GENERAL FUND BUDGET OUTLOOK

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GENERAL FUND BUDGET OUTLOOK

• November 9, 2007

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Highlights

• There have been significant revenue surpluses for
  the last three fiscal years. This was due in part
  to a strong state economy and the cautious
  revenue forecasts in light of sizable portion of
  the surplus coming from volatile sources.
• The biggest risk surrounding the 2007-08 forecast
  is the continuing real estate slump plus the
  financial sector upheaval.
• These risks should be adequately covered by a
  moderately cautious overall revenue forecast of
  only 3.8 baseline growth for 2007-08 (actual was
  9.2 for 2006-07).
• The revenue surplus in recent years has
  essentially eliminated the structural budget gap.

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How Do 2007-08 Revenues Look So Far?

• The first quarter of the fiscal year is the least
  important from an indicator point of view.
• Major receipts in these months (sales,
  withholding tax) closely track the experience of
  the last few months of the prior fiscal year
• Volatile revenue sources (corporate income,
  non-withholding), which have led to large
  surpluses in recent years, do not show up until
  the second half of the fiscal year.

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How Do 2007-08 Revenues Look So Far? (cont.)

• With these caveats in mind, we can report that
  the first quarter General Fund revenue came in
  about 70-75 million ahead of a 4.5 billion
  target for the period.
• In other words, collections are running 1.7
  above expectations. The target growth rate for
  the first quarter was 5.0, which is higher than
  total growth expected for the full fiscal year.
• Total General Fund growth for the year is
  expected to be 3.8. The slowdown is not
  expected to weaken revenue collections until
  later in the fiscal year and this is reflected in
  the targeted growth rates.

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How Do 2007-08 Revenues Look So Far? (cont.)
It is clear from looking at economy-based taxes
that the mid-cycle economic slowdown is underway.
Sales tax growth for July-September was 4.7,
well below the long-term average growth of 5.8
and the 8-10 rates earlier in the recovery.
It is, however, above the budgeted first quarter
growth rate of 3.7.
Sales Use Tax Collections (adjusted for tax
law changes)
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How Do 2007-08 Revenues Look So Far? (cont.)
Withholding continues to be surprisingly
resilient with growth of 7.8 through September,
which is essentially the same rate as 2006-07. It
has slowed slightly from the 9-10 rate during
2005 and part of 2006, yet remains above
historical growth of 6.3. This suggest
withholding has not been significantly impacted
by the real estate recession.
Withholding Tax Receipts
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How Do 2007-08 Revenues Look So Far? (cont.)
The real estate slump has significantly reduced
real estate conveyance tax collections, though
not at much as in many other states (California,
Florida, Virginia). Collections were down 4.1
compared to July-September of last year. Though
this tax does not go to the General Fund, it is a
good economic indicator and real estate activity
affects retail sales.
Real Estate Conveyance Collections
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2007-08 Revenue Estimates

• Estimates reflect consensus outlook of Governors
  Budget Office and Fiscal Research Division.
• Forecast philosophy recognizes that much of
  recent extra revenue has been concentrated in
  volatile items (non-withholding portion of
  personal income tax, corporate income tax),
  adding to forecast uncertainty.
• In addition, the projections provide a hedge
  against worsening residential real estimate
  market. Fiscal Research has been more bearish on
  housing outlook than most economists for last
  year. In our view, the unwinding of market
  bubbles is usually more severe and longer
  lasting than most observers believe.
• Baseline General Fund Revenue Growth and budget
  forecasts are shown below.
• 01-02 02-03 03-04 04-05
  05-06 06-07 07-08 08-09
• -6.3 -0.4 5.7 9.4
  12.1 9.2 4.0 4.6

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Revenue Forecast Assumptions

• The residential real estate market slowdown will
  continue into 2008 and continue to be the biggest
  drag on the economy.
• The effects of the slowdown have begun to show up
  in a major way in North Carolinas housing data
  (see page 6).
• The loss of household wealth from the real estate
  slowdown plus tighter consumer credit will lower
  consumer spending growth. This means that state
  sales tax growth, excluding tax law changes, will
  slow to 2.9 (4.5 in 06-07 and 9.2 in 2005-06).
• Modest job growth in North Carolina, due to real
  estate problems and economic slowdown, will
  eventually lead to lower growth of income tax
  withholding. However, the State should continue
  to exceed the national experience. The specific
  2007-08 forecast envisions withholding gains of
  5.3 (7.7 in 06-07).

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Revenue Forecast Assumptions (Cont.)

• Following years of very high growth, volatile
  sources of revenue (corporate income tax and
  non-withholding portion of the personal income)
  should experience minimal progress
• Non-withholdings portion of income tax projected
  to increase 4.0, versus 19.3 in 06-07.
• Baseline corporate income taxes will decline 3.5
  as corporate profits begin to dwindle because of
  the national and global economic slowdown (6.9
  positive growth in 06-07) .
• The continuation of the real estate slowdown and
  the difficulties in the financial lending markets
  suggest that many of the effects of the slowdown
  will spillover into 2008 and keep a lid on
  2008-09 revenues.

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National Economic Outlook

• Below normal economic growth is expected for the
  remainder of 2007 and 2008 1 to 2
  inflation-adjusted growth instead of 3.
• A slowing economy will mean below average growth
  in employment and consumer spending
• Partly to blame is the housing slowdown where the
  median housing price declined for the first time
  in 16 years.
• Sub-prime lending will continue to implode and
  affect financial sectors, prolonging the impact
  of the housing slump.
• Exports to developing countries has been a major
  support for economic growth in recent years. A
  slowdown in the international trade sector would
  raise recession fears in the U.S.
• The Federal Reserve has responded aggressively to
  lowered inflation expectations and problems in
  real estate with a 50 basis point cut in the
  banks lending rate. The Fed will be monitoring
  the financial sector upheaval closely for fear of
  spillover into other parts of the economy.

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Additional Thoughts on 2007-08 Outlook

• In general, the economy will remain in choppy
  waters for the next couple of years as the
  nations businesses and consumers work through
  the housing market slump.
• To date, the resilient job market in the North
  Carolina is putting enough extra dollars in
  consumers pockets to offset the economic slowdown
  resulting in only a mild slowdown in economy
  based taxes.
• The biggest impact to the states economy from
  the mid-cycle slowdown, along with the housing
  and financial sector slump, is projected to occur
  in 2008.
• Several risks are associated with the slowdown
  that will need to be monitored as we move into
  2008. While these risks exist, their occurrence
  is not anticipated and the economic slowdown is
  projected to be significant, but relatively mild.

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How is N.C. Economy Doing Relative To U.S.?
Change in Employment
CALENDAR YEAR
After the usual deeper decline during the
recession, N.C. has been surging ahead of U.S.
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Long-Term Budget Outlook

• Barring any major surprises, the cautious nature
  of the 2007-08 and 2008-09 consensus revenue
  estimates should help in meeting 2008-09 and
  future year spending needs.
• Budget availability for later years is highly
  dependent on health care costs (State Health
  Plan, Medicaid). During the last three decades,
  high growth in these areas has crowded out
  spending on other budget priorities.
• A tight budget situation can still occur if the
  improved outlook leads to an increase in
  commitments (expansion budget requests, tax cut
  proposals, catch-up pay raises). In addition it
  is still possible the economic slowdown could
  turn into a full-blown recession or Medicaid
  expenses could accelerate.

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Long-Term Budget Outlook (Continued)

• Fiscal Research has not estimated 2008 session
  budget availability. However, an outside group
  projects 645 million of budget resources to
  fund
• Pay raises for teacher and state employees (100
  million for each 1)
• 100-125 million in incentive compensation for
  outstanding teachers
• Any additional dollars needed for state health
  plan and higher education enrollment increases
  above tentative budget amounts
• New public school initiatives (Pre-K Programs,
  class size reduction)

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Turnaround in State Budget Reserves

• During the last decade a combination of natural
  disasters, tax lawsuit payouts, and economic woes
  depleted the states financial reserves. This
  was a major reason for temporary loss of our
  Triple A bond rating by Moodys.
• The strong economic performance in recent years,
  coupled with stock market and real estate gains
  and cautious revenue estimates, has helped to
  restore budget reserves.
• The current reserves are the highest in more than
  a decade.
• Rainy-day fund amounts to almost 800 million
• Repairs/renovations funding of 145 million can
  be pulled back in emergencies
• Capital appropriations can be reverted if
  necessary
• Governor can force agencies to revert more
  authorized spending
• Cautious revenue estimates for 2007-08 should
  provide a final cushion

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Why Is North Carolina Budget News Better Than
Other States?

• Recent news reports indicate budget shortfall
  problems in a number of other states. This could
  include special sessions, executive spending
  cutbacks, and concerns about the upcoming budget
  being out of balance.
• States with revenue concerns include Arizona,
  Florida, Virginia, South Carolina, Tennessee,
  Nevada, Rhode Island, Massachusetts, California.
  There very well may be others.
• There are a number of reasons why North Carolina
  is experiencing a revenue surplus while other
  states are having problems
• For one, our revenue estimates for the last
  couple of years have been more cautious

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Why Is North Carolina Budget News Better Than
Other States? (cont.)

• Our job growth in North Carolina is at least one
  percentage point higher than the national
  experience and has not slowed during last 12
  months. This is important because withholding
  tax collections represent 40 of total revenues.
• Residential real estate slowdown in North
  Carolina compares to an outright housing
  recession in many of the markets that experienced
  a pricing bubble.
• In at least two states (Virginia, Florida) real
  estate conveyance taxes are part of the General
  Fund revenue base. In N.C., the proceeds go to a
  special fund for dedicated purposes.
• Healthy income growth and a milder real estate
  slowdown means that our sales tax growth is more
  stable.

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Related Budget Issues in The News

• Medicaid Swap
• Transportation Funding
• Leandro Litigation
• Tax Reform
• Lottery

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