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

Perspectives on State Revenues

After falling sharply early in the decade, revenues are on the rise once again (see Figure 1). The administration assumes that General Fund tax receipts will increase by 8.7 percent in the current year and by 7 percent in 2005-06. These gains are indicative of a healthy expansion in profits, sales, and personal income in California. In this Part, we provide background information relating to the revenue outlook, discuss recent revenue developments, summarize the budget's revenue projections, and present our own revenue forecast.

The Budget's Forecast for Total State Revenues

The 2005-06 Governor's Budget projects that California's state government will receive nearly $107.6 billion in revenues during the budget year, a 7.3 percent increase from the current year. These revenues are deposited into either the General Fund or a variety of special funds. Figure 2 shows that:

• General Fund Revenues. About 78 percent of total state revenues are deposited into the General Fund. These revenues are then allocated through the annual budget process for such programs as education, health, social services, and criminal justice.
• Special Funds Revenues. The remaining 22 percent of revenues are received by special funds and are primarily earmarked for specific purposes, such as transportation, local governments, and targeted health and social services programs.

As the figure shows, some revenues, such as sales taxes, support both the General Fund and special funds.

Sources of General Fund Revenues. Figure 2 indicates that about 94 percent of total General Fund receipts are attributable to the state's "big three" taxes—the personal income tax (PIT), the sales and use tax (SUT), and the corporation tax (CT). The remainder are related to a variety of smaller taxes (including insurance, tobacco, and alcoholic beverage taxes), fees, investment earnings, and various transfers from special funds.

Recent and Proposed Revenue-Related Changes

Targeted revenue increases and related policy-related changes adopted with the 2004-05 budget will increase revenues by about $593 million in 2004-05 and $284 million in 2005-06. Figure 3 shows that the main provisions were a two-year suspension of the teachers' tax credit; a change in the application of the use tax on purchases of vessels, aircraft, and certain vehicles; and a tax amnesty program.

In 2005-06, the Governor's budget does not include any new state tax proposals. It would, however, eliminate the Senior Citizens' Property Tax Assistance Program and reduce the Senior Citizens' Rental Assistance Program. (These proposals show up as expenditure reductions for tax relief and are discussed in the "General Government" chapter of our Analysis of the 2005-06 Budget Bill.) The budget also proposes additional resources for tax compliance initiatives (see discussion in the shaded box), which are expected to generate about $104 million in additional receipts in 2005-06. Finally, it proposes to retain sales taxes on gasoline in the General Fund, instead of transferring them to transportation special funds, as required by current law.

The Budget's General Fund Revenue Outlook

Figure 4 shows the budget's revised estimate of General Fund revenues for the prior year and current year, as well as its forecast for 2005-06. (The revenue totals shown in this Part do not include the deficit financing bond proceeds used in 2003-04 or proposed in 2005-06. In "Part I," we display these proceeds separately in our estimates of the General Fund budget condition.)

Prior-Year Estimate. The budget estimates that 2003-04 General Fund revenues and transfers totaled $74.8 billion, a 4.8 percent increase from 2002-03. The administration's estimate is up $192 million from the level assumed when the 2004-05 budget was enacted.

Current-Year Estimate. The January mid-year forecast for 2004-05 assumes that General Fund revenues and transfers will be $78.2 billion, a 4.6 percent increase from the prior year. This is up by $968 million from the estimate in the 2004-05 Budget Act. The revision is the net result of two offsetting factors:

• The administration's forecast of revenues from the major taxes is up $2.2 billion, primarily reflecting much stronger-than-expected receipts from the CT, and more moderate gains from the SUT and PIT during the first five months of the fiscal year.
• In contrast, the new forecast assumes that nontax revenues associated with actions adopted in the 2004-05 budget will be down by roughly $1.2 billion. The reduction is due largely to (1) smaller-than-expected receipts from tribal gaming compacts and asset sales, and (2) a delay in the pension bond sale from 2004-05 to 2005-06.

2005-06 Forecast. The budget forecasts that General Fund revenues and transfers will be $83.8 billion in the budget year, a 7.1 percent increase from 2004-05. The major taxes are projected to increase by 7 percent, or about one percentage-point faster than statewide personal income.

The LAO's General Fund Revenue Outlook

Figure 5 shows our projections of General Fund revenues for 2004-05 through 2006-07. Our projections are based on our economic and demographic forecasts presented in "Part II" and reflect the impacts of the Governor's revenue-related policy proposals. Our revised estimates are significantly higher than the administration's forecast, mainly because of stronger-than-expected 2004 year-end tax collections.

Year-End Cash Trends Positive

Each year, the administration completes its economic and revenue projections sometime in early December—prior to when large year-end tax payments are due to the state. This is significant because the quarterly estimated payments due in December (from corporations) and January (from individuals) can fluctuate a great deal, and can provide an early indication of the strength or weakness in final payments that will be remitted in March and April.

As shown in Figure 6, prepayments from individual taxpayers were particularly strong near the end of 2004, increasing by over 35 percent from the previous year. The growth was about $500 million greater than assumed by the administration. Combined with smaller gains from other tax sources, the gains boosted cumulative cash receipts through late January to about $800 million above the administration's budget estimate.

Why the Strength? We believe that stronger-than-expected revenue gains are related to stock market-related capital gains and business earnings. To the extent that investment income and business earnings accrue to higher income taxpayers, the strength in these areas are subject to high tax PIT rates, and thus have a magnified effect on revenues. While the increases are welcome, they are also cyclical in nature, and thus may not fully continue into 2005 and beyond.

LAO Forecast

We project that revenues will exceed the administration's January budget estimates by about $1.4 billion in the current year and $766 million in 2005-06—for a two-year increase of $2.2 billion. Slightly less than $2 billion of the two-year gain is related to our estimate of higher tax receipts. The remainder is related to our inclusion of $294 million in Medi-Cal quality improvement fees. As discussed in more detail below and in the accompanying Analysis of the 2005-06 Budget Bill, the administration omitted these fee-related revenues from its estimates.

We specifically forecast that:

• In 2004-05, General Fund revenues and transfers will total $79.6 billion, a 6.5 percent increase from 2003-04. This is up $1.4 billion from the budget forecast, reflecting a $1.1 billion increase in the PIT and more modest gains from the other two major revenue sources. A partially offsetting factor is a $96 million reduction related to a transfer from the State Highway Account to the General Fund. The budget assumes this transfer in the current year. However, the federal government has informed the state that the transfer is in violation of federal law.
• In 2005-06, revenues and transfers will total $84.5 billion, a 6.2 percent increase from the current year. This is up $765 million from the budget forecast. About $530 million of the increase is related to our higher projection of tax receipts. The remaining $236 million is related to the quality improvement fees.
• In 2006-07, revenues and transfers will total $88.4 billion, an increase of 4.6 percent. Excluding the impact of recently enacted revenue measures (such as the two-year suspension of the teachers' credit), the underlying growth rate of major tax revenues is about 5.6 percent, or about the same as projected statewide personal income growth for the period.

The LAO's Forecast for Major Revenue Sources

As indicated above, the great majority of General Fund revenues are attributable to the state's three major taxes—the PIT, SUT, and CT. The performance of these taxes will have a major influence on the overall revenue outlook. In the following sections, we discuss in more detail recent developments and the outlook for each of these revenue sources.

Personal Income Tax

Background

We project that the PIT will account for 51 percent of total General Fund revenues in 2005-06. Although this share is significantly below the peak reached in 2000-01 (57 percent), the PIT remains by far the largest source of state General Fund revenues. In general, the PIT is patterned after federal law with respect to reportable types of income, deductions, exemptions, exclusions, and credits. Under the PIT, taxable income is subject to marginal rates ranging from 1 percent to 9.3 percent, with the top rate applying to taxable income in excess of $80,692 for joint returns in 2004 (and one-half of that for taxpayers filing single returns).

California PIT Liabilities Concentrated at High End of Income Spectrum

Over the past two decades, personal income in California has become increasingly concentrated. At the peak of the stock market boom in 2000, the top 5 percent of returns accounted for over 40 percent of adjusted gross income (AGI) reported on California personal income taxes. Under California's progressive PIT rate structure, these taxpayers accounted for over 70 percent of total PIT payments in the state. While these shares dropped following the stock market bust, the top 5 percent of taxpayers still account for over one-third of AGI and nearly two-thirds of PIT payments. The concentration of tax liabilities is significant because taxpayers at the top end of the income spectrum receive much of their income from such volatile sources as capital gains, stock options, and business earnings.

PIT Liabilities—History and Forecast

Recent History. Figure 7 shows the historical and forecasted levels of PIT liabilities. It shows that, after growing 8 percent in 2003, PIT liabilities jumped by a further 10 percent in 2004, the largest gain since 2000. The jump is nearly double the 5.6 percent increase in statewide personal income, as currently measured by the U.S. Bureau of Economic Analysis. The much larger gains in liabilities is likely related to strong growth in capital gains and business income. Business income is becoming an increasingly important component of AGI, as an ever-increasing number of companies file as S-corporations and limited liability corporations (whose income is largely taxable under the PIT—as opposed to under the CT).

Forecast. We forecast that PIT revenues will continue to expand during the next two years, but at rates that are more consistent with underlying growth in statewide personal income. The main reason for the slowdown is that the two cyclical sources that boosted PIT liability growth in 2004—capital gains and business earnings—are projected to grow more modestly in 2005 and 2006 than in 2004. Specifically, we forecast that:

• Business earnings growth will moderate from 12 percent in 2004 to about 5 percent in both 2005 and 2006, as business profit margins are restrained by slower productivity growth and higher wages.
• Capital gains and stock options-related income growth will slow from 25 percent in 2004 to just 4 percent in 2005 before partly rebounding to 5.5 percent in 2006. Our forecast assumes that slowing profit growth and slightly higher interest rates will restrain stock market prices during the next two years, which in turn will hold down capital gains and stock option income during the period.

The slowdown in the growth rates in the above sources will be partly offset by a modest acceleration in ordinary wages (that is, wages excluding stock option income) growth next year. We specifically forecast that wage growth will accelerate from 5 percent in 2004 to about 5.5 percent in 2005 and 2006 reflecting improvement in wage and salary employment growth in the state.

PIT Revenue Forecast

Based on our estimated changes in PIT liabilities, we forecast that fiscal-year PIT receipts will total $40.6 billion in 2004-05, $43.2 billion in 2005-06 and $45.7 billion in 2006-07. Compared to the budget forecast, our current projection of PIT revenues is up by $1.1 billion in the current year and by a more modest $305 million in 2005-06. Our large current-year gain reflects the positive year-end cash trends discussed above. Our relatively smaller gain in the budget year reflects our view that a portion of the current-year increase is due to cyclical factors (that is, above average growth in business profits and capital gains) and is thus "one time" in nature relative to the administration's forecast.

Sales and Use Tax

Background

The SUT is the General Fund's second largest revenue source, accounting for just under one-third of total revenues in 2004-05. The main SUT component is the sales tax, which is imposed on retail sales of tangible goods sold in California. Some examples of sales tax transactions include spending on clothing, furniture, computers, electronics, appliances, automobiles, and motor vehicle fuel. Purchases of building materials that go into the construction of homes and buildings are also subject to the sales tax, as are purchases of computers and other equipment used by businesses. Roughly 70 percent of the SUT is remitted by retailers, while the remaining 30 percent is directly paid by businesses who themselves consume or use the products being taxed. The largest exemption from the sales tax is for most food items consumed at home. The great majority of services are not subject to the sales tax.

The second component of the SUT—the use tax—is imposed on products bought from out-of-state firms by California residents and businesses for use in this 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 most 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.

SUT Rates

The total SUT rate levied in California is a combination of several different individual rates imposed by the state and various local governments. These include:

• State Rate. The basic state SUT rate is 6 percent. The largest single component is the 5 percent state General Fund rate. Also included in the overall state rate are two half-cent rates, whose proceeds are respectively deposited into (1) the Local Revenue Fund, which supports health and social services program costs associated with the 1991 state-local 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. This 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 their general purposes. Under the terms of Proposition 57, which was approved by the voters in March 2004, 0.25 percent of the Bradley-Burns rate is diverted to a special fund for purposes of repayment of the deficit-financing bond. (These diverted local sales taxes are replaced by a shift of property taxes from schools, which are in turn reimbursed by the state's General Fund. As a result of these various steps, state government is ultimately responsible for the bond's repayment.) The diversion of sales tax revenues will remain in effect until the bonds are paid off.

Optional Local Rates. The final overall SUT rate component involves optional local tax rates, which local governments are authorized to levy for any purpose. These taxes, which require local voter approval, are normally levied on a countywide basis—primarily for transportation-related purposes. They are generally levied in 0.25 percent or 0.5 percent increments and cannot exceed 1.5 percent in total (except in San Francisco and San Mateo Counties).

Combined SUT Rates. The combined state and local SUT rate varies significantly across California due to differences in the local optional rates that are levied (see Figure 8). The combined SUT rate currently ranges from 7.25 percent (for those counties with no optional rates) up to 8.75 percent (for Alameda County and the City of Avalon in Los Angeles County).

Taxable Sales Growth Accelerated in 2004

After falling in 2002, taxable sales started to rebound in 2003, and accelerated to an over 6 percent gain in 2004. As indicated in Figure 9, retail spending held up reasonably well during the recession and bounced back early in the ensuing recovery. In contrast, business-related sales were hit hard during the recession—as businesses sharply curtailed investment spending—and they took longer to recover.

By 2004, we estimate that both categories were on the upswing, and this balanced growth contributed to the largest gain in the overall total since 1999.

Outlook—More Moderate Growth in 2005 and 2006. Looking ahead, we believe that total taxable sales growth will moderate to 5.7 percent in 2005 and further to 5.4 percent in 2006. The main reason for the slowdown is our expectation that—like the rest of the nation—household spending in California will ease some due to high consumer debt levels and rising interest rates. In contrast, we expect business spending to continue at a solid pace during the next couple of years.

SUT Revenue Forecast

Based on our forecast of taxable sales, we project that SUT receipts will total $25.3 billion in 2004-05, $26.9 billion in 2005-06, and $28.2 billion in 2006-07. Compared to the budget forecast, our SUT revenue estimate is up $120 million in the current year, but down $97 million in the budget year. Our estimates take into account changes passed with the 2004-05 budget affecting the application of the use tax, as well as the proposed retention of "spillover" revenues in the General Fund.

Corporation Tax

Background

The CT is the third largest revenue source, accounting for 11 percent of total revenues in 2004-05. The tax is levied at a general rate of 8.84 percent on California taxable profits. Banks and other financial institutions subject to the CT 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. In exchange, the income and losses from these corporations are "passed through" to their shareholders where they are subject to the PIT. Similarly, businesses that are classified as Limited Liability Companies pay a fee at the corporate level and their income and losses are passed through to their shareholders, where they are subject to the PIT.

Approximately two-thirds of all CT revenues come from multistate and multinational corporations. These companies have their consolidated U.S. income apportioned to California based on a formula involving the share of their combined property, payroll, and sales that is attributable to this state. California's CT allows for a variety of exclusions, exemptions, deductions, and credits, many of which are similar or identical to those provided under the federal corporate profits tax. Major examples include the research and development tax credit and net operating loss carryforward provisions, whereby companies can use operating losses incurred in one year as a deduction against earnings in subsequent years. Under legislation enacted in 2002, corporations were not able to use these losses to offset their income during 2002 and 2003. However, such deductions were allowed again beginning in 2004, and the percentage of losses which may be carried forward and deducted against future taxes jumps from 65 percent to 100 percent beginning for losses incurred in January 2005.

Profits Soared in 2004

The key determinant of CT receipts is the strength of corporate profits reported on California tax returns by businesses. After falling in 2001 and most of 2002, California earnings rebounded in 2003 and then soared by over 20 percent in 2004 (see Figure 10). The recent boom reflects both intensive cost-cutting efforts by businesses throughout the economy, as well as a sharp rebound in sales and output last year. Profit growth was widespread, encompassing manufacturing, trade, services, real estate, and financial industries. The surge in oil prices also boosted earnings of refiners in the state.

Looking ahead, we forecast that taxable California corporate profit growth will slow significantly, to around 5 percent annually in each of the following three years. The more moderate increases projected for the next two years reflect (1) rising wage costs (as companies step up hiring), (2) a slowdown in productivity growth (as normally occurs as an expansion ages), and (3) a more moderate pace of economic expansion, which will result in more moderate gains in company sales and output growth.

CT Revenue Forecast

We forecast that CT receipts will be $8.9 billion in 2004-05, a 29 percent increase from the prior year, and $9.4 billion in 2005-06, a 5 percent increase. Our estimate for the current year is up by $250 million from the budget forecast, and our estimate for 2005-06 is above the budget estimate by $355 million.

Other Revenues and Transfers

The remaining 6 percent of total 2005-06 General Fund revenues and transfers consists primarily of taxes on insurance premiums, alcoholic beverages, and tobacco products. It also includes interest income and a large number of fees, loans, and transfers. We forecast that combined revenues from all of these other sources will fall from $7.5 billion in 2003-04 to $4.8 billion in 2004-05, and then rebound slightly to $5.1 billion in 2005-06. Of the annual totals, roughly $4.5 billion is related to ongoing taxes, fees, and interest earnings, and the remainder is related to various one-time factors. Key one-time factors include (1) $2.3 billion in 2003-04 associated with one-time proceeds of a tobacco securitization bond sale, (2) slightly over $600 million in 2005-06 from the assumed sale of a pension obligation bond authorized in the 2004-05 budget, (3) various other one time loans and transfers from special funds in each of the three years.

Quality Improvement Fees Omitted From Governor's Budget. The Legislature has approved three quality improvement fees on various health care service providers, thereby enabling the state to draw increased federal reimbursements. (This fee is discussed in more detail in the "Health and Social Services" chapter of the Analysis of the 2005-06 Budget Bill.) One of the fees has already been implemented and the budget assumes that the other two will receive federal approval in time for implementation in the budget year. The budget recognizes revenues from one of the proposed fees, but fails to recognize revenues from the other two—including one that has already been implemented. As a result, it has understated quality improvement fee-related revenues by $58 million in the current year and $236 million in the budget year. We believe that all three of the fees will be implemented, and thus have included the additional revenues in our estimates.

Estate Tax Phased Out. Our forecast includes the impact on the state of a provision included in the federal tax reduction package enacted in the spring of 2001 which is resulting in the phase out of revenues from California's "pick-up" estate tax. We specifically estimate that revenues from this tax will fall from $398 million in 2003-04 to $209 million this year, to zero in 2005-06 and thereafter.

The Budget's Forecast for Special Funds Revenues

Special funds revenues are related to a variety of sources:

• About $8.4 billion (or one-third of the budget-year total) is related to motor vehicle revenues. These include the vehicle license fee, which is in lieu of the property tax and whose proceeds are distributed to local governments, mostly for their general purposes. They also include fuel taxes and registration fees, which support transportation-related spending. 
• Another $4.3 billion is related to SUTs. Of this total, about $2.7 billion is used to fund health and social services programs that were realigned from the state to local governments beginning in the early 1990s, $1.4 billion is related to the diversion of local sales taxes for deficit-financing bond debt service, and about $275 million is used for transportation programs.
• About $920 million is from tobacco taxes that have been approved by voters in various elections.
• About $683 million is related to the PIT surcharge for mental health programs, which was approved by voters in November 2004.
• The remaining revenues are related to a wide variety of sources, including energy resource surcharge, beverage container redemption fees, and California State University fees.

Budget Forecast. As shown in Figure 11, the Governor's budget assumes that special funds revenues will total $22 billion in the current year (a 12 percent increase) and $23.8 billion in 2005-06 (an 8.2 percent increase). The large current-year increase is partly due to two key policy factors: (1) the diversion of about $1.3 billion of sales taxes to a special fund for repayment of the deficit-financing bonds approved by the voters in March 2004; and (2) a PIT surcharge for mental health programs. Ongoing revenues are expected to grow by roughly 4 percent, reflecting moderate increases in sales and vehicle registration taxes, and modest changes in most other taxes and fees.