When it comes to figuring out how much money it's taking in, California can't seem to get it right.

The state legislative analyst recently concluded that the governor's office had underestimated revenues for the 2004-2005 budget year by $1.4 billion. That's on top of the Schwarzenegger administration's own acknowledgement that revenues had been underestimated by nearly $1 billion.

But these misses are peanuts compared with what happened in late 2001 the other way. The state's budget deficit was projected at around $8 billion, but by the following May, it had jumped to a staggering $23.5 billion all because of plunging revenues that were not anticipated.

"When you're off so much like this, it makes it much harder to draw up responsible fiscal policy," said Kim Rueben, research fellow at the Public Policy Institute of California.

So why is it so difficult to forecast state revenues?

For starters, some of the primary revenue streams especially income and corporate taxes are notoriously volatile, causing wide swings in revenues depending on what the economy does.

In the late 1990s, revenues soared with the dot-com boom, resulting in a $12 billion budget surplus in 2000. Just two years later came that $23.5 billion deficit. With such huge swings, small errors in projections are magnified in a few months or even weeks.

When Gov. Arnold Schwarzenegger released his budget in early January, it was based on economic data collected in December. But when the legislative analyst's office issued its report in late February, it was based on early February data that showed revenues coming in hundreds of millions of dollars higher than expected.

Faulty assumptions

But that doesn't explain why the projections were off the mark in the first place.

A combination of factors is to blame, including an inability to accurately measure some of the components of the revenue stream, guessing wrong on the impact of fiscal actions like tax amnesties, and even faulty assumptions based on wishful thinking.

"We're forecasting future behavior," said H.D. Palmer, spokesman for the state Department of Finance. "We use the best tools available to us, but in the end, that's what it comes down to."

The biggest factor is the reliance on personal income taxes partly as a result of Proposition 13. What's more, California's income tax is more progressive than many other states, meaning it's skewed towards higher income earners.

While economists are generally pretty good at forecasting what will happen with wages, other components of personal income, such as capital gains and stock options, are harder to measure. These components are most often found among higher income people.

"We can only make rough estimates of these," said Martin Helmke, consultant to the state Senate Revenue and Taxation Committee and a former state revenue estimator.

"Even if the stock market starts turning down, if someone bought into the market years ago and rode the market up, they still report a gain on their income tax," he said. "No one else really knows until the income tax is filed whether selling the stock represents a gain or a loss. That's why it can often take a year to examine the returns before we understand why revenues jumped or fell."

In 1999 and 2000, stock options and capital gains counted for nearly 25 percent of all state general fund revenues. When that plunged to less than 15 percent in 2001 and 2002, it caught many people inside state government off-guard even though private sector analysts warned that such a dramatic drop might happen.

"I was one of the analysts on the phone questioning state officials on how comfortable they were on their revenue projections," remembered David Blair, senior analyst at Nuveen Investments in Irvine. "After such a steep run-up in revenues, any reasonable person looking at the performance of the stock market had to think a lot of that had to be given back."

'No one really knows'

One more factor: unexpected reactions to new or one-time fiscal policies. Last year, state officials launched a tax amnesty for people stowing money in illegal tax shelters. They expected to net about $90 million; instead, $1.6 billion poured in.

Now, the state is in the midst of a general tax amnesty, the first in 20 years. Officials expect $500 million by the time the amnesty ends on March 31, but "no one really knows," Helmke said.

On the flip side are overly optimistic assumptions of how much money new programs will bring in. Last year, Schwarzenegger announced a new program he said would raise $400 million by requiring a certain percentage of punitive damages in lawsuits to revert to the state. As it turned out, no money went into the fund, and the governor dropped the idea in his 2005-06 budget.

Likewise, tribal gaming revenues have come in short of predictions, as have promises to extract more funds from Washington.

Another case of wishful thinking is unrealistically high projections for revenues or savings from one-time measures designed to plug budget deficits. Both former-Gov. Gray Davis and Schwarzenegger proposed budgets relying on at least $1 billion from the sale of pension obligation bonds. But courts have found the state lacks the authority to sell these bonds.

"This is a direct consequence of trying to deal with past deficits," Blair said. "State officials get creative in their schemes to bring in more revenue and sometimes those schemes simply don't pan out."

Not all of the forecasting problems are on the revenue side. State officials have consistently underestimated spending growth in key social programs where spending is tied to caseloads or is subject to medical cost inflation. That's one reason the governor has talked about revising some of the formulas that put state spending on autopilot.

"The cruise control spending is out-of-control spending. The way the budget formulas now work, we will never catch up," Schwarzenegger said at a Jan. 10 press conference where he released his 2005-06 budget proposal.

Changing the process

So, given the poor track record in forecasting revenues and the size of budget deficits, what can be done about it?

Budget experts and analysts point to two general solutions. One is sequestering volatile or one-time revenues in a separate fund so that the money is not directed into normal program operations. Then it could either be kept in reserve or spent on one-time programs like specific highway projects.

That's what Davis tried to do with the extra revenues from capital gains and stock options in the late 1990s. He repeatedly said those funds should only be used for one-time expenditures, not ongoing programs.

But that only works for a while.

"If this goes on year after year, as it did in the late 1990s, pretty soon people want to know why their taxes are not being spent and they're going to demand some of it back," Rueben said. That's exactly what happened in 1998; in response, legislators and governors Pete Wilson and Davis agreed to cut the vehicle license fee.

The other approach is more complicated and politically risky: changing the tax structure so that it's less reliant on volatile and hard-to-predict revenue streams. The biggest single step would be to make property taxes generally the most stable of the major tax revenue streams a greater percentage of state revenues. But that would involve changing Proposition 13, long considered the "third rail" of California politics.

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