State Budget Is Heavily Reliant on Stock Market Earnings. California's progressive income tax system is heavily reliant on stock market earnings because the state has concentrated its tax collections among high-income earners whose incomes are most tied to the stock market through capital gains, equity compensation, and investment returns. When markets climb, this concentration supercharges state income tax revenues. When markets fall, the concentration causes equally large revenue losses.
AI Enthusiasm Boosting Income Tax Revenues, but for How Long? Recent enthusiasm around Artificial Intelligence (AI) has pushed the stock market to record highs and boosted compensation for the state's technology workers. The Nasdaq composite, which includes the California headquartered companies Nvidia, Google, Facebook, Apple, AMD, and Broadcom, has doubled since 2023. The meteoric rise in the value of these companies has led to sizable gains for their investors and their employees via stock options, which has led income tax collections to grow at double-digit rates.
This Time Might Be Different, but It Is Not Safe to Bet on It. As our office warned last November, it now appears time to take seriously the notion that the stock market has become overheated. While there is a chance that this time is different and no such downturn is forthcoming, the risk appears strong enough that we have incorporated it into the state's revenue outlook.
A Look at Prior Downturns Can Shed Light on Magnitude of Risk to State Budget. Understanding how past stock market downturns have translated into income tax revenue shortfalls is important context for anticipating the risks that any future correction in AI-driven valuations might pose.
Focus Here on Major Downturns Because Short-Lived Corrections Usually Have Little Impact on Revenues. Smaller, short-lived corrections occur frequently, among them the 1997 Asian financial crisis, the 2011 U.S. debt celing standoff, the 2015 Chinese growth slowdown, the early pandemic drop in 2020, and the 2025 tariff selloff. These episodes have had minimal lasting impact on state income taxes. At most, short-lived corrections have caused state income tax growth to stall briefly before resuming. For this reason, this post focuses on deeper downturns that lasted more than a few months.
Past Stock Market Downturns
The figure below shows past stock market downturns that have affected state revenues. The figures includes corrections (stock market decline of more than 10 percent) and bear markets (decline of more than 20 percent) that lasted more than a few months. The figure excludes short-lived corrections such as the three-month downturn at the start of the pandemic.
How Do Stock Market Downturns Affect State Income Tax Revenue?
Major Market Downturns Deeply Affect State Income Taxes. The figure below tracks income tax revenue following the seven long-lasting downturns noted earlier. The three minor downturns (1981, 1987, and 1990) led to income tax declines of less less than 10 percent (average of 5 percent), with revenues recovering quickly. The four major downturns were more severe, with income tax declines ranging from 17 percent to 30 percent (average of 24 percent). Perhaps more concerning, income tax revenues stayed depressed for years following major downturns. Revenues regained their nominal levels in 55 months after the dot-com bubble, 53 months following the global financial crisis, and 40 months after the 2022 rate hike drawdown. Multi-year revenue declines amplify the strain on the state budget during major market downturns.
Income Taxes Tend to Lag Major Market Turns by Up to a Year. State income tax growth typically lags stock market turning points by six to twelve months. Before past downturns, taxes have generally grown briskly, often due to the same stock market run-ups that preeceded the downturn. Once the stock market drops, revenue growth first slows, then stalls, then turns negative. The dot-com example below illustrates this pattern. In practice, this means the state could see continued but weakened revenue growth for some time after a correction before the outlook turns clearly negative.
Revenue Impact Also Depends on the Type of Downturn. No two downturns are alike. By most measures, the global financial crisis was more severe than the dot-com crash. The state's unemployment rate, for example, peaked at 7 percent following the dot-com crash but reached nearly double that during the financial crisis and remained elevated for much longer. Yet the dot-com bubble hit California revenues worse because the bubble was concentrated in technology companies headquartered here. The result was a deeper and more protracted revenue decline than the state experienced during the broader financial crisis and related recession. This dynamic may be especially notable today. The current run-up in stock prices is similarly concentrated in Silicon Valley technology companies, raising the risk of an outsized revenue loss if that market corrects sharply. With the concentration of stock market gains in technology companies, any event that shakes market confidence, including things beyond waning enthusiasm about AI, could be detrimental to state revenues.