California fiscal outlook remains grim

By David Schwartzman
July 20, 2017

California’s state government collected $2.68 billion less in revenues than expected during the 2016-17 fiscal year. The bad news will likely worsen California’s position relative to other states:  After crunching 2015 data for fiscal conditions in all fifty states, the Mercatus Center at George Mason University ranks California 43rd. While we rank a relatively strong 12th place in short-term budget solvency, we score much more poorly in other aspects:  45th in long-term solvency, 45th in cash solvency, and 41st in trust fund solvency (a measure of debt). Signs point to tough times ahead for California’s budget.

According to the Mercatus study, California has a 0.93 ratio of liabilities to assets while the national average is 0.61. Unfunded pension and retiree health benefits are 48% of personal income in California. In a January 2017 analysis, we found that California has between $713 billion and $1.02 trillion in unfunded pension obligations.

While California faces a harsh fiscal outlook in the future, the state is making life difficult for its citizens now. Taxes make it expensive to live in California. According to the Tax Foundation, California has the third-worst business tax climate in the United States. A Legislative Analyst’s Office of California report estimates the legislature’s decision to extend California’s cap and trade program will raise gas prices by up to 63 cents a gallon by 2021 and up to 73 cents a gallon by 2031.

California is particularly dependent on high earners and the tech industry. 70% of California’s $125 billion general fund comes from state income taxes, and half of income taxes come from the top 1% of taxpayers. In the last five years, California has further increased taxes on the highest earners. Proposition 30 changed the top marginal tax state to 13.3%, the highest tax rate in the United States. This was supposed to be a temporary increase, but Proposition 55 in 2016 extended the tax increase to 2030. California’s high marginal tax rate increases its revenue volatility. Between 1995 and 2013, California had the fifth-highest revenue volatility in the United States. With the higher taxes on top earners, volatility will only increase.

Market forces also indicate that the wealthy will be a smaller source of revenue in the future. Studies show that venture capital investments have slowed. Changes in the tech industry mean that we are unlikely to see new startups reach the size of Google, Facebook and Amazon. Consequently, confidence in the Bay Area’s economy has waned among residents: 56% see a Bay Area recession within 2-3 years. As a result of the Bay Area’s business climate, net migration was negative in 2016. Given California’s reliance on the wealthy to fund their budget, this portends further problems for California.

Another increase to the tax burden for California’s wealthy may be on the way. The federal government currently allows taxpayers to deduct state tax payments from their federal taxes, which costs the federal government an estimated $1.3 trillion over ten years, according to the Congressional Budget Office. The planned House Republican tax reform eliminates this deduction. The end of federal subsidies of high-tax states would increase the effective tax rate of Californians, particularly for high-income earners. This will damage California’s economy, as studies show that higher income taxes discourage economic growth.  

The real issues come from the expenditure side of California’s budget. In the 2017-2018 fiscal year, California has a $183.2 billion budget (excluding federal funds). The new budget increases spending by $12 billion compared to the previous year. This comes despite calls by Governor Jerry Brown to cut spending and an error by his administration that understated California’s deficit by $1.9 billion. The general fund reserve will be $8.5 billion, down from an $11.5 billion projection by the Legislative Analyst’s Office. This leaves California more vulnerable to recessions.

Big spending has not led to good results. High-speed rail, which has an estimated cost of $64 billion, has consistently been behind schedule and over budget. Figures show that the eventual cost may exceed $100 billion.

As a result of these shortcomings, people are leaving California. Since 2000, more people have left California than have arrived from other states every year. Although that trend had slowed earlier in the decade, migration losses accelerated to 110,000 in 2016.  This has cost California $36 billion in net personal income since 2010. These losses are also fueled by California’s restrictive housing policies. The greatest population outflows have come from the most expensive areas. The least well-off have been the hardest hit––the poor have disproportionately been chased out of California.

But it isn’t just that people are leaving California: citizens from other states don’t want to move to California. Low net migration numbers are primarily the result of California’s inability to attract immigration. According the U.S. Census data, 1.3% of residents recently arrived from other states, the worst in the United States.

The flow of people out of California indicates the state’s poor financial environment compared to other states. The outflow indicates that California is currently not a desirable place to live and work. California needs to make serious reforms to change its trajectory and make California an economic powerhouse again.

David Schwartzman is a Policy Research Fellow at the California Policy Center. He is a rising senior studying economics, mathematics, and finance at Hillsdale College.


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