This article is from Cal-Tax Digest, published
by the California Taxpayers' Association.
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After lagging in the first half of the 1990s, General Fund revenues have soared during the second half of the decade. Since 1994-95, total annual receipts have climbed from $42 billion to over $67 billion this year. This $25 billion increase has occurred despite significant tax relief enacted during the period. After adjusting for law changes, underlying revenues have grown by more than 10 percent annually. While there have been times when the state has experienced larger percentage increases in past decades, these have generally been during high-inflation periods. In contrast, the later 1990s' gains occurred in an environment where inflation was very low - only around 2 percent yearly. In addition, although the state's economic performance has been very good, revenue growth has outdistanced even what this strong economic growth would suggest.

Main Source of Strength: Personal Income Taxes
Almost three-fourths of the overall growth in General Fund receipts in this expansion has been from the personal income tax (PIT), which has grown from $18.6 billion in 1994-95 to $36.3 billion in 1999-00. Figure 1 compares the percentage growth in PIT receipts (adjusted for law changes) to that of the state's other two main taxes (the sales and use tax [SUT] and the bank and corporation tax [BCT]), as well as to statewide personal income. It shows that PIT receipts have increased at an average annual rate of about 15 percent per year, more than double the pace of statewide personal income during this period.

The figure also shows that growth in the state's other major taxes has been relatively moderate. Despite a large increase in taxable sales last year, SUT receipts during the past five years have averaged 6.8 percent, or only slightly more than personal income growth. Growth in the BCT has been even more subdued - just 4 percent annually.

Factors Behind Rapid PIT Growth
The rapid growth in PIT receipts can be attributed to two main factors - aggregate growth in employment and income, and a dramatic shift in the state's income distribution toward the "high" end.

Aggregate Growth in Employment and Income. California's PIT receipts have always been "elastic" with respect to growth in "real" (or inflation-adjusted) personal income. This is a reflection of California's progressive tax bracket structure, where increases in incomes beyond inflation are subject to higher marginal tax rates. We estimate that about 60 percent of the PIT growth in the current expansion (that is, about 9 percentage points of the 15 percent average annual increase in PIT liabilities) can be explained by the "normal" relationship that links personal income growth to PIT liabilities, given the tax-bracket structure and the way in which taxpayers are distributed throughout it.

Dramatic Earnings Growth at Top End of Distribution. The remaining 40 percent of the PIT increase during the past five years is due to the unusually strong growth in incomes (including capital gains) reported by taxpayers at the top end of the income distribution. Between 1994 and 1999, we estimate that adjusted gross income of the top one-fifth of taxpayers increased roughly twice as fast as that of the bottom four-fifths of returns. This rapid increase had a dramatic impact on tax liabilities, since under California's progressive tax rate structure, earnings at the high end of the distribution are subject to higher tax rates than are earnings at the lower end and middle of the distribution (see Figure 2).

Why Are Incomes at the Top End Soaring?
Several factors appear to be responsible for this development. One is the increasing returns to education and skill levels in the economy, which is resulting in sharply higher wages for workers in a variety of management, professional, and technical fields. In California, the rapid growth in high-paying computer services industries (discussed in "Part Two" of this volume) also is boosting wages at the high end of the distribution.

However, the main factor sending high incomes soaring in recent years has been the extraordinary increase in the stock market, which has led to major increases in capital gains and stock option-related income. Figure 3 shows that capital gains realized on California tax returns have quadrupled in the past five years, from under $20 billion in 1994 to nearly $80 billion last year. This increase has translated into about $5.5 billion, or over 30 percent of the total increase in PIT receipts. And even this is an understatement of the stock market's role. This is because the totals in Figure 3 do not include stock option income. Although comprehensive direct information on stock option income is not available, indirect information from withholding receipts and certain industry data suggest that stock option income has also risen sharply, perhaps contributing an additional $2 billion in new revenues during the past five years.

Overall, we estimate that capital gains now account for as much as 20 percent of total PIT receipts, and that stock options income accounts for an additional 5 percent to 10 percent.

What Do We Know About the Characteristics of These Capital Gains?
Given the role that capital gains and stock option income have been playing in the state's revenue picture, it is important to consider what we do and do not know about them. This is especially so since the assumptions we make about capital gains in 2000 and beyond are critical to our revenue forecast.

• Capital Gains Are Primarily Related to Stocks. In 1997 (the most recent year for which detailed capital gains information is available), over 75 percent of California's net capital gains realizations were related to stocks, with the balance related to sales of real estate and other tangible assets. The large share due to stocks partly reflects the tremendous appreciation in stock market valuations in recent years. It also reflects the fact that most capital gains associated with sales of personal residences are excluded from taxation, due to the $500,000 exclusion provided under both the federal and state PIT for such sales.
• Gains Reflect a Mix of Short-Term and Long-Term Investments. In 1997, net capital gains realizations related to stocks were associated with a mix of both short-term and long-term investing activity. Data on capital gains by holding period indicate that a majority of transactions in 1997 - about two-thirds of the total - were related to stocks held for less than one year. However, these transactions accounted for less than 20 percent of the dollar amount of net capital gains realizations. In contrast, stocks held for more than one year accounted for only one-third of the transactions, but 80 percent of the dollar gains realized during the year. This is because sales of long-term holdings generally produce much larger gains, given the greater time over which the gains have built up.
• Only Small Portion of Gains Are Realized Each Year. There is no direct information on the amount of unrealized capital gains held by households in California. However, national Federal Reserve Bank data on U.S. households' assets and liabilities suggests that total capital gains realized on federal tax returns in 1997 accounted for less than 15 percent of the annual appreciation of assets owned by households. Even after accounting for holdings attributable to pension funds, 401 (k) plans, Individual Retirement Accounts, and other tax-deferred investments, the portion of potentially taxable gains which were actually realized appears to be less than one-third. This implies that there is a very large amount of unrealized capital gains that have been "stored up" by households over time.
• Substantial Gains Also Are Embedded in Unexercised Stock Options. A comparatively larger share of the stock options annually granted by companies to their employees is exercised each year. Nevertheless, our review of 10-K reports filed by companies with the Securities and Exchange Commission indicates that there is still a large amount of stock options that have yet to be exercised. This is especially the case for many of California's high-tech firms, where the average "exercise" price on outstanding options is often merely a fraction of the stock's current market price.

Implications for the Revenue Outlook: Greater Unpredictability
The state has benefitted enormously in recent years from the boom in the stock market and its associated positive effect on both capital gains realizations and stock option income. These factors have directly raised PIT liabilities, and have indirectly boosted sales and other taxes through their impacts on wealth and confidence in the state's economy.

It is also the case, however, that the rise in stock market values has made the state's revenue stream much less predictable from year to year than in the past. This is because capital gains are inherently far more volatile than, for example, wages or taxable sales. Although capital gains account for only 20 percent of PIT receipts and about 10 percent of total General Fund revenues, their greater volatility can produce as large, if not larger, a revenue drop-off than other taxes typically experience during times of economic slowdown or recession. For example, capital gains historically have fallen by as much as 50 percent in one year, which would translate into a potential reduction of as much as 10 percent in PIT revenues and 5 percent in total revenues. A decline of this magnitude would amount to about $3.5 billion. By comparison, it would take an over 15 percent decrease in SUT receipts to produce the same dollar impact - a far larger drop-off than occurred in the severe recession of the early 1990s.

Conclusion
Most of the strong growth in General Fund revenues during the past five years is a reflection of the state's healthy economic expansion, and in particular, the rapid growth in its high-wage, high-value-added computer and software industries. The state has also benefitted enormously from the unprecedented increase in the stock market, which has led to a fourfold increase in capital gains and similar increases in stock option income. While the substantial amount of stored-up gains is clearly a positive factor in the state's fiscal outlook, it is also true that their increased importance makes California's revenue structure more volatile and less predictable than in the past. In addition, it means that the assumptions one makes regarding capital gains realizations are more important than ever in constructing a reliable forecast for General Fund revenues.