumptions concerning the revenue change resulting from the suspension—from 2008 through 2011--of larger businesses’ use of net operating loss deductions.

Multiyear Revenue Forecast

Lower Growth Than in Administration’s Projections. Figure 4 shows our current projections for Big Three General Fund revenues through 2015-16, as compared to the administration’s. These projections assume adoption of the Governor’s revenue proposals. In each year through 2014-15 (the end of the administration’s multiyear forecasting period), our office projects lower Big Three General Fund revenues than the administration.  Our lower forecasts for capital gains and corporate profits drive much of the difference between our estimates and the Governor’s.

Figure 4
Multiyear "Big Three" General Fund Revenue Forecasts^a
(In Millions)

^aAssumes adoption of Governor's January 2011 budget proposals.
NA-Not available.

Forecasting More Difficult Now Than Usual

We caution policy makers that revenue forecasts seem prone right now to an unusually large margin of error. Because the recently-concluded economic recession and the state’s policy responses to it were unprecedented, there are many open questions about how the economy and state revenues will react in the coming years as the recovery progresses. We have a great deal of uncertainty about the level of PIT refunds this spring, about how the large investment losses of recent years will affect capital gains-related PIT revenues in the coming years, about how recent CT changes will affect the use of credits and overall CT collections, about all of the effects of the fuel tax swap on SUT collections, and so on. It is quite easy to imagine General Fund revenues being several billion dollars higher or lower than our projections or the administration’s in 2010-11, 2011-12, and any of the subsequent fiscal years.