Every state and municipal budget in America will take a big hit because of the coronavirus lockdowns, but no public purse is in as much trouble as California’s. Its Department of Finance recently estimated that the Golden State could face a $54 billion shortfall in the fiscal year beginning July 1, which surely must be the largest deficit any state has ever accumulated, surpassing the $40 billion hole that nearly swallowed Sacramento in 2008. Still, though Governor Gavin Newsom said last weekend that the staggering deficit was “a direct result of Covid-19,” that’s clearly not true. Critics have long warned that the state’s tax base is volatile, being increasingly reliant on wealthy residents and vulnerable to sharp contraction in the next recession. Combine that with California’s spending spree—including expenditures to fix problems that the state’s own bad policies have worsened—and the swing from prosperity to penury isn’t hard to understand.
It’s no exaggeration to say that California—with its 13.3 percent personal income-tax rate, the highest of any state—is the model of progressive fiscal policy. The state also takes a big tax bite out of capital-gains income, another significant source of revenue. In 2017, Californians reported $142 billion in capital gains, by far the largest amount of any state. Two-thirds of that total came from people making more than $1 million. The top 1 percent of California earners now account for about 23 percent of the state’s adjusted gross income but pay 46 percent of the income tax—nearly $50 billion last year, all of which came from an estimated 15,000 households. Before the coronavirus recession hit, California projected that more than 70 percent of its general fund revenues—or $102 billion—would come from personal income taxes. That’s compared with just 25 percent in the 1960s, when the top rate was about half what it is today.
California’s problem: the income of the rich is highly variable, based heavily on dividends, capital gains, and bonuses, which mostly vanish in recessions. In the 2008–2009 downturn, for instance, California’s income-tax collections declined by $7 billion—from $50 billion to $43 billion—in one year. They’ve come roaring back, especially in the last few years, as the stock market reached new heights. California added new taxes, bumping up the rate for those earning more than $250,000 a year and increasing the state sales tax. Originally passed as temporary measures, these tax increases were extended in 2016 for another 15 years. That helped fill the till even higher during the recovery but means that any future tax increases will come on top of already-high rates.
California officials blame the projected $54 billion shortfall on the coronavirus shutdown, but steep deficits always loomed in the next recession. Last year, the Public Policy Institute of California estimated that, even in a moderate downturn, the state would face revenue shortfalls averaging more than $22 billion a year for the next four years—totaling more than $90 billion. For a severe recession—as we may now be facing—the study projected revenue losses of $170 billion stretching over five years.
Volatility is the enemy of government budgets because states and localities must continue to provide services in a recession, and their cost often rises. California projects, for instance, that its expenses will go up by an unanticipated $7 billion as it must increase spending on services for those hit by the downturn. It expects another $6 billion in costs associated with fighting the virus itself, though Washington may reimburse some of that.
A volatile tax base can also encourage overspending as governments amp up their budgets in good times. That’s certainly what happened in California. The state’s budget has grown by $59 billion since 2014, a compound annual rate of about 6 percent. Some of the added spending has addressed problems that seem to be of the state’s own making—a consequence of bad policies. For instance, in the last budget, the state added $3 billion to address homelessness and housing, in addition to money that municipalities like San Francisco were already spending. But the state’s housing and homeless problems are largely homemade. A Government Accountability Study found that California has the highest costs in the nation for constructing “affordable” housing—up to $750,000 for a single unit. California alone accounts for half of the shortfall in housing construction nationally in the last 20 years. Meantime, homelessness in the state has been increasing at far faster rates than in the rest of the country, as cities like San Francisco have made themselves more welcoming to street living by decriminalizing low-level property crimes and drug offenses and distributing syringes and free meals.
Some of this funding may be the first to be cut. But reducing spending won’t be easy because advocacy groups have locked in much of the expenditures with referenda and legislation. Proposition 98, for instance, guarantees funding for public schools based on the amount spent the previous year, and it requires a two-thirds vote of the legislature to override these constraints. In addition, the enormous pension debts accumulated by the state’s retirement systems have generated growing funding demands—only likely to rise further now. In the last 20 years, the amount that state government has been required to contribute to CalPERS has grown from less than $400 million in 2000 to $15 billion last year. The pension system’s administrators warn that stock market losses could require substantial new contribution increases over the next five years. It’s likely that the state and municipalities will do what they have done in previous recessions—decline to boost these payments—at the cost of increasing the state’s burgeoning pension debt, requiring bigger contributions when the state economy begins to recover.
Under former governor Jerry Brown, the state started accumulating a rainy-day fund, now amounting to $17 billion, but even that cushion won’t last long in California. Officials are counting on more federal aid, but after dishing out nearly $3 trillion already, Republicans in Washington are not in the mood for major new spending to help states solve budget problems that go beyond the virus. That might put pressure on Governor Newsom to reopen the state’s economy faster than originally planned, in hopes of a surge of tax revenues to cut the projected deficit. Barring that, the state may be looking at a repeat of strategies in the previous recessions, when it borrowed heavily to close budget gaps. To do that, however, the state must get permission from taxpayers, and such borrowing is expensive. In 2004, for instance, the state floated $15 billion in bonds to close deficit gaps precipitated by the bursting of the dotcom stock bubble. It cost $19 billion to repay those loans, and the state had to make payments throughout the next recession, and all the way into 2015, before it could close the books on that borrowing.
Earlier this year, when California was flush with revenues and spending liberally, Newsom boasted that his state was “America’s coming attraction.” Let’s hope not.