Strong tax collections belie California’s tough fiscal outlook
Given the continued strength in state tax revenues, it may come as a surprise that the California General Fund is likely to face a budget problem in the coming years. Yet that’s the main finding of a recent tax analysis of 10,000 possible revenue scenarios conducted by our office. In 95% of our simulations, the government encountered a budget problem by 2025-26. Notably, the likelihood of a fiscal problem is largely insensitive to the future path of government tax revenues. In other words, whether revenues trend up or down from here, the state is likely facing budget deficits. The central implication of our findings is striking and suggests that, in the interest of fiscal resilience, the legislature should consider rejecting a substantial portion of the governor’s January spending proposals.
How can strong revenue trends pose fiscal risk?
In the brief associated with our analysis, we described how continued revenue growth could increase the state’s constitutional funding obligations enough to cause large recurring budget deficits. Having essentially reached the State Appropriations Limit (SAL) of Proposition 4 (1979), every dollar of additional revenue must be allocated in accordance with the requirements of the SAL, making them generally unavailable to fund basic expenditures. In addition, the state must also continue to spend the amounts required for schools and community colleges and reserve and debt payments, in accordance with Propositions 98 (1988) and 2 (2014), respectively. Together, we estimate that for every dollar of tax revenue above the SAL, the state faces approximately $1.60 in constitutional funding obligations. Based on our scenario analyses, if revenues exceed projected median growth, SAL needs could most likely reach $20-45 billion by 2025-26. Therefore, unexpectedly, every additional dollar of revenue above the limit worsens the state’s fiscal outlook.
Given this conundrum, how should lawmakers consider responding?
In our brief, we have identified several short- and long-term options, with particular emphasis on the atypical fiscal risk arising from rising revenue performance. In the short term, the most divisive option is probably the one most conducive to preserving government fiscal resilience. We recommended that the Legislative Assembly consider rejecting the lion’s share of the Governor’s $10 billion in nonexclusive SAL budget proposals. Furthermore, we note that rejecting the proposed expenditure alone—even in favor of SAL expenses—probable would be insufficient since constitutional obligations would accrue faster than incoming revenues in future years. Further, therefore, we suggest that the legislature keep unspent funds in reserve to help pay anticipated state obligations related to SAL. Longer term, state policymakers will likely still have to weigh fundamental questions about the size of state government and whether to seek a voter-approved amendment to Proposition 4.
What about downside risk?
Although less specific, there are also risks to the budget from declining economic and revenue performance that increasingly deserve recognition in state budget planning efforts. Throughout the past year, inflation has accelerated faster than consensus forecast. Now at 40-year highs, the Federal Reserve (the Fed) has embarked on a cycle of monetary policy tightening aimed at calming inflation. In clearer terms, the Fed is trying to reduce inflation by orchestrating an intentional slowdown in economic growth. Ideally, the slowdown would reduce inflation without substantially increasing unemployment or causing a recession. History suggests it’s a daunting task, however, and at least increases the chances of a recession. Financial markets, and the US Treasury yield curve in particular, have recently signaled this. In normal economic times, there is a positive spread between ten-year and two-year bond yields. However, when this spread narrows or reverses, it suggests that bond investors anticipate that going forward, the Fed will keep interest rates low due to a weaker economy. As a result, the increase in yields on short-term Treasuries, reflecting the Fed’s efforts to fight inflation, may approach or exceed the yield on longer-term notes. As shown in Figure 1, this spread briefly dipped into negative territory in early April 2022, from 1.29 percentage points on October 8, 2021. While a temporary inversion of the yield curve alone does not constitute a comprehensive basis on which to base state fiscal policy, its occurrence is prudent.
Timing suggests resilience-building actions are needed now
Although the likelihood of a recession has increased, that doesn’t necessarily mean it’s around the corner. It is plausible that the economy could continue to produce strong revenues in 2022-23, but then fall into a recession soon after. This gives rise to a potential fiscal punch where the government generates large SAL-related liabilities (upside risk) in 2022-23, followed by declining revenues in subsequent years (downside risk ). In addition to SAL 2022-23 requirements in the range of $10-20 billion, a moderate-severity recession thereafter could result in annual deficits of $10-12 billion. If these dynamics were to occur simultaneously, or if the legislature postpones processing of the SAL 2022-23 requirement until 2023-24, the state reserves would be exhausted within a year. The risk presented by this possible sequence of events, which we have described as a worst-case scenario, now calls for actions to build resilience. A good starting point would be to apply scrutiny to the Governor’s spending proposals.
Overall, the Governor’s fiscal plan is not a financially viable starting point given that the Department of Finance estimates that the State’s Discretionary Reserve closing balances would turn negative from 2023-24 to 2025- 26. While this partly reflects the inclusion of significant one-time spending proposals that may change, it does not take into account future SAL requirements. Our main recommendation—to reject $10 billion of the Governor’s non-exclusive SAL spending proposals and instead save the funds – would improve the state budget outlook in two ways. First, disallowing spending would limit the growth of the government’s spending base, putting it on a stronger fiscal footing, regardless of future economic conditions. Second, by saving unspent funds, the state would have resources to help fund projected SAL needs or, alternatively, cover a recession-related budget problem. This action could also be combined with other measures to alleviate the constraints of the SAL, which we expose in our brief.
Recognizing that despite the risks we have identified, the legislature may still wish to make some budget increases, we suggest that it consider three criteria. First, we recommend a high threshold for new proposals. This means that the proposal must address a well-defined problem with a policy strategy that has been assessed and found to be cost-effective. Second, we suggest prioritizing proposals that mitigate future budget issues. Examples include proposals that, in the future, result in lower credits subject to the limit because they are excluded from SAL, reduce tax revenue, or result in savings to the state. Similarly, the legislature may want to focus on one-time spending commitments rather than ongoing spending. Finally, we recommend prioritizing proposals that may have other tax benefits, such as tapping into additional federal funds.
Fiscal outlook calls for building resilience now
Throughout the post-Great Recession period, state policymakers have steadily increased fiscal resilience by prudently accumulating large fiscal buffers. Are the government’s existing reserves sufficient to cover the fiscal problems we believe are likely over the period of its forecast horizon? No one knows for sure, but in some scenarios, we found that the cumulative estimated budget problem would significantly exceed the state’s current combined general purpose budget reserves by about $25 billion. Fortunately, however, these estimates come at a time when tax revenues are strong, providing policymakers with the opportunity to take protective measures. In light of the constraints presented by the SAL, creating additional fiscal resilience would help protect the policy priorities of the Legislative Assembly in the years to come.