NEW YORK - The California Legislative Analyst's Office (LAO) released its economic and revenue forecast for the remainder of fiscal 2012 and the subsequent five years. By incorporating the revenue effects of the governor's tax initiative, which was included in his January budget proposal, the LAO raised its state general fund revenue projections by $6.7 billion, or 3.92% through fiscal 2013, compared with its November 2011 forecast.

But even if the higher revenue from the increased taxes is not counted, the LAO projects that general fund revenues would be higher through fiscal 2013 than it projected in its November forecast, albeit by only $2.7 billion, or 1.58%. This revised revenue forecast is similar enough to the prior forecast that it does not alter Standard & Poor’s rating or outlook at this time.

The LAO's revenue outlook anticipates $6.5 billion less in revenue collections than the California Department of Finance (DOF) assumed in the governor's proposal through fiscal 2013. A key source of the difference between the LAO and DOF forecasts relates to each office's assumptions about capital gains income tax revenue, which both acknowledge are difficult to forecast.

Standard & Poor’s outlook change (published Feb. 14, 2012) speaks to a two-year time horizon and communicates our view that there is at least a one in three possibility that we will raise the state's rating during that period. Importantly, a shift toward an improved budget structure and a reduced risk of very late budget adoption, which is beneficial to the state's credit quality over the medium term.

Although these changes have yet to fully materialize in the form of a stronger cash position, the groundwork is in place for this to happen, notwithstanding that the state recently encountered a weakened cash position, Standard & Poor’s said. The inadequate cash cushion, which partially reflects the timing of certain cash flows, was restored through a mix of short-term borrowing and payment deferrals. Moreover, the outlook does not solely reflect a specific revenue forecast, nor is it predicated simply on near-term cash receipts and disbursements.

Insofar as the state's revenue profile tends toward cyclical performance, the governor's tax proposal -- if approved by voters -- would capitalize on the potential upswing in state revenues. However, if the LAO's forecast proves more accurate, the potential revenue boon would be lower.

Similarly, if voters reject the tax proposal, additional deficit solutions would be necessary. A budget that definitively offsets the potential revenue that would be foregone if the tax measure is rejected would be beneficial to the state's credit quality.

Although the structural fiscal and budget process changes are the most important to the state's fundamental credit quality, cyclical factors could also support incremental strengthening of the state's credit quality. Just as the economic recession weakened the state's credit quality, the recovery has potential to strengthen it. However, the absence of a budget reserve sufficient to cushion fluctuations in the state's fiscal position and a revenue base prone to volatility remain impediments to substantial rating improvement.

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