The unexpectedly quick recovery of tax revenues after Covid lockdowns has left many state coffers bursting. In California, though, the bounty may turn out to be as much a headache as a boon. Spending limits enacted decades ago to slow government growth—modified over time by special interests—constrain how Sacramento can use the money flowing into its treasury, directing much of it into just a few categories that state laws deem “acceptable.” Thanks to these spending limits and the state’s progressive tax code, California now faces a potential fiscal calamity as the national economy slows down and a recession looms. What was only recently a $98 billion surplus has quickly turned into at least a $23 billion deficit for Sacramento. That’s got progressives pushing to overturn rules that require some surplus revenues to go back to taxpayers during bountiful years. Only in California government can prosperity turn out to be such a mess.

A windfall revenue problem was hard to imagine when Covid struck in March 2020. Analysts initially projected that California state government could face a $54 billion deficit in the fiscal year starting in July 2020—the result of the devastating economic impact of harsh lockdowns. Instead, a year later, the state enjoyed a $75 billion budget surplus, thanks to a sizzling stock market and the expansion of remote work, which enabled many high-earning Californians to keep working throughout the pandemic. After the state boosted spending and rebated money to taxpayers, Sacramento’s next budget still saw its surplus swell, to nearly $98 billion, fed by federal stimulus and the still-hot stock market.

Those investment-driven tax dollars have brought fiscal headaches, however. California’s unique laws explain why. Back in the 1970s, California taxpayers, revolting against what they deemed out-of-control growth of state and local government, imposed various curbs on Sacramento spending. The most famous was Proposition 13, a 1978 ballot initiative that limited growth in property taxes. That wasn’t the end of taxpayer pushback. Prop. 13 largely applied to local governments; taxpayer activist Paul Gann then sponsored 1979’s Proposition 4, a successful initiative limiting state appropriations based on spending per resident in 1978, adjusted for inflation and population growth, and decreeing that surplus dollars be returned to taxpayers. Pre-Covid, California hit the Gann amendment restraints just once, in 1986.

Over time, advocacy groups have gotten measures adopted that tie up portions of government spending yearly for their agendas. That has considerably narrowed state budget flexibility. In 1988, for instance, the state’s teachers’ union, responding to the Gann limits, was able to get Proposition 98 passed, securing roughly 40 percent of general-fund revenues for education annually, and requiring that some of any excess money from the Gann spending cap also support education. In 2004, voters approved Proposition 68, a 1 percent tax surcharge on those earning more than $1 million a year, with that money designated for mental-health services. Then, in 2014, voters endorsed Proposition 2, an initiative heavily backed by then-governor Jerry Brown that hiked taxes and secured some of the money for the state’s reserves, further reducing Sacramento’s shrinking budget wiggle room.

Meantime, with the stock market supercharging capital gains, tax revenues surged in California. Back in 2017, budget analysts projected that the state’s three biggest taxes—the personal and corporate income taxes and the sales tax—would bring in $150 billion in revenues by the end of 2022’s fiscal year. Instead, collections blasted to $215 billion. A big part of that eye-popping total comes from the state’s hefty personal income tax, with Californians paying $136 billion in fiscal 2022, up from $93.6 billion in 2018—a 45 percent gain.

Upper-income Californians paid a lot of that extra money, thanks to the state’s highly progressive tax rate and the fact that capital gains from the sale of assets like technology stocks get taxed as income. Income-tax collections, heavily weighted toward those higher-income residents, have thus been growing faster than the rate of income growth of the average Californian. That’s significant, as adjustments to the Gann spending cap, put into place by voters in 1990, rely partly on the growth in per-capita personal income to set its limits. With tax collections mounting so much faster than average income, the money that California government had available to spend has exceeded the spending limit by billions of dollars for two years in a row. But since last year’s budget debate, a sharp decline in the stock market (which cut capital-gains tax collections) and an accompanying slowing of the national economy have flipped California’s fiscal predicament dramatically.

Theoretically, California should still have plenty of funds to cushion it in a recession. But the interest groups’ capture of tax revenues has meant that a few budget areas have benefited disproportionately from rising revenues—and none more so than K–12 education and community colleges. Last year alone, due largely to the efforts of teachers’ unions, funding required for schools by Prop. 98 rose by $37.2 billion—a sum larger than the entire budget of more than 30 other states. Over the last ten years, the funds going to California schools have climbed to $128 billion, from $47.3 billion, a total increase of 170 percent and a compound annual rate of growth of 9.5 percent yearly. The burden of such mandates is so heavy that once California hits its Gann spending limit, it must spend or return to taxpayers $1.60 for every extra dollar it collects in tax revenues.

Facing such fiscal strain, state leaders spent much of the spring 2022 budget season debating how to avoid the dire consequences of the self-created budgeting straitjacket. To do so, legislators spent tens of billions of dollars on items exempt from Gann limits, many of them one-time expenditures. That includes some $24 billion in capital expenditures for building projects, such as facilities for mental health, outside the regular budget, as well as some $9 billion in designated “emergency” spending, another category not subject to the limits, with much of that supporting Covid recovery projects. The state also provided $10 billion in a one-time rebate for every taxpayer and each dependent in a household, though legislators put income limits on the payouts, excluding anyone earning more than $125,000 annually ($250,000 for a couple).

The rebate program was the state’s second in two years. In 2021, Governor Gavin Newsom signed off on what he termed one-time stimulus checks for Californians, amounting to $12 billion. The checks proved controversial because Newsom was then under threat of a recall election, prompting critics to brand them voter payoffs. The rebates also violated the language of the Gann amendment, some contended. Joel Fox, former president of the Howard Jarvis Taxpayers Association and an adjunct professor at Pepperdine University, observed that Prop. 4 says that revenues can only be “returned by a revision of tax rates or fee schedules,” not by one-time rebates. The Newsom plan’s exclusion of higher-earning families, Fox also argued, amounts to a redistribution of income rather than a refund. Former San Diego mayor Kevin Faulconer, a Republican, criticized the rebates as falling short of what would truly benefit the state. “Californians need permanent, real tax relief,” he said. By contrast, when the state’s revenues exceeded Gann spending limits in 1986, Republican governor George Deukmejian sent the entire surplus back to residents in the form of a one-year, 15 percent tax cut—a $1 billion reduction.

California’s Gann woes come even as the Biden administration showered $350 billion on the states for Covid recovery and stimulus, with $27 billion going to the Golden State. A critical report from the Volcker Alliance—a good-government group founded by the late Paul Volcker, former chairman of the Federal Reserve—pointed out that California took nearly one-third of that money and rolled it into its state budget to pay for ongoing programs. The result, the Volcker Alliance said, could lead the state to face a “fiscal cliff” in a few years, if economic growth slows as federal money disappears—especially as the Federal Reserve hikes interest rates to combat inflation.

“A budget based on one-time expenditures and huge sums captured by special interests is a disaster waiting to happen.”

The looming fiscal cliff has drawn the attention of others as well. Last May, California’s Legislative Analyst’s Office took aim at Newsom’s proposed budget, arguing that much of it focused on spending one-time revenues instead of preparing the state for a future recession and fiscal challenges. Even if the state avoided a downturn, mandates that require it to spend more than it takes in of surplus dollars could complicate the budget soon, the report said. The revised budget that the state passed a month later helped ease some of the problem by finding spending loopholes on projects that fall outside state expenditure limits, but at the cost of tens of billions of dollars spent on one-time endeavors that don’t build in budget stability. Already, for instance, California mayors have warned Newsom and state legislators that unless they keep funding programs initiated in the past few years with federal money and state surpluses, such as homeless housing projects, cities face “a fiscal cliff that would result in the closing of countless shelters and entry points to housing assistance.”

The unprecedented trouble that the state faces because of its unusual and seemingly conflicting budget mandates may be just beginning. In part, that’s because state population expansion has slowed, with numbers actually falling in recent years. Because population growth plays a role in calculating Gann spending limits, slower increases would mean that the spending limitations would kick in more quickly in the future, thwarting a state government with ambitious spending plans year after year. Progressive calls to revise or dump the spending restrictions are thus getting louder. Though California has among the most robust social safety nets of any government, spending about $15 billion of state money this year just on new housing for the homeless, “the Gann Limit challenges California’s ability to adequately support current services,” one prominent left-leaning budget group complains. Fueling their ire is Newsom’s plan to help solve the new budget crisis with cuts, including to homeless funding, possibly eliminating $500 million designated to clean up homeless encampments.

Opponents are already planning a constitutional amendment in 2024 to undo Gann. Given that the spending limits rank right up there with Prop. 13 as a nemesis of the Left’s ambitions in California, such an initiative is likely to lead to one of the most expensive ballot battles in state history. Short of a complete repeal, the state may also try for revisions to the amendment. Among the possible changes would be expanding the categories that get excluded from the spending limit, making it easier for state officials to spend surplus dollars without sending money back to taxpayers. “I am open to reforms and discussions,” Newsom said last year about Gann limits.

Before he became governor, Newsom said of state government, “California is infamous for passing things and then waking up and saying, ‘What the hell did we just pass?’” The high-wire budget act that the state has created through a conflicting thicket of mandates—a case of California’s conservative past clashing with its free-spending, progressive present—exemplifies what Newsom meant. A budget based on vast amounts of one-time expenditures and huge sums captured by a few special interests is a disaster waiting to happen when the economy slows again, as it inevitably will.

Photo: Before he became governor, Gavin Newsom said of state government, “California is infamous for passing things and then waking up and saying, ‘What the hell did we just pass?’” (RICH PEDRONCELLI/AP PHOTO)


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