Legislative Analyst Gabriel Petek issued a new Fiscal Perspective today, March 18, 2020, to account for the economic and budget effects of the novel coronavirus (COVID-19) gripping the state, the nation, and the world. The Perspective, not unlike other accounts of the current crisis, highlights the sobering signals coming from Wall Street, but buffers it by acknowledging that California is better prepared to handle the rapidly evolving situation than it would have been even just a few years ago.
The Wall Street Effect on State Revenue
Let’s start with the bad news. Petek notes that Governor Gavin Newsom’s January State Budget projected that the state would benefit from $30 billion in capital gains taxes across fiscal years 2019–20 and 2020–21, which assumed that stock prices would remain relatively flat before gradually increasing. Importantly, capital gains taxes are a significant source of state revenue as California’s personal income tax structure is aggressively progressive, relying heavily on the state’s highest income earners who tend to invest more heavily in the stock market than most. Over two-thirds of all state general fund revenue is derived from personal income taxes.
Although the market had been outperforming budget expectations before the stultifying effects of COVID-19 were felt, the recent and magnitudinous correction of the stock market—namely, the S&P 500 index—puts current market performance well below the Governor’s projections. And while we cannot predict how the market will respond to the recent monetary policies put in place by the Federal Reserve—including cutting rates to near zero and reinstating the quantitative easing policies it reverted to during the Great Recession, along with an impending fiscal stimulus package from Washington DC—Petek notes that in the past a correction of this magnitude is not likely to recover quickly. He predicts that tax revenues from capital gains will be several billion dollars below the Governor’s January estimates.
Forecast Calls for Rain, California Has an Umbrella
Now, the good news. It appears that the fiscal prudence of the Brown Administration era continued by the Newsom Administration is paying off. Many of you will recall that former Governor Jerry Brown inherited a dizzying $27 billion state deficit when he assumed office in 2011. He committed his second tenure as governor to restoring California’s fiscal health by tearing down its wall of debt and aggressively saving for a rainy day. By the time he left office in 2018, the state had set aside roughly $16 billion in reserves. In January, Governor Newsom proposed increasing the current reserve levels to nearly $21 billion. While this will likely need to be adjusted given the current situation, California’s robust savings account makes the state “better prepared to weather the public health crisis and unfolding economic downturn.”
Of course, how much cushion the state’s reserves provide in a recession depends on how long it takes for the economy to recover and ultimately the path of the COVID-19 virus. In light of the rapidly changing economic situation, the Legislative Analyst suggests that the Legislature may consider adopting a “workload budget” for the near term (to meet its June 15th constitutional deadline to pass a budget) to be able to assess the state’s fiscal condition as more data becomes available.
What It All Means for Proposition 98
As we have discussed in recent reports, the Proposition 98 minimum guarantee is directly tied to the performance of state general fund revenues. In Test 1 years like 2019–20 and 2020–21, the minimum guarantee is no less than roughly 38% of general fund revenue. Notably, the last two of the fiscal year’s four quarters in 2019–20 are being significantly impacted by COVID-19, and we do not yet know if and how protracted the virus will be in the coming budget year. The uncertainty is exacerbated by the State Treasurer’s recent announcement that the Franchise Tax Board approved extending critical tax filing dates for corporations, entities, and individual tax filers to June 15. Given the urgency of the crisis, this is the right thing to do; however, it does make it much more difficult for lawmakers and the Governor to accurately estimate state revenue to inform state budget negotiations.
While we do not know the full impact on Proposition 98, we know that the collective call from local educational leaders to boost the Local Control Funding Formula (LCFF) revenue above the statutory cost-of-living-adjustment (COLA) of 2.29% will require re-evaluation, depending on any downward revision to the minimum guarantee. The LCFF COLA is derived from the implicit price deflator on a third-quarter to third-quarter basis (prior April 1 to current March 30) from the prior year, so it is unlikely that the LCFF COLA will significantly change from January as a result of the current health crisis, which was just starting to be felt earlier this month. You may recall that the 2019–20 State Budget Act (SB 76) authorized the Director of the Department of Finance to reduce the LCFF COLA to fit within K–12’s portion of the minimum guarantee in any fiscal year when it is insufficient to cover the statutory COLA. However, at this time, there appears to be sufficient cushion in the previously estimated growth in the minimum guarantee to prevent the triggering of this provision. In other words, there should be sufficient funding to cover the 2.29% LCFF COLA, but it may be that the COLA encumbers a greater share of the year-over-year growth in guarantee. We also have to acknowledge that events are moving quickly and estimates can rapidly change.
In closing, it goes without saying that these are unprecedented, rapidly changing times. We remain vigilant in our monitoring of events in order to report them quickly.