(January 17, 2014) Balanced budget. No new taxes. Rainy day reserve. Debt repayment.
These are phrases rarely associated with California’s fiscal outlook. But economics and politics have intervened to apply those phrases to today’s circumstances.
Governor Edmund G. Brown Jr. proposed a fiscal plan in January that harvests the fruits of the state’s economic recovery, and mostly reinvests right back into the state’s balance sheet.
California’s moderate economic recovery has proceeded steadily for the past year, but state revenues have blossomed. For the three fiscal years between 2012 and 2015, revenues are forecast to outpace initial estimates by $6.3 billion, almost all from the personal income tax. The reason: windfall capital gains tax receipts from a roaring stock market and rebounding real estate market.
The temporary tax increases passed in 2012 parlayed these windfall realizations into big tax receipts. The same taxpayers realizing capital gains profits also were the target of the tax increases. Indeed, revenues from capital gains in 2014 will be higher than in 2007, even though capital gains realizations were much lower in 2014 than in 2007.
The steeply progressive nature of California’s tax system will guarantee rapid revenue growth as long as the taxes are in effect and the economy grows.
Although they may be wealthy, upper-income taxpayers are relatively scarce. Only 1% of income earners in California pay more than 40% of income taxes (in 2011). That ratio has only increased as the 2012 tax increases have taken effect. Therefore, a relatively small number of taxpayers will have a dominant effect on state revenues, and their decisions on whether and how much to do business in California will disproportionately affect the state’s fortunes.
The temporary tax increases and the recovering economy played the largest roles in restoring fiscal health to California (see chart). But they don’t tell the whole story.
‘Live within Our Means’
Governor Brown has presided over three budgets that are notable for their frugality. With the exception of spending on schools (which are constitutionally guaranteed a generous share of new revenues), the Governor has kept the lid on spending and rejected legislative overspending. Indeed, Governor Brown began his administration in 2011 by reducing spending by about $10 billion. He also inherited a beneficial legacy from Governor Arnold Schwarzenegger—elimination of most automatic cost-of-living adjustments for state programs, which has reduced some of the pressure for annual budget increases.
But just because a tax increase was central to producing balanced budgets doesn’t mean that new taxes will be the go-to policy in the future—at least according to the Governor.
“I don’t think this is the year for new taxes,” said Brown. “I just think we need to do everything we can to live within our means.” This statement was in response to a question about an oil severance tax, but is supported by the absence of any new taxes in the budget proposal.
A balanced budget is apparently a multi-year goal for the administration, since a top fiscal priority is drawing down debts and creating a rainy day reserve.
Much of the windfall revenues from capital gains taxes will be used for one-time purposes:
- Making a deposit of $1.6 billion into the state’s Rainy Day Reserve—the first such deposit in six years.
- Paying off early the Economic Recovery Bonds, which were first issued to cover budget deficits from 2002: $1.6 billion.
- Repaying ahead of schedule loans from special funds, including money back to transportation programs: $440 million.
- Eliminating deferral of scheduled payments to school districts, which had required schools to incur short-term debt while waiting for state payments: $6.1 billion.
- The Governor also proposes to tweak a ballot measure, scheduled for the November ballot, to enshrine a rainy day reserve mandate in the state Constitution. His proposal would make some changes to the formula by which the reserve is calculated, and allows the reserve to be used for debt repayment, as well as economic downturns.
- The California Chamber of Commerce has supported past measures to create such a requirement, and will review the Governor’s proposal closely when it is revealed.
- Much of the state’s long-term liabilities remain unaddressed. The administration calculates more than $217 billion in unfunded retirement liabilities for state employees, the University of California and public school teachers (see pie chart). In addition, more than $100 million in additional infrastructure, maintenance and budget debt remain on the books.
Programmatically, the Governor maintains the priorities he has exhibited the past three years.
- Public schools again receive the major share of new General Fund spending: an additional $10 billion is devoted to schools over the three fiscal years between 2012 to 2014. The Proposition 30 tax increase was sold to voters in 2012 on a promise to restore public school funds and balance the state budget. So far, those priorities have driven state fiscal policy.
- Higher education spending is also being restored, but more slowly. State policy leaders’ top goal has been to halt any tuition increase, which they have achieved. However, state funds to support colleges and universities are increasing by about 5%, which system leaders consider only a mild restoration of prior cuts.
- Cap-and-trade auction revenues. One of the most contentious items in the budget proposal will have nothing to do with general revenues or budget deficits, but will directly concern how tax revenues from large energy users will be spent. The cap-and-trade auction has thrown off hundreds of millions in new revenues over the past year; the new budget is the first to propose how to spend that revenue.The Governor intends the money—totaling $850 million—to be spent on high speed rail, subsidies for zero-emission vehicles, weatherization projects for low-income residents, wetlands restoration, urban forestation and many other energy and carbon emission reduction projects. The CalChamber has challenged the legality of the cap-and-trade auction, and therefore believes that the proceeds of the auctions should not be spent, pending a final outcome of the litigation.
- The Judicial Branch has suffered some of the deepest cuts in recent years, resulting in less access to the civil justice system. The Governor proposes restoring $105 million, which stops the worst of the bleeding, but will not prevent additional service reductions next year, according to the courts. Past cuts were offset in part by using trial court reserves, which no longer are available.
- A new local economic development proposal purports to provide some new, limited financing authority for local infrastructure projects. Local economic development has been dealt a serious blow with elimination of redevelopment agencies and enterprise zones. The administration proposes to expand the scope and streamline formation of Infrastructure Financing Districts to use property tax increments from new development (not including property taxes devoted to schools) under some limited circumstances. There are many legal and organizational hurdles to making this authority a practical tool, but the administration’s attention to this local development financing void is welcome.
- Statewide infrastructure investment will benefit from the administration’s policy of using one-time revenues for one-time purposes. The administration is proposing more than $800 million in one-time investments in deferred maintenance projects, primarily on highways and for schools and public buildings. However, the administration has not provided a road map to finance other public works needs in transportation, public schools and water facilities.
- New health and welfare spending will be dominated by continuing escalation in the cost of the Medi-Cal program, largely in response to implementation of federal health care reform. The Governor also proposes providing one of the first increases in family welfare grants in many years.
Contact: Loren Kaye, President, California Foundation for Commerce and Education
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