Dan Walters

Dan Walters: California budget flunks Moody’s fiscal ‘stress test’

Watch the California Franchise Tax Board count your money

Hundreds of workers at the California Franchise Tax Board continue to process about 1.4 million income tax returns filed on paper. April is by far the largest volume month for tax returns at the Butterfield Way FTB office.
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Hundreds of workers at the California Franchise Tax Board continue to process about 1.4 million income tax returns filed on paper. April is by far the largest volume month for tax returns at the Butterfield Way FTB office.

Moody’s Investor Service last month delivered what should be a sobering message about California’s vulnerability to a massive fiscal meltdown.

The credit rating organization conducted a “stress test” of the nation’s largest states. California’s state budget, with its high dependence on volatile income taxes and its low spending flexibility, scored dead last among the five most populous states (Texas was No. 1) and virtually tied with Illinois for last place among the 20 most populous.

Income taxes make up two-thirds of general state revenue with the top 1 percent paying half of those taxes, and Moody’s stress test underscores the precariousness of a narrow tax base.

Jerry Nickelsburg, senior economist for UCLA’s Anderson Forecast and one of the most astute observers of California’s economy, laid it out in a monograph last year.

“As innovation, technology, and their concomitant entrepreneurial activity replaced large-scale manufacturing, the importance of high-income earners soared,” Nickelsburg wrote.

“The income of the new entrepreneurial class is quite different than their high-income predecessors. In good times, these entrepreneurs and their team rake in profits. Their companies issue IPOs, they exercise stock options, and they receive generous bonuses. But when the economy tanks, so do their incomes.”

As their incomes go up and down like yo-yos, they magnify the effects of recession, Nickelsburg continued, resulting in ever-deeper budget deficits.

The best antidote would be broad tax reform, reducing volatility by lessening dependence on income taxes from a relative few. But that is fraught with political peril, as a blue ribbon state commission found when its recommendations were quickly dumped.

After returning to the governorship five years ago, Jerry Brown proposed two major fiscal moves, both eventually approved by voters – a temporary increase in taxes, including higher rates on those with incomes of more than $250,000, and a “rainy day fund” to capture excess revenue and hold it for use when revenues dip.

A November ballot measure would extend the income surtax for an extra 12 years, making California even more dependent on volatile revenues from high-income taxpayers, while the rainy day fund is, as Nickelsburg and others have pointed out, an inadequate buffer.

“A dispassionate reading would suggest it is not even close,” Nickelsburg wrote – perhaps 10 percent of what a truly severe recession would require.

So Brown gets it, even if his remedy is tokenism. But his fellow Democrats in the Legislature are critical of Brown’s plans to put more in reserves and want to raise spending on education, health and social services, and virtually all support the income surtax extension.

Meanwhile, California is overdue for the kind of recession that Moody’s tells us would clobber the budget. And there are indications, such as a slowdown in the San Francisco Bay Area’s commercial real estate market, a decline in new tech startups and global stagnation, that such a recession may be just over the horizon.

We can’t say we weren’t warned.

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