During his much-touted recent debate with Florida governor Ron DeSantis, California governor Gavin Newsom described his state’s economy as without “peers,” claimed that business is “booming” in the U.S. under President Biden, and argued that his state’s steeply progressive tax regime was fairer than Florida’s “regressive” lower and flatter scheme. Not even 24 hours later, however, the Legislative Analyst’s Office, California’s nonpartisan budget watchdog, painted a strikingly different picture of the state’s economy. The LAO reported that a surging state unemployment rate and a slowing stock market had cratered California’s tax revenues, causing a potential $68 billion budget hole over the next two years. The shortfall is far greater than anyone had anticipated, and according to LAO, is reminiscent of cataclysms like the Great Recession and the dot-com bust.
The swift turnaround in California’s budget fortunes, at a time when the national economy is slowing but still growing, is a reminder of the Golden State’s volatile fiscal affairs. The progressive regime that Newsom defends relies on high taxes aimed at a narrow band of upper-income residents, whose own fortunes rise and fall dramatically with the stock market. At the same time, ballot initiatives crafted and passed by special interests over the years now tie up increasingly large portions of the state’s revenues, boosting a few areas, like education and mental health, at other areas’ expense. Nothing better illustrates the state’s precarious situation than the fact that merely 18 months ago, Sacramento projected a $98 billion surplus on the wings of a surging national economy and billions of dollars in aid from Washington.
California’s fiscal volatility is driven by its income-tax rates, the highest of any state, amounting to as much as 13.3 percent for those earning more than $1 million. As a result, the top one-half of 1 percent of California taxpayers—about 100,000 filers—pay about 40 percent of the state’s total income taxes. Much of those high earners’ income comes in the form of capital gains, that is, selling stocks or other assets for a profit. Unlike the federal government, California’s state government makes no distinction between short- and long-term capital gains, taxing both at the same rates as other types of income. But capital-gains revenues can vary greatly from year to year, essentially drying up when investment markets fall—as they did in 2022, when high interest rates slammed both the stock and bond markets. One consequence of those declines was an 80 percent contraction in the number of companies going public in California over the past two years, reducing the growth of the number of tech “millionaires” produced by the IPO market. As a result, for the fiscal year that started in mid-2022 and ended mid-2023, tax collections are $26 billion below projections. The LAO now estimates that the next two years’ tax shortfall could total $58 billion.
Officials compound California’s problems by refusing to budget in a way that recognizes this volatility. For instance, a report by the Volcker Alliance, a state-budget watchdog founded by late Federal Reserve chairman Paul Volcker, noted last year that California had spent an unusually large amount of the one-time money Washington sent to states under the Biden stimulus bill on programs that would continue after funding ceased. That decision left the state vulnerable to a “fiscal cliff” when the federal money ran out—a cliff that has now materialized.
California also has expanded its spending with controversial new programs. It now offers Medicaid coverage to all illegal immigrants at a cost of $2.6 billion, a figure that likely will skyrocket in coming years because of the migrant surge at the border. The state also offers illegals disability insurance and paid family leave; the legislature is even considering offering unemployment benefits to illegals, at a cost of $350 million.
Making this spending even more burdensome are budget mandates passed by California voters that force the state to maintain certain funding levels in areas like education. In 1988, for example, the state’s most powerful teachers’ union helped pass Proposition 98, which requires the state to spend 40 percent of its annual general-fund revenues on education. During years of plenty, schools have been left with soaring budgets. From 2012 to 2022, the money from the California state budget sent to schools grew by 130 percent, to $110 billion, an average annual growth rate of nearly 9 percent. Those mandated increases effectively limit the state’s ability to redirect money to other areas of need, or to use surpluses for tax cuts or to accumulate enough rainy-day money to cushion the blow of future revenue declines.
News of the tax shortfall has prompted the state’s dominant progressive faction to call for even higher taxes. Their favored levy would be a controversial wealth tax—that is, a tax on an individual’s wealth, rather than his income. It’s unclear whether such taxes, which dun taxpayers based on their estimated net worths, are even constitutional, since they tax the value of assets taxpayers own but haven’t sold to realize gains. California progressives are willing to test that idea. The state’s politicians are similarly eyeing other “creative” taxes, including a so-called “exit” tax, to be levied on individuals who leave the state. Though progressives often argue that people don’t leave a state because of taxes, California’s strikingly high rate of outmigration, including of prominent wealthy individuals and companies, clearly irks Sacramento policymakers. Newsom’s opposition to such taxes is likely to be severely tested in coming months, especially as the need for major budget cuts become clearer.
The search for innovative new ways to extract money from Californians reflects the reality that raising the state’s already-punishing taxes even further would yield diminishing returns. What never seems to diminish in California these days is the desire to tax and spend.
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