California saved billions for ‘rainy day.’ But two economic hurricanes are headed our way

The coronavirus pandemic already has wiped out tens of thousands of jobs in California. And that’s just the first act.

Even after the “stay at home” orders are eased and life starts getting back to normal, COVID-19 will likely inflict a second wave of economic misery on the state.

This second shock would come when wealthy Californians, their stock portfolios battered by coronavirus, file their income taxes next spring. Unless the stock market stages a major recovery over the next few months, income tax payments in 2021 are expected to decline by tens of billions of dollars. The drop-off in revenue could persist for several years, in fact.

That could mean more economic troubles for Sacramento.

Right now, the state government remains the bedrock of the region’s economy — tens of thousands of its workers are still on the job even as much of the rest of the economy implodes. But the state is hardly immune to economic convulsions.

Think back to a decade ago. While threatened mass layoffs didn’t materialize, the state treasury went so deeply into the red during the Great Recession that then-Gov. Arnold Schwarzenegger ordered unpaid “furlough Fridays” that turned downtown Sacramento into a weekly ghost town.

Unlike the last recession, the state government has partially cushioned itself against a downturn, in the form of more than $20 billion in “rainy day” funds and other reserves built up through several years of surpluses.

“We’ve never been in a better position to weather a recession,” Gov. Gavin Newsom said during a recent press conference on the coronavirus.

But the treasury is vulnerable to wild fluctuations in revenue, a function of the state’s tax structure.

California government relies heavily on tax payments from a few hundred thousand wealthy residents, whose incomes can vary dramatically with the rise and fall of the stock market and other volatile sources of wealth. This unpredictability has worsened over the years as the state has increased its dependence on its richest taxpayers.

A lot will depend on how long the crisis lasts. For now, with the stock market dropping by one third since the coronavirus washed ashore in California, experts believe the state budget will suffer.

History suggests it might not take long. In August 2007, Schwarzenegger had a $4 billion surplus. Barely a year and a half later, he handed lawmakers a budget proposal with a $42 billion deficit.

Coronavirus “is going to be a big hit on the budget,” said Michael Shires, a budget expert and public policy professor at Pepperdine University.

“The $20 billion, it’s good to have it, it softens the blow,” Shires said, referring to the rainy day fund. “But that $20 billion is going to go pretty quickly.”

Not only will revenues falter, but expenditures will jump as claims for unemployment and other benefits spike.

“This is going to put stress on the state budget. There’s no way it can’t,” said Terri Sexton, a retired public-finance expert at Sacramento State.

Newsom acknowledged as much in a recent press conference at the Office of Emergency Services headquarters. Despite the hefty rainy day fund, “the magnitude of this moment may exceed those reserves,” he said.

Weeks before coronavirus became a household term in America, Newsom’s administration released an economic forecast that raised the possibility of a moderate recession — defined as a downturn worse than the dot-com meltdown of 2001 but not as bad as the Great Recession.

Under this scenario, tax revenue would fall $50 billion over two years, the administration said, with further losses in future years.

Why so many years? In part because it typically takes time for investment gains — and personal income taxes - to bounce back, even after the economy is in recovery.

Shires said it won’t be enough for the Dow Jones average to recapture the 10,000 points it’s surrendered since mid-February. The market must keep rising well beyond that, Shires said, to generate enough capital gains to translate into the kind of revenue California’s tax collectors have enjoyed in recent years.

That helps explain why Sacramento, whose fortunes are closely tied with state budgeting, recovers from recessions slower than other cities, said economist Jeff Michael of the University of the Pacific.

“The state budget tends to act with a bit of a lag,” he said.

Despite its efforts to draw high tech jobs from the Bay Area, Sacramento is still largely a government town. The state government employs 91,000 workers, nearly 9 percent of the area’s workforce. Throw in the state universities, plus federal and local government agencies, and the public sector accounts for almost a quarter of the more than 1 million jobs held by area residents in January, the last month for which the figures exist.

Raising California income tax brackets

California’s precarious tax structure has been decades in the making.

In the early 1950s, personal income tax made up only 11 percent of general fund revenues. Sales tax, which is far more stable, generated 59 percent.

In Newsom’s proposed 2020-21 budget, which totals $222 billion, personal income tax will generate 67 percent of the revenue. Sales tax, less than 11 percent.

Two-thirds of all taxes come from personal income taxes, much of it paid by the wealthy. In 2017 the richest 1.5 percent of all Californians, or about 242,000 people, paid $41 billion into the treasury, according to Franchise Tax Board data. These Californians, all of whom earned at least $500,000 that year, accounted for about half of all personal income tax payments.

What’s so troubling to policymakers is that wealthy residents’ incomes are less predictable than those on the lower rungs of the economic ladder.

Among those making at least $1 million a year, ordinary wages account for barely half their incomes. The rest comes from capital gains (the profits reaped when an investment is sold), dividends, interest and other financial sources, according to a 2018 study by the Legislative Analyst’s Office. These income sources are far more volatile than what comes in the weekly paycheck, the LAO found.

Voters added to the problem when they approved Proposition 30, former Gov. Jerry Brown’s initiative to raise income and sales taxes.

On the one hand, the ballot initiative helped wipe out the deficits caused by the recession and contributed to the buildup of the rainy day fund that the treasury has today.

But by creating three new income brackets at the upper end of the scale - for Californians making at least $250,000 a year - voters also built more instability into the system. The top marginal tax rate in California is 13.3 percent, the highest of any states that levy income taxes, according to the LAO.

Elected officials and policymakers have known for years that California’s tax structure left the state especially vulnerable in a downturn. But overhauling the tax structure has proven nearly impossible politically. A proposal floated by Schwarzenegger in 2009 to flatten the income tax brackets went nowhere.

Newsom, speaking to reporters shortly before he was elected in 2018, acknowledged the difficulty of making changes.

“Nothing, nothing, no issue (is) more vexing than this one, because everyone has a trophy on the wall,” he said. “So I’m not naive about this, but I am not going to neglect this issue,” he said in 2018. “Volatility is not our friend, it’s our enemy.”

This story was originally published March 23, 2020 at 5:00 AM.