California Is in Big Trouble Again

(Bloomberg Opinion) -- Ten to 15 years ago, pundits liked to speculate that California was on the verge of becoming a failed state. In the early years of the new century the state suffered widespread blackouts thanks to a botched deregulation of its electricity market. Meanwhile, with long-standing ballot initiatives requiring a legislative supermajority to pass tax increases, and education expenses ballooning, the state’s budget seemed permanently mired in the red. Arnold Schwarzenegger, governor at the time, managed to cobble together a deal to limit deficits, but the Great Recession sent them soaring again. The collapse of the housing bubble hit California hard, pushing unemployment above 12%. Some commentators suggested that California’s governance model, heavy on regulation and subject to the whims of ballot initiatives, could lose out to the more laissez-faire systems of states like Texas.

California battled back. Under Schwarzenegger's successor, Jerry Brown, the state raised taxes on residents making more than $250,000, and bumped up the sales tax a bit. The new taxes on California’s high earners, along with the recovery in the housing and stock markets and a new technology boom, helped push the state’s budget back into the black:

But California’s victory over dysfunction may be short-lived. Earlier this month, California utility PG&E Corp. intentionally cut power to millions of residents, costing the state economy billions of dollars. The planned blackout was meant to keep power lines from sparking wildfires, which have raged across California with increasing fury in recent years:

The monetary losses from these fires are staggering — some estimates put them at $400 billion in 2018, or almost a seventh of the state’s gross domestic product. This includes health costs, lost property, lost jobs, decreased asset values and migration out of the state. Meanwhile, PG&E executives say that the intermittent blackouts will continue, meaning that much of the state may no longer have reliable year-round electricity. That will doubtless exert a further chilling effect on investment and property values.

Fires aren’t California’s only problem. Thanks in large part to spiraling urban rents, the homeless population increased by 5.3% from 2010 to 2018, in a state that already has almost half of the nation’s homeless. In Los Angeles and San Francisco, the crisis is especially acute, with destitute people and pitiful tent encampments crowding the sidewalks. Government pension costs are rising much faster in California than in the rest of the nation, forcing cost-saving measures that are degrading the state’s education system.

These forces are driving Californians to move out of the state in increasing numbers. Population growth is trickling off, and may soon go negative:

Even the wealthy are moving away. A recent paper by economists Joshua Rauh and Ryan Shyu found that out-migration of top-bracket taxpayers accelerated after the income tax hike of 2012. That’s bound to put even more pressure on state finances that rely so heavily on contributions from the top 1%. Just how much of that exodus is due to the tax hikes rather than to other factors is unclear, but Rauh and Shyu argue that tax avoidance plays a significant role.

So despite its heroic efforts and an unprecedented degree of political unity — Democrats now have a supermajority in the state legislature and the governor's office — California risks falling back onto the dysfunctional path that it seemed to be on in the early 2000s.

Much of this is for reasons beyond the state’s control. Climate change is exacerbating drought and wildfires. The rent crisis in California cities is largely due to a structural shift in the U.S. economy; as knowledge industries become more dominant, high-earning workers are crowding into cities like San Francisco and Los Angeles in order to be close to each other, driving rents up for everyone else.

But California’s political system is making it hard to respond to these pressures. Thanks to a 1978 ballot initiative called Proposition 13, California cities have stringent limits on raising revenue from local property taxes. That forces the state to provide many services, financing them with hefty income taxes. Those are inherently more unreliable than property taxes, since wealthy taxpayers can move away (while property can’t move), and since California’s income taxes fluctuate a lot because they depend so much on the profits residents earn on volatile stock prices.

Meanwhile, despite one-party control of the state legislature, California has been unable to meaningfully address its housing crisis. Powerful local property owners prevent municipal governments from allowing new housing to accommodate the influx of workers from out of state. And they wield power at the state level too, as demonstrated by the demise last year of a bill that would have permitted more apartment buildings near transit hubs.

As for the state’s beleaguered power companies, it’s not clear that any plan exists. PG&E is resisting pressure to sell its assets to local governments, Governor Gavin Newsom is considering breaking up the company and the state utility commission is looking at a restructuring. None of that answers the fundamental question of how the state will provide reliable electricity in an age of intensifying wildfires.

If California is going to avoid this dark path, it will need the political will to carry out bold reforms. Proposition 13 must be repealed, and property taxes raised. The state legislature needs to pass bills to allow greater housing density and more construction throughout the state. Cities will have to make deals on benefit cuts for pensioners in order to spend more on schools. And the state will probably have to bite the bullet and shell out more money to bury power lines.

California can still save itself from becoming a failed state, but its days of complacency and easy prosperity are over.

To contact the author of this story: Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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