The more things change… Governor Brown’s first budget was the first on-time budget in years and the first majority vote budget in decades. At the same time, it relied on optimistic economic forecasts, ($4 billion in additional tax revenue not reflected in the May Revision) and spending reduction “triggers” if the revenue didn’t materialize as projected. The rosy forecast was in lieu of getting a 2/3’s vote from the Legislature to put tax revenues on the ballot. Five months later, the non-partisan Legislative Analyst’s Office (LAO) reported that the state’s finances are back in the red by as much as $13 billion. This development resulted in the Director of Finance “pulling the trigger” on cuts of approximately $981 million to K-12, Higher Education, and Health and Human Services. Even with these triggered cuts, Governor Brown faces difficult choices once again as he works with the Legislature to craft a budget that brings California’s fiscal house into order. Governor Brown is asking the voters to raise personal income tax (PIT) by 1% to 2% on individual tax filers who make more than $250,000 per year and raise the state’s base sales and use tax (SUT) rate by ½ cent from 5% to 5.5%. While both of these proposals would raise state revenues, both have a fiscal policy downside that highlights the need for a strong rainy day fund.
First, let’s look at the PIT. California is blessed with a large number of highly affluent individuals so raising the top brackets from 9.3% to 11.3% for income earners of $500,000 will definitely raise revenues - in good years. The problem with this approach is that the state’s General Fund already gets almost 60% of its revenue from PIT and these high net worth individuals receive much of their income from capital gains which are volatile and hard to predict. Much of California’s boom-bust budget cycles have been directly attributed to these taxpayers. When they get a “financial cold” the state gets a severe case of “fiscal influenza.” So in a good year, the revenue peaks are higher but in bad years the valleys are lower. The overall impact is greater volatility making it more difficult for the Legislature and Governor to do long-term budget planning. The fiscal roller coaster would likely continue under this approach unless safe guards were built in.
Next, let’s consider the SUT which makes up about 22% of the General Fund revenue. California already has the highest total SUT rate of any state in the country (up to 9.25% in some jurisdictions). Many believe that the very high rate has accelerated out-of-state internet purchases where some either knowingly or not dodge the state use tax and receive their goods tax free. Many fights over this issue in the Legislature have resulted in new laws being enacted which attempt to address this issue. Raising an already high SUT rate could cause other economic distortions. But beyond that, the SUT is also highly regressive. That is, citizens with lower incomes pay a higher percentage of their disposable income in SUT than the more affluent do. Some argue the SUT regressive nature is an unfair burden for the less fortunate in the state. However, the fiscal advantage to increasing the SUT is that it does not suffer from the same volatility issues as the PIT so it tends to “stabilize” the revenue picture.
It appears that Governor Brown has tried to “balance” these competing fiscal issues by proposing both - at the same time. However, he also signed SB 202 which moved a strong rainy day fund ballot measure (ACA 4 is a Legislature-sponsored constitutional amendment) from the June 2012 ballot to the November 2014 ballot. Some have argued that the Legislature and Governor may not want to have the rainy day fund voted on at all due to various stakeholders who have a vested interest to maintain maximum flexibility in state spending. This would be an unfortunate development because as former Governors know, it is extremely difficult to build a General Fund reserve when getting a budget passed means meeting the needs of many special interests in any given year. The last time the state had a double digit surplus was the Budget Act of 2000 when the May Revision produced a $12 billion surplus! Then Governor Davis, needing a two thirds majority, provided billions of dollars in vehicle license fee tax breaks that Republicans demanded and provided billions of dollars in additional spending on schools, health and human services and other programs that Democrats demanded. The unfortunate result for Governor Davis, was that the $12 billion surplus, which was primarily one-time money, got entirely spent. When the dot com bubble burst a year later, the General Fund went billions of dollars in the red and with no rainy day fund, Governor Davis spent the rest of his time in office trying to recover from a structural budget deficit. He was ultimately recalled, in part, due to his inability to un-ring the bell he had rung in 2000.
If Governor Brown is successful in getting the additional tax revenue he is seeking to balance the budget, he needs to stand strong against special interests trying to undermine real budget reform and a rainy day fund. He and future Governors will need a mechanism or reform that 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. This approach needs to make sure that the peak revenue funds stay in the rainy day account unless and until it is actually “raining” and the state needs the funds to stabilize the budget in times of economic downturn. It needs to be an approach that can not be un-done on a majority or even super majority vote. There are a myriad of opinions about how best to accomplish this. Whether it is through spending limits, revenue limits, or related reforms, the bottom line is that this state, with its high net-worth earners and volatile income, needs a viable reform put into place; especially if PIT increases become a permanent part of balancing the state budget. Failure to achieve this will keep California on a fiscal roller coaster for years to come.
Tom Sheehy is the former Chief Deputy Director of Finance
and Acting Secretary / Undersecretary of the State and Consumer
Services Agency under Gov. Arnold Schwarzenegger. He joined
Greenberg Traurig's Sacramento government affairs practice
in October 2010.
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