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2006-07 Revenue Estimate for the 79th Legislature,
Third Called Session

April 2006

Transmittal Letter

Tables Attachments News Release

The State of Texas will have $71.9 billion in General Revenue-Related funds to finance appropriations in the 2006-07 biennium. (See Tables 1, 2, and 3.) This revenue will come from three sources: tax collections; non-tax receipts such as fees, lottery proceeds, and interest; and the 2004-05 biennium ending balance.

Tax collections will generate $60.5 billion; and non-tax revenues will produce an additional $10.0 billion. Factoring in the $3.7 billion ending balance carried forward from 2004-05, these three sources total $74.2 billion. Against this amount, $2.5 billion must be placed in reserve for future transfers to the Economic Stabilization (“Rainy Day”) Fund, and $214 million must be added in adjustments to General Revenue-Related dedicated account balances.

In February, 2006, the Comptroller’s revenue estimate indicated that $4.3 billion in General Revenue–Related funds remained available to be appropriated or reappropriated, based solely on revenues received and legislative actions in 2005, and before taking into account any economic forecast revisions relative to the 2006-07 Biennial Revenue Estimate. The figure now stands at $8.2 billion.

The dramatic increase in available revenue is largely the product of three factors: stronger than expected national and state economic growth, sustained high oil and gas prices, and greater than expected non-tax revenue. (See Table 4.)

Largely as a consequence of strong growth in the national economy, state sales tax collections have been revised upward by $1.7 billion (4.8 percent); and franchise tax collections have been revised upward by $719 million (18.1 percent).

In addition, severance tax collections have been revised upward by $2.5 billion (77.5 percent), largely as a result of sustained high oil and gas prices. Of these, oil production and regulation tax revenues have been revised upward by $524 million (57.5 percent), while natural gas tax revenues have been increased by $2.0 billion (85.3 percent).

The increased severance tax revenues, however, also imply an increase in transfers of General Revenue-Related funds to the Economic Stabilization Fund. At the end of fiscal 2007, the balance is expected to total just under $1.1 billion.

Finally, non-tax revenues have been increased by $761 million (8.2 percent), largely because of a surge in the number and amount of fees, higher investment returns, and greater than anticipated vendor drug rebates and other federally related revenues.

Texas Economic Outlook

In addition to inflicting enormous human suffering, hurricanes Katrina and Rita are having a significant impact on the Texas economy during the 2006-07 biennium. In the aftermath, U.S. economic growth temporarily decelerated in response to surging oil and gas prices and the economic dislocation along the Gulf Coast. After this pause, however, the Texas economy benefited from new oil and gas exploration and development, as well as increased construction output and employment as Texas firms play a major part in rebuilding the affected areas.

Hurricane Aftermath. Overall, the combined damage from hurricanes Katrina and Rita is expected to reach almost $100 billion and could take many years to repair, especially in the New Orleans area, which formerly supported a population of 1.3 million. Some of the jobs and output in this area may be lost forever.

The negative fallout from the two storms extended far beyond New Orleans and the Gulf Coast. Even before hurricanes Katrina and Rita, increasing worldwide demand and limited supplies were causing oil and natural gas prices to rise. By eliminating—at least temporarily—almost 30 percent of U.S. oil and 20 percent of U.S. natural gas production, Katrina and Rita accelerated this trend.

From a low of $19.73 per barrel in January 2002, the NYMEX one-month futures price of oil more than tripled to $65.55 per barrel in September 2005. During this same period, the one-month futures price of natural gas increased more than five-fold, from $2.19 per thousand cubic feet (Mcf) to $12.11 per Mcf. Subsequently, the price of natural gas reached almost $13.50 per Mcf in October and again in December. The reduction in the nation’s oil refining capacity—already close to its physical limits—helped push U.S. gasoline prices up to almost $3.00 per gallon for a brief period.

By March 2006, oil prices still averaged $62.97 per barrel, but the average price of natural gas had fallen to $6.93 per Mcf because of rising inventories and a warmer than normal winter in most parts of the country. And, although gasoline prices had retreated to just over $2.00, they subsequently inched back upward to almost $2.60 per gallon and are likely to climb even higher as the summer driving season approaches.

Looking at the nation as a whole, rising energy prices, at least temporarily, put a chill on consumer spending throughout the entire country. The portion of disposable income consumed by energy costs jumped to an estimated 6 percent—a relative increase of 20 percent—between the fourth quarter of calendar 2004 to the fourth quarter of calendar 2005. The drag of higher energy costs, coupled with poor auto sales, caused national consumer spending and Gross Domestic Product (GDP) growth to fall from an annual rate of approximately 4 percent in the third quarter of 2005 to about 1.0 to 1.5 percent in the fourth quarter. However, most national economic forecasters expect U.S. consumer spending and GDP to register annual growth rates of 4.5 to 5.0 percent in the first quarter of 2006, essentially making up for the previous quarter’s anemic performance.

Despite the initial negative impact of higher energy prices on the U.S., the rebound in Texas oil and gas exploration and development, plus increased statewide nonresidential construction activity (including Texas’ contributions to Gulf Coast rebuilding efforts) are now exerting even greater positive effects on the Texas economy.

Higher Energy Prices Spur the Texas Oil and Gas Industry. Even though oil and gas are no longer as dominant a force in the Texas economy as they were 20 years ago, the prospect of higher oil and gas prices over the long term has and should continue to encourage statewide exploration and development activities. Since Texas oil and natural gas prices hit a recent bottom in fiscal 2002, the statewide rotary rig count has increased by almost 100 percent, with almost two-thirds of new drilling activity associated with the search for natural gas.

Oil and gas employment has increased directly with the new drilling activity. From the fourth quarter of calendar 2002 through the first quarter of calendar 2006, Texas oil and gas employment increased by an estimated 25,900 jobs, or 18 percent.

As the nation ends the winter heating season, relatively high oil and gas prices are expected to continue past the first half of fiscal 2006. Over the full 2006 fiscal year, the taxable price of Texas oil is expected to average $55.78 per barrel, while taxable natural gas prices should average $6.94 per Mcf.

Sustained high energy prices tend to encourage conservation as well as exploration and discovery activities, so oil and gas prices are expected to ease to $47.79 per barrel and $6.10 per Mcf in fiscal 2007—prices still high by historical standards.

Post-Hurricane and Commercial Building Favor Texas Construction. After three straight years of employment declines, the Texas construction industry began to recover in 2005, reflecting continued strength in residential activity, as well as in portions of non-residential (e.g., highways and utilities) activity across the state. As of the first quarter of calendar 2006, statewide construction employment was up by almost 5 percent over the job level in the first quarter of calendar 2005.

According to Global Insight, Inc., approximately 150,000 housing units and $26 billion in oil and gas rigs, power lines, pipelines, and other nonresidential infrastructure are expected to be rebuilt in New Orleans and other parts of the Gulf Coast over the next few years. Because of its specialization in rig construction and repair and the close proximity of Houston and other Texas construction firms to the damaged Gulf Coast, Texas economic activity has benefited.

In addition, as vacancy rates decline and rents increase, retail, office, and other commercial construction have begun to rebound. Consequently, statewide nonresidential construction is expected to increase almost 11 percent in fiscal 2006. However, as U.S. residential construction falls, Texas housing construction will eventually begin to decline over the next two years. Overall, Texas construction employment will increase by 3.5 percent in fiscal 2006 and by 2.2 percent in fiscal 2007, largely because of the rebuilding effort.

Slower Economic Growth in 2006 and 2007. Two factors will combine to cause U.S. economic growth to decelerate in fiscal 2006 and 2007.

First, rising household debt levels—coupled with increasing interest rates and higher minimum credit card payments—are expected to slow consumer spending. In 2005, the national personal savings rate fell below zero on an annual basis for the first time since the Great Depression. This means that some rebuilding in household savings—and retrenchment in consumer spending—can be expected, especially if the financial gains from rising house prices dissipate.

Second, overvalued housing prices and rising mortgage rates are expected to cool national-level housing sales and residential construction activity. By most accounts, housing prices in certain populous regions—particularly California, the Northeast, and Florida—are now significantly overvalued relative to household incomes. Nationally, new home sales—a bellwether of future housing activity—have dropped by 20 percent over the last several months, leading to the expectation that U.S. residential construction activity will fall significantly in 2006 and 2007. So far, this has not occurred in Texas, largely because of the sharp downturn in housing prices during the high-tech slump at the beginning of this decade.

Over the last few years, U.S. consumer spending has been fueled to a significant degree by the rapid rise in housing prices. The escalation in housing prices has not only made homeowners feel wealthier, it has put additional cash in their hands either by allowing them to “cash out” their equity directly or draw it out indirectly via home equity loans or other financial tools.

According to the Federal Reserve Board and Moody’s, U.S. net “mortgage equity withdrawals” from cash-out refinancing, home equity loans, and capital gains from home sales (after closing costs) have more than tripled from just above $200 billion in 2000 to $700 billion in 2005.

Consumer spending accounts for approximately two-thirds of Gross Domestic Product, and the health of the state economy remains firmly tied to the national economy. Hence, a reduction in national economic growth attributable to the falloff in national consumer spending also will slow the state economy. Moreover, as the housing downturn and rising debt levels surface within this state, Texas households can be expected to cut spending in direct response—further reducing state revenue growth.

Texas Economic Growth Should Outpace U.S. Economic Growth. Even though economic growth is expected to slow down, higher oil and gas prices and the post-hurricane rebuilding efforts should allow Texas to continue to outpace national economic growth to a modest degree in 2006-07. Real, inflation-adjusted Gross State Product is expected to increase by 4.9 percent in fiscal 2006 and by 4.0 percent in fiscal 2007, or about 1.5 percentage points per year faster than the national rate. Thanks largely to strong job gains in the first half of the year, statewide non-farm employment will grow at a robust 2.6 percent rate in fiscal 2006, with personal income rising by 7.0 percent. In fiscal 2007, Texas non-farm employment growth is expected to slow to a still respectable 1.9 percent rate, with personal income growth dropping in tandem, to 6.4 percent. (See Table 5.)

Finally, even though the state’s relatively high birth rate and continuing net in-migration will increase the Texas population by approximately three-quarter of a million persons, a relatively strong job market should cause the state’s jobless rate to fall to below 5 percent in the second half of fiscal 2006.

Forecast Risks. Although the outlook for the Texas economy is generally positive, there are at least three major risks that could lead to lower economic growth in 2006-07.

The first and by far the most important risk is that, rather than slowing, as expected, a sharp downturn in national housing prices could take an even bigger chunk out of U.S. consumer buying power. Even though a similar downturn in Texas housing prices is extremely unlikely, the resulting potential slump in U.S. consumer spending also would adversely affect Texas.

Second, a major long-lasting spike in world oil prices could seriously disrupt national and worldwide economic growth. As evidenced by the high volatility in oil prices in recent months, there remains a razor-thin margin between worldwide oil production and demand. Thus, any politically-induced or other significant disruption in worldwide oil supplies would likely send energy prices sharply higher and adversely affect economic growth in Europe, Asia, and the United States.

Finally, higher than expected inflation and the continued drag of the nation’s budget and international trade deficits could force the Federal Reserve Board to sharply increase short-term interest rates. The current state economic forecast assumes that as the Federal Reserve continues to gradually nudge up the federal funds rate, the prime rate will increase from an average of 5.7 percent in fiscal 2005 to 7.9 percent in fiscal 2007. However, if short-term rates rise at a significantly faster pace, national as well as state economic growth would be expected to falter.

The 2004-05 Ending Balance

The state ended the 2004-05 biennium with an available General Revenue balance of $3.7 billion. This balance, in addition to estimated revenues, will be used to fund the 2006-07 appropriations.

The Economic Stabilization Fund

For the fifth time since the creation of the Economic Stabilization Fund (ESF) in 1989, the 2005 Legislature drew down the fund balance. For the three-year period 2005-07, the Legislature appropriated and/or authorized the transfer of $1.7 billion from the ESF.

Transfers from state natural gas and oil production tax collections to the ESF are estimated to total $2.9 billion over the three-year period 2005-07. As required by the Texas Constitution, estimated transfers to the ESF have been deducted from available revenues and balances. In addition to the transfer of $594 million from fiscal 2004 tax collections and $905 million from fiscal 2005 tax collections, this estimate anticipates that an additional $1.4 billion will be transferred to the ESF in fiscal 2007. At the end of fiscal 2007, the ESF balance is expected to total just under $1.1 billion.

Tax Revenue

Taxes provide the most important source of general revenue for the state. As in years past, sales and use tax collections will continue to dwarf all other tax revenue sources, with motor vehicle sales tax revenues a distant second. The state’s general business tax, the franchise tax, is the third largest general revenue source and the largest state tax not levied directly on consumption. The natural gas tax ranks a close fourth.

Sales Taxes. In fiscal 2005, Texas sales and use tax receipts totaled $16.2 billion, up 5.8 percent from 2004. This increase followed a gain of 7.9 percent in 2004 and continued the positive trend for collections following two years of declines in 2002 and 2003.

The growth in sales tax for fiscal 2005 was driven by several major sectors of the economy. The communications, construction, and wholesale sectors each experienced gains of more than 10 percent for the year. Additionally, higher energy prices led to significant increases in the mining and utility sectors, which were up 44.6 percent and 10.6 percent respectively. Sales and use tax collections from the retail sector, which accounted for more than 54 percent of total sales tax revenue, rose by 5 percent in fiscal 2005.

For the first of half of fiscal 2006, the strength in the sales tax has continued with the retail and construction sectors growing by more than 10 percent. Energy prices also continue to drive the mining and utility sectors, which recorded increases of 47.0 percent and 25.6 percent, respectively.

Sales taxes are expected to generate $36.4 billion in 2006-07. Compared to the $31.6 billion collected in 2004-05, this represents a 15.1 percent biennial increase.

Franchise Tax. In 2004-05, franchise tax collections totaled $4.0 billion, compared to the $3.7 billion collected in the previous biennium. The 9.7 percent gain reflects the strong surge in national corporate profits that began in calendar 2002. Corporate profits of U.S. industries in 2004 were 63 percent above the calendar 2001 low point. Franchise tax collections responded (with about a two-year lag) by increasing 6.9 percent in fiscal 2004 and 18.3 percent in 2005.

Franchise tax revenues for 2006-07 are expected to total $4.7 billion—up 17.9 percent when compared to the $4.0 billion collected in the preceding biennium.

Motor Vehicle Taxes. The state’s principal motor vehicle taxes consist of the motor vehicle sales and use tax, the motor vehicle rental tax, and the manufactured housing sales and use tax.

Throughout most of 2004-05, manufacturer and dealer price incentives spurred a prolonged surge in new vehicle sales. As manufacturers reduce or abandon their use of incentive programs, new car sales should slow down in the later half of fiscal 2006 and register only modest growth through the remainder of the biennium. This softening in sales will be reinforced to the extent that elevated gasoline prices will cause some consumers to turn from relatively expensive sport utility vehicles and trucks to more fuel-efficient—and less expensive—four- and six-cylinder sedans and station wagons.

As a group, motor vehicle taxes should contribute $5.8 billion to state revenue in 2006-2007, up 4.1 percent from the $5.6 billion collected in 2004-05.

Motor Fuels Taxes. In fiscal 2005, year-to-year gasoline tax collections decreased—for the first time since 1991—by 0.6 percent. Diesel fuel tax collections, however, rose by 4.6 percent, down from the 5.5 percent annual growth registered in 2004.

In 2004-05, the excise taxes on gasoline, diesel fuel, and liquefied gas totaled $1.6 billion. Motor fuels tax revenues are expected to increase by 4.1 percent in 2006-07, reaching $1.6 billion.

Oil and Gas Severance Taxes. Fiscal 2005 was another volatile year for oil and gas prices. Oil prices surpassed $50 per barrel toward the end of the year, pushing the average annual taxable price up to $46.88, a 44.4 percent increase over the previous year. The dramatic rise in oil prices had two revenue effects. First, because the tax is levied as a percentage of price, there was a direct translation to increased oil production tax revenues, despite ongoing production declines. Second, the level of oil production tax collections in 2005 triggered the constitutional transfer of revenues to the Economic Stabilization Fund. This transfer—only the second in response to oil production revenues since 1991—totaled $112.1 million.

Oil production and regulation taxes are expected to generate $1.4 billion in the 2006-07 biennium, compared to $1.2 billion in 2004-05—a 21.9 percent increase.

Following the price spike to $4.03 per Mcf in fiscal 2003, taxable natural gas prices continued to rise in fiscal 2004 to $4.49 per Mcf, and again in fiscal 2005 to $5.46 per Mcf. Natural gas tax receipts are expected to total $4.2 billion in 2006-07—up 36.7 percent from the $3.0 billion collected in 2004-05.

Insurance Taxes. Total insurance tax revenues for 2004-05 came in at $2.39 billion—an 8.1 percent rise over the $2.21 billion collected in 2002-03, reflecting a cooling-off in premium growth relative to the dramatic 37.0 percent jump registered in the 2002-03 biennium. Net insurance tax revenues are expected to remain virtually flat at $2.44 billion in 2006-07.

Tobacco and Alcoholic Beverage Taxes. In response to declining consumption, combined collections from the cigarette and cigar/tobacco products taxes in 2006-07 are expected to decline by 2.4 percent—to $1.11 billion—relative to the $1.13 billion collected in 2004-05.

Alcohol taxes are expected to generate $1.3 billion in 2006-07, up 6.2 percent from $1.2 billion collected in 2004-05.

Utility Taxes. Utility tax receipts increased to $736 million in 2004-05, up 15 percent when compared to 2002-03 collections. This relatively strong revenue growth is expected to continue into 2006-07—on the order of 13.2 percent—yielding a total of $833 million.

Other Taxes. Hotel occupancy tax revenue has been increasing each year since 2003. Following the 4.9 percent downturn registered in the 2002-03 biennium, 2004-05 saw a 9.2 percent increase in tax revenues, to $501 million, as tourism and business travel rebounded. Tax receipts for 2006-07 are expected to grow somewhat faster, rising 15.1 percent to $576 million.

The Texas inheritance tax is linked to the federal estate tax, which includes provisions for the states to share the revenue from the estate tax. Due primarily to changes in federal law, the inheritance tax generated $102 million in fiscal 2005—a 69.5 percent decrease from fiscal 2002. Although Texas no longer imposes a tax on estates, it will collect its last revenue in fiscal 2006, estimated to be $15.0 million, because the tax is due nine months after a person’s death.

The state’s remaining taxes, levied on such disparate entities as cement, sulphur, coin-operated machines, oil-well services, attorneys, and bingo rental receipts, are expected to produce $121 million in 2006-07, up 17.9 percent from the $103 million collected in 2004-05.

Non-Tax Revenue

In addition to the $60.8 billion in tax revenue estimated for the 2006-07 biennium, the state’s General Revenue-Related funds are expected to collect $10.0 billion in non-tax revenue. Non-tax revenue comes from the Permanent School Fund (PSF) interest and investment earnings, state lottery proceeds, fees, and other sources. The 2006-07 estimate represents a 1.2 percent decrease from the $10.2 billion collected in 2004-05.

Interest and Investment Income. Interest and investment income is expected to decrease by 3.5 percent to $1.6 billion in 2006-07. The $21.6 billion Permanent School Fund (PSF) produces most of the investment income accruing to General Revenue-Related funds.

Lottery Proceeds. In fiscal 2005, overall Texas lottery sales increased by 5.0 percent, with instant tickets, which accounted for nearly 74 percent of total dollar sales, posting a 16.3 percent sales increase.

All game types combined, Texas lottery sales totaled more than $3.7 billion in fiscal 2005, of which $1.0 billion was transferred to the Foundation School Fund. Lottery transfers to the state are projected to remain flat at $2.0 billion in 2006-07, the same amount collected in 2004-05.

Other Revenues. In fiscal 1999, Texas began receiving regularly scheduled court settlement payments from tobacco product manufacturers. Beginning in 2000-01, payments were adjusted for changes in the national consumer price index and the settling tobacco companies’ U.S. cigarette sales and domestic operating profits. In 2004-05, Texas tobacco settlement receipts totaled $982 million; in 2006-07 receipts are expected to yield $995 million, an increase of 1.4 percent.

With respect to federal payments, revenues from the Disproportionate Share Program, which helps pay for indigent care at state and local hospitals, are expected to fall by $89 million, or 12.3 percent, to $634 million in 2006-07. State Disproportionate Share payments jumped in 2004-05 because the federal government temporarily allowed participating hospitals to receive payments for up to 175 percent of the cost of indigent care, but in 2006-07 reimbursements will return to the traditional 100 percent rate.

Buoyed by the supplemental state rebates approved during the 2003 regular legislative session, General Revenue rebates from major pharmaceutical manufacturers participating in Medicaid’s vendor drug program are expected to increase by $79 million, or 16.2 percent, to $568 million in 2006-07. Although state vendor drug rebates are expected to eventually decline as Medicare, rather than Medicaid, assumes responsibility for providing prescription drugs to low-income senior citizens, this impact is not expected to occur until fiscal 2007. Premium credits, which used to be based on the differential between state Medicaid premium payments and the cost of patient care, are expected to fall from $49 million in 2004-05 to $4 million in 2006-07 because the state now pays Medicaid providers directly for their services.

Finally, 2006-07 revenues will decline by $355 million due to the temporary federal state fiscal relief payments initially authorized by Congress in 2003. Under the Flexible Grant Program, Texas received two equal payments of $355 million—one in fiscal 2003 and the other in fiscal 2004. These payments ended in fiscal 2005.

Revenue to All Funds

Revenue to all funds will total $139.2 billion in 2006-07. Of this amount, general revenue-related receipts will total $70.5 billion, and dedicated federal income will account for $48.4 billion. Most of the federal funds will be used for health and human services, highway construction and maintenance, and public education programs. A second large source of all funds revenue is the State Highway Fund’s share of motor fuels tax revenue, which is constitutionally dedicated to highway construction and maintenance and public transportation.

Total revenue to all funds does not equal appropriations to all funds because the total estimated revenues do not include the fiscal 2005 ending balance in the General Revenue Fund, which provided part of the $138.6 billion appropriation for 2006-07.

In addition, total estimated revenues do not include certain local funds that are appropriated but not deposited into the State Treasury, but they do include certain revenues that are deposited in the State Treasury but not appropriated, such as royalties deposited to the Permanent School Fund. (See Table 6.)