Department of business and finance

Deep in the bowels of the California Department of Finance, a small group of economists toils at producing the economic forecast on which the governor's budget is based. It's not glamorous work, and too often it seems thankless; but it certainly is interesting.

The Department of Finance is in the executive branch of California state government and, as such, is part of the governor's administration. Its principal functions are to prepare, enact, and administer the state's annual budget; establish appropriate fiscal policies to carry out the state's programs; and analyze legislation with a fiscal impact on the state.

Forecasting

The economics unit contributes to all three functions, but its primary responsibility is producing the economic forecasts on which budgets are based. As part of the annual budget process, the unit develops three forecasts each fiscal year. Each of these consists of a near-term national economic forecast, a near-term California economic forecast, a Consumer Price Index forecast, and a set of long-range economic assumptions. In addition, the unit forecasts the values of the many cost of living adjustment (COLA) factors that are used in state programs.

The Planning Estimate forecast, developed in September, begins a new budget cycle and is the department's first take on the economic outlook for upcoming fiscal year--the budget year. This forecast provides input for the economics unit's Planning Estimate COLA factor forecasts and for the revenue forecasts made by the financial research unit, a separate unit. The revenue forecasts are important input for the program expenditure forecasts made by other units in the Department of Finance. The purpose of this department-wide undertaking is to get a preview of the state's finances before work begins in earnest in November on the Governor's budget for the next fiscal year.

In early November, the economics unit prepares an initial version of the Governor's budget forecast, which is reviewed by the department's executive office before being mailed to the participants of the economic outlook conference, usually held the week before Thanksgiving. For more than 50 years, the Department of Finance has invited private and public sector economists from around the state to convene with us so that we can get their comments and advice on our preliminary forecast, hear their views on current conditions in state industries and regional economies, and discuss with them the outlook for those industries and economies.

In the past, large commercial banks and utilities were well represented at the table, but retirements, deregulation, and mergers and acquisitions have taken a toll on the number of business economists in those industries. Still, we have been able to maintain coverage of most industries and regions in the state by tapping university forecasting projects, economic development organizations, and consultants. Finding an expert in retail trade has been a persistent problem, however.

After the conference, we re-run our forecasts taking into account what we learned at the conference. Once approved by our executive office and the governor, we distribute the results to the revenue estimators and other units of the department. In early January, the governor holds a press conference outlining the new budget. Meetings with rating agencies (Standard & Poor's, Fitch, and Moody's) follow. Sometimes they are very interested in the economic forecast. More recently, however, plans for dealing with large budget shortfalls have taken center stage.

In March, we begin the third round of budget forecasting, with input from the University of California in Los Angeles's Anderson Forecasting project. In conjunction with their March economic outlook conference, Anderson holds a seminar largely devoted to a presentation and critique of the Governor's Budget forecast. Shortly after returning from the seminar, we go to work on the May Revision forecast.

"May Revision" is shorthand for the May Revision of the Governor's Budget. The process is not much different from the earlier Governor's Budget exercise. We produce a new set of economic forecasts, taking into account economic developments that have occurred and economic statistics that have been released since the governor unveiled his or her budget in January. Similarly, the revenue forecasts and expenditure estimates are revised. In mid May, the governor presents the May Revision to the budget at a press conference.

Forecasting the economy for purposes of developing a budget is more challenging than, say, forecasting how much real GDP will grow next year. What matters in economic forecasting for a budget is getting the level right, not the growth rate. This is because the ultimate goal is to accurately forecast tax revenues. For example, because personal income tax revenues are so closely tied to total wages and salaries, accurately predicting the level of wages and salaries in the budget year is critical. If wages and salaries are predicted to grow by five percent in 2004, and the Bureau of Economic Analysis of the U.S. Commerce Department revises down the historical wages and salaries data that was used in making the forecast, a perfect forecast of the growth rate translates into an overestimate of the level.

A more recent challenge is the effective lengthening of the short-run forecast horizon caused by the budget problems California has experienced in the last three years. Some of the transfers, loans, and deferrals that have been used in recent years come due in the next few years rather than the next few months. As a result, the focus in budgeting can no longer be primarily 18 months; and 30 months is becoming the relevant horizon.

Analysis of Legislation

The economics unit also helps with the analysis of legislation that has a fiscal impact on the state. Traditionally, we have acted as reviewers of analyses or as consultants. The passage of Senate Bill 1837 in 1991 got us more directly involved in analysis of proposed legislation, however. The bill required the Department of Finance to conduct a dynamic revenue analysis of any new revenue legislation expected to have a fiscal impact of $10 million or more on a static basis. (The traditional static analysis does not take into account any of the effects the tax change would have on the economy and, thus, any feedback effect on tax revenues.)

Our dynamic revenue analysis model is a computable general equilibrium model designed to estimate the effects a tax law change would have on the economy and, through these effects, on tax revenues. Building such a model is a significant undertaking. Thus, the department hired an economist who had earned a Ph. D. in this specialized field. In addition, we contracted with professors at the University of California at Berkeley. The resulting model has more than one thousand equations. After hundreds of analyses, we have not found a tax cut that would have such a large feedback effect that it would result in higher tax revenues. Neither have we found a tax increase that would not exert a drag on the economy. The law expired in January 2000 without a free lunch ever being found. We still receive plenty of requests to have proposed tax cuts tested, however. Hope springs eternal.

Other Activities

One of the other tasks of the economics unit is responding to information requests. We receive a large number of these, and to lessen the burden we post a considerable amount of data on the state economy on the department's website. We also post our publications there: the California Statistical Abstract, California County Profiles, California Economic Indicators, and the Economic Report of the Governor. The Finance Bulletin, which we produce jointly with the revenue unit, is also on the website.

We also act as economic advisers to other state government departments and agencies, sit on inter-departmental committees, testify before the legislature, and on request, review the work of economists in other state government departments and agencies.