California has lost 25% of income taxes. Now, a new budget reality must set in | Opinion

California’s independent financial watchdog, the Legislative Analyst’s Office, is sounding a budget alarm that both Gov. Gavin Newsom and the State Legislature may not want to hear, but must.

The state’s heavy reliance on income tax leaves the California budget uniquely vulnerable to the gyrations of Wall Street and the economy. The LAO is estimating that income tax collections fell a stunning 25% during the 2022-23 fiscal year, with some late payments still trickling in. And the pattern appears to be continuing this fiscal year.

Absent an unexpected upward shift in the economy, the LAO is bracing Newsom and the legislature to anticipate a $68 billion budget gap. To put this in perspective, Sacramento could exhaust its $22.3 billion in reserves for “budget stabilization” and still face a $46 billion problem.

California has survived these cycles before, but not without severe pain and leaders who don’t sugar-coat the problem. Finance is emerging as a real test for the governor and new legislative leadership.

California taxes higher income earners more than most states — something that Newsom is proud of as a progressive way of revenue generating by government. But this isn’t nearly as reliable a source of income as others, such as property taxes that are limited by a third rail of California Politics, Proposition 13 of 1978.

California companies that go public, for example, can create a stock windfall for its founders and big tax bills. In 2022 and 2023, the number of companies that went public is down 80% compared to 2021, according to the LAO.

The rank and file aren’t doing so well either: The California economy began to turn south in the summer of 2022 and nearly 200,000 Californians have lost their jobs since.

Costs have gone up. The mortgage payment for a median California home has risen from $3,500 to $5,400 in the past two years, in large part due to higher interest rates. Higher costs have resulted in Californians buying less, and the result has been a drop in sales tax revenue. Combine that with the drop in corporate tax revenue and personal income tax revenue, and California has a triple whammy budget problem.

“As always, this forecast is highly uncertain,” the LAO warns. But the uncertainty cuts both ways. “It is entirely possible that revenues could end up $15 billion higher or lower than our forecast for 2023-24 and $30 billion higher or lower for 2024-25.”

Ultimately, it is Newsom’s Department of Finance which will be the official bearer of the bad news, based on its own ongoing tabulations and forecasts. But there is nothing to suggest that the LAO isn’t in the ballpark when it comes to assessing the problem.

The solution? Newsom should make every effort to dive into the existing fiscal year budget and cut discretionary spending where possible. One of the most expensive bills Newsom signed this year, for example, was to increase the minimum wage for an array of health care workers to $25 an hour over time. That single action is expected to add $4 billion worth of costs to next year’s state budget.

The legislature, meanwhile, has tens of billions of dollars worth of bond proposals for the November ballot that have yet to make it to the governor’s desk. The idea of borrowing to maintain necessary investments will be tempting. But borrowing isn’t free, and comes with sizable annual debt repayments. Both the governor and the legislature should be cautious on additional debt.

What worried us about the existing budget was the autopilot nature of the spending plan. The state budget doubled in just six years before the post-COVID downturn began to happen. Any budget that grows that fast will have some fat to be trimmed. Nobody likes the scalpel, but making the effort to find the questionable spending at every level of state spending will lessen the inevitable pain that is coming.

All signs point to some ugly budget cycles facing Sacramento and the state. The sooner Newsom and the legislature confront the challenge, the better.

This story was originally published December 23, 2023 at 5:00 AM.