Just one month after the passage of the latest budget in California’s history, the non-partisan Legislative Analyst (LAO) issued its fall update on Nov. 10 and identified a combined current year and budget year shortfall of $25 billion. How can the budget required to be balanced by the state constitution be so out balance so soon? The answer to this question illustrates just how challenging fixing the state’s finances will be for Gov.-elect Brown and the new Legislature.
The LAO estimates that approximately two-thirds of the $18.3 billion in “solutions” adopted this year to balance the state budget are “temporary” or “one-time” in nature. Add to that the sunset of $8 billion in tax increases that were agreed to two years ago but which go away by June 2011, and finally updated expenditure information that shows the state spending $4.5 billion more than anticipated just one month ago. This all adds up to a new $25 billion headache.
Assumptions of more federal funds, accounting gimmicks, transfers and loans of special funds, receipts of asset sales and related budget maneuvers simply delay difficult decisions necessary to actually balance the state budget. To achieve fiscal stability, the state must align its long-term expenditures with a reasonable estimate of it’s long-term revenues. Budget solutions must be permanent and not one-time in nature. The gap between ongoing revenues and expenditures is now approaching 23 percent of the General Fund. No credible economist believes that the economy will rebound in the next two years, much less the current fiscal year, sufficiently to bridge such an enormous structural deficit.
So, assuming that Governor Brown and the Legislature will ultimately be successful in making necessary long term budget solutions, how does California make sure it does not end up back in the same place? How do we get off of this fiscal roller coaster?
The answers are simple and complex at the same time.
Beyond the terrible toll in state and local revenues the great recession of 2008 and 2009 has exacted on the state budget, California had an underlying “structural deficit” that most fiscal experts estimate at $8 billion to $10 billion dollars. This was largely created when then Gov. Davis and the Legislature took $12 billion in one-time surplus revenue in the Budget Act of 2000 and committed it to ongoing tax cuts and increased state spending. The surplus came mostly from capital gains taxes paid by very wealthy individuals and was driven in part by the dot com boom.
In fact, almost 50 percent of all personal income taxes (PIT) collected in the state come from only 1 percent of the taxpayers and the PIT is the most important part of the general fund revenue accounting for almost fifty five percent of the general fund totals. So when these highly affluent individuals get a financial cold, the state budget gets a severe case of influenza – or worse. And that is what happened to Gov. Davis when the dot com bubble burst. The fiscal situation was further strained when Gov. Schwarzenegger cut the car tax by $4 billion dollars without making corresponding cuts on the spending side of the ledger.
How do we avoid repeating history when the budget is finally balanced?
The Governor and Legislature agreed to put a constitutional amendment on the next ballot as part of this years late budget agreement as a step in that direction. It would divert peak revenues like we had in 2000 away from the General fund and deposit them instead into a rainy day fund so legislators and future governors could not commit them to ongoing spending. It would make sure the funds stayed in the rainy day account unless and until it was actually “raining” and we needed the funds to stabilize the budget in times of economic downturn.
On the revenue side of the equation, both Republicans and Democrats agree on the need to broaden the state tax system so that we don’t have such a small minority paying such a huge percentage of the taxes. This makes state tax revenue very vulnerable to future changes in capital gains and related types of income streams.
Although there is far-reaching agreement on the need to broaden the base, there is much controversy over how to achieve it. For example, some argue for lowering the state sales tax rate but spreading it to all purchases including services that are now exempt. Others argue for widening the tax brackets and ensuring that all income levels pay some tax. These ideas would reduce volatility but are also quite controversial.
However a one-two punch of broadening the tax base, which can be done in a revenue neutral way, and creating a safety relief valve to divert peak revenues into a strong rainy day fund is the type of medicine that could keep California on its fiscal train tracks and avoid future derailments and massive budget deficits.