Analysis: Record Surpluses Show Need for Tax Reform
A recession could bring a dramatic reversal in California’s volatile tax revenues, from a surplus to deep and lasting deficits.
California Governor Gavin Newsom recently signed into law a record $308 billion budget that includes a projected surplus of nearly $97.5 billion. The budget implements new spending initiatives that include a $17 billion inflation relief package, $200 million in new funding for increased access to abortion, a $2.6 billion per year increase in health care spending to cover undocumented immigrants, and $128 billion for K-12 education and community colleges. It also allocates $23.3 billion for the state’s rainy day fund. The budget, according to the governor, “invests in our core values at a pivotal moment, safeguarding women’s right to choose, expanding health care access to all and supporting the most vulnerable among us while shoring up our future with funds to combat the climate crisis, bolster our energy grid, transform our schools and protect communities.” The projected surplus, however, represents a different set of values: not planning for the worst and hoping for the best.
“No other state in American history has ever experienced a surplus as large as this,” Newsom said while introducing his revised $286.4 billion budget in May. The massive windfall shows “the concentration of wealth and success in the hands of a few that are enjoying abundance in historic and unprecedented ways,” he said. “I am proud of California’s progressive tax system…and we’re the beneficiary of that.” Embedded in this progressive tax system is dependence on capital gains, a volatile source of tax revenue that could decline sharply and turn the surplus into a massive deficit.
California’s progressive tax system is largely dependent on revenue from the personal income tax, which is the state’s largest source of funding at more than two-thirds of the general fund revenue. The state’s income tax now relies disproportionately on the wealthiest taxpayers and a significant portion of tax revenue comes from capital gains, which are largely from record stock market returns and initial public offerings (IPOs) in Silicon Valley. California’s dependence on the personal income tax is a relatively recent phenomenon. In 1990, for example, the state’s revenues depended on relatively equal shares of revenue from personal income taxes, corporate income taxes, and sales taxes.
Additionally, a small number of taxpayers are providing an increasing share of tax revenue. Approximately 0.5% of taxpayers provides about 40% of the state’s personal income tax revenue, according to the Los Angeles Times. (This is about 100,000 people with incomes of more than $1 million.) About 17% of taxpayers, which expands the group to people with incomes of more than $500,000, pay more than half of the state’s personal income tax revenue.
This reliance on high-earners and their capital gains means that the state has tax revenues that are higher than other states when the economy or the stock market are doing well but experiences a disproportionate downturn when the economy or the stock market decline. The Legislative Analyst’s Office (LAO) estimated in 2017 that the income for the top 10 percent of earners in California is seven times as volatile as the remaining 90 percent. By contrast, the corporate income tax and the sales tax also fluctuate with the economy, but they are less volatile and contribute to a smaller share of the general fund.
Past economic downturns and financial market declines have caused dramatic drops in tax revenue that led to spending cuts, tax increases, and borrowing to balance the state’s budget. California has also experienced cyclicality in economic activity that is greater than that of other states. For example, in 2010, California revenue fell by 20% with a drop in state GDP of less than 2%. To counteract these falls requires the state government to enact countercyclical fiscal policy through a “rainy day” fund, raise taxes, or cut spending.
Governor Newsom, to his credit, recently outlined the risks that California faces, noting that that the budget “must continue to be prudent and the state must be prepared for an uncertain future.” The May revision noted that revenue from capital gains “as a percent of the state's personal income are at levels last seen in 1999—just before the dot-com bust,” a market crash led to state budget deficits for more than a decade. “For those that are concerned about that, they are right to be concerned about that. We are deeply mindful of that,” Newsom said.
The record stock market returns and IPOs that have pumped of California’s tax revenue are a result of the dramatic monetary inventions of the Federal Reserve, as continued low interest supported financial markets. With increasing economic uncertainty and the highest inflation rates since the early 1980s, the Federal Reserve seems likely to continue to raise interest rates. Increased rates would bring falls in financial markets and a likely disproportionate fall in California tax revenue. The LAO in its comments on the May budget warned of a “heightened risk of a recession within two years,” and urged the governor and legislature to add to California’s budget reserves.
Newsom “Leans In”, then Out, on Tax Reform
Newsom acknowledged the dependence on stock market gains and interest rates back in 2018, when he said the California tax system is “too reliant on what Janet Yellen does.” Newsom said then that he believes in a progressive tax code, and wants to avoid a repeat of the cuts that occurred during the recession in 2010, as those cuts fell the hardest on people who rely on social services.
During his campaign for governor in 2018, Newsom said he wanted to reform the tax system but noted the political challenge. “Nothing, nothing, no issue more vexing than this one, because everyone has a trophy on the wall,” Newsom said before the election. “Governor Brown had no interest in pursuing it. And I would argue there’s no greater political mind in our lifetime than Governor Brown,” he said. “So I’m not naive about this, but I am not going to neglect this issue, and I’m going to lean into it and express a desire to see if we can possibly come together across our differences.”
In 2019, Newsom spoke of “broadening the tax base, addressing the issue of volatility” in tax reform. “I want to convene an effort to more broadly look at our tax code. Modernize it,” he said. Newsom again discussed tax reform while introducing his budget proposal in January 2019. “This economy is radically different than it was 100 years ago,” he said. “And we're not taxing the modern economy, we're taxing the old economy,” he said. “This is the good times,” Newsom said. “But the key in a progressive tax system with the volatility that we experience — that needs to be addressed, but will not be a short-term endeavor — is to stack away as much money as you can and pay down as much debt as you can.”
Newsom’s shift from lamenting being “too reliant on what Janet Yellen does” in 2018 to trumpeting the results of Federal Reserve policy in 2020 began with the state’s dramatic fiscal turnaround in 2020. In May and June 2020, amid the COVID-19 economic downturn, California projected a $54 billion deficit—the largest in state history. Newsom declared a budget emergency in June 2020 that allowed him to access the state’s rainy day fund.
By October 2020, California had regained nearly 44% of the more than 2.6 million jobs lost during the previous March and April. In November 2020, the LAO projected a one-time surplus of $26 billion, as revenues were anticipated to fall but actual tax collections remained steady. The LAO then projected a balanced budget for 2021.
In explaining why revenue did not drop as anticipated, the LAO noted that high-income taxpayers did much better during the COVID-19 pandemic than did less-educated and lower-wage workers. High-income taxpayers had fewer job losses and benefited from a strong stock market. As of the end of November 2020, year-to-date revenue was $74.4 billion, with $52.5 billion, or 72%, coming from the personal income tax. A year later, year-to-date revenue was $66.8 billion, with $45.2 billion, or 68%, coming from the personal income tax. The LAO reports make clear that the multiyear surpluses are a result of California’s dependence on that single source of tax revenue.
Facing criticism for California’s increasing business tax burden, Newsom noted “all the new billionaires” created by IPOs. The stock market boom in late 2020, caused partly by the Federal Reserve’s unprecedented monetary interventions during the COVID-19 pandemic, led many firms to the IPO market to take advantage of historical highs. As a result, collection of capital gains tax from the stock market and IPO boom drove the state’s budget from deficit to surplus.
In January 2021, Newsom introduced a record $227 billion budget proposal that increased spending. “While we are enjoying the fruits of a lot of one-time energy and a surplus… it’s not permanent,” he said. “We have to be mindful of over-committing.” Newsom said calls for new taxes on the wealthy were “not part of the conversation” and proposed more tax credits for businesses that stay in California and create full-time jobs. Newsom also noted that the state was on track to exceed the Gann Limit by about $52 billion. Under the Gann Limit, the state cannot exceed its 1978 spending level, per resident, as adjusted for inflation.
In May 2021, Newsom reported a projected $75.7 billion budget surplus and proposed direct stimulus payments to taxpayers (the LAO put its estimate the at $38 billion). There were repeated concerns about “over-committing” to new recurring spending commitments. The budget largess continued into 2022, when in January 2022 Newsom introduced a record $286.4 billion budget proposal for 2022-2023.
Brown’s Budget Reforms
The current budget surplus is largely a result of reforms implemented under Governor Jerry Brown. In 2011, Brown took office with a $27 billion deficit. Brown helped pass several measures to stabilize the state’s finances, including a ballot initiative to increase taxes on the state’s highest earners. During his term, California paid down debt, made contributions to pension funds, and passed a constitutional amendment to shore up its rainy-day fund. Brown left office with an estimated $21.6 billion surplus.
Brown’s final budget proposed $190.3 billion in spending for the 2018-19 fiscal year and included an increase in the rainy day fund by more than $5 billion, to a total of $13.5 billion. During this time, California was experiencing one of the longest periods of economic expansion in U.S. history following the Great Recession. With strong job growth and tax revenue exceeding projections, the state’s fiscal position was vastly improved.
Nonetheless, Brown warned that the expansion would someday come to an end. “It’s so important we prepare for the recession not when it comes but years before,” he said. Brown captured the issue succinctly in 2018, after releasing his final budget, which had a nearly $9 billion surplus. “We have a whole political system that judges our executives by the state of the economy, over which they have virtually no impact,” Brown said. “The next governor is going to be on the cliff,” he said. “What’s out there is darkness, uncertainty, decline and recession. So good luck, baby.”
On the Cliff
With worsening economic conditions, the outlook for the state’s finances are uncertain. Newsom noted in his May 2022 budget proposal that 94% of the surplus will be spent on one-time expenditure. However, a downturn could bring a budget deficit similar to the projected $54 billion deficit in 2020 that would easily overwhelm the state’s reserves and make the $23.3 billion set aside for the rainy day fund look meager.
Instead of looking to increase tax and spending, even one-time expenditures, California should be preparing for worsening economic conditions and the likelihood of budget deficit. Part of preparing for a downturn should include tax reform that involves “broadening the tax base, addressing the issue of volatility” and promoting broader economic growth. Such broadening of the tax base would reduce state dependence on “all the new billionaires” created by IPOs. As observed since 2020, these high earners are highly mobile, and California has seen an increasing number of individuals and businesses leaving for states with lower taxes.
In the meantime, state lawmakers are doubling down on California’s dependence on high earners through such proposed measures as Proposition 30, a ballot initiative to impose a 1.75% tax on incomes of more than $2 million a year to fund zero emissions vehicles. In registering his opposition to Proposition 30, Newsom again noted the central problem. “California’s tax revenues are famously volatile, and this measure would make our state’s finances more unstable — all so that special interests can benefit,” he said. “Prop. 30 is fiscally irresponsible and puts the profits of a single corporation ahead of the welfare of the entire state.”
Along with reducing volatility, tax reform presents Newsom with an opportunity to show that he is a national leader willing to address tough political challenges. Not just as an academic exercise during the boom times of 2018 but as an exercise in preparing California for the future. Newsom may not be “on the cliff” yet, but the “darkness, uncertainty, decline and recession” that Brown warned against is surely coming.