What a difference a year makes.
California’s recent approval of Proposition 2 is already paying dividends. The Legislative Analyst’s new Fiscal Outlook shows Proposition 2 is doing what it was designed to do: capturing a run-up in unsustainable spikes in revenue, paying down debts and setting aside revenues for the next economic downturn so that education and other vital programs have some protection.
The Analyst should be applauded for urging lawmakers to use Proposition 2 to think smartly about the long-term – by paying off debt to local governments (including school districts), which will increase support for those public services, and by reducing unfunded liabilities for the state’s retirement systems, saving taxpayers billions of dollars down the road.
The main LAO economic forecast shows steady economic growth through the end of the decade and concludes that by the end of 2015-16, a total of $4.2 billion will be available in a reserve to maintain fiscal stability (assuming no new major budget commitments are made). If the economy grows at a steady pace later in the decade as the LAO is forecasting, the budget reserve will continue to grow, bolstering the state’s ability to further cushion the impact of the inevitable next downturn.
Despite the optimism in their Fiscal Outlook, though, the LAO sounds an alarm as to what might occur should its predictions of steady economic growth not hold.
The LAO presents an alternative scenario in which the economy slows down mid-decade. With the economy in its sixth year of expansion, to assume unending growth is to ignore the lessons of the past. In this alternate scenario, stock prices drop 20 percent in 2016 and growth in personal income in 2016 and 2017 slows.
Because more than 60 percent of California’s general fund revenue comes from capital gains taxes on high income individuals who make most of their income from investments, a market downturn would have a significant impact on the state’s general fund and overall fiscal outlook. It’s true that the state is better prepared to weather such a scenario with $2 billion in reserve, another $2 billion earmarked for debt and more to be set aside in 2016 and 2017, thanks to Proposition 2.
Even so, the potential for an economic downturn overshadows the growing conversation about whether to extend Proposition 30’s temporary tax increases, and the impact of that decision on long-term budget stability. Since Proposition 30 derives its revenue from those same high income earners, any decline in the stock market and slowdown in the economy will magnify the decline in state revenue.
California Forward’s estimate based on the past two recessions shows a decline of capital gains tax revenue in the 50 to 60 percent range when that downturn arrives. This economic scenario provides is an opportunity to begin a conversation about the stability and long term sustainability of the state’s revenue structure. This topic should be high on the 2015 policy agenda.
Fred Silva is the Senior Fiscal Policy Advisor at California Forward