As shown earlier in Figure 3, the personal income tax accounts for the largest share of state General Fund revenues. The PIT's structure has a series of marginal tax brackets for each of several categories of taxpayers, including single taxpayers and married couples who file jointly. As one moves to higher income levels, the rates which apply to the income of each successive bracket rise. These marginal rates currently range from 1percent to 11percent. Thus, the PIT has what is known as a progressive graduated marginal rate structure.
The PIT tax base generally conforms to federal law and includes various income exclusions, exemptions, deductions, and credits. An Alternative Minimum Tax (AMT) is levied, which assesses a special tax when taxpayers have unusually large amounts of tax deductions, exclusions and exemptions. The PIT AMT tax rate currently is 8.5 percent, and is scheduled to return to 7 percent after 1995. In addition, income brackets and other key elements are indexed for inflation so that taxpayers' real income generally must rise before their real tax liabilities rise.
The effect of the progressive PIT structure is that higher-income taxpayers generally pay a higher proportion of their income in taxes than do lower-income taxpayers. This is illustrated by the fact that, in 1992 (the most recent data available), the top 10percent of taxpayers paid nearly 60percent of all liabilities, and the top 1percent paid nearly 30percent of all liabilities, considerably more than their share of taxable income. In contrast, the 50percent of taxpayers with the lowest incomes paid only 1.3percent of all liabilities. Sources of PIT Liabilities by Income Type Figure 7 shows that about two-thirds of PIT liabilities are attributable to wages and salaries paid to individuals. The next largest share is from business-related income, including partnerships and sole proprietors--12percent. The remaining 20percent is from interest, dividends, capital gains and other sources.
PIT revenues began experiencing abnormally weak growth in 1989-90 and actually declined in 1990-91, due to the recession. Relatively weak PIT growth persisted throughout the remainder of the recession, especially after removing the effects of legislation adopted to enhance revenues. Due to the strengthening economy, however, moderate PIT revenue growth now has returned and is expected in both the current and budget years.---- Figure 4 shows that PIT revenues are projected to reach $19.5billion in the budget year, an increase of $1billion, or 5.4percent. Current-year revenues are projected to be $18.5billion, an increase over the prior year of $895million, or 5.1percent. After adjusting for the Governor's tax proposal, the budget year increase is about 6percent. These moderate growth rates are roughly in line with underlying trends in projected personal income growth, the main determinant of both taxable income and PIT tax liabilities.
Because wages and salaries account for the largest share of PIT liabilities, overall PIT liability growth depends in large part on growth in wages and salaries. Figure 8 (see next page) shows that taxable income is expected to rise by 6.1percent in both 1995 and 1996. This primarily reflects growth in wages and salaries, which are predicted to rise moderately--by 5.3percent in 1995 and 6.3percent in 1996.
Figure 8 also shows expected growth for the other main sources of taxable income. The principal reason why taxable income growth is predicted to exceed wage and salary growth in 1995 involves a sharp upturn from 1994 in capital gains realizations (that is, profits from the sale of capital assets). Although Figure 7 indicates that capital gains accounted for only about 7percent of PIT liabilities in 1992, capital gains realizations tend to experience considerable volatility that can significantly influence year-to-year changes in PIT liabilities. For example, capital gains realizations rose by 24percent in 1988 and 5percent in 1989, then fell by over 20percent in both 1990 and 1991. Given this volatility, capital gains are one of the hardest components of taxable income to predict.
Capital gains realizations since the late 1980s are shown in Figure 9. It indicates that the budget predicts capital gains to be $18.6billion in 1994 (down 5percent), $22.3billion in 1995 (up 14.2percent), and $24.5billion in 1996 (up 4.9percent). Figure 9 also indicates, however, that an estimated $980million of the 1995 amount is assumed to have been shifted out of 1994, as taxpayers delayed realizing some of their gains in expectation of a federal tax cut in 1995. Exactly what the shift will turn out to be is unknown at this time, but the department's allowance for some shift makes sense.
Without this shift, capital gains would be flat in 1994, up a modest 3.5percent in 1995, and up 10percent in 1996. The shift has the effect of reducing current-year revenues by around $100million, and increasing 1995-96 revenues by an equivalent amount.
The sales and use tax is imposed primarily on retail sales of tangible goods, but generally not services, to consumers in the state. It also generally applies to goods purchased by businesses to the extent that they are not intended for resale (such as machinery used in the production process). Somewhat over one-third of all taxable sales fall into this latter category. The “use” tax is imposed on products bought from out-of-state firms by California individuals and businesses for use in the state. Such purchases generally are difficult to monitor, and an increasingly large portion of purchases by individuals appear to be escaping taxation due to the state's inability to require out-of-state “mail order” businesses to collect this tax. -- Figure 10 (see next page) shows that the overall sales and use tax rate actually consists of a number of different individual rates of tax, reflecting the different purposes for which the sales and use tax is levied. As the figure shows, both the state and local governments levy multiple rates of tax. Figure 10 also indicates how the Governor's realignment proposal will affect these rates.
Statewide State Rates. Under current law, the basic state sales tax rate is 6percent, of which the state General Fund portion is 5percent. In addition, the state levies two 0.5percent sales taxes: one to fund health and welfare program costs associated with the 1991 program realignment legislation, and one dedicated to local public safety programs. The local public safety monies do not appear in the budget totals, and are directly given to localities. The Governor's 1995 realignment proposal includes shifting .2215 cents of the state sales tax from the General Fund to localities to pay for children's social services.
Statewide Local Rates. At the local level, a 1.25percent rate is levied in all counties. Of this amount, revenue from the 0.25percent portion of the rate is deposited in county transportation funds, while the 1.0percent portion of the rate is allocated to city and county governments for general purposes. City governments receive the proceeds generated within their boundaries and counties receive the remainder.
Optional Local Rates. In addition to statewide sales taxes, many local governments--mostly on a county-wide basis--levy sales taxes for a variety of other purposes (primarily transportation). These taxes can be imposed at rates of either 0.25percent or 0.5percent, and generally cannot exceed an aggregate of 1.5percent. In total, existing sales tax rates range from 7.25percent in counties with no optional taxes, to 8.5percent in the City and County of San Francisco. At this time, no county levies the maximum rate generally possible of 8.75percent. -- Figure 11 shows how the total sales and use tax rate varies in different counties in California. --
The budget projects that General Fund sales and use taxes will total $14.9billion in the budget year (1percent growth) and $14.8billion in the current year (6.4percent growth). After adjusting for the realignment proposal, however, budget-year growth is 5.8percent.
Aerospace-Related Refunds. The estimates for both the current and budget years assume that $60million will be paid out in each year as refunds associated with direct overhead items purchased under U.S. government cost-reimbursement contracts. Based on a 1990 Supreme Court ruling, an estimated $325million in state revenue, plus interest, will need to be refunded. The budget reflects the assumption that these refunds will be paid out over a 5-year period starting in 1993-94.
The key to the outlook for sales and use tax revenues is the outlook for taxable sales. Figure 12 shows that taxable sales are anticipated to grow moderately by 6percent in both 1995 and 1996, following a 5.2percent gain in 1994. Taxable sales performed poorly during the recession, declining in both 1991 and 1993 and remaining essentially flat in 1992. In contrast, taxable sales grew at an average rate of over 7percent during the 1980s. The taxable sales increases predicted for 1995 and 1996 are pretty much in line with personal income growth. -- The strongest areas of growth in taxable sales are expected to be in construction-related categories like building materials and in motor vehicles. This is consistent with the increased spending on consumer durable goods and housing activity that typically accompany economic recoveries.
New Low for Taxable Sales Ratio. Figure 13 shows that, even with the moderate growth expected for taxable sales, their ratio to personal income will be at a near-record low of 40percent in 1996. This ratio has generally followed a downward trend over the past 15-plus years. The ratio's decline is due largely to increased spending on services, which means that an increasingly large portion of sales transactions are not subject to taxation. This is especially so given the dominant role of the services sector in California's economy, and the fact that, according to a recent study by the Federation of Tax Administrators, California taxes fewer services than most states.----
Banks and corporations doing business in California are subject to a general tax rate of 9.3percent measured against the portion of their net taxable income (profits) that are earned in California. Corporations that qualify for California Sub-Chapter S status are taxed at a 1.5percent rate. Banks and other financial corporations pay an additional tax, currently set at 2percent, which is in lieu of all other state and local taxes except those on real property, motor vehicles and business licenses. An $800 minimum tax applies to all taxpayers, and an Alternative Minimum Tax (AMT) similar to the federal AMT is imposed on taxpayers based primarily on the amount of their tax exemptions and deductions. The B&C AMT tax rate is 7percent.
Taxpayers with multistate or multinational activities are subject to having their business income apportioned to California based on a formula which takes account of California's share of their sales, property and payroll. Multinational taxpayers, however, can elect to have only their U.S. (versus worldwide) income included in calculating their California taxable income.--
Bank and corporation (B&C) revenues have been weak for a number of years. For example, B&C revenues have declined in four of the past seven years. As a result, 1993-94 revenues were nearly 10percent below their previous peak in 1988-89, five years earlier. In contrast, B&C revenue growth averaged eight percent annually during the 1980s.
Several factors explain this poor recent performance. The most important was the national recession, which both directly and indirectly hurt the profitability of many corporations doing business in California. The rapid growth in net operating loss (NOL) deductions and corporate conversions to Sub-Chapter S status also were key factors. For example, NOL deductions and Sub-Chapter S provisions reduced 1993-94 revenues by an estimated $300million and over $490million, respectively.
The budget forecasts that B&C revenues finally will be experiencing good growth in the current year. It predicts revenues of $5.5billion in the current year, an increase of 17percent. Budget-year revenues are forecast to drop to $4.8billion, a decline of 13percent. However, the large current-year growth and budget-year reduction are both overstated, due to special factors. After adjusting for these special factors, current-year revenue growth is in the range of 14percent and budget-year revenues are up slightly.
The most important factors responsible for distorting the B&C revenue trend are the following:
Taxable Corporate Profits--Strong 1994 Growth
The key to the B&C revenue forecast is the projection of taxable California corporate profits. Figure 14 shows that profits are estimated to have risen by 16percent in 1994. Although 1994 has already ended, this figure is necessarily a rough estimate because it will be nine months before many of the corporate tax returns for 1994 are even filed, given the common corporate practice of filing for extensions. Figure 14 also indicates that modest profit growth of 5percent in 1995 and 4percent in 1996 is forecast. Despite this growth, the post-recession recovery of profits is considerably weaker than what occurred after the 1980s recession. ----
The ratio of corporate profits to personal income is one indicator of how strong the corporate tax base is relative to the overall economy. This ratio is cyclical, given the inherent volatility of corporate profits, declining when the economy weakens and rising when the economy strengthens. Figure 15 shows that the ratio hit an all-time low in 1992. The ratio is estimated to increase moderately for 1994. However, it is predicted to decline again slightly in 1995 and 1996, leaving it well below the post-recession recovery years of the 1980s. Thus, although corporate profits are again growing, from an historical perspective only a relatively limited snapback is projected. --
The budget includes revenue increases of $17million in the current year and $5million in the budget year associated with the enactment of 1994 legislation allowing for limited liability companies (LLCs) in California. In addition, a budget-year reduction of $5million is included for the impact of various Trade and Commerce Agency initiatives with respect to enterprise zones and program areas. The forecast also includes a variety of other adjustments relating to 1994 enacted legislation.--
As shown in Figure 4, most of the remaining 8percent of General Fund revenues after accounting for the “Big 3” taxes are raised from insurance taxes, death-related taxes, and taxes on cigarettes, horseracing and alcohol. These smaller taxes account for around 5percent of all General Fund revenues. The remaining 3percent comes from interest income, abandoned property, and a wide variety of relatively small sources, including fees.
Insurance taxes are the fourth largest General Fund revenue source. They are predicted to experience a drop of 19percent in the current year and a gain of 30percent in the budget year. However, the underlying revenue growth trend is modest, after adjusting for some large tax refunds anticipated to be paid out later this fiscal year.
Decline in Worker's Compensation Premiums. Insurance tax revenues depend on taxable insurance premiums. Figure 16 shows premium amounts for 1993 through 1996 for major categories of insurance. It indicates that, over this entire four-year period, total premium growth is only 5.3percent. However, the performance for individual lines of insurance varies greatly. For example, estimated growth in life insurance premiums is over 26percent. In contrast, workers' compensation premiums show a large decline--over 18percent. This reflects the effects of workers' compensation reform, which became effective in July 1993. -- Modest Growth in Total Premiums. The budget forecast of premiums is based on a large survey of insurance companies doing business in California. Premiums are predicted to rise by 3percent in 1995 and 4percent in 1996. The strongest growth is expected for life insurance premiums--9percent in each year.
Revenues are predicted to decline in both the current and budget years for excise taxes on alcoholic beverages, cigarettes and horseracing wagering. This is a continuation of past trends, reflecting declining per capita consumption of these items and activities.
Figure 17 shows, for example, that per capita consumption of cigarettes is projected to reach an all-time low of 82 packs in 1996, down from 185 packs as recently as 1982. This dramatic decline reflects both societal attitudes about smoking and the effects of increased cigarette prices due to the increased taxes imposed on tobacco under Proposition 99. Because per capita declines have exceeded population growth, total cigarette consumption has fallen continuously. The same general trend also holds true for alcohol consumption and horseracing wagering. ----
Like its economic forecast, the budget's General Fund revenue forecast is reasonable. The moderate revenue growth that it assumes is generally consistent with its forecast for a “soft landing,” with continued moderate economic recovery and modest inflation. Our own estimate also is for moderate revenue growth. However, based on our own economic assumptions and revenue-estimating models, we project a bit more revenues than the budget does.
Figure 18 shows that our estimate is $170million more in the current year and $425million more in the budget year than the department's forecast, or $595 million for the two years combined. Compared to the budget, our forecast reflects somewhat higher ratios of taxable sales and corporate profits to income, and somewhat greater sensitivity of the PIT tax structure to personal income growth.
It should be noted, however, that the difference between our revenue forecast and the budget forecast is not as great as the revenue change that would occur if either a boom-bust economic scenario, significant economic slowdown, or extremely strong sustained economic expansion were to take place. As discussed in Part Two, many economists think the odds are only about 50-50 that a “soft landing,” such as that assumed both by us and the department, will occur.--
Special fund revenues support a variety of specific state and local government programs. These range from transportation-related activities to health services.
Figure 19 indicates that motor vehicle-related revenues account for nearly 50percent of projected 1995-96 special fund revenues. These include motor vehicle license fees (21percent), fuel taxes (18percent), and vehicle registration and related fees (11percent). Other major sources of special fund revenues include sales and use taxes (27 percent) and tobacco-related revenues (3percent). Figure 20 shows the dollar amounts and growth rates for special fund revenues by type, projected for the current and budget years and compared to actual revenues for 1993-94. The amounts we show include Local Public Safety Fund revenues, which do not appear in the Governor's Budget totals. --
Total 1995-96 special fund revenues are predicted to reach $15.1billion, an increase of 10percent over 1994-95. In contrast, budget-year revenues are projected to increase by 5.9percent compared to the prior year. These year-to-year growth patterns are distorted by various special factors. For example:
After removing the effects of these factors, underlying special fund revenue growth is about 5percent in 1994-95 and 4percent in 1995-96.
Motor vehicle license fee revenues are projected to rise by about 2percent in both 1994-95 and 1995-96. Registration fee revenues are expected to rise somewhat faster--about 4percent. The registration fee increase results from changes in new and existing vehicle registrations.-- Figure 21 shows that beginning in 1989, new vehicle registrations declined for five straight years before rising by 5percent in 1994. Further increases of 10percent in 1995 and 2percent in 1996 are projected. Even with these increases, new registrations will lie about 7percent below their pre-recession peak in 1988. --
Fuel taxes are projected to increase by 1.3percent in the budget year, to over $2.7billion. This is considerably less than the 7percent increase projected for the current year. However, the high current-year growth is due to it being the first full-year effect of the final year of tax increase provided for under Proposition 111 (November 1990).
The low growth in fuel tax revenues is largely because total gasoline consumption is basically stable, having been flat over the past five years (as shown in Figure 22). This reflects declining per capita fuel use due to increased fuel economy and conservation efforts. This has been sufficient to offset growth in aggregate fuel demand from such factors as population growth. --
Figure 23 (see next page) shows the share of tobacco-related tax revenues going to special funds. In 1995-96, special funds will receive an estimated 74percent of these revenues, with 69percent being distributed in accordance with Proposition 99 and 5percent going to the Breast Cancer Fund. The remaining 26percent of total revenue goes to the General Fund.
As is true for General Fund cigarette tax revenues, special fund tobacco-related tax revenues are projected to decline modestly in both the current and budget years. In 1995-96, they are projected to be $468million, down from $482million in 1994-95. As discussed previously, this drop reflects declining per capita consumption of tobacco products, due to both societal attitudes and price hikes attributable to past tobacco tax increases.
The 8percent growth shown in Figure 20 for “other” special fund revenues includes $147million in proceeds from the sale of tax and revenue anticipation notes that are to be deposited in the State Highway Account. These notes are to be retired using future fuel tax revenues. Although these note proceeds do represent resources that can be spent for transportation-related purposes, proceeds from note sales are not normally treated as revenues. Rather, the taxes themselves are counted as revenues when they are received. Absent counting these note proceeds as revenues, growth in the “other” revenue category would be less than 3percent in the budget year.