California’s volatile tax system strikes again

Gov. Gavin Newsom’s penchant for braggadocio was in full flower eight months ago when he declared that California had a $97.5 billion budget surplus and boasted that “no other state in American history has ever experienced a surplus as large as this.”

He and the Legislature then wrote a 2022-23 budget with major increases in education, medical care and social services, plus a multi-billion-dollar cash rebate to taxpayers and other one-time expenditures.

On Tuesday, a more subdued Newsom acknowledged that the projected surplus had morphed into a $22.5 billion shortfall. He proposed a $297 billion 2023-24 budget that throttles back some of the additional spending and indirectly borrows billions of dollars to close the gap.

Moreover, Newsom warned that if the Federal Reserve System’s interest rate increases trigger a recession, the deficit could become much worse.

The situation is another reminder that California’s public finances are at the mercy of an extremely volatile revenue system, one dominated by personal income taxes, especially those paid by high-income Californians on their stocks and other capital investments.

As he began his presentation to reporters, Newsom displayed a chart demonstrating the ups and downs of capital gains as a percentage of personal income – reaching a peak of 9.7% in 2021 and now expected to decline to 5% by 2025.

Newsom said it “sums up California’s tax structure, sums up boom and bust.”

The decline in investment earnings, Newsom said, is the primary reason for a $29 billion reduction in projected income. His estimate of revenue declines and the resulting $22.5 deficit is a bit more optimistic than a November forecast from the Legislature’s budget analyst, Gabe Petek.

The situation rekindles a decades-old debate in political, academic and media circles about the state budget’s volatile dependence on the investment earnings of a relative handful of affluent taxpayers.

Former Gov. Arnold Schwarzenegger and legislative leaders created a blue-ribbon commission to recommend tax system changes that would lessen volatility. The badly divided commission proposed to reduce the reliance on the income tax by flattening it to just two brackets, eliminating sales and corporate income taxes, and creating a new “net business receipts tax.”

When the “Parsky Commission,” so dubbed for its chairman, businessman Gerald Parsky, finally released its report in 2009, it was quickly consigned to oblivion. When Jerry Brown returned to the governorship in 2011, he proposed to deal with volatility by creating a “rainy day” reserve financed by windfall revenues.

That fund and other reserves now total $35.6 billion, which would easily cover the current deficit, but Newsom – agreeing with Patek – is not tapping them, citing the danger of recession.

“We’re not touching these reserves,” he said. “We’re in a very volatile moment.”

As hefty as the reserves appear, it’s questionable whether they would be enough to counter even a moderate recession.

Petek, who pegged the current shortfall at $24 billion without a recession, warned in his November forecast that “Based on historical experience, should a recession occur soon, revenues could be $30 billion to $50 billion below our revenue outlook in the budget window.”

In other words, a recession could have as much as a $74 billion negative impact on the budget, more than twice the state’s reserves. In relative terms, the state has faced deficits of that magnitude in past recessions.

“What’s consistent is the inconsistency of our tax structure,” Newsom acknowledged.

Ideally, California would alter that structure to make it less dependant on a narrow base of taxable income – but as the fate of the Parsky Commission’s report indicates, there’s little political appetite for such reform.