Briefing Report: Irresponsible Budgeting, Its Effect, and a Solution

Wednesday, March 4, 2009

Overview

In November 2008, two months after he signed the state budget, Governor Schwarzenegger called for a special session of the Legislature to address a budget deficit. Citing rapidly deteriorating economic conditions precipitated by the housing market collapse, the Governor announced that the state faced a whopping $42 billion shortfall by the end of the 2009-10 fiscal year. Now, drastic measures must be implemented in order to avert fiscal insolvency. How did we get here and what must the state do to prevent a reoccurrence of this magnitude?

The Road to Perdition

Some believe that we got into this fiscal crisis because of a spending problem. Others say it’s a revenue problem. The reality is that California’s budget woes are due to overspending of volatile one-time revenues, as discussed below.

First, California’s overly progressive tax structure subjects the state’s primary source of funding to massive volatility.

Under the current tax system, the top one percent of California taxpayers pay about half of all state personal income taxes1. Since revenues from the personal income tax make up more than 50 percent of all General Fund resources, this means that a large portion of all the money the state has available for spending is entirely dependent on the fortunes or mishaps of just one percent of the taxpayers. And, because they’re tied to capital gains in the stock market and other investments, these taxpayers’ incomes are highly volatile.

As a result, when the economy is robust, these taxpayers have more taxable income and the state General Fund is flush with cash. However, when the economy takes a downturn and these taxpayers take losses, the state’s primary source of funding nosedives, as shown in the chart below.

Second, the Legislature has chosen to use one-time revenues to fund ongoing spending.

As discussed above, the state General Fund goes through boom and bust cycles because of its over-dependence on volatile income tax revenues. During the boom years the state goes on a spending spree, expanding entitlement programs, giving huge pay raises pushed by union bosses, growing state bureaucracy, etc. However when the economy takes a tumble, the state is left with a pile of bills and no money to pay them.

According to the Department of Finance, a structural deficit was created between 1998 and 2000 when the state, under the Davis administration, used a one-time 23 percent revenue increase from stock market earnings and the dot-com bubble to add new permanent spending increases. When revenues declined the following year, the state had no money to fund these costs. Rather than taking the fiscally responsible approach to reduce overspending on ongoing programs, the state made minor one-time reductions and ran up the bill using borrowed money. This exacerbated the financial situation and left the state with a $14 billion deficit the subsequent year.

Third, California does little to set aside funds for a rainy day.

Another reason why California is in its current predicament is that the state tends to spend every nickel it gets. A couple of years ago, the state a ttempted to institute a constitutional requirement for funds to be set aside in a rainy day fund, also known as the Budget Stabilization Account. However, the parameters were too loose and weak to be effective. Essentially, the Governor was able to withdraw money shortly after a couple of deposits. Moreover the set-asides have been, on average, no more than one-and-one-half percent. To put this in perspective, financial experts advise households to maintain a cash reserve to get them through at least three months. The state’s reserve is the equivalent of five days.

The Comeback Trail

Opinions vary on how the state got itself into trouble, but economists and fiscal experts generally agree that an approach that includes an effective reserve requirement; a true spending cap on state expenditures; and a more stable revenue source would go a long way towards mitigating budget deficits in the future.

Solving the spending crisis

According to the non-partisan Legislative Analyst’s Office (LAO), the most effective tool for mitigating deficits is to implement a reserve requirement. Then, when the state receives revenue growth that is determined to be above average (based on various calculations) the state is required to set aside these funds for a rainy day. The state would only be allowed to withdraw these funds in years when revenues were determined to be below average and under very stringent conditions.

In tandem with a reserve requirement, fiscal experts recommend implementation of a spending cap. Specifically, the amount that the state is authorized to spend in a given year would be limited to an amount determined by the average level of revenues over the last ten years. Together these two proposals would, in effect, hold the state to a specified spending level even in years when the state is flush with cash, and force excess funds into a reserve account as a fallback in lean years.

Note: As mentioned above, the current reserve requirement is ineffective. Proposition 1A, proposed for the May 19, 2009 election, would increase the reserve and impose spending caps.

Stabilizing revenues

Besides fixing the spending problem, economists believe that stabilizing revenues would help guard against future deficits. Some proposals include fla ttening the income tax, or rebalancing the mix of tax revenues.

The Tax Foundation reports that California has one of the most progressive tax structures in the country. This progressive nature makes California’s revenues highly volatile because they are so dependent on the incomes of the very few. Fla ttening the income tax structure by changing the rates so that the burden is more evenly distributed among a broader base of taxpayers would make General Fund revenues more stable. This approach also has added benefits, such as – fairness, since all taxpayers will pay the same tax rate; simplicity through elimination of various tax calculations; and transparency, since taxpayers will know exactly what taxes they are paying.

Other economists suggest rebalancing the mix of revenues among the three major taxes (income, sales/use, and corporation tax) so that the General Fund draws more evenly among them as opposed to the current 50 or so percent draw from personal income tax. Specifically, this proposal would entail increasing or expanding the sales/use and corporation tax, which tend to be more stable because they are less progressive. However, this approach does not fix the inequities in the income tax rates.

Conclusion

California has go tten itself into a deficit crisis of unprecedented proportions because it relied on an overly progressive income tax system that produced volatile one-time revenues, and overspent those funds on ongoing programs. Now, the state must take drastic action in order to prevent insolvency. Economists advise implementation of an effective reserve requirement coupled with a spending cap to solve the overspending problem. To stabilize revenues, the state could revise the income tax structure to distribute the tax burden more evenly and make it less progressive at the same time.

 

1. Franchise Tax Board Revenue Estimating Exhibits – May 2008