fiscal outlook 112013

8/13/2019 Fiscal Outlook 112013

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Legislative Analysts Of ce www.lao.ca.gov

Table of Contents

Chapter 1

Te Budget Outlook .................................................. 1Chapter 2

Te Economy and Revenues .................................. 11Chapter 3

Spending Projections ..............................................29


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Californias Fiscal Outlook

www.lao.ca.gov Legislative Analysts Of ce

Legislative Analysts Ofce

EducationJenni er Kuhn

Edgar CabralCarolyn ChuNatasha CollinsRachel EhlersPaul Golaszewski

Judy HeimanKenneth KapphahnJameel NaqviPaul Steenhausen

Health and Human ServicesMark C. NewtonShawn Martin

Ross BrownAmber Didier

Rashi KesarwaniLourdes MoralesGinni Bella-NavarreFelix SuRyan Woolsey

Legislative AnalystMac aylor

State and Local FinanceJason Sisney Marianne OMalley

Chas AlamoJustin GarosiSeth KersteinRyan Millera

Nick SchroederBrian UhlerBrian Weather ord

Corrections, Transportation, and EnvironmentAnthony SimbolBrian BrownDrew Soderborg

Ashley AmesAaron EdwardsAnton Favorini-CsorbaJeremy FraysseHelen KersteinSarah LarsonAnita LeeLia MooreJessica Digiambattista Peters

iffany Roberts

Administration and Information Services

Larry Castro

Sarah KleinbergKarry Dennis-Fowler

Michael GreerVu ChuDouglas DixonSandi Harvey

Izet Arriaga

Anthony Luceroina McGeeSarah ScanlonJim Stahley Jim Will

Support

a Forecast coordinator.


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Executive Summary

Forecast Reects Continued Improvement in Cali ornias Finances. In November 2012,

we projected that with continued growth in the economy and restraint in new programcommitments, the state budget could see multibillion-dollar operating surpluses within a ewyears. In 2013, the Legislature and the Governor agreed to a restrained state budget or 2013-14,and our orecast o state tax revenue collections has increased since last year. Accordingly, wenow nd that Cali ornias state budget situation is even more promising than we projected oneyear ago.

The Budget Outlook Under Current Policies, $5.6 Billion Projected Reserve at End o 2014-15. Te states 2013-14

budget plan assumed a year-end reserve o $1.1 billion. Our revenue orecast now anticipates$6.4 billion in higher revenues or 2012-13 and 2013-14 combined. Tese higher revenues are

offset by $5 billion in increased expenditures, almost entirely due to greater required spendingor schools and community colleges. Combined with a projected $3.2 billion operating surplusor the state in 2014-15, these actors lead us to project that, absent any changes to current laws

and policies, the state would end 2014-15 with a $5.6 billion reserve.

Future Operating Surpluses Projected. We assume continued economic growth in utureyears. In such a scenario, we project that, under current laws and policies, state General Fundrevenues will grow aster than expenditures through 2017-18, when the states projectedoperating surpluses reach $9.6 billion. Te states temporary personal income tax rate increasesunder Proposition 30 (2012) expire at the end o 2018, resulting in a more gradual ramping downo these revenues over the last two scal years o our orecast. Tis helps prevent a cliff effect inour orecast, as our projected operating surpluses remain stable at just under $10 billion per yearin 2018-19 and 2019-20.

Healthy Local Property ax Growth Important or State Finances. Proposition 98 undingor schools and community colleges is provided by a combination o state General Fund

spending and local property tax revenues. Troughout our orecast, healthy property taxgrowtha byproduct o the recovering housing markethelps moderate the growth o required


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www.lao.ca.gov Legislative Analysts Of ce

state General Fund spending on schools and community colleges. In addition to normalproperty tax growth, the states scal situation is helped by additional increases in schoolproperty taxes due to the dissolution o redevelopment agencies and the expiration o the triple

ip. Both o these actors play a signicant role in keeping annual state expenditure growthbelow revenue growth or much o our orecast period.

LAO CommentsContinued Caution Needed. Despite the large surplus that we project over the orecast

period, the states continued scal recovery is dependent on a number o assumptions that maynot come to pass. For example, our orecast assumes continuing economic growth and slow,but steady, growth in stock prices. As we discuss in this orecast, an economic downturn withinthe next ew years could quickly result in a return to operating decits. Further, the normal volatility o capital gains could depress (or boost) annual revenues by billions o dollars. Inaddition, our orecast assumes that the state repays liabilities with payment schedules set in

current law. Other liabilities, including some items on the Governors wall o debt and the stateshuge retirement liabilities (particularly those related to the Cali ornia State eachers RetirementSystem), remain unpaid under our orecast. I additional payments are made in the utureto repay these liabilities or to provide ination adjustments to universities, the courts, stateemployees, and other programs, the operating surpluses in our orecast would all signicantlybelow our projections.

A Strategic Approach to Allocating Operating Surpluses. Te states budgetary condition isstronger than at any point in the past decade. Te states structural decitin which ongoingspending commitments were greater than projected revenuesis no more. We orecastthat schools and community colleges will receive billions o dollars o new unding underProposition 98. Across the rest o the budget, the Legislature and the Governor now ace choices

or how to allocate projected multibillion-dollar operating surpluses. We believe the Legislatureshould be strategic in how to make such allocations, taking into account the inherent volatilityo the states revenue structure and uncertainty about the uture course o the economy. We offerone possible approach. In it, we suggest giving high priority to building a strong reserve andpaying off the budgetary liabilities accrued over recent years. We also believe the state shouldbegin setting aside unds to address the growing un unded retirement liabilities noted above.Finally, we also allocate amounts each year or the state to provide inationary increases orexisting programs and to create new commitmentswhether they be or program restorationsor expansions, tax reductions, or added in rastructure spending. Such an approach wouldwell position the state or the next economic downturn, while at the same time allowing orincremental commitments to meet other priorities.


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Chapter 1

Te Budget Outlook

Tis publication summarizes our officesindependent projections o Cali ornias

economy and budget condition. Specically,our budget orecast projects tax revenuesand expenditures rom the General Fundthrough 2019-20, including the Education

Protection Account created by Proposition 30.Our orecast is based on current state law and

policies, as discussed in the box on the nextpage. Tis is our rst state budget orecast toconsider 2019-20, the rst ull scal year aferexpiration o Proposition 30.

THE BUDGET FORECAST

Te Legislature will make decisions aboutthe states 2014-15 budget in the comingmonths. As shown in Figure 1, assuming no

change to current law and policy, we projectthat the state would have a $5.6 billion GeneralFund reserve at the end o the 2014-15 scalyear. Tis is the sum o a $234 million endingreserve or 2012-13, a $2.2 billion operatingsurplus in 2013-14, and a $3.2 billion operating

surplus or 2014-15. (Operating surpluses equala scal years revenues less that scal yearsexpenditures.)

Higher 2012-13 Revenues . . .Higher School Spending Required

Projected to End With a Small Reserve. Te2013-14 budget assumed that 2012-13 wouldend with a $254 million reserve. Our General

Fund revenue orecastor 2012-13 now projects

$1.65 billion in higherrevenues or 2012-13,compared to the budget

acts assumptions.Revenues or 2012-13ended stronger than wasassumed, principally dueto personal income tax(PI ) collections. Ourhigher revenue orecastresults in $1.75 billion

Figure 1

LAO Projections of General Fund ConditionGeneral Fund and Education Protection Account Combined (In Millions)

2012-13 2013-14 2014-15

Prior-year fund balances -$1,637 $852 $3,061Revenues and transfers 99,841 101,847 107,617Expenditures 97,352 99,639 104,436 Ending fund balance $852 $3,061 $6,242 Encumbrances 618 618 618 Reserve $234 $2,443 $5,624


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www.lao.ca.gov Legislative Analysts Of ce2

in additional General Fund expendituresunder the Proposition 98 minimum guarantee.Tat is, or every $1.00 o extra revenue, statespending or schools and community colleges

on average is projected to grow by $1.07. Tisis due to the manner in which the budget planmakes so called maintenance actor paymentsto schools and community colleges. Assumingonly minor changes in the entering undbalance, we estimate that 2012-13 ended with a$234 million reserve. While this small reserveequals only 0.2 percent o 2012-13 spending, itnevertheless would be the rst positive year-endreserve since 2007-08.

Projected 2013-14 Operating Surplus of$2.2 Billion

Te 2013-14 budget assumed the state wouldend the scal year with a reserve o $1.1 billion.

We now estimate that the reserve will more thandoubleto $2.4 billionprimarily as the netresult o the ollowing actors:

$4.7 Billion in Higher Revenues. Largelydue to a higher orecast o capital gainsand stronger-than-expected stock pricegrowth, our orecast o PI revenues or2013-14 is about $5.2 billion higher thanwas assumed in the 2013-14 budget. Tatincrease in revenues is partially offset

Basis for Our ProjectionsPurpose o Our Forecast. Tis orecast does not attempt to predict the budgetary decisions

that will be made by the states elected leaders. Rather, it is our offices best estimate o thestates scal condition i current law and current policies remain unchanged through 2019-20.In the near term, there ore, the purpose o this orecast is to provide the Legislature with ourbest estimate o the resources that will be available in next years budget deliberations. Beyond2014-15, the orecast aims to provide lawmakers with a general sense o the uture health o theGeneral Fund budget.

Uses Standard Economic Forecasting Practices. Economic conditions affect not onlytax revenues that the state collects, but also state spending levels. For example, the statesProposition 98 minimum guarantee or schools and community colleges is determined based onchanges in state revenues and economic actors. Further, state spending or health and humanservices tends to change along with actors such as unemployment, age, and income. Consistentwith other mainstream economic orecasts, our orecast assumes that the economy will growthroughout the orecast period. We do not presume that we can predict the timing o recessions.

Forecast Generally Based on Current Laws. Our estimates generally are based on currentlaws, including those in the State Constitution (such as the Proposition 98 minimum guarantee

or schools and community colleges), state statutes, and ederal law. In general, this means

that we assume taxes and programs operate throughout the orecast period consistent withcurrent law. For example, i state law authorizes a certain tax or program through only parto our orecast period, we generally assume that the law is allowed to play out and that the taxor program expires. For instance, our orecast assumes that the temporary taxes approved by voters in Proposition 30 will expire during the orecast period because it would take a utureaction either by the Legislature or by voters to extend those taxes.


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Legislative Analysts Of ce www.lao.ca.gov 3

Forecast Also Considers Certain Recent State Practices. In some cases, we have reliedon what has been recent state practice in orecasting revenues and spending. For example,although the states hospital quality assurance eewhich offsets General Fund Medi-Calcostsexpires in 2016, the Legislature has extended the ee three times since its initial adoption.In this case, we assume that the current state practice is to continue reauthorizing that ee.Similarly, trans ers to the Budget Stabilization Account, the states rainy-day und created byProposition 58 (2004), have been suspended each year since 2008-09. We assume those suspen-sions continue throughout the orecast period. Later in this chapter, we discuss how the statemight build a comparable reserve under an alternate scenario.

COLAs and Ination Adjustments Generally Omitted. Consistent with the state lawsadopted in 2009 that eliminated automatic cost-o -living adjustments (COLAs) and priceincreases or most state programs, our orecast generally omits such ination-related costincreases. Tis means, or example, that budgets or the universities have not been adjusted

or general price increases throughout the orecast period. We include ination-related costincreases when they are required under ederal or state law, as is common in health programs.

Many State Liabilities Remain Unpaid Under Current Law. In the case o state liabilitieswith repayment dates in state law, we generally assume those liabilities to be repaid accordingto schedule. For example, our orecast assumes that the decit-nancing bonds authorized

by Proposition 57 (2004) continue to be repaid under their established nancing mechanism.Other liabilities, however, are not required to be repaid by the state General Fund on any specictimeline under todays laws and policies. Tese include some o the items on the Governorswall o debt (a collection o various budgetary liabilities), along with un unded liabilities othe Cali ornia State eachers Retirement System. I the state were to make additional paymentstoward repaying these liabilities, the operating surpluses projected in our orecast would bereduced by like amounts.

by lower projections o sales and use tax(SU ) and corporation tax (C ) revenueso about $200 million or each o thesetwo tax sources.

$3.1 Billion in Higher General FundProposition 98 Spending. Most o theincreased spending in our orecast or2013-14 is or schools and communitycolleges. Specically, we estimate that theProposition 98 General Fund spendingwill be $3.1 billion higher than theamount provided in the budget due toour orecast o higher state revenues.

$0.3 Billion in Other Spending. Weestimate that other General Fundspending will be nearly $300 millionhigher than assumed in the 2013-14

budget. For example, in September 2013the Legislature passed Chapter 310,Statutes o 2013 (SB 105, Steinberg),which appropriated additional undingto address a ederal court order requiringthe state to reduce the prison population.We estimate that the Cali orniaDepartment o Corrections andRehabilitation will have net additionalspending o nearly $250 million in2013-14.


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Tese changes have the effect o increasing the2013-14 operating surplus rom the $817 millionassumed in the budget to $2.2 billion.

Projected 2014-15 Operating Surplus of$3.2 Billion

We project that the General Fund operatingsurplus in 2014-15 will be $3.2 billion, anincrease o about $1 billion rom our orecasto the 2013-14 operating surplus. Generally,the larger operating surplus is the result o our

orecast o revenues growing aster than ourorecast o expenditures. In 2014-15, we project

that General Fund revenues and trans ers willgrow 5.7 percent and that spending will grow4.8 percent. Specically, our orecast reects the

ollowing:

$5.8 Billion in Higher Revenues. While revenue growth is expected to besomewhat depressed in 2013-14duemainly to higher income taxpayersaccelerating 2013 income into 2012weexpect revenues to bounce back in2014-15, principally related to PIgrowth. Specically, we orecast PIgrowth in 2014-15 to be 8.1 percent ora year-over-year increase o $5.4 billion.Further, we orecast 2014-15 growth in

the C and SU to be 6.9 percent and3.3 percent, respectively.

$3.3 Billion in Higher General

Fund Proposition 98 Spending. Ourorecast o healthy revenue growth in2014-15 produces additional growth inProposition 98 spending. We estimatethat General Fund spending needed tosatis y the Proposition 98 guarantee willincrease $3.3 billion over our revisedprojection o 2013-14 spending levels.

$1.5 Billion in Higher Spending inOther Parts o the Budget. Outside oProposition 98, we orecast that spendingwill increase by $1.5 billion in 2014-15.Most notably, this includes increases o$630 million in debt service on in ra-structure bonds and about $600 millionin health and human services (excludingCali ornia Work Opportunity andResponsibility to Kids [CalWORKs]). Tehigher spending is offset by increasedsavings o $650 million related to adecision in the 2013-14 budget to redirectcertain realignment unds to help pay orwhat otherwise would be state costs orCalWORKs.

SURPLUSES PROJECTED TO GROW STEADILY

As shown in Figure 2, we project thatoperating surpluses will grow at a rate o betweenabout $1 billion and $3 billion each year between2014-15 and 2017-18, at which point we estimate

that they will reach $9.6 billion under current lawsand policies. As the temporary taxes authorized byProposition 30 phase out over several scal yearsnear the end o our orecast period, we project thatoperating surpluses will remain stable as revenuesand expenditures grow at similar rates. All thisis premised upon our assumption o continuingeconomic growth through 2020.

In the Near and Medium erm, StrongRevenue Growth. Proposition 30 increasedPI rates on high-income taxpayers rom 2012through 2018, and SU rates rom 2013 through

2016. Under our orecast, Proposition 30 greatlyinuences revenue growth, particularly in thecase o the PI . Because taxable income hasbeen growing aster or high-income taxpayers,by increasing the marginal PI rates on thoseindividuals, Proposition 30 has the effect oboosting PI growth higher than it would beotherwise. In 2014-15 and 2015-16, we orecast


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total General Fund revenues and trans ers togrow 5.7 percent in each year. We project revenuegrowth to slow thereafer to 4.6 percent in2016-17 and 4.3 percent in 2017-18, due largely

to the phase out o the -cent sales tax increaseauthorized by Proposition 30.

As Proposition 30 PI Increases PhaseOutMuch Slower Revenue Growth Forecasted.Under Proposition 30, the increase in PI rates

or high-income taxpayers generates a muchgreater proportion o revenue than the sales taxincrease. As a result, the phase out o the higherrates in 2018-19 and 2019-20 has a much moresignicant impact on revenue growth. Overthese two scal years, we project that GeneralFund revenues grow at an average annual rateo only 1.9 percent. As shown in Figure 2, thishas the effect o stabilizing the projected trendo annual operating surpluses, as revenues andexpenditures grow at similar rates in those twoyears. In act, the phase out o Proposition 30would have had the effect o reducing those

operating surpluses in 2018-19 and 2019-20, wereit not or projected property tax growth and theend o the triple ip, as described below.

General Fund Benets From Propertyaxes, End o riple Flip in Our Forecast. Te

Proposition 98 minimum guarantee is undedby two revenue streamsstate General Fundsupport and local property tax revenue distributedto schools. In most years, this local propertytax revenue offsets the amount that the statemust spend on schools and community colleges,resulting in dollar- or-dollar savings or theGeneral Fund. We project that in the later yearso our orecast increases in the Proposition 98minimum guarantee will largely be paid romschool property tax growth. Specically, whilewe project that General Fund Proposition 98spending will increase by 7.8 percent in 2014-15and 4.4 percent in 2015-16, we orecast it toslow thereafer to an average annual rate o just0.9 percent or the remainder o the orecastperiod. Te property tax-related actors include:

Operating Surpluses Projected Throughout Forecast Period

Figure 2

General Fund and Education Protection Account Combined (In Billions)

Carry-In Balance From 2013-14

Annual Operating Surplus

2

4

6

8

10

$12

2014-15 2015-16 2016-17 2017-18 2018-19 2019-20


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Healthy Local Property ax Growth. As described in Chapter 3, over the nextseveral years, we project underlying localproperty taxes to grow, on average, about

7 percent each year. Tis is consistentwith average historical growth, but abovelevels seen in recent years.

Increased Property axes Due toRedevelopment Dissolution. We projectthat school property taxes related to thedissolution o redevelopment agencies

(RDA) will increase rom $763 million in2013-14 to $1.9 billion in 2019-20. Tesestate savings will be offset somewhatby decreases in the revenues rom RDA

assets over the period. End o riple Flip. Finally, we project

that the triple ipa complex nancingmechanism created to repay the statesdecit-nancing bonds o the 2000swill turn off in 2016-17, resulting in anannual General Fund benet o about$1.6 billion beginning in 2016-17.

LAO COMMENTS2013-14 Budget Restraint Commendable

Forecast Reects Continued Improvementin States Finances. In our November 2012Fiscal Outlook report, we projected that withcontinued growth in the economy and restraintin new program commitments, the state budgetcould experience multibillion-dollar operatingsurpluses within a ew years. Since that time,our orecast o General Fund revenues and

trans ers has increased by a ew billion dollars or2013-14 and 2014-15, and by between $2 billionand $3 billion or each o 2015-16 through2017-18. In the June budget package or 2013-14,the Legislature and the Governor limited newcommitments to a small hand ul o areas. Tese

actors produce a budgetary situation or 2014-15that is even more promising than we projectedlast year.

Still, Continued Caution Needed

Surpluses Dependent on Several Key Assumptions. Despite the large reserve that weare projecting or the 2014-15 budget process, thestates continued scal recovery is dependent ona number o assumptions that may not come topass. Specically, our orecast assumes:

Continued Economic Growth. Ourorecast assumes steady, moderate

economic growth, typical o that seenduring a mature economic expansion.Tis growth drives the increase inrevenues and contributes to lowerGeneral Fund spending in some areaso the budget (such as CalWORKs grantpayments). Tis assumed economic

growth also in orms our orecast o localproperty tax growth, which as mentionedearlier offsets General Fund spendingrequired to meet the Proposition 98minimum guarantee. Economic growth,there ore, is probably the most importantassumption in our orecast.

Many Budgetary and Retirement Liabilities Remain Unpaid. As describedearlier, our orecast assumes that some

o the states budgetary and retirementliabilities are repaid. For example, weassume that the state increases paymentsto the Cali ornia Public EmployeesRetirement System (CalPERS) as requiredby the CalPERS board, which willreduce the states un unded liabilities

or state employee pension benets over


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time. Other liabilities, however, are notrequired to be repaid rom the stateGeneral Fund on specic timelines undertodays laws and policies. Tese include

some o the items on the Governors wallo debt, along with massive retirementliabilities related to the Cali orniaState eachers Retirement System. Iadditional payments are made in the

uture to repay these various liabilities,the operating surpluses in our orecastwould be reduced by a like amount.(Besides support rom the General Fund,other sources o unding rom schooldistricts and teachers, or exampleand

other policy decisions may be neededto address some o these liabilities overtime.)

Planning for a Possible RecessionRecession Possible During Forecast Period.

Like other economic orecasters, we are unableto predict the timing o either a major slowdown

in the economy or an actual recession. Teseverity o the most recent recession may resultin a longer-than-average economic expansion.However, it is possible that a recession will occur

be ore 2020. In act, the current U.S. economicexpansion is already over our years old. SinceWorld War II, the average expansion has been just under ve years.

Sketch o Hypothetical Recession. odemonstrate the budgetary effects o a possiblerecession, we have produced one hypotheticalrecession scenario, as displayed in Figure 3.We developed this scenario to simulate how amoderate recession could affect state nances,

but this is merely an illustration o one possiblescenariothe severity o an actual recessionsometime during the uture could be strongeror weaker than that portrayed in Figure 3. Inthe scenario displayed in Figure 3, revenues

all 10 percent below what our orecast wouldotherwise be or 2015-16, and then 15 percentbelow orecasted levels or 2016-17. Te revenue

Operating Deficits Return Under Hypothetical Recession Scenario

Figure 3

General Fund and Education Protection Account Combined (In Billions)

-3

-2

-1

0

1

2

3

$4

2013-14 2014-15 2015-16 2016-17


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losses would be offset somewhat by lowerProposition 98 minimum requirements, and weassume that the state would reduce spending tothe lower allowed spending levels. Specically,

the Proposition 98 minimum guarantee woulddecline 8 percent below what our orecast wouldotherwise be in 2015-16, and then 12 percentbelow or 2016-17.

Hypothetical Moderate Recession WouldProduce Operating Decits. In 2013-14and 2014-15, Figure 3 starts with the same$2.4 billion carry-in balance rom 2013-14and the same $3.2 billion operating surplus or2014-15 as under our standard orecast. Aside

rom the actors mentioned above, we assumethe same set o current laws and policies as underour standard orecast. As such, we assume thatno additional ongoing commitments are madein either 2013-14 or 2014-15 and that the entire$5.6 billion is effectively held in reserve. Underthis scenario, the state would ace a roughly$900 million operating decit in 2015-16, whichwould then grow to about $2.4 billion in 2016-17.

A $5.6 Billion Reserve Could Absorb DecitsUnder Hypothetical Scenario. As we mentionedearlier, this is merely a sketch o one hypotheticalrecession. Te severity o an actual recessionduring our orecast period could be strongeror weaker. Nevertheless, absent additionalongoing commitments, the $5.6 billion reservethat we project or the state budget by the end o2014-15 could more than absorb the combined$3.3 billion in operating decits over thetwo-year period o this hypothetical recession.On the other hand, i the entire $5.6 billion werecommitted to ongoing spending prior to 2015-16,under this scenario the operating decits wouldgrow by a similar amount (to perhaps $6.5 billionin 2015-16 and $8 billion in 2016-17), requiringthe Legislature and the Governor to address largebudget short alls. Tis illustration demonstratesthe importance o building a sizable reserve inpreparation or the next economic downturn.

Caution, there ore, is appropriate in weighingnew spending both within Proposition 98astotal unding or schools and communitycolleges would decline under this scenarioand

on the non-Proposition 98 side o the budget.Absent a prudent reserve, the Legislature couldwell ace during the next economic downturnsome o the same difficult decisions that it wasrequired to make during the past decade.

Allocating Operating SurplusesTe states budgetary condition is stronger

than at any time in the past decade. Te statesstructural decitin which ongoing spendingcommitments were greater than projected

revenuesis no more. Furthermore, assumingcontinued economic growth, the Legislatureand the Governor will have choices or howto allocate multibillion dollar surpluses. Our

orecast indicates that there is room in the budgetor new ongoing spending commitments. (Inact, Proposition 98 willrequire major additional

spending or schools.) But as discussed earlier,committing too much too soon could createbudget short alls in the event o an economicdownturn. Further, the state has commitments

that were made in the pastprincipallyretirement liabilities and, to a lesser extent,budgetary liabilitiesthat have yet to be unded.And the state in recent years has not providedmany o our existing programs with inationadjustments. As ination increasesas mayoccur in the next ew yearsit will be harderto ignore its limiting effects on purchasingpower or state programs. Figure 4 displaysone rough approach or using potentialsurpluses that prepares or the next economicdownturn while paying or past commitments,maintaining existing programs, and making newcommitments.

Preparing or the Next Economic Downturn.In our view, this is the most important categoryin Figure 4 during the early years o our orecast.Building a strong reserve and repaying some


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o our budgetary liabilities would enhance thestates scal condition in preparation or the nexteconomic downturn. In Figure 4, we suggestthe state aim or an $8 billion reserve in the

states Special Fund or Economic Uncertaintiesby 2016-17. (We chose a target o $8 billionbased on the size o the reserve envisionedby Proposition 58 [2004].) We suggest thatthe Legislature begin building this reserve bymaintaining the entire $2.4 billion carry-inreserve rom 2013-14 that we orecast. Giventhat we are nearly hal way through 2013-14, thestrategy or other categories in Figure 4 wouldbegin with the 2014-15 scal year. As discussedin Chapter 3, i the Legislature used all o the

additional unds that would be provided toProposition 98 in our orecast or 2012-13 and2013-14, along with hal o the growth in 2014-15,the state could retire at least three-quarters othe Proposition 98 obligations in the Governorswall o debt. In 2015-16, we show how the state

could begin to pay down the non-Proposition 98items in the wall o debt not already assumedto be repaid under our orecast, includingsettle-up payments to schools and community

colleges. Tis approach satises the dual goals o(1) building a strong reserve and (2) eliminatingthe budgetary liabilities be ore the temporarytaxes authorized by Proposition 30 expire at theend o 2018.

Paying or Past Commitments. While ourrecent scal orecasts have indicated a sharpturnaround in the states budgetary condition, wehave continued to highlight various retirementobligations that remain unaddressed. Most

notably, these include the $71 billion un undedliability or pension benets already earnedby the states teachers and administrators. TeUniversity o Cali ornias (UCs) pension planalso must continue addressing a signicant

unding issue, and state and Cali ornia State

Figure 4

An Approach to Using Possible Surpluses

General Fund and Education Protection Account Combined (In Billions) 2013-14 2014-15 2015-16 2016-17 2017-18a 2018-19a 2019-20a

LAO Operating Surpluses $2.4b $3.2 $5.6 $8.3 $9.6 $9.6 $9.8Prepare for Next DownturnBuild $8 billion reserve by 2016-17 2.4 1.9 1.9 1.9 Pay off remainder of wall of debtc 1.2 2.3 3.1 Pay for Past CommitmentsPay down unfunded retirement liabilities (CalSTRS,

retiree health, and UC pensions) 0.5 1.0 1.5 2.0 2.5 3.0

Maintain Existing ProgramsInation increases for various state programsd 0.4 0.6 1.2 1.8 2.5 3.2Create New CommitmentsProgram expansions, tax reductions, and infrastructure 0.5 1.0 1.5 2.0 2.5 3.0a Operating surpluses not entirely allocated in these years.b Reects projected year-end reserve of $2.4 billion.c Cost of paying off Governors wall of debt in excess of amounts already assumed in our baseline forecast. Includes Proposition 98 settle-up, deferred Medi-Cal costs,

June/July payroll deferral, and California Public Employees Retirement System deferral. Includes partial repayment of special fund loans and mandate reimbursements to citiand counties, as some of these amounts are assumed to be repaid in our baseline forecast.

d Cost of providing ination increases to state programs that are not assumed to receive such increases in our baseline forecast, such as UC, CSU, SSP grants, the judicialbranch, and California Department of Corrections and Rehabilitation. Amounts in 2014-15 and 2015-16 are net of recently negotiated employee compensation increases alreadassumed in our baseline forecast.CalSTRS = California State Teachers Retirement System; retiree health = other post employment benets (health and dental); and SSP = State Supplementary Payment.


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University (CSU) retiree health benets are notbeing unded as employees earn those benets.Te approach outlined in Figure 4 would commitan additional $500 million each year to address

these liabilities, which would result in $3 billiono total new annual unding or these liabilitiesby 2019-20. Even i the state provides this addedannual unding, additional payments rom otherunits o government and public employeesorother policy changeswould be required toaddress these un unded retirement obligationsover the next three decades or so.

Maintaining Existing Programs. Statelaws adopted in 2009 ended automatic

ination adjustments or many state programs.(Some programs are either exempt rom thisrequirement or must provide adjustments by

ederal rules.) I a programs budget is heldconstant over a given period, public services arein a sense reduced by ination or that period.Tis is because as the price o goods and servicesincrease over time, a xed dollar amount is ableto purchase less goods and services. Over thepast ew years, this has been a minor problembecause ination rates have been very low. Overthe next ew years, however, ination may returncloser to historical norms. When this occurs,there will be more spending pressures on state-

unded programs. Figure 4 shows the cost oproviding ination adjustments to programs thatdo not already receive such adjustments in our

orecast. Tese programs include UC, CSU, StateSupplementary Payment (SSP) grants, and the judicial branch. (Amounts listed in Figure 4 or2014-15 and 2015-16 are net o costs in recentlynegotiated pay increases or state employees.)

Creating New Commitments. Te Legislaturehas implemented billions o dollars in cutsover the past decade. Clearly, there is pentup demand or restoring some o those cuts,as well as creating new commitments. It isappropriate or the Legislature to begin debatinghow to prioritize the use o possible surpluses

or new commitments beginning in 2014-15.We estimate that the 2014-15 Proposition 98minimum guarantee will increase $6.4 billioncompared with the 2013-14 spending level.

Outside o Proposition 98, gradual spendingincreases would avoid overcommitting stateresources, thereby reducing the possibility o

uture budget imbalances in the event o aneconomic downturn. As a rough example, theapproach in Figure 4 provides $500 millionin new commitments each year above totalsalready assumed in our orecast or programrestorations/expansions, tax reductions, andin rastructure spending (including any uturebond authorizations, such as a water bond). By

2019-20, this would result in $3 billion or suchnew commitments.

Importance of Balanced StrategyOvercommitting Now Could Bring Back

Budget Short alls. Te states elected leaders havemade very difficult choices in recent years thatwere necessary to eliminate the states structuralbudget decit. Tese choices included reductionsin ongoing spending commitments, as well asthe temporary taxes authorized by the voters in

Proposition 30. Te states actions, combinedwith modest economic growth over the past ewyears, have put the state budget on the verge o apossible multibillion dollar surplus. Continuingto improve the states scal health will requirea balanced strategy o building reserves,retiring budgetary liabilities, and paying orpast commitments. Such a strategy would alsoallow our current programs to keep up withination and provide an opportunity to makenew program commitments. I , however, toomany ongoing spending commitments are madetoo soon, and a prudent reserve is not built upin the next ew years, the state budget could beunprepared or the next economic downturn. Inthat case the states elected leaders could be acedwith many o the same difficult choices that theywere orced to make over the past decade.


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Te Economy and Revenues

Chapter 2

THE ECON OM Y

Figure 1 (see next page) summarizes ourcurrent orecast assumptions or the U.S. andCali ornia economies between now and 2020.Our orecast assumes continuation o thecurrent economic recovery, but at a somewhat

aster pace than recent years. Te recovery isprojected to be driven by the ollowing key

actors:

Te recovery o housing markets(discussed later in this section).

Little or no additional scal contractionby the ederal government over the next

ew years and a gradual tightening omonetary policy by the Federal Reserve(also discussed in this section).

Improving job markets, accompaniedby a decline in national and stateunemployment rates.

Comparisons With Recent EconomicForecasts. Figure 2 (see page 13) comparessome key orecast assumptions or the U.S.and Cali ornia in 2013 and 2014 with thoseo some other recent orecasts by our office,the states Department o Finance, and theUCLA Anderson Forecast, a research effort othe UCLA Anderson School o Management.

All o these orecasts assumed the same threeactorsdescribed abovehelped uel this

recovery. In general, however, we now orecastsomewhat weaker economic growth or thenation and Cali ornia in 2013 and 2014, ascompared to our last orecast in May. Federalscal and tax policiesand, to a minor extent,the uncertainty resulting rom last monthsshutdown and debt ceiling debateseem tobe slowing economic growth somewhat in2013. (Signicant methodological changesaffecting the calculation o personal incomeand various other national and state economicdataespecially changes to state personalincome calculations implemented by ederaldata agencies in late September 2013makeit difficult to compare our current personalincome orecast to prior orecasts.)

While several key economic variablesare weaker than assumed in our most recent

orecast, stock prices were considerablystronger through early November 2013 thanour office assumed earlier this year. Tis hasimportant implications or the states personalincome taxes, which we discuss later in thisreport.

Te Possibility o a Future Recession. Arecession occurs when there is a signicant


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decline in economic activity that spreads acrossthe economy and lasts at least a ew months.Our economic orecast currently does notassume that a recession occurs between now and

2020, but o course, one is possible. Consistentwith other mainstream economic orecasters, wegenerally assume in our orecast the continuationo the current economic expansion cycle inline with projected long-term trends. In otherwords, like most economic orecasters, we do notpresume that we can predict the timing o uturerecessions or signicant economic downturns.

Te current, slow national economicexpansion began in June 2009. Since the Civil

War, the longest U.S. economic expansion lastedten years ( rom March 1991 to March 2001).Since World War II, the average U.S. economicexpansion has lasted just under ve years. Te

severity o the most recent recessionthe longestand deepest since World War IImay give riseto a longer than average economic expansionthat lasts well into the late 2010s or early 2020s.

In other words, with growth currently so slowand so many unemployed, it may be a whilebe ore the economy overheats again and thencontracts. On the other hand, recessions couldbe triggered by various causes that are difficult topredict (such as a terrorist attack or internationalconict), and there ore, a recession could occurat any time. In Chapter 1, or example, wediscussed how one uture, hypothetical recessionscenario might affect state nances.

Federal PolicyTe ederal government is the nations largestemployer and purchaser o health care services.It levies considerably more taxes than either

Figure 1

LAO Economic Forecast Summary

United States 2013 2014 2015 2016 2017 2018 2019 2020Percent change in: Real gross domestic product 1.5% 2.5% 3.2% 3.2% 3.1% 2.9% 2.8% 2.5% Personal income 2.8 4.7 4.9 5.2 5.4 5.1 4.8 4.5 Wage and salary employment 1.6 1.7 1.8 1.8 1.6 1.2 0.9 0.7 Consumer price index 1.5 1.6 1.7 1.9 1.9 1.9 1.9 2.0Unemployment rate 7.5% 7.1% 6.5% 6.0% 5.7% 5.4% 5.1% 5.0%Housing starts (thousands) 914 1,152 1,481 1,611 1,605 1,613 1,634 1,615 Percent change from prior year 16.7% 26.1% 28.5% 8.8% -0.4% 0.5% 1.3% -1.2%S&P 500 average monthly levela 1,637 1,780 1,850 1,930 1,992 2,055 2,128 2,203Average target federal funds rate 0.1% 0.2% 0.4% 2.2% 3.8% 4.0% 4.0% 4.0%

California 2013 2014 2015 2016 2017 2018 2019 2020Percent change in: Personal income 2.1% 5.4% 5.5% 5.5% 5.6% 5.4% 5.4% 5.2% Wage and salary employment 1.7 2.2 2.0 1.8 1.5 1.2 1.4 1.3

Consumer price index 1.5 1.6 1.7 1.9 1.9 1.9 1.9 2.0Unemployment rate 8.9% 7.8% 7.1% 6.5% 6.0% 5.7% 5.3% 4.9%Housing permits (thousands) 88 120 136 149 155 158 160 161 Percent change from prior year 50.4% 36.1% 13.9% 9.6% 3.7% 1.8% 1.3% 0.9% Single-unit permits (thousands) 40 61 68 76 78 79 78 78 Multi-unit permits (thousands) 48 59 68 74 77 79 82 84Population growth rate 0.8% 0.9% 0.9% 0.8% 0.7% 0.7% 0.7% 0.7%a Assumes S&P stock index remains fairly at at around 1,760, on average, from October 25, 2013 through March 31, 2014 and thereafter grows more slowly than the rate of

growth of nominal gross domestic product.


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state or local governments. Federal regulationsalso affect most parts o the economy. TeU.S. governments scal, policy, and monetarydecisions, there ore, affect virtually every

element o our economic orecast. Tis sectiondiscusses the effects o the October 2013 ederalgovernment shutdown and debt ceiling debates,how currently restrained ederal scal policyaffects our orecast, and our orecast assumptionsconcerning monetary policy.

Effects of Shutdown andDebt Ceiling Debate

Assumed Slowdown in Growth in Late 2013.wo key eventsthe partial shutdown o ederal

government operations in October 2013 anduncertainty about whether ederal leaders wouldincrease the governments maximum authorizeddebt levels (the debt ceiling)are believed tohave slowed U.S. economic growth during the

current quarter (October through December2013). Our offices economic orecastlargelydeveloped in the rst hal o October duringthe shutdownassumes that 2013 annual real

gross domestic product (GDP) growth is between0.1 and 0.2 percentage points lower than itotherwise might be due to the various negativeeffects o the shutdown and debt ceiling debate.(Other actions o the ederal government earlierthis yeardiscussed later in this sectionresulted in an additional drag on 2013 growth.)

Te main effects o the shutdown and debtceiling on economic growth may have been theloss o some economic activity and hiring by

ederal contractors during the current quarter,as well as increased consumer and businessuncertainty. Because the shutdown has affected

ederal economic data gathering (and is resultingin one-time changes to certain economic

Figure 2

Comparing LAO November Forecast With Other Recent Forecasts2013 2014

LAOMay2013

DOFMay2013

UCLASept.2013

LAONov.2013

LAOMay2013

DOFMay2013

UCLASept.2013

LAONov.2013

United StatesPercent change in: Real gross domestic product 2.0% 2.0% 1.5% 1.5% 2.8% 2.8% 2.8% 2.5% Personal income 2.8 2.8 2.6 2.8 5.1 5.1 5.1 4.7

Wage and salary employment 1.5 1.5 1.6 1.6 1.6 1.6 1.6 1.7Consumer price index 1.4 1.8 1.5 1.5 1.6 1.9 1.7 1.6

CaliforniaPercent change in: Personal incomea 3.3% 2.2% 3.8% 2.1% 5.9% 5.7% 5.7% 5.4%

Wage and salary employment 2.0 2.1 1.7 1.7 2.5 2.4 1.9 2.2Unemployment rate 9.3% 9.4% 8.9% 8.9% 8.3% 8.6% 7.9% 7.8 %Housing permits (thousands) 91 82 79 88 123 121 104 120a State and national personal income data, as well as U.S. gross domestic product and other federal data, now reect various methodological changes that were implemented

by federal data agencies during 2013. For state personal income data, for example, these changes began to be implemented at the end of Septemberafter both the LAO andDOF May forecasts, as well as the UCLA September forecast. State personal income forecasts in November and later, therefore, are not directly comparable to prior forecastIn addition, the LAO and DOF May personal income forecasts for 2013 assumed virtually identical levels of 2013 California personal income, but r eected different assumpabout the previous years level of personal income in the state.

DOF = Department of Finance; UCLA = University of California, Los Angeles Anderson School of Management Forecast.


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statistics or the month o October), it willtake some time be ore the effects o the ederaldebates can be known with a higher degree ocondence.

Shutdown and Debt Ceiling Deadlines Not Assumed to Affect Economy in 2014.Enactment o a continuing appropriations act onOctober 17 ensured that the ederal governmentavoided de aulting on debt or its other spendingcommitments until at least a ew weeks afer thenext ormal debt ceiling deadline: February 7,2014. As occurred this year, the U.S. reasurywill be able to use extraordinary measures inother ederal accounts to avoid de ault until a

ew weeks afer the February 7 deadlinelikelyuntil some point in March, a period during whichthe reasury typically sends out large amountso individual income tax re unds. Te act also

unds the ederal government until January 15at current spending levelsreduced earlier thisyear under the U.S. governments sequestrationprocess or automatic spending reductions.Accordingly, afer January 15, another partialgovernment shutdown is possible.

While these ederal deadlines create thepossibility o additional economic disruptionsin early 2014, our orecast assumes little or noeconomic slowdown next year related specicallyto those deadlines. Financial markets andmany other participants in the economy seemdesensitized to the recurring budget debates inWashington, and with the last shutdown, ederalleaders acted on a bipartisan basis to repay ederalworkers who were prohibited rom workingduring the period. (I such repayments occurredafer any uture shutdowns, the economic impactwould be minimized.) Our orecast assumption

or little or no economic effect next year due tothese ederal debateswill more likely proveto be correct i ederal leaders either come toagreement quickly on 2014 budget matters or passyet another continuing appropriations bill anddebt ceiling expansion in advance o the current

deadlines. I our assumption proves incorrect andthe 2014 deadlines result in additional drags oneconomic growth, various economic metricsGDP, personal income, employment, stock prices,

and other assumptionscould be negativelyaffected, and Cali ornias scal situation could beweakened to an unknown extent.

Forecast Could Be Affected by Major ax,Budget, and Other Policy Choices. Our orecastalso could be affected to the extent that ederalleaders come to agreement soon on some o themajor policy issues they have been discussing,including changes to the nations tax code,alterations to uture health and Social Security

benets, modications to the 2010 health care lawknown as the Patient Protection and AffordableCare Act (ACA), and changes to immigrationpolicies. Tese types o changes could affect various aspects o the economy in signicantwayseither positively or negatively.

Spending on health care makes up 18 percento U.S. GDP. Implementation o the ACAwill affect many decisions by businesses andemployers, state and local governments, insurancecompanies, and health care providers. Both ourstate spending and economic orecasts contain various assumptions about health care costsin uture years. It is likely that the signicantchanges resulting rom the new law will result ineconomic changes that differ rom those assumedin mainstream orecasting models, such as thosein our orecast. Tis will affect both the U.S. andCali ornia economic orecasts in the utureeither positively or negatively.

Restrained Federal Fiscal PolicyTe U.S. government runs annual budget

decits in most years. It issues sovereigndebtU.S. reasuriesto the investing publicand to certain government accounts (such as theSocial Security trust und) to und those decits.Te annual budget decits and total federal debt each are expressed as a percentage o GDP in any


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given year. Currently, the annual budget decito the ederal government totals about 4 percento GDP, and total ederal debt held by the publictotals 73 percent o GDP.

Shrinking Recently, Decits Expected toGrow in the Future. In recent months, as a resulto various ederal tax and spending actions, theend o spending or recession stimulus programs,and the recovery o the economy, the ederalgovernments annual budget decits have shrunkconsiderably rom 10 percent o GDP in 2009to roughly 4 percent o GDP now. Health careination also has been slowing, contributing tolower annual decits. Te Congressional Budget

Office (CBO) estimates that decits woulddecline urther under current ederal policies to2 percent o GDP by 2015. Decits are orecast togradually rise again thereafer due to projectedincreases in interest rates (which increasesinterest costs on the national debt), spendingpressures resulting rom the nations rapidlyaging population, and continued ination inhealth care costs. According to the CBO, thesegradual increases in decits could take total

ederal debt held by the public to near-recordlevelsaround 100 percent o GDPby the late2030s. As its sovereign debt levels rise, the U.S.economy and ederal budgets could become more vulnerable to economic shocks. For example,the ederal government could be less able to rundecits, as it did in recent years, to aid state andlocal government nances during recessions.

Federal Fiscal Policy Has Slowed the RecentEconomic Recovery. In the past ew years, ederalscal and policy decisions have slowed the rateo U.S. economic growth. In September, MoodysAnalytics, an economic advisory rm, estimatedthat the drag on the economy rom (1) recentsequestration and other ederal spending cuts,(2) increases in payroll taxes, (3) increases intaxes on high-income earners, and (4) other scalactions that went into effect this year is reducing2013 real GDP growth by about 1.5 percentage

points. Tis ederal scal policy drag is greaterthan in any other year since the de ensedrawdown that ollowed World War II, accordingto that rm. Other estimates vary. I , however,

one assumes that the Moodys analysis is correct,this would mean that, i ederal scal policywere economically neutral (producing no scaldrag), our orecast might be or real GDP growthin 2013 o about 3 percentroughly double thelevel o economic expansion we are currentlyprojecting.

Forecast Assumes No Additional MajorFederal Fiscal Restraints. With the ederalsequestration policy scheduled to ramp up in the

coming months, it appears that the economicdrag rom ederal scal restraint is approacingits peak, assuming no urther substantialincreases in taxes or decreases in spending inthe near term. Our orecast assumes that ederalpolicymakers act in the coming months to relaxthe currently scheduled sequestration cuts abit or example, by reducing scheduled de ensecuts. For ederal scal year 2014, the orecastassumes a ederal budget slightly higher than the$967 billion or annually appropriated domesticand de ense programs that was approved by theHouse o Representatives. Federal spending is

orecast to grow in uture years at less than therate o nominal GDP growth. Our economic

orecast also assumes the gradual elimination oextended unemployment insurance benets overseveral years, rather than having them disappearentirely in 2014.

Budget Adjustments Will Affect FutureEconomic Growth. Tere is general consensusthat the ederal government will have toimplement scal and/or tax policy changes toreduce its debt levels in uture decades. Tere are,however, substantial disagreements over whenand how such changes should be implementedand on the size o such adjustments. As CBOhas noted, ederal leaders ace trade-offs indeciding how quickly to implement policies


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to moderate the uture growth o ederal debt.For example, to reduce projected ederal debtin the late 2030s to about 70 percent o GDP,the combination o increased revenues and

decreased spending would have to equal about1.9 percent o GDP per year i implementedbeginning in 2025, rather than 0.9 percent oGDP per year i implemented beginning in 2014.(Tose simulations omit the effects that decitsand debt would have on economic growth andinterest rates. Incorporating such effects wouldmake the impact o delaying policy changes evenlarger, CBO says.) o the extent that these policychanges affect the overall economy, economicgrowth or Cali ornia and the nation may slow in

the uture, relative to past trends.Monetary Policy Expected to TightenGradually

Accommodative Monetary Policy Still inPlace. In September 2013, the Federal Reservesurprised many nancial market participantsby opting to keep in place its current monetarypolicy or the time being. Tat policy involvesboth short-term interest rates (specically,the ederal unds rate) o near zero and

regular purchases by the Federal Reserve oboth mortgage-backed and longer-term U.S.reasury bonds. Tese purchasesknown as

quantitative easingare intended to maintaindownward pressure on long-term interestrates, support mortgage markets, and generallyboost the slow economic recovery. At the sametime, ination remains very low, such that theFederal Reserves Open Market Committeehas noted that ination persistently below its2 percent objective could pose risks to economic

per ormance.Forecast Assumes Gradual ightening o

Monetary Policy. As the economy expands,gradual tightening o ederal monetary policy islikely. Our orecast assumes that taperingthegradual elimination o the Federal Reserves bondpurchase programsstarts in late 2013 or early

2014. Further, the Federal Reserve is expected tokeep its near-zero ederal unds rate target untillate 2015, when the U.S. unemployment rate isassumed to decline to about 6.5 percent. In the

later years o our orecast, the ederal unds rateis assumed to rise again to around 4 percentin 2017. (Te ederal unds rate was last above4 percent in January 2008.)

HousingBy most measures, the recent collapse

o Cali ornias housing market was morewidespread and severe than downturns inother parts o the country. From the peak othe market in 2006 and 2007 to the low point

during the housing crisis, a key measure ohome values suggests that they ell about50 percent. Te median home sales priceacommon measure that is inuenced by whichhomeowners choose to sellplummeted rom apeak o $600,000 to $245,000. Over roughly thesame period, Cali ornia shed nearly 1.4 million jobs, a contraction o 9 percent. For many, theinteraction o these two declines represented anunprecedented shock to household net worthand monthly nances. Households have slowly

repaired their balance sheets since then whilehome prices, especially since early 2012, havemade up substantial lost ground. In this section,we discuss housings role in the Cali orniaeconomy, recent trends, and our orecast ohousing activity.

How Does Californias Housing MarketAffect the Economy?

Te housing market affects the economyin three major ways: household net worth,

migration trends, and construction activity.First, rising home prices improve homeownersnancial standing, ofen leading them to increasespending. On average, each dollar increase inhome values leads to a three-cent increase inspending. By contrast, each dollar decline inhome value leads to a 10-cent reduction in otherspending. Trough this channel, home prices


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affect consumption o goods and services, whichhas ripple effects throughout the economy.Home prices also affect migration trendsthatis, where people decide to live and work. For

example, a localized increase in house pricesbeyond what occurs in the rest o the countrymakes residing in Cali ornia comparativelymore expensive, resulting in a negative effect onpopulation growth. Te nal way housing pricesaffect the economy is more indirect. Rising pricesencourage new construction. An increase inconstruction jobs typically spurs job growth inother sectors that are dependent on local demandsuch as retail and restaurants.

Although construction activity andemployment are crucial to the states near-termprospects, construction itsel cannot sustain alocal economy over the long-term. Tis is becauseeconomic growth, including demand or newhousing, relies on increased overall income in anarea. Tis, in turn, can be spurred by such sectorsas manu acturing and technology, which sellproducts in national and international markets,thereby capturing outside income.

Recent Trends: Is the Housing MarketReturning to Normal?

Cali ornias housing sector improved broadlyduring 2012 and the rst hal o 2013. Oneyear ago, we noted that a sustainable housingrecovery appeared imminent. Afer losingground throughout 2011, Cali ornia single-

amily home prices have climbed 25 percent.Tough initially led by the states coastal areas,home price appreciation is now widespread,with year-to-date increases that exceed 8 percentin each o the states 28 metropolitan regions.Tese gains indicate healthy housing demand,but also help to mend household balance sheetsas price appreciation boosts homeowner equity.Equity improvements reduce the number ounderwater homeowners, whose outstandingmortgage balances exceed the value o their

homes and should, albeit slowly, increasethe inventory o homes up or sale (a criticaltransition i the housing market is to normalize).Tough strong price increases come as

com orting news or many homeowners, we viewthe pace o the recent gains as having more todo with short-term supply constraints than withunderlying growth in the states economy.

Why Have Home Prices Grown So Quickly? In the short-term, job growth and wage gainsboost demand or single- amily housing, puttingupward pressure on prices. Higher prices tend tocompel more owners to put their homes on themarket. Te supply o additional homes absorbs

existing demand, causing price increases to slowor stop altogether. In step with an improvingeconomy, the demand or housing increasedin early 2012, yet the supply o homes did notrespond accordingly. Instead, short-term actorslimited the number o available homes, drivingprices up 25 percent since January 2012. Tese

actors include:

Cash Investors. Nationwide, 6 millionowner-occupied single- amily homesconverted to rental units over the courseo the housing crisis. In most o thesecases, investors purchased distressedhomes in cash and converted them torentals, sometimes purchasing hundredso homes at one time. In Los Angeles,cash purchases as a portion o all homesales increased rom 5 percent in 2005to 34 percent in May 2013, the largestincrease in the country. Other areas oCali ornia have similarly high all-cashsales rates. Investor demand pushedprices upwarda help ul boost ormany distressed areas o the statebutalso contributed to reductions in theinventory o owner-occupied homes orsale, which, as shown in Figure 3 (see nextpage), has contracted signicantly sinceJanuary 2012.


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Strategic Sellers. Te supply o homes orsale depends primarily on the eagerness ocurrent homeowners to sell. Short suppliesindicate a general unwillingness or aninability to sell. Unwilling owners maywait to list their homes so as to benet

rom expected upward price trends,especially as price gains are accelerating.A national survey o homeowners romearlier this year ound that only 25 percento owners elt it was a good time to sell(whereas two-thirds agreed it was a goodtime to buy), a sign that potential sellersare waiting. On the other end, more than15 percent o Cali ornia homeownersremain underwater on their homes. Tismeans some would-be sellers are unable todo so, keeping a sizable share o the stateshousing stock off the market.

Cautious Homebuilders. Responding torising home prices, construction activityhas begun to improve. Authorizedsingle- amily permits, the rst step inconstructing a new home, increased rom

less than 15,000 in the rst seven monthso 2012 to more than 21,000 in the rstseven months o 2013. Tough large inpercentage terms, this gain representsa historically small response relative tothe price increases seen over the sameperiod. (For comparison, the rst sevenmonths o 2002 saw 72,000 single- amilypermits.) In our view, it appears thatsingle- amily homebuilders, and, perhaps,their lenders, have remained cautious,wary that increased supply in the shortterm could dampen prices, threateningthe protability o newly constructedhomes. Restricted credit, as well asland-use and development constraintsin some areas, also may be holdingback some new construction. Untilhomebuilding quickens, home demandwill not be tempered much by new homeconstruction.

Latest Data Suggest Home Prices AreDecelerating to More Normal rends. Recentprice gains appear to be decelerating. Rising

Home Inventories Have Fallen Significantly

Figure 3

2

4

6

8

10

12

14

Less Than $300,000 $300,000 - $500,000 $500,000 - $750,000 $750,000 - $1 Million More Than $1 Million

Historical Average

Number of Months Needed to Sell All For-Sale Homes, if Current Number of Sales Per Month Continues

January 2013

September 2013


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mortgage rates and expanding inventories havelikely contributed to this deceleration. Interestrates on a 30-year xed rate mortgage haveclimbed 1 percentage point since May, equating

to a 15 percent increase in the monthly paymenton a $200,000 loan. In turn, increased mortgagecosts have cooled housing demand. In August andSeptember, home inventories expanded or therst time in a year. Tese data in orm our homeprice orecast or 2014, which is described below.

Looking Ahead: Housing Strength Expectedto Normalize

We view the pace o recent price gains asunsustainable, and accordingly expect housing

inventories to expand as more homeowners eel itis a good time to sell, as cash investor purchasesdecline, and new housing construction begins toratchet up, each o which should absorb existingdemand and there ore slow price increases. In

particular, we expect home price growth todecelerate signicantly, to 7 percent in 2014. Weproject that construction activity, responding torecent price and rent increases, will post strong

gains in 2014 (as shown in Figure 4). In 2014, weorecast residential housing permits to increaseby 31,000 units to 120,000 permits total. Permitsare projected to increase to 136,000 units in 2015be ore stabilizing around 160,000 units annuallyby the end o our orecast period. Compared topast years, multi- amily unit permits are projectedto make up a larger portion o newly constructedhousing stock. Our residential permits orecasthas been lowered notably since our prior orecast,released in May 2013, due primarily to our

lower expectation or new single- amily homeconstruction. We caution, given the sizable shifstaking place in todays housing market, that actualprice gains and construction activity in the comingyears could vary widelyeither above or belowour offices orecast over the next ew years.

Residential Construction Projected to Return to Normal Levels

Figure 4

25,000

50,000

75,000

100,000

125,000

150,000

175,000

200,000

225,000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Multi-Family Permits

Single-Family PermitsProjected


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Figure 5 summarizes our November 2013multiyear General Fund revenue orecast.

In June 2013, the Legislature approved the2013-14 Budget Act . Te State Constitutionrequires the Legislature to determine the revenueestimates underlying each annual budget, sothat the budget meets the requirements or abalanced budget in Proposition 58 (2004). Indeveloping the 2013-14 budget, the Legislatureconsidered both our offices May 2013 revenue

orecast, as well as the May 2013 revenueorecast o the administration. Compared to the

administrations orecast, our offices May 2013orecast projected $3.2 billion more in General

Fund revenues and trans ers across the threescal years (2011-12, 2012-13, and 2013-14), dueprincipally to our higher assumptions or capitalgains-related personal income taxes in 2013and 2014. Te Legislature and the Governoragreed to base the 2013-14 budget plan on theadministrations May 2013 revenue orecast.Figure 6 compares our November 2013 revenue

orecasts by scal year with those assumed in the2013-14 budget.

Higher Revenues Now Projected, Comparedto 2013-14 Budget Assumptions. Our officesprojections or General Fund revenues in

2011-12, 2012-13, and 2013-14 combined haveincreased since May by over $3 billion. As shownin Figure 6, we now project that General Fundrevenues and trans ers or 2011-12, 2012-13, and2013-14 combined will be $6.4 billion higherthan the amounts assumed in the 2013-14state budget plan. For 2012-13, state collectionsexceeded orecasts. For 2013-14, most o theincrease in our orecast since May results romhigher assumptions concerning capital gainsand some other categories o taxable incomeattributable largely to higher-income personalincome tax (PI ) lers. Our increased capitalgains assumptions result primarily rom strongerstock market and real estate market per ormancesince May.

Personal Income TaxPI Collections Running Stronger Tan

2013-14 Budget Act Forecast. In 2012-13,revenue collections were stronger than projectedby either our office or the administration in May2013. Trough the end o October, 2013-14 PI

estimated paymentstied in large part to capitalgains and business incomehave exceededthe administrations monthly projections by34 percent. Several key PI payment datesremain during the scal year, but to date, the

Figure 5

LAO November 2013 Revenue ForecastGeneral Fund and Education Protection Account Combined (In Billions)

2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20

Personal income tax $65.0 $66.0 $71.4 $75.9 $79.6 $83.2 $82.9 $84.1Sales and use tax 20.5 22.8 23.6 24.9 25.4 25.8 27.0 28.2Corporation tax 7.7 8.3 8.9 9.5 10.1 10.6 11.2 11.8 Subtotals, Big Three taxes ($93.2) ($97.1) ($103.8) ($110.3) ($115.1) ($119.6) ($121.1) ($124.1)

Insurance tax $2.2 $2.2 $2.3 $2.4 $2.5 $2.6 $2.7 $2.8Other revenues 2.7 2.3 1.9 1.9 1.8 1.8 1.8 1.8Net transfers and loans 1.7 0.3 -0.4 -0.8 -0.4 0.2 0.3 0.3 Totals, Revenues and Transfers $99.8 $101.8 $107.6 $113.8 $119.0 $124.2 $125.8 $128.9

REVENUES


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available in ormation suggests that PI revenuesare running considerably stronger than wasassumed in the budget act.

Uncertainty remains, however, given that 2012income tax collections were elevated or a varietyo reasons, as discussed below, and preliminarytax agency data on what was reported on 2012 PIreturns will not begin to be made available until a

ew weeks rom now. (Final tax agency data relatedto 2012 returns will not be available until severalmonths rom now.) Moreover, the per ormance othe stock market has been much stronger than ouroffice assumed in May, and stock per ormance inthe coming ew weeks will affect 2013 capital gains

to some extent. Uncertainty also results rom thestates complicated revenue accrual methodologies,which move some PI and other revenues romone scal year to a prior one or budgetaryaccounting purposes. We discuss accruals in thebox on the next page.

Key Forecast Trends2012-13 PI Collections Were Elevated . . .

PI collections grew substantially in 2012-13due to voters approval o Proposition 30, largeone-time withholding payments related to

the initial public offering (IPO) o stock byFacebook, Inc., and one-time accelerations o various types o income in 2012 by high-incometaxpayersespecially accelerated realizations

o capital gains. (Such accelerations o incomeallowed some taxpayers to avoid higher ederaltax rates that went into effect or some in 2013.)For tax year 2012, by our offices estimation,capital gains seem to have produced slightlyover $10 billion o revenue or the statearound15 percent o the current annual PI base. Wenow estimate that 2012-13 PI revenues willend higher than the levels projected in both theLAO and administration May 2013 orecasts.Specically, our current estimate o 2012-13 PI

revenues$65 billionis $1.1 billion above the2013-14 Budget Act assumption, which was basedon the administrations May 2013 orecast.

. . . Which Means PI Growth to Be MuchSlower in 2013-14 . . . In our May 2013 orecast,we projected that PI collections would all by0.2 percent in 2013-14an unusual assumptionsince PI revenues typically all only in recessionyears. Because so much income was accelerated

rom 2013 to 2012 to avoid higher ederal taxes,we assumed that net capital gains realizations by

Figure 6

Comparing LAO November 2013 Revenue Forecast With2013-14 Budget Act Forecast(General Fund and Education Protection Account Combined, in Millions)

2012-13 2013-14

2013-14Budget ActForecast

LAONov. 2013Forecast Difference

2013-14Budget ActForecast

LAONov. 2013Forecast Difference

Personal income tax $63,901 $65,030 $1,129 $60,827 $66,002 $5,175Sales and use tax 20,240 20,482 242 22,983 22,809 -174Corporation tax 7,509 7,669 160 8,508 8,278 -230 Subtotals, Big Three taxes ($91,650) ($93,181) ($1,531) ($92,318) ($97,089) ($4,771)

Insurance tax $2,156 $2,249 $93 $2,200 $2,163 -$37Other revenues 2,641 2,664 23 2,249 2,254 6Net transfers and loans 1,748 1,748 331 342 10 Totals, Revenues and Transfers $98,195 $99,841 $1,646 $97,098 $101,847 $4,749 Note: Our ofces current 2011-12 revenue estimatesincorporating, as best we can, the net nal payment accrual methodology for Proposition 30 and 39 revenues and other

budgetary revenue accrual practices of the stateare $21 million higher than assumed in the2013-14 Budget Act .


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Cali ornia residents would all by 30 percent in2013, affecting both estimated payments in late2013 and January 2014. Since May, however, theper ormance o the stock market has exceededour prior assumptions. While we continue toassume a large drop in net capital gains realizedby Cali ornia taxpayers in 2013, our capital gains

assumption or that year is now a ew percentagepoints higher than it was in May. Moreover,our 2014 capital gains assumptionwhich alsoaffects 2013-14 PI collectionshas risen by over10 percent, given the recent growth in stock prices.Our new orecast also assumes stronger growth

or PI withholdingrevenue collections that

Legislative Action Needed to Oversee Complex Accrual ProcessPrior-Year Revenue Estimates Now Change or at Least wo Years Tereafer. As the

2014-15 budget process begins, we think it is important to emphasize that, under the new

net nal payment accrual process authorized in recent annual budgets or Proposition 30revenues, personal income tax revenues essentially are still changing or 2011-12. As we under-stand the accrual process, 2011-12 revenue estimates should keep changing until at least May2014, given that estimates o 2012 capital gainsa key driver o Proposition 30 revenues orthat yearwill change until at least that point in time, as tax agencies review and sample orstatistical purposes more and more 2012 tax returns. otal 2012-13 revenues will change untilMay 2015, and so on. Even as legislators make budget decisions and weigh various uncertaintiesabout 2013-14 and 2014-15 revenue and spending, they may know less than ever be ore aboutthe previous two scal years budget results and the state budget reserves remaining there rom.We acknowledge that our revenue estimates may be too high or too low by hundreds omillions o dollars per yearor, in some scenarios, over $1 billion per yeardue simply to the

challenges we ace in making projections concerning this complex part o the budget process.

Revenue Calculations Will Affect Future Budgeting. I the administration ollows its pastpractice, it will not display in its 2014 budget publications up-to-date estimates o 2011-12revenues based on these accrual changes. Based on past practice, 2011-12 revenues wouldhave been closed in 2013. Any changes to prior-year revenuesofen minor under pastaccrual policieswould be listed, along with many expenditure reconciliations, as changesto the incoming General Fund balance. I the administration sticks to this past practice, theLegislature will lack complete, transparent access to in ormation that would be important tobudgetingespecially in ormation that will help them decide whether Proposition 98 obliga-tions have been appropriately estimated.

We recommend that the Legislature require the administration to display publicly orbudgetary decision-making purposes the adjusted prior-year revenue amounts included in itsadjustments to the incoming General Fund balance. Such prior-year revenue changes shouldbe incorporated in all historical documents related to state revenuesotherwise, the reliabilityo that historical data could decline signicantly. Finally, we recommend that the Legislaturerequire the administrationat least once a year on its websiteto describe in plain Englisheach o the calculations used to move revenue rom one scal year to a prior year via the accrualprocess.


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result mainly rom Cali ornians wage income.Tis assumption seems more consistent withrecently strong year-over-year PI withholdinggrowth (afer adjusting or the one-time

withholding payments resulting rom theFacebook IPO in October 2012). Afer accountingor accruals, we now orecast that 2013-14 PI

revenues will rise by 1.5 percent to $66 billion.Tis is $5.2 billion above the amount assumed inthe budget approved in June.

. . . And PI Should Bounce Back in 2014-15.Te acceleration o large amounts o revenue

rom 2013 to 2012 articially depresses growthin PI revenues in 2013-14. Accordingly, both

our offices orecast and the administrationsorecast have projected that the growth rate orPI revenues will bounce upward in 2014-15. Inthis orecast, we project that PI revenues growby 8 percent to $71 billion in 2014-15.

2015-16 and Beyond. Our orecast assumesroughly 5 percent average annual growth in PIrevenues between 2015-16 and 2017-18. Tis rateo annual growth is consistent with what wewould expect in a mature economic expansionsuch as that assumed in our multiyear economic

orecast through 2020accompanied by somegrowth in stock and house prices. We thenproject much slower growth in 2018-19 and2019-20 due primarily to the expiration oProposition 30s higher PI rates or high-incometaxpayers at the end o 2018. Tis means that thePI revenue loss rom Proposition 30s expirationwill not occur all at once, but instead will bespread over those two scal years. We nowproject that PI revenues will all by 0.4 percentin 2018-19 to under $83 billion be ore rising by1.4 percent in 2019-20 to $84 billion.

PI Revenues Make Up Bigger Percentageo General Fund Tan Ever Be ore. Prior to therst scal year affected by Proposition 30, thePI s share o total General Fund revenues andtrans ers had exceeded 60 percent only onceatthe end o the dot-com bubble in 2000-01.

We are now projecting that PI revenueswill comprise two-thirds o total GeneralFund revenues in 2014-15the highest suchpercentage recorded to date in Cali ornia history.

Proposition 30with its temporary marginal taxrate increases or high-income householdshasincreased PI revenues recently. Te percentageo the budget paid or rom PI revenues also hasrisen recently due to other tax policy changes.Specically, the shif o a portion o the statessales and use tax (SU ) rom the General Fundto local realignment accounts and a ew otherchanges have reduced the percentage o theGeneral Fund paid rom other revenue sources,thereby increasing the share o the General

Fund paid by the PI . Finally, the amount otaxable income received by the top 20 percento taxpayers has, in real terms, grown much

aster than the amounts or middle-income andlower-income taxpayers in recent decades. Asthese higher-income taxpayers pay the highestmarginal tax rates, the increasing concentrationo income in that group tends to generatesignicant growth in PI revenues over time.

Our orecast projects that PI will maintainthat two-thirds share o annual General Fundrevenues. (As our orecast assumes a airlymodest level o capital gainscompared tothe size o the economyin uture years, thisamount could be higher in particularly strongcapital gains years, and it could be weakerwhen capital gains are very low.) We note,however, that the proportion o the GeneralFund supported by PI revenues likely would begrowing even i Proposition 30 were not in effectdue to more income concentration among thehighest-income taxpayers and the other actorsdescribed earlier.

The Stock Market and Capital GainsHigher Stock Market Driving Higher PI

Projections in the Near erm. Te change romyear to year in the states net capital gains hasproven over time to be closely correlated with


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changes in stock and house prices, as well asstock trading volume. Recently, both stock andhouse prices have been growing rapidly. Ouroffices May 2013 orecast assumed that the

S&P 500 index remained close to its May 14, 2013level o 1650 through the rest o 2013. As oOctober 25, when we nalized our economicassumptions or this orecast, it closed at 1760(7 percent above our prior assumptions). Tis isthe key reason or the higher capital gains in our

orecast in the near term and a major reason orour higher orecast o 2013-14 PI revenues.

Stock Market Valuations Near Historical Norms. In general, key stock market valuation

metricssuch as the price-to-earnings (PE)ratio or the S&P 500are in line with historicalnorms. Some such metrics are somewhat abovenorms, and some are below. We note, however,that PE ratios are considerably below the levelsexperienced during the dot-com bubble, whenCali ornians net capital gains realizationspeaked as a percentage o personal income inthe state at 10.6 percent. Our orecast assumesthat net capital gains total 5.9 percent o personalincome in 2012, 4.3 percent in 2013 (lower dueto the income accelerations described earlier),and 6 percent in 2014. Tis incorporates anassumption that stock prices remain stableator near their October 25 levelthroughMarch 2014. Tereafer, we assume that stockprices grow slower than the overall growth othe U.S. economy, which results in net capitalgains alling to 4.4 percent o personal incomeby the end o our orecast period in 2020. Tis

orecasting assumption is intended, in thecontext o the economic expansion we assumethrough 2020, to keep stock prices near historicalnorms throughout the period.

Volatile Stock Prices Certainly Cannot BePredicted With Precision. Because PI is thestates largest revenue source, and a signicant, volatile portion o that tax is generated romcapital gains on the sales o stocks and other

assets, every orecast o Cali ornias public nancesmust reect an assumptioneither explicit orimplicitabout the direction o the stock market.Our orecasting methodology attempts to use

the most realistic assumptions possible aboutstock per ormance in the near term and, to theextent that these assets seem overpriced relativeto historical norms, to bring them closer to thosenorms over time. Currently, there is not clearevidence that stocks are overpriced signicantlycompared to those norms. Accordingly, weassume stable stock prices in the near term andmodest growth thereafer.

Nevertheless, over any given orecast period

even the next ew quartersstock prices can beexpected to differ rom any set o assumptions.Tey may be lower in some periods, and theymay be higher in others. Tis volatilityas wellas undamental changes in stock prices thatoccur during bull and bear marketsmay causeactual capital gains to differ signicantly romany orecast. In the near term, or example,annual PI revenues can be $2 billion higheror lower than orecast based on differingcapital gains results alone. (Other orecastingdifferences could produce additional changesin revenues.) State leaders should consider allo this in ormation when making budgetarycommitments and determining the level onancial reserves or the state to have at anygiven time.

Sales and Use TaxEstimated General Fund SU revenue totaled

$20.5 billion in 2012-13, about $240 million higherthan the amount assumed in the 2013-14 budget.

In 2013-14, we expect SU receipts to increaseby 11 percent to $22.8 billion (about $170 millionbelow the 2013-14 budget assumption). Teprojected growth in 2013-14 reects (1) the

ull-year effect o Proposition 30s temporaryone-quarter cent SU increase and (2) projectedgrowth in underlying taxable sales o 6.9 percent.In 2014-15, we orecast SU revenue to increase


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by 3.3 percent to $23.6 billion. Tis lower revenuegrowth is largely due to the new tax credit

or manu acturing equipment established byChapter 69, Statutes o 2013 (AB 93, Committee

on Budget), which begins in 2014-15. (Underlyingrevenue growththat is, without the impacts othe creditis 5.4 percent, in line with projectedgrowth in taxable sales.) Projected SU revenuesthen increase by 5.6 percent in 2015-16 be oregrowing more slowly over the ollowing twoyears as the one-quarter cent Proposition 30SU increase expires at the end o 2016. Revenuegrowth stabilizes towards the end o our orecast,closely tracking projected growth in taxable sales.

Housing Permits Play a Major Role in theSales ax Forecast. Te main determinant oSU receipts is taxable sales. For a variety oreasons, taxable sales and housing permits tendto move together, making housing permits ause ul economic indicator or orecasting taxablesales. House construction generates some taxablesales directly (through purchases o constructionmaterials and othergoods), but it also actsas a proxy or consumercondence, which isdifficult to measuredirectly. As a result,housing permits canaccount or year-to-year variation in taxable salesthat cannot be explainedby variation in personalincome or nationwideretail sales. For taxablesales and housingpermits, we projectsignicant growth rom2012-13 to 2013-14 andslower growth thereafer.Specically, we expecttaxable sales to growabout 7 percent in2013-14 be ore alling

to below 5 percent later in the orecast period.Similarly, we expect housing permits to grow by36 percent rom 2013 to 2014, with slower growthin later years.

2011 Realignment and Other Local Salesaxes. Roughly hal o Cali ornias sales tax

revenue is distributed to counties, cities, andspecial districts through various mechanisms,including the unding stream established tosupport the 2011 realignment plan. Some actorsthat affect the growth in state General Fundsales tax revenuesuch as the Proposition 30quarter-cent SU rate increase and the new salestax exemption or certain equipment purchases

do not affect local sales tax revenues. Instead,growth in taxable sales is the primary driver ochanges in local sales tax revenue. As shown inFigure 7, we expect steady growth in 2011 LocalRevenue Fund sales tax revenue despite theuctuations in General Fund sales tax revenue.Specically, we estimate that 2011 realignmentsales tax revenues will grow by 7 percent in

General Fund Sales Tax Revenue Will Fluctuate

More Than 2011 Local Revenue Fund Sales Tax RevenuePercent Change From Prior Year

Figure 7

2

4

6

8

10

12%

2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20

General Fund

2011 Local Revenue Fund


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