California Dreamin'

January 31st, 2013

by Eric Schaefer

On Election Day, November 6th, 2012, Californians who went to the polls were greeted with a raft of state-wide ballot initiatives. Eleven propositions in all — 30 through 40 — covered the spectrum of fiscal, political and social issues. When the votes were tallied, five of the eleven passed. Two which passed directly impact California's chronic fiscal woes. Propositions 30 and 39 were never very well camouflaged tax increases on the affluent and business, respectively. In the latter case, those businesses which derive significant sales in the state but have few employees or facilities located there.

The new flood of revenues expected from the two referendums help explain the lifting of the fiscal cloud over Sacramento. Governor Jerry Brown gushes this is the start of a new golden age for the golden state: a generation of deficits is over, the age of the fiscal surplus has begun. True, the deficit for the 2012-13 fiscal year (FY) in the governor's 2011-12 budget was projected at $19.2 Billion. In the latest cut, released with much fanfare on January 10th, the forecast is for a modest surplus of $0.9 Billion. Even the non-partisan Legislative Analyst's Office concedes the state's fiscal affairs are improving, although a surplus at fiscal-year end is no certainty.

But all the self-congratulatory rhetoric cannot change the fact that the future is uncertain. Unless the state's economy improves dramatically, and the recovery is sustained, the swing from deficit to surplus may prove ephemeral.

First, the tax increases at the heart of Proposition 30 are temporary. The 1/4 percent increase in the sales tax expires in four years while the surtax on incomes exceeding $250,000 lasts for seven years. So, unless extended in the future, the revenue fix is not permanent. California's mountain of debt was not accumulated in just one year or even just seven. It will likely take a generation to erode the burden to a more manageable level. Second, the corporate tax increase at the heart of Proposition 39 does little to endear California to businessmen in and out of the state; much less buff the state's considerably tarnished reputation as an already difficult place to do business. Short-term, individuals and firms are locked into commitments keeping them situated in California. Over time, we anticipate a number will decamp and relocate their lives and businesses elsewhere. Propositions 30 and 39 do nothing to staunch the exodus already underway.

The most important long-term detrimental impact to California and its finances is in Proposition 30, entitled The Schools and Public Safety Protection Act of 2012. The referendum resulted in yet another amendment to the state's constitution. And, yet again, the change will commit California's tax payers to earmark revenues for the benefit of public servants, largely K-12 teachers and other employees in the public education establishment. No surprise then that the California Teachers Association and the American Federation of Teachers were among the largest donors supporting Proposition 30's passage.

Our concern is this education entitlement has been tried in the past and found wanting. Proposition 98 (passed in 1988) was intended to place education spending on a firm fiscal footing. Instead, it caused state spending (and, deficits) to balloon. For FY 2013-14, Proposition 98 related expenditures account for almost 42% of total spending. The state guarantee has fostered a beggar-thy-neighbor policy at the local level. Municipalities have no incentive to raise taxes (where they can) to fund schools. Nor does it provide any incentive for local school districts to force voters to re-think Proposition 13 (passed in 1977 which limits assessed property taxes to one percent).

Sacramento may pass budgets balanced this year and next without borrowing or the usual chicanery. But, the long-term structural issues remain. The hard choices have yet to be made and the hard battles (with the unions) yet to be fought. Californians may find they are living in a dream.

Notes on Sources and Methods:

Debt levels reflect the aggregate of debt incurred by the state of California. Components include general obligation debt backed by the full faith and credit of the state of California as well as public debt issued for private purposes.

The debt to nominal gross domestic product (GDP) ratio is the ratio of the state's debt issued by the government to the size of its economy. GDP is a widely used measure of the total goods and services produced (consumed) by a nation (or, state) over a period of time. Nominal GDP reflects the value of the aggregate goods and services at current price levels. The ratio provides a useful gauge of a state's ability to service its government's debt.

(Sources: Census Bureau; Bureau of Economic Analysis; California Department of Finance; California Treasurer's Office; and, AIFS estimates.)

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