California Enjoys Surplus Now, But Long-Term Woes Remain

Investor's Business Daily

Mountains of financial liabilities. Forced to issue IOUs when cash ran dry. A legislature in perpetual stalemate. Prickly relations with powerful public sector unions. At the worst of the financial crisis, California was often compared to Greece.

For state-budget watchers, Gov. Jerry Brown's $107 billion fiscal 2015 budget marked a historic event. "The state is now on its most stable fiscal footing in more than a decade," he declared in his introduction to the budget, which provides for a small surplus and begins to scale back some outstanding debts.

Analysts agree that the governor has skillfully steered the state out of crisis and onto firm footing faster than expected. But California's wounds are years in the making, and will take years to fully heal — something Brown is the first to acknowledge.

"Past budgetary borrowing, unfunded retirement obligations, bond costs, and deferred maintenance have created a mountain of long-term liabilities that totals hundreds of billions of dollars," he wrote in his letter to lawmakers. "In the face of such liabilities, our current budget surplus is rather modest.

The 1% Solution

California's skewed tax system puts most of the burden on higher-income earners and capital gains taxes, magnifying a tendency to booms and busts. Overspending before the recession and hard decisions during the budget crisis left it with a mountain of liabilities. The Democrat-dominated legislature is toeing the governor's line for now, but has a dysfunctional history and incentives to overspend.

"Some of the news stories about the California miracle have put a lot of emphasis on the tax increase and the recovering economy. But there's something more to be said," said Gabriel Petek, a senior analyst at Standard & Poor's. S&P recently changed its outlook on California to positive from stable, yet maintains its credit rating at A, the second-lowest in the country.

"They've brought the recurring expenses and revenues into alignment," Petek said. "It's a pretty remarkable turnaround.

Personal income taxes from California's top 1% of earners account for roughly 27% of all general fund revenue, and capital gains are a major portion of that income. Think of all those millionaires and billionaires from Apple (AAPL), Tesla (TSLA), Facebook (FB) and other tech giants. A temporary sales and income tax championed by the governor and passed by voters in 2012 exacerbates that imbalance, with the top personal rate at 13.3%.

Spend The Boom

That means business-cycle ups and downs become periods of huge swings in tax revenue. Since 2000, the state has had only two short periods of budget balance, 2001 and 2007, both followed by revenues that plunged by as much as $40 billion.

The state was guilty of assuming that booming revenues would never bust. In a report called "Understanding California's Fiscal Recovery," Petek wrote that "the state had established an unaffordable expenditure baseline," locking in spending based on rosy revenue forecasts.

Brown and the legislature deserve "tremendous credit" for steadily whittling expenses, said Brad Williams, a Sacramento-based economist who's analyzed the state budget for years. A 2010 budget plan showed that lawmakers expected to spend $120 billion in fiscal 2015, he noted. Now that amount is 11% less.

"They clamped down on every area of the budget," he said, from public employee wages and benefits to higher education.

But lawmakers are itching to start spending again. "Prudence is never easy," Brown acknowledged in his press conference, even as he called for restraint.

Brown is calling for an 8.5% spending hike in fiscal 2015, and makes use of a $4.2 billion carryover from the prior year, which he assumes will be halved by the end of FY15. But expenses are more streamlined than may appear at first glance.

During the recession, the state ran up what Brown calls "the Wall of Debt" — huge medium-term liabilities that totaled $35 bil lion at the end of fiscal 2011. This "wall" does not refer to bonded debt except for a small chunk of special-purpose bonds, but to underfunding, deferring payments, or borrowing from local cities and agencies, higher education, state transportation programs and pension plans, and so on.

By June 30, the end of FY14, $25 billion will remain. Brown wants to pay that off over the next two years, which would mean that approximately 12% of the budget will retire and not be part of future baselines the way social program spending or salaries might.

Brown also has proposed an education reserve fund, doubling the maximum amount allocated to a statewide rainy day fund, and limiting the amount that can be withdrawn from such a fund. Those ideas will be put to voters in November 2014.

But that's been tried before. In 2004, voters amended the constitution to require a 3% deposit into the rainy day fund, yet the state suspended that deposit every year since 2007.

Wall Of Debt The Easy Part

The Wall of Debt isn't the only set of long-term liabilities now coming home to roost. California has long had an uneasy relationship with its massive public pension funds. The $282 billion California Public Employees' Retirement System, or CalPERS, is well funded, primarily because it can unilaterally impose funding increases on its member municipalities and agencies. That puts huge strains on cities and counties. Los Angeles now spends an estimated 18% of its budget on pensions vs. just 3% in 2002-03.

But the state teachers' retirement system, CalSTRS, doesn't have that ability, and lawmakers resisted granting it increases for decades. CalSTRS estimates its unfunded liability at $80.4 billion, even with generous investment return assumptions. While that amount doesn't need to be made up all in one year, or a few, it will take several billion dollars annually to get on track.

Now that the budget has stabilized, more money is flowing to school districts, Williams said, and some of that may be allocated back into CalSTRS as an employer contribution. But that could set up an uncomfortable situation: teachers and students duking it out for a share of resources after a dry spell.

Another growing issue is the stark inequality in the state. "This is a geographically disparate recovery," wrote Jerry Nickelsburg, a senior economist at the UCLA Anderson School responsible for well-regarded economic forecasts.

"There are local labor markets that are beginning to look like the Appalachia of yore," he continued, adding that the gap is only widening.

That imbalance is increasingly becoming a credit concern, said Petek. Inequality can exacerbate California's boom-bust patterns in unpredictable ways. During the housing downturn, people whose incomes had stagnated felt more inclined to over-leverage themselves, he pointed out.

Nearly eight years after the housing downturn began, some local markets are booming again, but others have stagnated. California has one of the highest jobless rates in the country, 8.3% as of December, and owes the federal government nearly $10 billion for funds borrowed to pay unemployment insurance.

A recession, especially with a stock market slump, would send tax revenues plunging yet again.

Still, analysts like Williams prefer to highlight the positives in California's comeback. "There are very real challenges, but for the first time we have the luxury of thinking about them," he said. "Until recently the question was, 'Is the patient going to live?' "

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