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April 2007

MARCH REVENUE (IN MILLIONS):  SALES TAX: $1540.5  OIL PRODUCTION: 66.5  NATURAL GAS: $142.5  MOTOR FUELS: $237.2
MOTOR VEHICLE SALES: $281.9  TOBACCO: $139.1

The State of the Texas Economy: The Biennial Revenue Estimate
Comptroller Forecasts State Economy, Revenues.

The Texas economy is cooling, but far from cold. Its growth will continue to meet or exceed the national average over the next several years. And that will keep state revenues healthy.

Those are the major conclusions of the Comptroller's biennial revenue estimate (BRE) for the 2007 Texas Legislature, covering the state's next two-year budget period, 2008-09.

"This is a great time in Texas," said Texas Comptroller Susan Combs. "Our state's strong economy is continuing to produce revenue growth to serve Texans' needs. However, it is my duty as Comptroller to point out that I do expect a cooling of the economy in the months ahead."

For the 2008-09 biennium, Combs estimates that the Legislature will have $82.5 billion in general revenue available for appropriation, in addition to $79.3 billion in state and federal funds dedicated to various specific purposes, such as Medicaid and the Permanent School Fund.

Looking Ahead

For every regular session of the Legislature, the Comptroller's office produces an estimate of available state revenues for the following two years, based on its forecast of the underlying state economy.

Texans gave the Comptroller this responsibility more than 60 years ago, with the 1943 adoption of a "pay as you go" provision in the Texas Constitution. This provision requires the Comptroller to produce an itemized estimate of anticipated revenue for an upcoming budget cycle. The Legislature cannot make appropriations for the budget period exceeding the Comptroller's BRE except by a four-fifths vote of each house.

"To produce the BRE, the first thing we do is a forecast of the Texas economy," said John Heleman, the Comptroller's chief revenue estimator. "We consult with large economic forecasting houses throughout America, and find out what they think is going to be the direction of the U.S. economy. Then our economists develop our own forecast for Texas. That forecast of the Texas economy provides the underlying basis for the BRE, as all taxation depends upon economic activity of some sort."

Comptroller revenue estimators assigned to specific taxes follow the industries involved and the effects of economic events and changes in law on likely tax collections, often using sophisticated econometric models to track and predict trends.

High-Tide Years

In the last two years, Texas enjoyed its most rapid economic growth in nearly a decade. The state economy expanded at an estimated, inflation-adjusted rate of 4.5 percent this biennium, easily surpassing the national growth rate. This expansion is expected to add nearly 462,000 jobs in the state during the current 2006-07 budget cycle.

And that growth showed up in Texans' wallets. Rising employment and higher wages lifted statewide personal income by 7.4 percent in fiscal 2006 and an estimated 6.7 percent for fiscal 2007. That performance marked a stark--and welcome--contrast from just a few years earlier. In the 2002-03 biennium, the economy grew by just 1.8 percent annually, and lost more than 155,000 jobs.

The recent strong performance resulted from several factors. One of them was simply the strong national economy; many Texas companies serve national and international markets, and benefited from the general improvement as the shocks of 9/11 receded. After declining for six years, for example, Texas manufacturing employment increased modestly in 2005-06.

The soaring energy prices that raided wallets and raised blood pressure last summer also provided a boost to Texas' producers.

"The rapid acceleration in the price of natural gas and oil over the past few years has led to more exploration and drilling activity [in the state]," Heleman said.

In fiscal 2006, the state's rig count hit its highest level since 1985.

And one of the nation's strongest housing markets also buoyed the economy, in more ways than one. Low mortgage rates, for instance, spurred an increase in homeowner refinancing.

"We saw a rapid rise in the number of people using the cash-out option when they refinanced their homes," Heleman said. As U.S. and Texas housing markets have moderated, mortgage equity withdrawals have as well. In fact, national data indicates these types of transactions quadrupled between 2000 and 2005.

Bloom off the Boom

For better or worse, the heated economic activity of the last few years seems poised to cool down, not in a slump, but a correction.

Oil and gas prices remain extremely sensitive.

"Oil was up around $70, and gas was around $7 or $8 per mcf [thousand cubic feet]. In [2008-09], we see oil in the range of the lower to mid-50s, in terms of taxable value, and gas at about $6 per mcf," Heleman said. "And that is going to translate into less revenue for the state."

Of course, lower energy prices have positive effects as well, said Bruce Keller, associate director of the University of Texas" Bureau of Business Research (BBR).

"The energy situation is a double-edged sword," Keller said. "It [hurts] energy producers and some service companies, but it benefits the state's consumers. So it's sort of a wash."

Over 2008 and 2009, the Texas housing sector will feel the effects of the nationwide slump in housing starts and prices, although not as keenly as most other states.

"The country's coasts are having significant downturns in housing," Heleman said. "Texas will not see a drastic downturn because our housing has never been overvalued, but we certainly are going to see a slowdown.

"And we can see from federal data that refinancings are dropping off from the levels of the past few years. As that happens, of course, you have more and more people that don't have these extra dollars in their pockets, and they're not turning around and spending money. So retail spending is expected to return to a more sustainable level," he said.

Yet housing remains a relative bright spot for Texas, particularly compared with other states.

"The housing market will slow, but non-residential construction remains strong," said Ray Perryman, president of The Perryman Group, a Waco-based economic and financial analysis firm.

BBR's Keller agrees.

"The housing market has held up remarkably well compared to other states in the Southwest," he said. "We haven't seen the softness in prices that they have in other markets. That's definitely an encouraging sign."

Despite the slowdown, the Comptroller's office expects Texas to add more than 412,000 jobs during 2008-09.

Revenues Rise Anyway

Since state finances rely on the condition of the underlying state economy, a slowdown inevitably will result in less growth in revenue for state government. Even so, the $82.5 billion for general-purpose spending estimated for fiscal 2008 and 2009 represents a 10 percent increase over revenues for the previous two fiscal years.

This amount represents a combination of taxes ($67.7 billion); other revenues such as fees, licenses, lottery proceeds and interest and investment income ($9.8 billion); and the previous biennium's ending balance, less transfers to the state's Rainy Day Fund and other adjustments ($5 billion).

Sales taxes are the state's biggest single source of revenue. After jumping an impressive 12 percent in fiscal 2006, the largest such increase (after adjusting for inflation) since 1978, the BRE reports that the growth in sales tax collections will taper somewhat. The BRE projects that sales taxes will generate $41.5 billion in the 2008-09 biennium, a 10.1 percent increase over the previous two years.

Motor vehicle sales taxes, the state's second-largest tax, are expected to bring in $6.9 billion in 2008-09, about 8.7 percent more than in the previous biennium.

The state's primary business tax, the franchise tax, will change during the course of the next budget cycle as 2006 legislation goes into effect on January 1, 2008. At present, the tax applies to corporations, but under the new law, a modified version of the tax will be applied to other forms of business as well, including partnerships, but excluding sole proprietorships.

This will generate total 2008-09 revenues of $11.9 billion, more than twice as much in the previous biennium. But only $5.8 billion of that will be available for general appropriations, with the remainder devoted to school property tax relief.

The BRE projects that some tax collections will fall, particularly those on oil production and natural gas. These still important contributors to the state economy will play a somewhat smaller role in the next budget cycle, falling 13.6 percent and 15.1 percent respectively--due to declining energy prices--bringing in a combined $4.9 billion over 2008-09.

Down the Road

Of course, any attempt to forecast the future of an economy as large and vibrant as Texas' is subject to events that cannot be predicted. The BRE highlights some potential factors that could change the outlook for the state.

Most importantly, any significant increase in interest rates could hurt economic growth and in particular could deepen and lengthen the housing downturn. And a sustained increase in interest rates would increase the cost of borrowing, limiting household and business spending on "big-ticket" items such as vehicles, large appliances and computer equipment.

Furthermore, political or other disruptions to world oil supplies could drive energy prices up sharply again. This would have some good effects for Texas' oil and gas producers, but these would likely be outweighed by the long-term drag on the state and national economies.

On the other hand, independent economists seem upbeat about the future.


Angelos Angelou

"Overall, I'm very bullish. [Metropolitan economies] are moving on eight cylinders," said Angelos Angelou, principal of Angelou Economics, an Austin economic development consultancy. "Yes, we may be seeing a [national] slowdown in residential housing, but I think Texas is going to be spared from most of those declines.

"There's a lot of venture capital spending in the state, and hopefully, the growth in the technology sectors will offset any slowdown that may occur in housing and soften the impact that lower energy prices might have," he said. "[Technology] entrepreneurship is exactly what is driving the Austin economy and to some extent the Houston and Dallas economies."

Angelou stressed the contributions of the state's economic development efforts.

"Texas has done rather well, particularly because two state incentive programs--the Enterprise Fund and the Emerging Technology Fund--are making a big difference. I think they're fueling economic growth in all parts of Texas," he said.

Keller said he would focus on the changing demographics of the state.

"The state is getting more Hispanic, and opportunities for minority entrepreneurs are going to be significant," he said. "Business that caters to the Hispanic market is going to expand hugely in the next two decades. There will be more and more roles for Hispanic entrepreneurs, including Mexican-based companies moving into the Texas market."

Increasingly, the state economy is going to be driven by demographics that are rapidly altering the landscape, Keller said. State funding targeted for encouraging minority entrepreneurs could pay big dividends.

"That's where the bigger bang for the state's dollars is going to be," he said.

Bruce Wright

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