The state Capitol at night. Photo by Max Whittaker for CALmatters
California has a near-$100 billion budget surplus, which has set off a completely predictable pit fight in Sacramento over how to spend the extra cash. Let’s take a vote. The best thing to spend the surplus on is:
A) Expanding social programs or
B) One-time expenditures (to be safe)
The Democratic majority in the Legislature will choose option A. Gov. Gavin Newsom has been trying to play the adult at the budget table and is pushing for option B. Unfortunately, there should be an option C: none of the above.
While it is understood that our surplus is temporary, even Newsom’s approach misses the underlying issue. The surplus is being driven by California’s personal income taxes. On average, they make up 25% of the state’s revenues, and in fiscal year 2022-23 they will constitute a full two-thirds.
The surplus is driven by the high marginal tax rate on high-income earners. When financial markets are hot, tax revenues surge.
The Department of Finance made this clear in its revenue report when it showed the history of capital gains for taxpayers in the state. This is income earned from various forms of capital transactions — selling property far above its buying price, for example, or income from a tech firm going public.
Such income accrues mainly to very high-income Californians, who are subject to the state’s excessively high marginal tax on high incomes. Over the last two years, state income from capital gains taxes has been close to $250 billion, twice as high as ever before and four times the average. A record surplus is no surprise.
What the markets giveth, however, the markets taketh away.
The last two periods of high capital gains occurred in the late 1990s and then again when the dot-com and subprime mortgage bubbles overheated the economy.
When those markets crashed, so too did asset values and, of course, capital gains. Huge budget surpluses were followed by huge budget deficits.
Here we go again.
The last two years might be best characterized as the “stimulus bubble era.” Yes, the pandemic was a tragic natural disaster, but it was a completely different kind of recession with few long-term consequences. A bit of economic help would have served the purpose fine, but instead, in today’s era of populist politics, the stimulus firehose was turned on. The $12 trillion in what was largely unnecessary federal stimulus has set the U.S. economy on fire.
This is what is driving soaring federal as well as state tax revenues. But it can’t last.
Overstimulated economies begin with a bang, but fizzle in the face of inflation and rising interest rates. All those tax revenues built on capital gains will start falling or, more likely, dry up. But not according to the state Department of Finance’s revised revenue estimate. In the department’s outlook, the economy will cool, but only modestly.
While we can debate how far and how rapidly state tax revenues will fall, the idea that they will plateau is nonsensical. The debate over how much of the surplus to spend on ongoing versus one-time expenditures is a dangerous red herring. California should be preparing instead for the $40 billion budget deficit coming at us.
This view is, of course, a political nonstarter. Tragically, there has been little opposition to the administration’s view or even discussion among business leaders, the government bureaucracy or former officials.
Have we forgotten the fury of voters that pushed Gray Davis out of the governor’s office in 2003? Do we really not remember Controller John Chiang issuing IOUs to pay the state’s bills because we ran out of cash?
Buckle up. It’s going to be a rough few years.
Christopher Thornberg is the director of the UC Riverside School of Business Center for Economic Forecasting and Development and founding partner of Beacon Economics. He wrote this for CalMatters, a public interest journalism venture committed to explaining how California’s Capitol works and why it matters.