California taxes: Economy is strong, but shortfall may be coming

California's economy is on fire, but the state's finances are facing the cold reality of a revenue slowdown. And experts blame the state's unusual tax system for the problem.

"Right now, the surging tide of revenue is beginning to turn," Governor Jerry Brown said earlier this month at a press conference announcing a revised $122.2 billion state budget and potential deficits ahead due to expiring tax increases.

California Gov. Jerry Brown
Rich Pedroncelli | AP

Brown is urging Sacramento lawmakers to refrain from any massive new spending programs, due to the possibility of an economic slowdown or recession.

State legislators have been holding budget committee hearings this week to discuss Brown's revised spending plan for California's next fiscal year, which begins July 1. There's a June 15 deadline for the legislature to adopt a new state budget — and it comes as the governor's May revision warns that the state's commitments in coming years "will exceed expected revenues" to the tune of more than $4 billion by fiscal 2019-20.

Also, the state this month trimmed its current fiscal-year revenue forecast by about $1.9 billion due to April's lagging tax receipts, including a shortfall in personal income taxes — that decline has come in part from stock market fluctuations, which have brought lower capital gains. Also, the state's cap-and-trade quarterly auction last week produced lower-than-expected revenues for the carbon emission permits up for sale.

California has turned around and taken the volatility of the stock market and made it the central component of the revenue system. There's nothing right about that, because what it means is that we're constantly in either boom or bust.
Christopher Thornberg
founding partner, Beacon Economics

"The revenue picture has dimmed a little bit," said Gabriel Petek, a credit analyst for Standard & Poor's Credit Market Services. He noted that there are only three states with a lower credit rating than California (New Jersey, Illinois and Kentucky).

Nevertheless, California's economy still appears strong.

Last month, the state's unemployment rate fell to 5.3 percent, down from 5.4 percent in March and the lowest rate since June 2007, before the Great Recession. Also, April's statewide median home price broke $500,000 for the first time in nine years, according to the California Association of Realtors.

"There's no sign whatsoever of a slowdown in the expansion," said Christopher Thornberg, founding partner of research and consulting firm Beacon Economics.

That said, the L.A. economist is critical of the state of California's fiscal situation and the tax structure that's resulting in increased volatility for state coffers.

Head coach Bill Self of the Kansas Jayhawks signals a play from the bench in the first half of play against the Iowa State Cyclones at Hilton Coliseum on January 25, 2016 in Ames, Iowa.
How Kansas' highest-paid state employee pays almost no income tax
Cut taxes in retirement with these moves
Tax measure could cause financial jolt to California smokers

"We have an enormous budget problem, and that's because of the structure of our revenue system, not because of the fundamentals of the California economy," said Thornberg. "California has turned around and taken the volatility of the stock market and made it the central component of the revenue system. There's nothing right about that, because what it means is that we're constantly in either boom or bust."

According to state data, the top 1 percent of Californians account for nearly half of the state's income taxes, which in turn accounts for two thirds of general fund taxes. In recent years, capital gains — taxed in the state like any other income — have represented around 10 percent of California's general fund revenues.

In the governor's May budget revision, the California Department of Finance modeled the potential impact of a recession of "average magnitude" next year. The agency found such a downturn would result in a $55 billion decline in state revenue over a three-year period. To soften the impact of a downturn, Brown has proposed ending the next fiscal year with $8.5 billion in total reserves, or about $4 billion more than the fiscal 2015-16 state budget plan.

"Paradoxically, the moment everybody feels the best is the moment right before a recession is about to hit," Brown remarked this month when discussing the May budget revision. "So instead of pulling back in the last two recessions, the state of California accelerated its spending and therefore made the budget cuts all the more painful."

Trump vs. Clinton? Doesn't matter in California: CEO
Trump vs. Clinton? Doesn't matter in California: CEO

Last month, Moody's Investors Service conducted a "fiscal stress test" on the nation's four most populous states and found California's preparedness for a recession "weaker" than the others. It cited the Golden State's highly volatile tech industry and California's reliance on personal income taxes, particularly from top earners.

"It's not just Wall Street but the tech industry where there are huge bonuses that can be paid, which result in big swings in capital gains and therefore in personal income taxes," said Moody's credit analyst Emily Raimes. "Things will continue to look positive for California, but that will not be the case forever."

Meanwhile, California is planning on a November vote on a long-term extension of Proposition 30, a temporary tax increase originally passed by voters in 2012. The measure raised income taxes on Californians at the highest end of the income scale and also put into place a temporary one-quarter cent increase on the state's sales tax.

CalPERS is now an investor in the Indiana Toll Road, which carries on average 50 million vehicles annually.
Why a California pension fund is betting on an Indiana toll road

California's Chamber of Commerce has come out against the proposed ballot initiative, which would extend Proposition 30's income tax hikes (but not the sales tax) until 2031, by arguing that the measure was supposed to be temporary. Brown hasn't taken a formal position on whether to extend the measure. Observers suggest belt-tightening by the state is likely without passage of the measure.

"Prop 30 is pretty much driving every decision being made about what the state does or doesn't do with its budget," said Chris Hoene, executive director of the California Budget and Policy Center, a Sacramento-based think tank focused on fiscal and policy analysis. If it's allowed to expire, he estimates an impact to the general fund is about $4.5 billion in 2018-19 and approximately $8 billion in 2019-20.

Ultimately, Thornberg believes California would be better served with a Texas-style tax revenue system where there's less reliance on personal income taxes and capital gains tied to the stock market, and more of a focus on property taxes and sales taxes.

Brown was asked at the May budget press conference if he would support overhauling California's tax structure.

"I do think reducing the revenue volatility would be good," the governor said. "Maybe over the next year or two Republicans can join in, and we can come up with something that would make sense. It's not that simple. There's a reason why we tax the 1 percent. It's because that's a tax people have shown their willingness to vote for."