Perspectives on State Revenues

Part I

California's state government will collect an estimated $72 billion in taxes, fees, and other revenues in 1998-99. This represents a 4.5 percent increase from the current year. These revenues are deposited either into the states General Fund, or into a variety of special funds.

General Fund revenues are allocated each year through the budget process and support a wide variety of state expenditure programs, including education, criminal justice, and health and social services. Revenues deposited into special funds are earmarked for specific purposes, such as transportation, and targeted health and welfare programs. Some taxes, such as the sales tax, are allocated among both the General Fund and a variety of special funds.

Figure 1 (see next page) shows that slightly over three-fourths of total state revenue collections are deposited into the General Fund, while the remaining one-fourth are received by special funds.

Revenue Performance Over Time

Total revenues collected by state government have risen at a moderate pace over the past decade. As indicated in Figure 2 (see next page), total revenues (excluding transfers and including Local Public Safety Fund revenues) have grown from $38 billion in 1987-88 to over $68 billion in 1997-98, an average increase of just over 6 percent per year. After adjusting for inflation, "real" (that is, constant-dollar) revenues have increased at an average annual rate of about 3 percent. During this period, total revenues have increased slightly faster than the states overall economy.

The figure also indicates that the rate of revenue growth has fluctuated significantly during this ten-year period, reflecting both tax law changes and the impact of the states economy on tax receipts. After growing strongly in the late 1980s, revenues remained relatively flat during the early 1990s' recessionary period. Revenues resumed an upward path from 1994-95 through 1996-97, roughly in line with Californias expanding economy. We expect that revenues will grow at a healthy pace in the current year, before moderating somewhat in 1998-99.

General Fund Versus Special Funds Revenue Growth. Despite large dollar increases in General Fund receipts during the past two years, the annual rate of growth over the entire past decade has been higher for special funds (11 percent) than for the General Fund (5 percent). This is largely a result of tax law changes affecting the special funds. The voter approval of gasoline tax increases in 1990, the creation of the one-half cent Local Revenue Fund sales tax in 1991, and voter approval of a one-half cent sales and use tax for local public safety in 1993, have significantly added to the special funds revenue totals. In contrast, most of the General Fund tax increases enacted during the early 1990s have since expired, and the state has recently enacted income tax decreases. Thus, the net impact of state tax law changes on General Fund revenues has been modest when the period is viewed in its entirety.

Overview of General Fund Revenues

Over 93 percent of General Fund revenues are from the states three major taxes--the personal income, sales and use, and bank and corporation taxes. As shown in Figure 3 (see next page), the largest of these is the personal income tax (PIT), which is projected to account for nearly one-half of total General Fund receipts in 1998-99. The second largest General Fund revenue source is the sales and use tax, which will account for slightly more than one-third of the total. The third largest General Fund revenue source is the bank and corporation tax, which will account for about one-tenth of the total.

The remaining 7 percent of General Fund receipts is related to numerous smaller taxes, fees, interest earnings, and other sources. These include taxes on insurance premiums, alcoholic beverages, and cigarettes.

General Fund Revenues Closely Mirror States Economic Fortunes. The single largest factor affecting General Fund revenues is the performance of the state's economy. This reflects the fact that changes in wages, employment, consumer spending, and business earnings directly affect state receipts from the personal income, sales and use, and bank and corporation taxes.

Revenue Estimates Reflect Recent Tax Reductions

Both the administration's and the Legislative Analyst's Office's (LAO's) revenue projections summarized later reflect the tax-relief package agreed upon and enacted last summer, which provides tax reductions to both individuals and businesses. Figure 4 shows that its provisions are projected to reduce General Fund revenues by an estimated $189 million in the current year, $593 million in 1998-99, and $1.1 billion in 1999-00 (when its provisions are fully phased in).

As indicated in the figure, the majority of the fiscal impact is attributable to the provision raising the dependent exemption credit claimed on personal income returns from $68 in 1997 to $120 in 1998 and $222 in 1999. Other significant provisions include those conforming California to federal tax law in the areas of capital gains on sales of principal residences, Subchapter "S" corporations, research and development tax credits, and individual retirement accounts. The measure also reduces the alternative minimum tax by raising its exemption amounts and indexing them in the future to changes in the California Consumer Price Index.

Figure 4
Revenue Effects of California's

1997 Tax Relief Package

1997-98 Through 1999-00

(In Millions)

Provision 1997-98 1998-99 1999-00
Increase in PIT dependent exemption -$15 -$295 -$780
Increase in and indexing of AMT exemption -44 -74 -85
Federal conformity:
Capital gains/home sales -25 -110 -70
Subchapter "S" corporations -18 -21 -22
Research and development credit -63 -58 -48
Individual retirement accounts -4 -14 -31
Other -20 -21 -50
Totals -$189 -$593 -$1,086

Beyond these changes, the Governor' budget contains no new proposed tax law changes. (The only change from current law assumed in the revenue forecast is a $1 million reduction in horse racing revenues relating to legislation that would repeal certain fees collected on out-of-state wagering. The budget also proposes permanent elimination of the renters' tax credit, although we view this not as a tax program per se, but rather akin to an expenditure program which uses the tax structure as a convenient means of disbursing its benefits.)

The Budgets General Fund Revenue Outlook in Brief

Figure 5 (see next page) summarizes the 1998-99 Governors Budgetrevenue forecast. It shows that General Fund revenues and transfers are projected to increase from $49.2 billion in 1996-97 to $52.9 billion in 1997-98 (a 7.5 percent growth), and $55.4 billion in 1998-99 (a 4.7 percent growth).

1997-98 Revenues. The administration's projected healthy revenue increase for the current year is lead by an 11.6 percent growth in personal income taxes. Sales tax receipts are projected to increase by 5.9 percent, and bank and corporation taxes are forecast to rise just 0.8 percent. The small increase in the latter partly reflects the impact of the 5 percent corporate tax rate reduction passed last year. Collections from the state's smaller revenue sources are affected by a variety of one-time anomalies and policy changes. For example, the decline in "other revenues" and transfers reflect agreements reached between the Governor and the Legislature on trial court funding and other subjects.

Figure 5
Summary of Department of Finance's

General Fund Revenue Forecast

1996-97 Through 1998-99

(Dollars in Millions)

Revenue Source Actual 1996-97 1997-98 Forecast 1998-99 Forecast
Amount Percent Change Amount Percent Change
Personal Income Tax $23,273 $25,980 11.6% $27,640 6.4%
Sales and Use Tax 16,566 17,545 5.9 18,290 4.2
Bank and Corporation Tax 5,787 5,835 0.8 6,175 5.8
Insurance Tax 1,200 1,224 2.0 1,281 4.7
Other taxes 1,129 1,246 10.3 1,270 2.0
Other revenues 1,194 911 -23.7 720 -21.0
Transfers 70 149


Totals $49,220 $52,890 7.5% $55,383 4.7%

1998-99 Revenues. The 4.7 percent increase in revenues projected for the budget year assumes moderate increases in the state's major taxes, along with declines in some of the smaller revenue and transfer categories. The slowdown in personal income tax growth (from 11.6 percent in the current year to 6.4 percent in the budget year) partly reflects the impact of the increase in the dependent credit exemption that will take place in 1998. As in the current year, the decline projected for the "other revenues" and transfers categories partly reflects the impact of the trial court funding agreement reached last year.

Recent Cash Trends Suggest Budget Revenue Forecast Is Low

Although one-time refunds and other factors caused cash revenue receipts to lag early this fiscal year, the more recent trend in cash revenue collections has been extremely positive. Specifically, General Fund revenue receipts in December 1997 were up by well over $700 million from the 1997-98 Budget Act forecast, more than offsetting the weaknesses that had occurred in the earlier part of the fiscal year. These strong December payments, which were received after the administration had completed its budget revenue forecast, reflect major increases in quarterly estimated payments toward 1997 personal income tax liabilities. Such year-end quarterly payments provide a good indication of the strength of non-wage earnings, such as business income, bonuses, stock options, and investment income. Historically, major increases in these payments have been followed by equally strong gains in final payments filed in April. If this pattern holds in the current year, we would expect revenues to exceed the budget forecast, and by a significant margin.

The LAO's General Fund Revenue Outlook

Figure 6 presents our General Fund revenue outlook for 1997-98 and 1998-99. In addition, to help the Legislature in its fiscal planning, we also provide our fiscal projections for one additional year--1999-00. Our projections are based on our economic forecast presented in Part 2 of this volume. As discussed there, our economic outlook assumes continued, though moderating, economic growth in California through the year 2000.

Figure 6
Summary of LAO's

General Fund Revenue Forecast

1997-98 Through 1999-00

(Dollars in Millions)

Revenue Source 1997-98 1998-99 1999-00
Forecast Amount Percent Change Forecast Amount Percent Change Forecast Amount Percent Change
Personal income tax $26,600 14.3% $27,800 4.5% $29,100 4.7%
Sales and use tax 17,570 6.1 18,560 5.6 19,580 5.5
Bank and

corporation tax

5,850 1.1 6,120 4.6 6,300 2.9
Insurance tax 1,220 1.7 1,280 4.9 1,330 3.9
Other taxes 1,235 9.4 1,266 2.5 1,290 1.9
Other revenues 911 -23.7 710 -22.1 735 3.5
Transfers 149 -- 7 -- 100 --
Totals $53,535 8.8% $55,743 4.1% $58,435 4.8%

1997-98 Revenues. We forecast that General Fund revenues and transfers will reach $53.5 billion in the current year, an 8.8 percent increase from 1996-97. As shown in Figure 6, we project that personal income tax receipts will increase by 14.3 percent in the current year. This reflects the combination of healthy economic growth, an assumed increase in capital gains realizations associated with the rise in the stock market, and reductions in federal tax rates on capital gains. We assume that the sales and use tax will increase 6.1 percent, or slightly less than the rate of growth projected for statewide personal income. Bank and corporation taxes are projected to increase by 1.1 percent, reflecting modest growth in California taxable profits and the impact of the 5 percent tax rate reduction enacted in 1996.

1998-99 Revenues. We forecast that General Fund revenues will increase to $55.7 billion in 1998-99, a 4.1 percent rise from the current year. Growth in personal income taxes is expected to decline sharply in the budget year, reflecting the impact of California's 1997 tax relief agreement and our assumption that tax receipts from capital gains will fall from current-year levels. Other factors holding down the growth rate in forecasted revenues next year include sluggish gains in corporation tax receipts and a decline in "other" revenues related to recently enacted trial court legislation.

1999-00 Revenues. We forecast that General Fund revenues and transfers will be $58.4 billion in 1999-00, a 4.8 percent increase from 1998-99. Our estimates assume continued moderate growth in sales taxes. As in the budget year, growth in personal income tax receipts will be affected by the phasing in of the 1997 tax cuts.

Our forecasts for the individual major General Fund revenue sources are discussed in greater detail below.

The LAO's Forecast for Major Revenue Sources

As noted above, California's fiscal performance is highly dependent on the performance of its three largest revenue sources--the personal income, sales and use, and bank and corporation taxes. Together, these taxes account for over 93 percent of state General Fund revenues. The following sections provide additional detail regarding the outlook for these three taxes.

Personal Income Tax


The PIT is by far the General Fund's single largest revenue source, accounting under our forecast for $26.6 billion in tax receipts in the current year. The tax is levied on personal income that is attributable to California. In general, California's income tax is patterned after federal law with respect to the calculation of most types of income, deductions, exemptions, exclusions, and credits. Taxable income is subject to marginal tax rates ranging from 1 percent up to 9.3 percent. From 1991 to 1995, high-income taxpayers were subject to 10 percent and 11 percent marginal rates.

Sources of PIT Taxes. As indicated in Figure 7, as of 1995 (the most recent year for which detailed tax return information is available), about two-thirds of total state income tax liabilities was attributable to wages and salaries. The remaining one-third was due to nonwage sources such as business earnings, interest, dividends, and capital gains.

The Special Importance of Nonwage Income Behavior. Although only accounting for one-third of total tax liabilities in 1995, the performance of nonwage earnings can have a disproportionate impact on the change in tax liabilities from year to year. This is partly because (1) nonwage earnings are more volatile than wages and (2) they accrue to higher-income taxpayers, who are subject to higher marginal tax rates (thus, their impacts on revenues tend to be proportionately greater). These factors are particularly true for capital gains, which in the past have risen and fallen by more than 50 percent from one year to the next. For these reasons, the outlook for nonwage income--and in particular, capital gains--is extremely important to the PIT revenue forecast and thus the state's overall revenue picture.

PIT Liabilities Have Soared in Recent Years

Figure 8 shows the changes in PIT liabilities reported on California income tax returns since 1992. It shows that after lagging in the early 1990s, PIT liabilities jumped by over 12 percent in 1995, and 13 percent in 1996 (despite the expiration of the temporary 10 percent and 11 percent marginal income tax brackets in that year). Based on our preliminary estimates for 1997, it appears that liabilities rose an additional 17 percent last year.

Capital Gains a Major Factor. The especially strong growth in PIT liabilities in recent years has reflected widespread increases in earnings. As indicated in Figure 9, wages increased at a solid pace in both 1996 and 1997. However, nonwage income--and particularly, capital gains--soared during this period. Based on preliminary tax return information, it appears that capital gains increased by 60 percent in 1996, accounting for more than $1 billion of the growth in overall state tax liabilities in that year. Based on the continued strength of estimated payments in 1997, we estimate that capital gains jumped an additional 30 percent last year.

Figure 9
Growth in California PIT Components

Subject to Taxation

1996 Through 2000
Income Component 1996 1997 1998 1999 2000
Wages 8.2% 7.4% 7.5% 6.0% 5.4%
Dividends 15.7 12.4 6.4 6.0 5.0
Interest 9.8 8.4 4.4 2.0 2.5
Business income 14.1 7.6 6.0 5.5 5.3
Capital gains 60.0 30.0 -10.0 0.0 5.0
Other 11.8 6.9 6.0 5.8 6.0
Totals, Adjusted Gross Income 11.5% 8.8% 5.8% 5.4% 5.4%

These increases in capital gains are partly related to the major rise in stock prices that has occurred over the past two years. This stock price appreciation has contributed to growth in capital gains reported by company shareholders and mutual fund investors. The stock market increases have also contributed to growth in earnings from stock options granted to employees of companies in California. We also believe that some of the 1997 strength in capital gains was related to the "unlocking" of gains that had been held in anticipation of the federal capital gains tax rate reduction, which was enacted last summer.

PIT Outlook--Slower Growth. Despite a positive outlook for California's economy generally, we are projecting a slowdown in the growth in PIT liabilities during the next three years. As indicated in Figure 8, we project that PIT liabilities will increase by between 5 percent and 6 percent during the next two years, or slightly more slowly than statewide personal income growth. This is in marked contrast to the past two years, when PIT liabilities grew by more than double the rate of statewide personal income.

Our projected slowdown in PIT receipts reflects two key factors:

Personal Income Tax Revenue Forecast. Based primarily on our forecast for PIT liabilities, we estimate that fiscal-year PIT revenues will be $26.6 billion in 1997-98, $27.8 billion in 1998-99, and $29.1 billion in 1999-00.

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