1 Forecasting Revenue Receipts in the States Forecasting Revenue Receipts in the States: Current Challenges in California Abstract - General Fund revenue growth in California has been quite strong in recent years, led by major increases in personal income taxes (PITS). This paper reviews the performance of the state s major taxes in the recent expansion, then turns to the main issue facing revenue estimators in California today namely, the impact of shifting income distributions on PIT liabilities in the state. It then briefly discusses issues relating to forecasting California s other major revenue sources. INTRODUCTION After a severe slowdown in the early 1990s, General Fund revenues in California have rebounded in the second half of the decade. The recent growth has significantly outpaced projections and has contributed to a substantial improvement in California s fiscal picture. The increases have enabled the Governor and the Legislature to enact both tax relief and spending increases in education and other state programs. This paper looks at the performance of California s major revenue sources in the 1990s and discusses key challenges facing the state s revenue estimators today. After providing background information on California s tax structure and the approaches used by state revenue estimators to forecast revenues, it turns to the single largest issue facing revenue estimators in California today namely, the impact of shifting income distributions on personal income tax (PIT) liabilities in the state. It then briefly discusses issues in California relating to the state s other major tax sources. BACKGROUND Brad Williams, Robert Ingenito, & Jon David Vasché Legislative Analyst s Office, Sacramento, CA National Tax Journal Vol. LII, No. 3 California s Tax Structure California state government collects revenues from over 100 different sources, including taxes, licenses, fees, and interest on investments. However, the great majority of the state s General Fund revenues come from three major taxes the personal income, sales and use, and bank and corporation taxes. As indicated in Figure 1, these taxes are expected to account for over 94 percent of total revenues in The figure shows that the PIT is by far the state s largest General Fund revenue source. It now accounts for slightly 361
2 NATIONAL TAX JOURNAL Figure 1. General Fund Revenues by Source more than one-half of total revenue collections, up from roughly one-third of total collections two decades ago. In general, the California PIT is patterned after federal income tax law with respect to the definition and treatment of most types of income, deductions, exclusions, and credits. One notable exception is that California did not conform to recent federal law changes providing for reduced tax rates on long-term capital gains realizations. Taxable income is subject to marginal rates ranging from 1 to 9.3 percent. The second largest General Fund revenue source is the sales and use tax. This tax accounts for about one-third of total receipts. It is imposed primarily on the retail sales of tangible goods purchased in California. Combined state and local sales tax rates can range up to 8.75 percent in California, of which 5 percent is attributable to the General Fund. The bank and corporation tax is California s third largest General Fund revenue source, accounting for about ten percent of total receipts. The tax is patterned after federal corporation tax law, although there are differences in areas such as depreciation allowances. A corporate tax rate of 8.84 percent is levied on earnings that are attributable to California. In addition, banks and other financial corporations pay an additional two percent bank tax, which is in lieu of certain other state and local tax levies. All other revenues account for the remaining five percent of General Fund receipts. These include receipts from insurance, cigarette and alcoholic beverage taxes, estate taxes, interest earnings on pooled money investments, and a variety of other sources. Revenue Forecasting Approaches in California In California, both the Governor s Department of Finance (DOF) and the Legislative Analyst s Office (LAO) project state General Fund revenues using a top down approach, where economic variables from national and state 362
3 Forecasting Revenue Receipts in the States econometric forecasts are used to project various tax bases and ultimately tax receipts from the major revenue sources. 1 In most cases, the tax-related variables are estimated using either structural or reduced-form equations. For example, taxable sales are forecast as part of the LAO s California econometric model using a variety of independent variables such as personal income, unemployment rates, residential and nonresidential building permits, and consumer confidence levels. Likewise California taxable profits are estimated using national profits and various apportionment factors comprised of California and U.S. payroll, property, and sales levels. A key exception to our general practice of using aggregate structural or reduced form equations is the approach we use to forecast collections from the PIT. For this tax, we have developed a microsimulation approach, which attempts to estimate the tax liabilities of individual taxpayers (or groups of taxpayers) with varying income and other tax-related characteristics, such as amounts of deductions. Such an approach is based on a sample of actual taxpayers from a base year (currently, 1997) which is stratified by income classes. For each such income class, the sample includes information on the number of returns, incomes, and deductions by component, credits, and other characteristics. 2 The taxpayers income and deduction components are aged into the future using empirically derived relationships between economic and tax variables. The tax rate schedules are then applied to the resulting distribution of taxable income. After various adjustments for credits and other factors are made, individual tax liabilities are summed to arrive at the state s estimated aggregate tax liabilities. A key element of a microsimulation approach is that revenue estimators can explicitly incorporate assumptions about tax rates, tax credits, deductions, and other law changes into their estimates. Just as importantly, a microsimulation approach enables revenue estimators to make explicit assumptions about how aggregate changes in adjusted gross income (AGI) are distributed among taxpayers with different income levels. This is important, because, as discussed below, changes in California s income distribution have had substantial impacts on state revenues. Recent Performance of General Fund Revenues Total Revenues Figure 2 compares growth in General Fund revenues (adjusted to eliminate the effects of law changes) to growth in statewide personal income during the 1990s. It shows that revenues fell sharply during the recession in the early part of the decade, reflecting major declines in taxable sales, personal income, and corporate profits in the state. More recently, however, the improvement in the economy has translated into large gains in revenues. In fact, revenue growth between and has been significantly greater than statewide personal income growth. 1 For a description of the general methodologies used, as well as the potential sources of forecast error, see: Jon David Vasché and Brad Williams. 2 Three agencies in California use PIT simulation models for estimation purposes. The LAO and the Governor s DOF use PIT models primarily for forecasting purposes. In contrast, the Franchise Tax Board (FTB) uses microsimulation modeling primarily for analyzing the effects of proposed and current-law tax provisions. The data used by all three of these entities are those developed by the FTB from stratified random samples of annual PIT tax returns. The FTB s model uses record-by-record microdata, whereas the DOF and LAO rely on databases reflecting microdata aggregated within income classes (due to data-confidentiality issues). Altogether, 59 income classes within each tax filing status are used for these purposes. 363
4 NATIONAL TAX JOURNAL Figure 2. Underlying General Fund Growth a Individual Taxes The majority of revenue increases during recent years has been attributable to the PIT. As indicated in Figure 3, collections from this source increased at an average annual rate of 15.8 percent between and , or more than double the rate of personal income growth in California for the same period. In contrast, the sales tax increased at about the same pace as personal income, while the bank and corporation tax and other revenues experienced only modest growth during the period. ISSUES RELATED TO THE PERSONAL INCOME TAX Given the significance of the PIT to overall revenues both in terms of its overall size and its volatility we first address major factors that have influenced revenue growth from this source during recent years. We then discuss their implications for the future. 364 Recent Growth in PIT Liabilities Has Been Extraordinary The rapid growth in PIT revenues is consistent with major increases in annual liabilities reported on California income tax returns. Figure 4 provides data from the Franchise Tax Board (FTB) on California income tax liabilities. It shows that these liabilities increased at an average annual rate of 14 percent during 1995 through This was more than double the growth rate of California personal income for the comparable period. Many factors can affect the elasticity of income tax growth over time (that is, the ratio of percent change in PIT liabilities to percent change in income). These factors include changes in deductions, exemptions, and the indexing adjustment factor applied to the tax brackets, standard deductions, and exemption credits to compensate for inflation. However, the single largest factor especially in recent years has been a substantial outward shift in the distribution of income reported on tax returns.
5 Forecasting Revenue Receipts in the States Figure 3. Annual Average Percent Change in General Fund Revenue Sources a Figure 4. Recent PIT Growth Has Been Spectacular 365
6 NATIONAL TAX JOURNAL Shifts in the income distribution are important because California, like the federal government and a number of other states, has a progressive marginal tax rate structure, where higher levels of income are subject to increasingly higher marginal tax rates. A progressive tax rate structure implies that PIT revenues will depend not only on total statewide income subject to tax, but also on how such income is distributed by income level (or income class). Shifts in California s Income Distribution A number of studies have documented shifts in the distribution of household incomes, both in California and at the national level. Using such sources as the U.S. current population survey, these studies have reported increased concentrations of income in higher-income ranges and reduced concentrations in lower-income ranges. 3 The distributional shifts in household incomes are clearly evident in tax return data for California. In a previous study, we reviewed the distribution of total California AGI as reported on California tax returns over the period 1975 through Over that period, the distribution of AGI reported on tax returns had shifted substantially, with high-income taxpayers accounting for a steadily increasing share of total AGI reported in the state. In this paper, we update the previous study to include information for 1996 and These two years are significant, because they correspond to major increases in California tax liabilities. Figure 5 provides a measure of how much AGI reported on California tax returns has shifted outward during the past 22 years. It specifically shows Lorenz curves for 1975, 1985, 1995, and Figure 6 provides data on the quintile and high-income distribution of total AGI for various years in the same timeframe. The figures show the following. Over the long term, the share of total AGI attributable to the top 20 percent of taxpayers has consistently increased, going from 41.7 percent of the total in 1975 to 53 percent of the total by During this same period, the share of income at the very top end of the distribution that for taxpayers with incomes exceeding 99 percent of the population doubled from 7 to 15 percent. Over the past two years, the outward shift in the distribution not only continued but accelerated, with the share of income attributable to the top 20 percent of returns increasing from 53 percent in 1995 to nearly 56 percent in During this twoyear period, the share of income reported by the top 1 percent of taxpayers increased from 15 to over 18 percent. Causes of Distribution Shifts Recent studies have attributed the longterm shift in California s income distribution to a variety of economic and societal factors, including a change in the state s industry makeup and structure, shifts in the distribution of labor force education and skill levels, as well as changing economic returns to education and skill levels. 5 During the current business cycle, a number of cyclical factors have also contributed to the shifts in the state s distribution. For example, investment and business earnings fell sharply in the early- 1990s recession, but have increased dramatically in the state s more recent eco- 3 For example, see Deborah Reed, Melissa G. Haber, and Laura Mameesh. 4 Brad Williams, Kristin Szakaly, and Jon David Vasché. 5 Deborah Reed. 366
7 Forecasting Revenue Receipts in the States Figure 5. Lorenz Curves and Gini Coefficient (GC) for Distribution of Total California AGI Figure 6. Quintile and High-Income Shares of Total California AGI a nomic expansion. These categories have distributions that are highly skewed toward high-income taxpayers. Thus, their declines caused the overall distribution to temporarily shift inward in the early 1990s, while their subsequent strong upturn contributed to the outward shift in 367 the overall distribution between 1995 and Of particular significance to recent changes in the overall amount and distribution of AGI in California has been the performance of capital gains. As shown in Figure 7, after lagging in the early 1990s,
8 NATIONAL TAX JOURNAL Figure 7. Strong Capital Gains Growth in Recent Years: California capital gains realizations nearly doubled between 1995 and 1997, due in large part to the major increase in stock market equity values. Changes in the level of capital gains reported on tax returns are particularly significant, because over 90 percent of total realizations typically accrue to taxpayers in the top quintile of income. Revenue Effects of California s Distribution Shift The outward income distribution shift has had major implications for PIT liabilities. This is because, under California s progressive tax rate structure, the average tax rate applicable to taxpayers in the top quintile is roughly double the weightedaverage rate for those in the bottom four quintiles combined. We estimate that over one-third of the increase in tax liabilities that occurred between 1994 and 1997 can be attributed to the outward shift of the income distribution that occurred between those years. 368 Key Forecast Challenges Revenue estimators face challenges in identifying and forecasting both the shortand longer-term factors affecting the amount and distribution of PIT liabilities over time. In the near term, a key challenge relates to predicting future changes in stock market values and how such changes will affect capital gains. In this regard, one important question is how much a major retrenchment in the stock market would affect capital gains realizations. A market decline would undoubtably reduce the net level of gains associated with private accounts and mutual funds that are actively traded. However, the impact on gains realized by investors that have long-term stock holdings is less clear. Its net effect would depend on (1) the decrease in the average amount of capital gains embedded in long-term holdings that resulted from a stock market decline and (2) the potentially offsetting increase in the volume of sales that could be prompted by a shift in perceptions about stock market conditions. The latter factor could occur if, for example, a market decline induced investors to reallocate their investment portfolios away from stocks, thereby causing a
9 Forecasting Revenue Receipts in the States substantial increase in stock-related sales activity. A closely related question concerns the impact of current and future stock market changes on wages reported on California tax returns. A significant portion of employee compensation in recent years has been in the form of stock options, which themselves are related to stock market performance. This is especially true in such high-wage industries as computers, electronics, and software development, which have accounted for a significant share of overall economic growth in California during recent years. A downturn in the market would be likely to reduce earnings related to stock options, but the exact linkage would depend on the amount and characteristics of options that are currently outstanding. Over the longer term, a key question is whether the forces that have been at work during the past two decades will continue to operate in the future. For example, will the returns to rising education or skill levels continue to increase in the future, producing greater wage differentials between skilled and unskilled workers, or will the differential returns stabilize at some point? In the former case, revenue estimators should assume continued outward shifts in taxpayer distributions, while in the latter case, it would be appropriate to assume a more stable distribution in the future. PERFORMANCE OF OTHER TAXES In marked contrast to the PIT, revenues from California s second and third largest revenue sources have expanded at a relatively moderate pace during the current economic expansion. Bank and Corporation Tax The relatively slow pace of growth in this tax reflects sluggish growth in California taxable profits in 1996 through Part of the profit weakness can be attributed to restructuring in the utilities, telecommunications, and certain manufacturing industries, which has depressed profits in each of the past three years. More recently, Asia s economic problems have also had an adverse impact on California s high technology manufacturing corporations. 6 We would expect corporate profit growth to recover once these factors have had a chance to run their course. Sales Tax Figure 8 provides a historical perspective on California taxable sales, by comparing annual percentage changes in taxable sales to the annual percentage changes in California personal income. It shows that taxable sales were quite volatile during the 1980s and early 1990s, booming during the early stages of the 1980s expansion, but falling sharply during the early 1990s recession period. In the current expansion, however, the growth rate has been relatively subdued. Over the full 16-year period from 1982 through 1998, taxable sales growth has lagged personal income growth in the state. As a result, the ratio of taxable sales to personal income today is about 39 percent, which is down nearly 10 percentage points from the mid-1980s. The declining ratio is consistent with longer-term national trends, in which a decreasing proportion of total consumer spending is being devoted to tangible goods (which are taxable) and a larger share to services (which are not taxable). The relatively slow growth in the current expansion can also be attributed to a sluggish recovery in home building (which has produced smaller gains from building materials and related sales than in past recoveries) and depressed commodity prices. 6 See, for example, Mary Daly. 369
10 NATIONAL TAX JOURNAL Figure 8. Taxable Sales Restrained Due to Structural Change State Forecasting Challenges The corporation and sales taxes pose significant challenges to revenue estimators, in terms of both their near-term and long-term outlook. In the near term, most of the uncertainties relate to the strength of different California economic variables, such as corporate profits, residential construction activity (which results in taxable sales of building materials, appliances, and home furnishings), and business and retail spending by consumers. Over the longer term, a key issue affecting the sales tax involves the extent to which the trend in consumer expenditures toward services and away from tangible commodities continues over time. Also of potentially great significance is the increasing share of transactions being conducted over the Internet, which currently are protected from taxation both nationally and in California by a three-year moratorium. While both the sales and use and bank and corporation taxes present serious revenue estimation challenges, the magnitude of potential forecast errors is considerably less than that for the PIT. 370 CONCLUSIONS California s positive revenue performance in recent years is due primarily to extraordinary increases in PIT receipts. In contrast, the increases in the state s other major tax sources have been relatively subdued. The PIT increases reflect both the growth and the outward shift in the distribution of AGI reported on the returns of PIT payers in the state. Looking ahead, revenue estimators and policymakers face several challenges with respect to both the state s short-term and long-term revenue outlook. In the near term, the increased importance of the PIT and the increased significance of high-income returns implies that revenues are becoming more and more highly dependent on volatile elements in the state s economy, such as the performance of the stock market, bonuses, and stock options. Over the longer term, key revenue estimating challenges relate to predicting ongoing shifts in the distribution of income and future patterns in consumption shifts between goods and services.
11 Forecasting Revenue Receipts in the States REFERENCES Daly, Mary. East Asia s Impact on Regional Growth In California. Economic Letter No San Francisco: Federal Reserve Bank of San Francisco, January 15, Reed, Deborah. California s Rising Income Inequality: Causes and Concerns. Public Policy Institute of California, Reed, Deborah, Melissa G. Haber, and Laura Mameesh. The Distribution of Income in California. Public Policy Institute of California, Vasché, Jon David and Brad Williams. The Significance of Statistical Error Margins in California State Revenue Estimating. Western Tax Association 5 No. 2 (Fall, 1994). Williams, Brad, Kristin Szakaly, and Jon David Vasché. Forecasting State Personal Income Tax Revenues in the Midst of Shifting Income Distributions The Case of California. In Proceedings of the 90th Annual Conference on Taxation, Washington, D.C.: National Tax Association,