Analysis of the 2005-06 Budget Bill Legislative Analyst's Office February 2005

Perspectives on the Economy and Demographics

Summary

Both the U.S. and California economies grew at a solid pace in 2004. As shown in Figure , U.S. real gross domestic product (GDP) expanded by 4.4 percent, the largest gain since 1999. Employment grew modestly despite continued cost-cutting and merger activity by businesses. Prices for oil and raw materials jumped during the year, but overall inflation accelerated only modestly. Looking ahead, we expect economic growth at both the nation and in California to slow some, but continue at moderate pace through the forecast period.

Recent U.S. Developments

Economic growth in 2004 was driven by a sharp acceleration in business spending and continued above-average gains in consumption. As indicated in Figure 2 :

• The fastest-growing category was nonresidential fixed investment, which jumped 9.9 percent (in inflation-adjusted terms). The increase was driven by healthy growth in spending on computers, software, and communications equipment. The rapid growth in investment spending benefited the many California businesses that are engaged in the production and sales of information technology (IT)- related products
• Consumer spending increased at a solid 3.9 percent inflation-adjusted rate, reflecting gains in purchases of home furnishings, clothing, and services.
• Government spending rose 1.6 percent during the year, reflecting 5.5 percent growth in federal purchases of military equipment, but a much smaller gain in state and local spending (0.2 percent).
• The trade deficit expanded by 20 percent during the year, as a healthy increase in exports was offset by an even larger rise in imports during the year.

Personal Income and Jobs Finally Improved

The current expansion has been characterized by intense competition and a major focus by businesses on reducing costs and finding efficiencies. Over the recent expansion period, these actions have boosted productivity gains, restrained inflation, and contributed to large increases in business profits.

At the same time, however, the intense focus on costs and efficiencies also translated into extremely slow improvement in labor market conditions through 2003, as businesses remained extremely reluctant to add to their payrolls. Economists had become concerned that the lack of hiring would eventually undermine consumer confidence, leading to a downward spiral in spending and output in the economy. However, these concerns eased once employment started to grow in 2004. The lack of stronger job growth remains a concern—for example, it was a factor cited for the decline in one key consumer confidence survey index in January. However, the continued strength in retail spending and home sales suggests that these concerns have not yet had a chilling effect on actual spending by households. (We more fully discuss recent productivity increases and their implications for the economy in the box on page 22.)

Oil Prices Soared, But Did Not Fuel Inflation

Inflation accelerated significantly in 2004, but the increase was relatively mild in view of the dramatic jump that occurred in energy and raw material prices. As indicated in Figure 3, growth in the U.S. consumer price index (CPI) rose from 1.8 percent in the first quarter of 2004 to 3.4 percent by the final quarter of the year. Much of the increase, though, was concentrated in the energy-related components. The CPI excluding the volatile food and energy categories (which is often referred to as the "core rate" of inflation) rose much more modestly during the year—from 1.3 percent to only 2.2 percent. The rapid growth in energy-related prices was largely absorbed by businesses and not "passed along" to customers in the form of higher prices. The lack of more widespread price increases was a welcome development. Higher inflation would have quickly translated into higher short- and long-term interest rates, which would have had damaging effects on housing and other sectors of the economy.

Recent Monthly Reports Suggest Continued Growth

Although high energy prices and the lack of strong job growth remain a concern to consumers, most recent indicators suggest that the economy is entering 2005 with significant momentum. For example:

• Retail spending jumped 1.2 percent between November and December, reflecting strength in sales of "big ticket" items such as automobiles and home furnishings. Department stores reported solid, if unspectacular, sales during the holiday shopping season. Over the full year, retail spending was up 8 percent, the largest gain since 1999.
• Housing starts jumped to over 2 million at an annual rate in December, bringing the full-year total to 1.95 million, the strongest since 1978.
• The Federal Reserve's "beige book" survey, which reflected business conditions from mid-November 2004 through early January 2005, found that business conditions remain solid throughout the country, with the pace of sales and orders in many regions accelerating late in the year. The survey also found that businesses planned to further increase hiring and capital spending in 2005.

California Trends

Because of data limitations, gross domestic product data are not reported on a current quarterly basis at the state level. (Currently, such estimates are available on an annual basis only through 2003.) Given the lack of current state-level output data, economists focus on the information that is available for jobs and personal income. In the current environment, however, the slightly weaker job growth in California is providing an incomplete picture of California's economic performance compared to the rest of the nation.

This is because while job growth is lagging slightly behind other states, a variety of other reports suggest that sales and output growth is probably exceeding the nation (see Figure 4). Specifically:

• Exports of products made in California jumped 23 percent in 2004, with quarterly levels approaching the all-time peak reached in 2000. The improvement reflects economic growth in several key foreign markets and the recent decline in the U.S. dollar on international currency markets, which make our products less expensive in foreign countries.
• Company sales and profits reports to shareholders indicate that California-based firms in a variety of industries enjoyed major growth in sales and profits during 2004.
• Tax receipts have been strong in recent months, particularly those related to business earnings. For example, quarterly estimated payments by corporations in the final six months of 2004 were up by 20 percent from the prior year. Withholding payments, which reflect wages, bonuses, and stock options, were up by 8.7 percent during the same time period.
• Permits for new home construction jumped to an annual pace of 237,000 units in November, the strongest monthly pace since 1988. Other real estate indicators point to continued demand, especially in the more affordable areas of the state. Sales of existing homes reached a 650,000 annual rate in November, the highest on record, and the median home price stood at $473,000, up 23 percent from November 2003.

One key to the divergent trends between jobs and other growth indicators is that the competitive pressures discussed earlier are extremely intense in California's high-tech industries. These trends are particularly evident in Silicon Valley, which continues to experience mergers, acquisitions, restructurings, and job cuts, even as sales and profits of its major companies rebound.

How Strong Is Job Growth?

A basic question related to California's economic picture is: Exactly how strong is employment growth? As shown in Figure 5, two surveys of employment are providing decidedly different pictures of employment strength in this state. Specifically:

• According to the payroll survey of employers, nonfarm employment increased about 1.1 percent (152,000 jobs) between December 2003 and December 2004.
• According to the survey of households, the job gain for the same period was about 2.3 percent (376,000 jobs).

While there is often some discrepancy between the two series, the current difference is much larger than normal. It may reflect the growth in use of independent contractors (which are picked up in the household survey but not in the payroll survey), and rapid job growth in newly created small businesses (which are often missed in initial payroll surveys and only appear after annual benchmark revisions). While the payroll series with its larger sample size is normally a better indicator of employment trends, the household series is presently more consistent with other measures of growth evident in California at this time.

Even the modest gain in the payroll series during 2004, however, is an improvement from the prior two years, when this series was showing job losses. The overall growth in payroll employment reflects a 4.8 percent year-over-year gain in construction, a 3.1 percent increase in businesses and professional services, and more modest increases in most other private sector categories. Government employment fell 0.7 percent, reflecting tight budgets at the state and local government levels.

Regional Picture—Bay Area Finally Stabilizing

California's job downturn during 2001 through mid-2003 was concentrated in the Bay Area. As shown in Figure 6, that region lost nearly 12 percent of its job base between 2001 and mid-2003, reflecting major declines in the high-tech industry. In contrast, job losses in Southern California were mild and the Central Valley continued to grow during the period. As Figure 6 indicates, the overall improvement in California's job picture is largely the result of (1) continued steady, albeit slow, growth in Southern California and the Central Valley and (2) the stabilization in the Bay Area's job market.

The Budget's Economic Outlook

The budget's economic forecast, which was prepared in early December, assumes that economic growth will ease some from the 2004 pace, but that growth will continue at a moderate pace in both 2005 and 2006. It assumes that jobs and personal income will accelerate as a result of a stepped-up pace of business hiring.

National Outlook

As shown in Figure 7, the budget forecasts that real GDP growth will slow from 4.4 percent in 2004 to 3.3 percent in 2005, and further to 3 percent in 2006. The administration assumes that both consumer spending and business investment will ease from the 2004 pace, as rising interest rates diminish home mortgage refinancing and the fiscal stimulus from the previous federal tax cuts fades. Finally, the forecast assumes that inflation will retreat from 2004 levels, as the result of less upward pressure from oil prices.

California Outlook

The administration's forecast also assumes that California's economy will expand at a moderate pace in both 2005 and 2006. It assumes that businesses will step up the pace of hiring, which will result in an acceleration in wages and jobs. It specifically projects that the state's personal income growth will accelerate from 5.6 percent in 2004 to 5.8 percent in 2005 and 6 percent in 2006, and that job growth (as measured by the payroll survey) will accelerate from 1 percent in 2004 to 1.8 percent in both of the subsequent two years.

LAO's Economic Outlook

Our economic outlook has changed only modestly since our November 2004 fiscal forecast. We continue to believe that economic output will slow some in 2005 from last year, but that the national and state economies will continue to expand at a moderate pace.

National Outlook

As shown in Figure 8, we project that real GDP growth will shift down from 4.4 percent in 2004 to 3.6 percent in 2005 and 3.3 percent in 2006. This reflects a slightly slower pace in consumer spending and business investment, partly offset by improvement in the foreign trade deficit. Specifically:

• Real consumer spending is expected to slow from 3.7 percent in 2004 to around 3 percent in 2005 and 2006. These increases are roughly in line with projected gains in real disposable income. The main factors behind the slowdown are high debt loads, less mortgage debt refinancing (as interest rates rise), and fading impacts from previous federal tax cuts.
• Real business fixed investment is forecast to ease from 10 percent in 2004 to 9 percent in 2005 and about 7 percent in 2006. The slight slowdown partly reflects the expiration of "bonus depreciation" provisions in federal law. These provisions allowed accelerated-depreciation deductions for equipment put in place through the end of 2004, and likely resulted in some acceleration in equipment spending late last year. The still-healthy gains projected for 2005 and 2006 reflect continued strong investment in IT-related equipment. They also reflect an improvement in spending on facility expansion and modernization, as businesses focus on meeting future increases in demand.
• The trade deficit is expected to peak in 2005 before starting to decline in 2006. The main factor behind the assumed turnaround is the weaker U.S. dollar against the Euro and other foreign currencies. The decline in the dollar should further boost exports by making U.S. goods less expensive on foreign markets, and depress imports by making foreign goods relatively more expensive in the U.S.

In other developments, inflation is forecast to ease some in 2005 and 2006, reflecting more stable prices for energy products, and modest increases in other categories. Solid (although slower) productivity growth and continued intense competition are also expected to restrain price increases in the forecast period. In this environment, we expect continued slow but steady increases in interest rates.

Other Elements of the U.S. Outlook

Oil Prices. After jumping from $35 per barrel at the beginning of 2004 to $55 per barrel in late October, oil prices fell back to below $45 in late 2004, before partly rebounding to near $50 as of late January. The price will continue to fluctuate in the months ahead, as updated reports of inventories, production, and demand are issued. However, we forecast the overall trend will be downward, with prices averaging around $40 per barrel by the end of 2005. Factors suggesting somewhat lower prices include (1) slowing worldwide economic growth, especially among major oil importers such as China and (2) increases in drilling and oil production. We would note, however, that the oil market remains quite vulnerable to supply disruptions and other factors.

Federal Policies. Federal policies had a stimulative impact on the economy in 2002 through 2004, as tax reductions were spent by consumers and increased federal defense purchases boosted growth in the aerospace sector. However, federal policies will become much less stimulative in 2005 and beyond, as the effects of tax cuts fade and financing of the deficit adds upward pressure on interest rates. Given that there is still plenty of liquidity in worldwide credit markets, we expect the upward pressure on interest rates to be modest in the near term. Although social security reforms that are being discussed could have significant effects on the economy, the timing and nature of these effects could vary widely, depending on policies that are eventually adopted.

California Outlook

We believe that overall sales and output growth of California firms will continue at a solid but moderating pace over the next two years, reflecting slowdowns in consumer and business spending. We expect that, while business earnings growth will ease, an accelerated pace of hiring will result in a modest increase in employment growth during the year. As shown in Figure 8:

• Personal income growth is projected to expand by 5.5 percent in 2005, or about the same pace as 2004. Compared to 2004, we expect income related to wages to accelerate modestly but earnings attributable to businesses to moderate.
• Payroll employment growth is projected to increase from 0.8 percent in 2004 to 1.5 percent in both 2005 and 2006. Compared to 2004, we project growth to accelerate in most industry sectors.
• Housing permits are expected to remain above the 200,000 unit pace in 2005 reflecting continued strong demand in moderate-priced regions of the state, before easing back in 2006 (see Figure 9).
• Nonresidential building permits are projected to grow modestly in 2005 and 2006, as businesses step up expansion plans.

Outlook for Individual Geographic Regions and Industries. We expect that employment growth will encompass all major economic regions in 2005 and 2006. In terms of industry sectors, we also expect growth to be broad-based, encompassing services, trade, finance, manufacturing, and construction. The one industry sector that will continue to lag is the combined state and local government sector, which will continue to be affected by difficult budget circumstances facing governments in California.

Gasoline Prices. We forecast that, while seasonal factors will likely push gasoline prices upward from their present levels in 2005, they will remain slightly below the peaks reached last summer. This forecast assumes that that (1) crude oil prices will remain below last year's levels and (2) serious shortages in California refinery capacity will not develop—whether from unexpectedly strong demand or refinery problems. These assumptions are obviously subject to major risks, and while the economy was resilient to energy price increases last year, substantially higher gasoline prices could have a more significant negative effect in 2005 and 2006.

Comparison to Other Forecasts

Figure 10 compares our forecasts for the nation and California to our November 2004 forecasts, as well as to a variety of other economic projections made in recent months by other forecasters. These include the projections made by the University of California, Los Angeles (UCLA) Business Forecast Project in December 2004, the consensus forecast published in the Blue Chip Economic Indicators (January 2005), the consensus outlook forecast in the Western Blue Chip Economic Forecasters (February 2005), and the 2005-06 Governor's Budget forecast.

Overall, there is not a great deal of variation among recent forecasts, with most outlooks calling for continued moderate economic growth. The figure shows that our updated forecast for the nation is similar to the consensus of forecasters polled in January by Blue Chip Economic Indicators. However, it is slightly higher than either the UCLA or administration's January projections. With respect to California, our forecast for personal income growth is modestly higher than the UCLA December projection, but slightly lower than the budget forecast.

Risks to the Outlook

The economic outlook is subject to numerous risks from both abroad and at home. One of the main near-term risks relates to further price increases for oil and other raw materials. In 2004, the economy was hit with sharply rising costs for these commodities. These increases did not, however, translate into a more generalized rise in inflation, as businesses were able to absorb the costs through offsetting efficiencies.

Our forecast assumes that the economy will not be beset by a second round of sharp price increases that would push prices for oil and raw materials to well above last year's levels. If such a shock were to occur—either from faster-than-expected growth in worldwide demand or from supply disruptions—it would be increasingly difficult for U.S. businesses to hold the line on their product prices. The result would be more inflation, higher interest rates, and weaker growth, particularly in the interest-sensitive sectors of the economy. The impacts could be particularly significant in California, where many individuals have financed recent expensive home acquisitions with large variable-rate mortgages. For these households, a rise in market interest rates would translate into substantial increases in monthly mortgage payments, leaving less funds for other purchases.

The Demographic Outlook

California's demographic trends both directly and indirectly affect the state's economy, revenue collections, and expenditure levels. For example, they influence the size of the labor force, the demand for homes and automobiles, the volume of taxable sales, and the amount of income taxes paid. Similarly, the population and its age distribution affect school enrollments and public programs in many other areas, such as health care and social services. Consequently, the state's demographic outlook is a key element both in estimating economic performance and in assessing and projecting the state's budgetary situation.

State Population to Approach 38 Million in 2006

Figure 11 summarizes our updated state demographic forecast. We project that California's total population will rise from an estimated 37.1 million in 2005 to 37.7 million in 2006, and 38.3 million in 2007. These population projections use as their starting point published 2000 Census data for California, and have not been adjusted to correct for issues related to potential undercounting (for a detailed discussion of the issue of undercount in the Census, see page 32 of The 2003-04 Budget: Perspectives and Issues).

Slight Slowing Projected. The state's population is projected to grow at an average rate of about 1.6 percent annually over the next three years. This is down slightly from the 1.7 percent average for the 2002 through 2004 period. Birth rates are forecast to stabilize at historically low levels, and net in-migration is projected to continue its modest downward trend.

In numeric terms, the number of new Californians being added each year—about 576,000 people—is well above the size of such cities as Long Beach, Fresno, and Sacramento, and very similar to such states as Wyoming.

Population Growth Components

California's population growth can be broken down into two major components—natural increase (the excess of births over deaths) and net in-migration (persons moving into California from other states and countries, minus people leaving the state for other destinations). The population growth associated with natural increase accounts for just over one-half of California's projected annual growth over the forecast period and is assumed to be fairly stable. Net in-migration accounts for the other roughly one-half of the growth over the period, but varies with California's economic cycle.

Natural Increase. We project that the natural-increase component will contribute an average of 316,000 new Californians annually over the forecast period. This reflects stable birth rates, but growth in the female population of child-bearing age groups.

Net In-Migration. The population growth associated with net in-migration is projected to continue its downward trend. This component dropped from 388,000 in 2001 to 284,000 in 2004, due to declines in net in-migration from both other states and other countries. The drop was partly related to California's economic downturn in the early part of this decade. We expect a modest partial rebound in domestic migration during 2006 and 2007, as the state's economy strengthens.

Growth to Vary by Age Group

The implications of demographic trends for the budget depend not only on the total number of Californians, but also on their characteristics. California is well known for having one of the world's most dynamic and diverse populations, including an increasingly rich ethnic mix and a large number of in-migrants. The state's age and ethnic mix is shown in Figure 12.

The age-related characteristics of California's population growth are especially important from a budgetary perspective, given their implications for such program areas as education, health care, and social services. Figure 13 shows our forecasts for both the percentage and numeric changes in different population groups. The 45-to-64 age group (baby boomers) continues to be the fastest growing segment of the population. About 919,000 new people are expected to move into this age category over the next three years, as the tail end of the baby-boom generation moves into its mid-40s.

Overall Budgetary Implications

California's continued strong population growth—including its age, ethnic, and migratory characteristics—can be expected to have many implications for the state's economy and public services in 2005-06 and beyond. For example, strong growth of the 45-to-64 age group generally benefits tax revenues since this is the age category that normally earns the highest wages and salaries. Alternatively, the below-average growth in the 5-to-17 age groups imply slower growth in K-12 school enrollments. More general examples of demographic influences include the following:

• Economic growth will benefit from an expanded labor force, due to a stronger consumer sector and the increased incomes that accompany job growth.
• However, overall demographic growth will also produce additional strains on the state's physical and environmental infrastructure, including demands on the energy sector, transportation systems, parks, and water-delivery systems.
• Similarly, the "graying" of the baby boomers will place strains on the state's health programs and related services, including the portion of Medi-Cal related to the elderly and disabled.
• The increasing ethnic diversity of the state's population will also mean that many public institutions, especially schools, will serve a population that speaks a multitude of languages and has a wide range of cultural backgrounds. Currently, for example, more than one-third of students in kindergarten and first grade are English language learners.