Like weather forecasters who missed a devastating storm, economists in Sacramento have failed to accurately predict state tax revenues for years.
When the stock market boomed, the state reaped the benefit of a phenomenal increase in the wealth of upper-income Californians. Forecasters were caught by surprise when revenues exceeded their expectations by billions of dollars a year.
Then, when stock prices plunged, the state's fiscal fortunes nose-dived, confounding forecasters yet again.
"The economic forecasts haven't been all that bad, but the recent revenue forecasts have been off the mark," said Brad Williams, senior economist for the legislative analyst's office. "It has been very tough forecasting the unknowable, which is the stock market and what would arise out of the stock market."
That has played havoc with economic forecasts across the country, but it has had particularly serious effects in California, where the state budget relies heavily on income taxes, including income derived from capital gains made by stock market investors.
Moreover, few of those problems are directly addressed by the $96-billion budget that Gov. Gray Davis introduced last week. Although it relies somewhat more heavily on sales taxes, which are easier to forecast than income taxes, it also raises taxes on the wealthiest Californians, those whose income is most volatile and most linked to the fortunes of the stock market.
Davis' budget also is built on some assumptions that may not materialize, most notably its reliance on $1.5 billion from Indian gambling. That money will come to the state only if California tribes agree to pay state taxes in return for more gambling; if they don't, the revenue forecasts for next year will need to be revamped.
California's revenue predictions are the byproduct of a select group of economists, drawn from the public and private sectors. They start each fall with a prediction of growth in the U.S. economy. That forecast is then adapted for the California economy to produce estimates of personal income, jobs, taxable sales, bank and corporate income, housing construction and other factors.
"The pace of job growth and the pace of personal income are ultimately the drivers of the income tax estimate," said outgoing state Finance Director Tim Gage.
Personal Income Is Key
Tom Lieser, senior economist for UCLA's Anderson Forecast, said the income numbers are more important than most elements in the forecast because the state relies so much on income tax to support government programs.
Each October, state forecasters put together a preliminary estimate of revenues likely to be available for the fiscal year that begins the next July.
In mid-November, the state Department of Finance meets privately with outside experts to discuss the economic outlook for the coming fiscal year.
That select group includes economists from universities and certain key industries such as high-tech, telecommunications and agriculture. But attendance at the annual event has dropped as major banks and utilities move their headquarters to other states or eliminate in-house economists.
When the experts got together in Sacramento last fall, the legislative analyst's office had just released its own economic forecast, predicting slower economic growth and weaker revenues.
Jack Kyser, chief economist for the Los Angeles County Economic Development Corp., said the mood at last fall's meeting could be summed up in one word: gloomy.
By early December, the respected Anderson Forecast from UCLA's business school also was painting a darker picture of the state economy's prospects.
Lieser said UCLA lowered its forecast because California's economy is now likely to sputter through the first half of this year. He predicted slower growth, higher taxes and reduced public services.
A week before Christmas, Davis stunned observers by announcing that the budget deficit had grown to $34.8 billion, far larger than any previous estimate.
The governor's estimate was far higher than the $21.1-billion gap reported by the legislative analyst's office only a month earlier. That figure was developed using different assumptions about revenues and spending.
Davis blamed half of the problem -- $17.7 billion -- on earlier revenue estimates that were too high. Of that, almost $12.4 billion of the reduction was because of lower projections of income tax receipts.
The gap between the revenue forecast made by the Davis administration last May and the one contained in the governor's budget released Friday is particularly noteworthy.
Last spring, the Department of Finance told lawmakers that income tax revenues would reach $40.5 billion in the coming fiscal year, the highest level since the stock market boom. But the administration abandoned that forecast recently, and now expects such revenues to reach only $33.6 billion, a decrease of $6.9 billion, or 17% in seven months. Projected revenues from sales taxes and bank and corporation taxes also dropped, by about 5%.
Connie Squires, one of the department's revenue forecasters, said a weaker outlook for the state's economy, combined with lower income tax receipts and higher tax refunds last year, contributed to the sharp decline in projected revenues.
"The economy took a turn for the worse over the summer," said Gage, the outgoing state finance director. "There had been the prospect of a modest recovery beginning this fall, but that has not materialized."
Gage said the administration now expects "very, very sluggish growth" in the California economy this year, followed by modest growth next year.
"This is our best shot at what we think the economy is doing," he said. But, Gage cautioned, "like any forecast, it can be wrong."
They have been wrong before.
During the boom years of the late 1990s and early 2000, upper-income Californians -- who pay the lion's share of state income taxes -- benefited from the run-up in stock prices. Corporate executives and workers in some high-tech industries earned more by cashing out stock options than they did in their paychecks. Other California investors simply sold stocks and took capital gains.
Although the surge in stock values was readily apparent to anyone watching the market, the magnitude of the state's good fortune was not known until income tax returns were opened each spring in Sacramento. The windfall came as a surprise.
"You got this huge avalanche of money," said Ted Gibson, then chief economist for the state.
When the tax returns arrived a year after the stock market peaked in early 2000, income tax receipts reached a record high of almost $45 billion. The state surplus grew to heights never seen before.
Lawmakers of both political parties joined Davis in spending billions of dollars in unanticipated tax receipts during his first two years in office.
Despite warnings from budget writers that the Wall Street boom might not last forever, Sacramento's politicians kept spending at a record pace.
As stock prices fell, so did the state's income tax receipts, dropping to $33 billion in two years.
The drop was even more pronounced in the state's take from income taxes on stock options and capital gains on the sale of stock. From a peak just shy of $17 billion in 2000, the state's income from stock options and capital gains fell to $4.6 billion, a precipitous decline that cost $12.4 billion in lost tax revenue.
The lesson was there for all who were willing to learn it: "If you live by the stock market, you die by the stock market," Gibson said. "It's a volatile and unpredictable beast."
Credibility Is Damaged
Gibson said economists have lost credibility over the last three or four years because of their failure to correctly forecast Wall Street's rise and fall.
As they confront the state's current predicament, Gibson said, the challenge for economic forecasters is to predict the direction of the stock market and how taxpayers who own stocks and hold options will behave. "Do you sell the stock? Do you exercise the option and take the income now?"
Until four or five years ago, he said, "we never discussed the stock market." Now the stock market is one of the most important factors in the economic forecast used by the state Department of Finance to predict state revenues.
The state's vulnerability to huge swings in revenue has increased dramatically as Sacramento has become increasingly dependent on the income tax.
Today, nearly half of all the revenue for the state's general fund comes from income taxes. Those dollars help pay for government programs ranging from schools to colleges, courts to prisons, welfare benefits to health care for the poor.
Forty years ago, the income tax accounted for only 18% of general fund revenues. Today, it provides about 48%.
Sales Tax Share Shrinks
Although the sales tax rate has risen, its share of the general fund tax receipts has shrunk from 45% in 1962-63 to 29% in the 2002-03 budget. In the same period, the share of general fund revenues from bank and corporation taxes has fallen from 17% to 9.25%.
Unlike income tax revenues, which veer wildly with the stock market, sales, bank and corporation taxes are all relatively stable and thus easier to predict.
Sales taxes have proved difficult to predict at times. Forecasters were stumped, for instance, when car companies began offering low-interest lease deals. Those drew more car buyers into leases, which confounded predictions about sales taxes until economists could catch up with the new consumer habits.
Still, Legislative Analyst Elizabeth Hill said Sacramento has become so dependent on taxes paid by high-income Californians that "when they have poor times, the state has poor times."
The heavy reliance on high-income taxpayers for state revenue means that forecasters are increasingly operating with limited information, forced to make predictions on the investment decisions of a small sliver of the population.
An analysis of state tax returns for the year 2000 shows that the 10% of California taxpayers who have an adjusted gross income of $100,000 or more paid 78% of all the state's income taxes. And just 1% of wealthy Californians account for 48.7% of the state's personal income tax revenue.
Gage said the Davis administration had to lower revenue estimates last month after an analysis of 2001 tax returns found that the growth in wages among high-income households had come to a halt.
Those quick adjustments are unlikely to cease anytime soon, experts said, because California's budget remains heavily tied to the fortunes of rich residents and to their assessment of a volatile stock market.
"We are always going to have volatility here," said Williams, the senior economist for the legislative analyst's office. "We have a volatile, exciting economy. We're not Iowa."
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Relying on income taxes
Over the past 40 years, the state has become far more dependent on personal income taxes to pay for government programs. That makes the state vulnerable to swings in Californians' income.
Sales tax: 45%
All other sources: 19%
Personal income tax: 18%
Bank and corporation tax: 17%
Personal income tax: 48%
Sales tax: 29%
Bank and corporation tax: 9%
All other sources 14%
Note: May not add up to 100% because of rounding.
Wall Street sparks boom, bust
The state income tax receipts from stock options and capital gains surged during the late 1990s and early 2000. But when stock prices nose-dived, so did revenues.
State income tax receipts from stock options and capital gains:
1998: $7.7 billion
2000: $16.9 billion
2002: $4.7 billion
Source: Legislative Analysts Office