How does somebody miss the mark by $2.5 billion?
When Gov. Jerry Brown issues his May budget revision Monday, it will likely include billions in state tax revenue not envisioned by forecasters just five months ago.
For some, the revelation has turned the state budget debate on its head. Republicans say it shows that tax extensions sought by Brown are unnecessary. Schools are less likely to face the doomsday scenarios that were contemplated in recent weeks.
It could have been worse; just two years ago during the Great Recession, forecasters were short by $19 billion.
"You can do everything right, but your forecast comes out wrong," said Jay Chamberlain, who became chief of financial research at the Department of Finance last year. "You know you're going to be wrong. It's just a question of how much you're going to be wrong."
The state is running $2.5 billion ahead of projections through April, less than 3 percent off the forecast in last year's budget act. Brown's forecasters also are likely to increase by billions the amount of money the state takes in for the fiscal year that begins July 1.
Democrats say the revenue bump is so slight in an $89.7 billion budget that it doesn't solve the state's long-term imbalance between revenue and spending. Brown is expected to maintain his call Monday for extending higher tax rates on vehicles, sales and income to stabilize the budget beyond the coming year.
To determine how much the state will receive in future taxes, the Department of Finance first has to predict how the economy will perform, using data from international, national and state sources. The department also consults each fall with economists from outside agencies and industries, who provide proprietary information behind closed doors.
Chamberlain's team then funnels a laundry list of economic projections, from the unemployment rate to housing permits to the S&P 500 Index, through computer models that translate those figures into tax revenue.
The models typically rely on past relationships between economic indicators and tax collections. For instance, a certain level of car sales translates into a certain amount of sales tax revenue.
Jeff Michael, director of the Business Forecasting Center at the University of the Pacific in Stockton, focuses on economic forecasts, itself an imperfect pursuit. He described state revenue forecasting as even more daunting.
"The analogy I sometimes use is a combination shot on a pool table," he said. "You have to hit the cue ball so it hits the 2 ball, which has to hit the 5 ball, which makes it into the pocket. An economic forecast is the first ball in that chain."
Tax system volatile
California's roller-coaster tax system makes the job that much harder.
Since 1970, the personal income tax has grown from 27 percent to 51 percent of California's general fund revenue, according to the nonpartisan Legislative Analyst's Office. Over the past two decades, much of that income tax growth has come through capital gains, bonuses and stock options that fluctuate dramatically from year to year.
Brad Williams, a longtime forecaster for the legislative analyst and Commission on State Finance, wrote a report in 2005 detailing the state's ever-volatile tax structure.
If the revenue forecast were a house, he said, capital gains and stock options were just one room during the 1980s and early 1990s.
"Now it's become the foundation of the forecast," said Williams, now a private consultant. "Movements in these categories can have a profound effect. You can develop as sophisticated a model as you wish, but at the end of the day these are driven by psychology and taxpayer behavior."
Virtually all of the $2.5 billion in current surprise revenue is due to personal income tax gains. It is too early to tell the exact cause, said Jerry Nickelsburg, senior economist with the UCLA Anderson Forecast.
"You wouldn't want to ascribe all of it to systematic economic growth because there's a possibility that's not what it is," he said. "So now you're dealing with a political judgment on how to view this increase in revenue."
Brown's budget will rely on a new projection for 2011-12 revenue that takes into account the recent bump. Assembly Republicans said the state can count on another $2.5 billion bump next year, a figure they considered conservative.
Some suggest the governor has incentive to be even more conservative, since greater revenue could further reduce the deficit and hurt his argument for tax extensions. But Chamberlain insisted his projection will be based on economic data and modeling, not Brown's political motivations.
Still, there are good reasons to aim lower rather than higher in government forecasts, Nickelsburg said. It's easier for lawmakers to deal with greater-than-expected revenue than less. The latter situation requires more taxes or cuts, whereas the former can offset those tough choices, as the state may now see.
Even if the Finance Department projects low, however, the Legislative Analyst's Office will provide a second opinion days later. Jason Sisney, state finance director with the analyst's office, said erring in either direction has real consequences.
"The basic thing in people's nature is they would rather manage their budgets to make sure they end up with a windfall," he said. "But clearly there are also consequences if we or Finance overstates revenues." He said legislators may take that as a license to spend or cut taxes more than they should.
"If there's one thing being involved in budget forecasting has taught me, it's humility," Sisney said. "Policymakers who have a much bigger stake in this than I do really should regard our forecasts with a degree of skepticism."