III Perspectives on State Revenues

Figure 6

Key Factors Affecting the Revenue Outlook

Strong 2000 Economy Boosting Current-Year Revenues

Economic growth in 2000 produced even more revenues than previously expected.

Major tax receipts in January were up by over $650 million from the budget forecast, due primarily to strong year-end capital gains, stock options, and bonuses.

But Weak 2001 Economy to Restrain Budget-Year Receipts

Slowing employment and income growth will adversely affect taxes attributable to 2001 economic activity.

Most of these effects will show up in 2001-02, when revenue growth is expected to taper to just 1.7 percent.

Net Effect—LAO's Two-Year Revenue Forecast Is Slightly Above the Administration's

Given the normal time lags between changes in economic activity and corresponding changes in tax payments, the majority (about two-thirds) of the revenue picture in the current year is related to economic activity that has already occurred in calendar year 2000, while a similar share of budget-year revenues will be related to economic activity in 2001. As indicated in "Part II," California experienced strong economic growth and cash receipts through the end of 2000, and this has contributed to our outlook for healthy revenue growth in the current year. In fact, year-end withholding and quarterly estimated tax prepayments received in January exceeded the budget forecast amount by over $500 million, suggesting that PIT liabilities in 2000 were even stronger than projected by the administration.

However, we anticipate that the economic slowdown projected for 2001, coupled with the expected decline in stock options and capital gains, will restrain growth in revenue receipts during the months ahead. Given the time lags between when tax liabilities are incurred and when payments toward these liabilities are received by the state, only about one-third of current year receipts will be affected by the 2001 economic slowdown. Thus, the predominate effect of the slowdown will be felt in 2001-02, when we expect revenue growth to fall to only 1.7 percent.

The LAO's Forecast For Major Revenue Sources

As indicated earlier, 94 percent of General Fund revenues are attributable to the state's three major tax-revenue sourcesthe PIT, SUT, and BCT. Below we provide a detailed discussion of the forecasts for these taxes and factors affecting their projected growth.

Personal Income Tax

The PIT is levied on taxable income attributable to California, with taxable income equaling total income minus various statutory exclusions, exemptions, and deductions. This taxable income is subject to a progressive marginal tax rate schedule, with the individual marginal rates ranging from 1 percent to 9.3 percent. Once a taxpayer's liabilities on this taxable income have been computed, various credits are applied to arrive at the final tax liability. In general, the state's PIT is patterned after the federal PIT and many of its provisions conform to federal PIT law.

The PIT Share of Total Revenues Has Increased Substantially

As shown in Figure 7, the share of total General Fund revenues attributable to the PIT has increased from about 38 percent in 1980-81 to nearly 57 percent in 2000-01. The share increased considerably throughout the 1980's economic expansion, retreated slightly during the early 1990's recession, and then soared during the second half of the decade. Between 1995-96 and 1999-00, receipts from this source increased at an average annual rate of 17.3 percent, or nearly three times as fast as statewide personal income growth.

Some of the increased PIT share merely reflects the interaction of strong California personal income growth and the state's progressive PIT
rate structure. However, the rapid growth has also been due to the stock market, which has contributed to major increases in capital gains and stock option-related income. As shown in Figure 8, these two sources grew from a combined total of about $25 billion in 1995 to $130 billion in 1999a more than five-fold increase. As a result of these increases, we estimate that capital gains and options together now account for more than one-third of total PIT collections. While gains in these sources are responsible for much of the state's strong revenue performance in recent years, their increased importance also adds an additional element of volatility and uncertainty to the state's revenue stream.

Current Outlook for Capital Gains and Stock Options Based on cash receipts through the end of 2000, we estimate that capital gains and stock option-related income grew by over 30 percent during 2000. This growth occurred even as the stock market's major indexes fell during the yearwith the NASDAQ down at year-end by more than 40 percent from the beginning of the year and by more than 50 percent from its March 2000 peak. It appears that many stocks were sold as investors and employees attempted to "cash out" gains that had accumulated in previous years. While this increased "profit taking" boosted gains attributable to 2000, the amount of "stored-up" gains that remain to be realized has correspondingly diminished. As a result, we are forecasting that revenues at tributable to these sources will fall by 15 percent in 2001, before rebounding by 9 percent in 2002.

Forecast for PIT Receipts. Based on the state's strong income and job performance through the end of 2000, we estimate that PIT revenues in the current year will total $44 billionan 11 percent increase from 1999-00. We expect revenue growth to subside in the budget year, however, with PIT receipts totaling $44.5 billiona marginal 1.3 percent growth rate. Thereafter, the subsequent rebound in economic activity is projected to boost PIT receipts in 2002-03 by 8.4 percent, to a total of $48.3 billion.

Sales and Use Tax

The SUT is the General Fund's second largest revenue source, accounting for slightly less than 30 percent of total receipts in 2001-02. The SUT actually is comprised of the following two separate levies:

• The largest is the sales tax, which is imposed on retail sales of tangible goods purchased in California. These include spending on such items as clothing, furniture, computers, electronics, appliances, automobiles, and motor vehicle fuel. Also included are business purchases of equipment and building materials. Most services are exempt.
• The use tax is imposed on products bought from out-of-state firms by California residents and businesses for use in the state. With the exception of automobile purchases (which must be registered), out-of-state purchases are difficult to monitor, and the state is prohibited under current federal law from requiring out-of-state sellers to collect the use tax for California. As a result, use tax receipts account for only a small portion of total SUT revenues.

Sales and Use Tax Rates

The total SUT rate levied on transactions subject to the tax is a combination of several different individual rates imposed by the state and various local governments.

State Rates. The main component of the overall SUT rate is the 5 percent General Fund rate (which in January was reduced to 4.75 percent for 2001 under the terms of 1991 sales tax trigger legislation discussed earlier). Also included are two 0.5 percent rates, whose proceeds are deposited, respectively, into (1) the Local Revenue Fund, which supports health and social services program costs associated with the 1991 realignment legislation and (2) the Local Public Safety Fund, which was approved by the voters in 1993 for the support of local criminal justice activities.

Uniform Local Rate. There is a uniform local tax rate of 1.25 percent levied by all counties (the so-called Bradley-Burns rate). Of this total, 0.25 percent is deposited into county transportation funds, while the remaining 1 percent is allocated to city and county governments for general purposes.

Optional Local Rates. The final component involves optional local tax rates, which local governments are authorized to levy for a variety of purposes. These taxes, which require local voter approval, are normally levied on a countywide basis, primarily for transportation-related purposes. They can be levied in 25 cent or 50 cent increments and cannot exceed 1.5 percent (except in San Francisco and San Mateo Counties).

Combined State and Local Tax Rates. The combined state and local SUT rate varies significantly across California, due to the optional local rates. As depicted in Figure 9, the combined rate currently ranges from 7 percent up to 8.25 percent (the latter for the City and County of San Francisco). No county currently imposes the maximum allowable SUT rate of 8.5 percent.

Taxable Sales Soared In 1999 and 2000 . . .

After several years of moderate growth, taxable sales jumped by 10 percent in 1999 and by about 11 percent in 2000the strongest back-to-back years in recent history. As shown in Figure 10, taxable sales increases in recent years have generally tracked growth in personal income, which peaked in 2000. The healthy gains experienced have also been due to high consumer and business confidence levels, as well as the "wealth effect" related to sharply rising stock market values.

The taxable sales increases experienced in recent years have been spread among many different industry categories, including major growth in auto sales, home furnishings, computers, electronics, and other durable goods. Also contributing to the growth has been strong business spending on investment equipment and in new facilities (important because building materials are subject to the SUT). In most cases, the taxable sales growth has reflected increased real spending as opposed to just price increases. Gasoline sales, however, are an exception, as price increases have been a key factor behind their taxable sales growth.

. . . But Will Slow Sharply In 2001 Before Rebounding

We forecast that taxable sales growth will slow sharply during 2001 before partially rebounding in 2002. Key factors behind the expected slowdown are the downturn in California's personal income growth, the effects of sharply reduced consumer and business confidence levels, and a partial reversal of the wealth effect (caused by declining stock market values). Recent sharp increases in energy costs and rents are also likely to cut into the budgets of lower-income and moderate-income households, thereby putting more downward pressure on their discretionary spending on taxable items. Finally, the sharp cutback in business investment plans will have a dual adverse effect in California. First, it implies less business-to-business sales of information technology products in the state. Second, it will also have impacts on the expansion plans of California's high-tech companies, which will reduce taxable sales of building materials.

We expect that consumer and business spending will rebound in line with overall California economic growth beginning in early 2002, leading to annual increases in taxable sales of 5.8 percent in 2002 and 7 percent in 2003.

Forecast for SUT Receipts. Based on our projections of taxable sales, we forecast that SUT receipts will increase from $21.1 billion in 1999-00 to $21.8 billion 2000-01, a 3.1 percent increase. This current-year estimate reflects the impact of the 2001 quarter-cent SUT rate reduction, as well as a diversion of $500 million in sales taxes on gasoline from the General Fund to a transportation fund.

We estimate that sales tax receipts in 2001-02 will total $23.2 billion, an increase of 6.6 percent. However, part of this healthy increase reflects a change in the accounting treatment of sales taxes used to support transportation programs. Specifically, under the terms of last year's budget agreement, the full $1.2 billion in sales taxes on gasoline will support transportation programsup from the $500 million noted above for the current year. The budget, however, is reflecting this commitment as an appropriation from the General Fund for transportation purposes, rather than as a diversion of sales taxes as is their treatment in the current year. Adjusting for this accounting change, the underlying increase in SUT receipts is a more modest 4 percent.

Bank and Corporation Tax

The BCT is levied at a general tax rate of 8.84 percent on California taxable profits. Banks and other financial corporations also pay an additional 2 percent tax, which is in lieu of most other state and local levies. Corporations that qualify for California Subchapter "S" status are subject to a reduced 1.5 percent corporate rate (but, in exchange, have their income for tax purposes "passed through" to their shareholders where it also is subject to the PIT). Approximately two-thirds of all BCT revenues come from multi-state and multi-national corporations, a share of whose income is apportioned to California based on a formula. California's BCT allows for a variety of exclusions, exemptions, deductions, and credits, many of which fully or partially conform to, or are based on, the federal BCT. Major examples include the research and development tax credit, and the ability of companies to carry forward a portion of any operating losses so that they can deduct them later on when they have positive profits.

Recent Profit Growth Has Been Erratic

During the current economic expansion, California taxable profits have performed erratically, jumping by 13 percent in 1997, falling by 1 percent in 1998, and then rebounding by roughly 8 percent per year in 1999 and 2000. During the past five years, profits have generally benefitted from strong sales and high rates of productivity growth. However, earnings within certain specific industries have been adversely affected by such factors as the Asian economic and financial crisis (which depressed high-tech manufacturing and banking profits in 1998), and industry restructuring involving banking, utilities, and telecommunications.

Earnings To Dip In 2001

We expect that the national and state economic slowdowns will cause corporate profits to decline in 2001 (see Figure 11). All industries will feel the impacts of slowing sales, as well as rising costs for compensation (particularly health care benefits) and energy. The slowdown in information technology-related sales will have a particularly significant negative impact on California's high-tech manufacturers and service providers. We look for profit growth to rebound in 2002, however, as cost pressures subside and sales improve.

Forecast for BCT Receipts. We forecast that BCT revenues will rise by 7.4 percent in the current year to $7.1 billion, largely based on the strength of profit growth through the end of 2000. We forecast that BCT receipts will decline slightly to $6.9 billion in 2001-02, primarily reflecting the profit decline expected for 2001, and then grow by nearly 10 percentto $7.6 billionin 2002-03 as profits rebound.

Outlook for Other General Fund Revenue Sources

The remaining 6 percent of General Fund revenues is related to a variety of sources, including the insurance, estate, tobacco, and alcoholic beverage taxes, as well as a variety of lesser sourcesincluding minor taxes, fees, interest earnings, and transfers from special funds.

We forecast that revenues from these other sources will total $4.7 billion in the current year, decline to $4.2 billion in 2001-02, and then partially rebound to $4.3 billion in 2002-03. The year-to-year comparisons of revenues from these other sources are affected not only by their underlying trends, but also by accounting changes affecting tobacco settlement funds and child support reimbursements, one-time asset sales, and certain other anomalies. Our forecast assumes modest growth in insurance and estate taxes receipts, but slight declines in collections from the tobacco taxes during the next three years. Pooled money investment earnings are expected to rise from $470 million in 1999-00 to $680 million in the current year (due to large investable General Fund cash balances), before falling back to about $450 million in 2001-02 and 2002-03.

The Budget Forecast for Special Funds Revenues

Special funds revenues support a wide variety of state and local government programs. As shown in Figure 12, about one-half of these revenues are related to motor vehicle-related taxes and fees. These include VLF revenues (which are distributed to local governments for general purposes) and fuel taxes and registration fees ( which support transportation-related projects). The other one-half of special funds revenues consist of certain SUT receipts; certain cigarette and tobacco tax revenues; and a variety of other taxes, fees, and interest earnings.

Special funds revenues are projected by the administration to total $16.8 billion in 2000-01 (a 7.4 percent increase from 1999-00) and $17.4 billion in 2001-02 (a 4.1 percent increase from the current year). Underlying these moderate increases are the effects of accounting and other changes implemented in prior years, as well as new changes proposed in the 2001-02 budget.

The large current-year increase in special funds SUT revenues is partly related to the one-time diversion of $500 million of General Fund sales taxes on gasoline to a transportation special fund. Finally, the major increase in other special funds revenues in 2001-02 is partly related to the budget's proposal to shift $468 million in tobacco settlement revenues from the General Fund to a newly created Tobacco Settlement Fund.