California's governor is betting the wealthy will grow wealthier still to help right his state's finances, a wager that is expected to help the budget in the short term, but leaves it at risk of a revenue slump if assets such as stocks lose value.
Democratic Governor Jerry Brown sees a budget surplus within reach, in contrast to the deficits that have bedeviled the state for the past decade, in part due to new revenue from increases in income tax rates on the wealthy approved by voters in November.
California's increased reliance on its wealthiest taxpayers offers the potential for revenue gains when financial markets are on the upswing and budget turmoil when they are on the slide, Fitch Ratings Senior Director Douglas Offerman said.
"The higher reliance on personal income tax is a double-edged sword," Offerman said.
When financial markets do well, the most populous U.S. state's wealthy do well and that helps fill its coffers because they provide the lion's share of the revenue from personal income taxes.
Personal income taxes are projected to provide an estimated 62.7 percent of general fund revenue in Brown's budget plan for the state's next fiscal year, slightly up from 62.4 percent in the budget plan presented a year ago.
REVENUE BOOMS AND BUSTS
Neighboring Oregon relies much more on personal income taxes, said Standard & Poor's Senior Director Gabriel Petek, noting they make up 85 percent of its revenue. What makes California's revenue from personal income taxes of greater concern is how much of it comes from wealthy households whose income can swing wildly.
In 2010, nearly three of every four dollars of California's revenue from personal income taxes came from the top 10 percent of its income earners, according to the state's tax agency.
The top 1 percent of income earners provided 40.9 percent of the state's revenue from personal income taxes in 2010, down from 48.1 percent before the recession of 2007-2009.
A handful of U.S. states, including Texas and Florida, do without income taxes and rely on property, sales and other taxes, a model the Republican governors of Louisiana and Nebraska, have proposed their states take up.
California's high reliance on personal income taxes, a more volatile source of funds than sales and property taxes, proved disastrous during financial crisis.
Michael Genest was running the state's finance department when revenue plunged in 2008 as the financial crisis thinned the ranks of its millionaires by a quarter. He sees Brown at increased risk for a plunge in revenue should stock prices reverse course because the state is now relying even more on the volatile income of the rich.
"What happens if revenues fall through the floor? He's going to be right back where we were in 2008," Genest said.
Good times on the stock market, however, would boost the income of California's wealthy and the revenue it produces for the state's government.
As Genest's predecessor as the state's finance director, Tom Campbell recalled how the good fortunes of high-tech companies helped California's finances in the past.
"When Google did its IPO, the state's revenue shot up," said Campbell, now dean of Chapman University's law school.
Mountain View, California-based Google's 2004 initial public offering pumped up revenue for the state well into 2006.
HOLDING DOWN SPENDING
Brown, elected in 2010, proposed a lean state budget earlier this month for the next fiscal year, saying the state cannot afford to restore most spending cuts sharply.
Brown plans to restrain spending to swing the budget to a modest surplus in the coming fiscal year, a plan he said faces risks from uncertainty around the economic recovery, healthcare costs and the federal budget.
His latest budget plan mentioned the risk stemming from financial markets: "Changes in the income of a relatively small group of taxpayers can have a significant impact on state revenues. In particular, capital gains income is concentrated among the high income earners and can fluctuate significantly from year to year."
An example of that volatility is the revised revenue target for last May's rocky IPO of Menlo Park, California-based Facebook, lowered to $1.3 billion from $1.9 billion.
Still, Brown's plan forecasts a bump in revenue from tax rises approved in November to help the state get into the black.
The measure created new rates ranging from 10.3 percent to 12.3 percent on income between $250,000 and $1 million. Income over $1 million remains subject to a surcharge to fund mental health services so California's overall tax rate on millionaires' income is 13.3 percent, the highest of any state.
The rate increases prompted golf pro Phil Mickelson to hint recently that he could bolt from California like fellow golfer Tiger Woods, who left for Florida in 1996 over taxes.
Demographer Joel Kotkin sees California's fabulously wealthy adapting to tax increases, but doubts there will be sustained revenue gains. Kotkin said he knows affluent Californians who make over $250,000 who are sorting out how to minimize tax liabilities.