Amid Good Fiscal Times, Planning for the Future Is Crucial

In this second installment of Fiscal Perspectives, I focus on the state’s fiscal outlook under the May Revision, identify several risks to the state budget over the next few years, and offer key issues for the Legislature to consider as it closes out its budget deliberations.

Through the adoption of countercyclical fiscal policies, California is better able to navigate the business cycle within the constraints of its constitutional balanced budget requirement. The idea here is that in good times—when revenues are strong—the state spends somewhat below its capacity, sequestering the difference in reserves. Later, when the economy and tax receipts weaken, the state can draw upon its accumulated savings to fund a spending level above what revenues would otherwise support. Exercising spending restraint during good times promotes fiscal sustainability and dampens the need for austerity in subsequent recessions, thus, facilitating policy stability. The more robust California’s countercyclical fiscal policies are, the more the state can avoid boom-and-bust budgeting, which most policymakers view as anathema.

At a moment when the state anticipates $22 billion in discretionary resources (also referred to as its surplus), few would dispute that California is in the midst of “good times.” Yet, while the notion of countercyclical fiscal policy may be agreeable in principle, the policy trade-offs it requires—particularly when times are good—can be difficult in practice. The Legislative Analyst’s Office (LAO) has sought to assist the Legislature with balancing this tension in our The 2019‑20 Budget: The May Revision—LAO Analyses. Having evaluated the Governor’s proposals with an eye toward the state’s longer term fiscal structure, we arrived at two overarching conclusions: (1) the amount of new ongoing spending proposed by the Governor in the May Revision is approaching the upper limit of what is consistent with prudent countercyclical policy and (2) larger discretionary budget reserve deposits than what the Governor proposes are warranted at this time.

New Ongoing Spending in the May Revision Is Nearing the Sustainable Limit

To assess whether the state has capacity for new ongoing spending commitments, we estimate the difference between revenues and expenditures in the budget year and for several years ahead. When this exercise shows a recurring operating surplus, meaning annual revenues exceed expenditures, it generally suggests a fiscally sustainable situation. This is what we found in our recent May Revision—Multiyear Budget Outlook, which is based on LAO revenue estimates and shows an operating surplus through our outlook horizon (2022‑23). At that point, revenues would exceed spending by $4.3 billion.

Importantly, however, this surplus reflects that under the Governor’s proposal, $1.8 billion of spending would sunset within a couple of years. Without sunsets, we estimate the costs—initially proposed at $3.4 billion—would grow to $4.4 billion upon full implementation. And given that the programs affected by the sunset proposals are more ongoing in nature than they are temporary, we recommend that the Legislature weigh the proposals without assuming the proposed sunsets. In that case, we estimate there is a smaller, though still positive, operating surplus of about $2.5 billion in 2022‑23.

By planning for an operating surplus, the state creates fiscal space that can absorb higher than anticipated expenditures. This is prudent considering the systematic tendency of actual costs to exceed projections, often due to factors that are difficult to account for in advance. Although the multiyear fiscal outlook is useful for illustrating the budget trajectory under baseline conditions, consider how the following assumptions can cause us to overestimate future surpluses.

• First, beyond the level of new ongoing spending proposed for 2019‑20, we assume the Legislature makes no additional program expansions through the period covered by our outlook. Any additional spending commitments in the intervening years would subtract from the surpluses anticipated in our outlook. Likewise, our expenditure projections do not include costs associated with multiyear spending plans that the Legislature has already previously endorsed but not yet appropriated for, such as increased grants for California Work Opportunity and Responsibility to Kids (CalWORKs) beneficiaries. Similarly, our multiyear outlook does not take into account spending on future, but not yet proposed, program expansions that the Governor has indicated he supports, such as universal preschool.

• Second, throughout the multiyear outlook period, the inevitability of unanticipated events (such as natural disasters) mean the risk of underestimating expenditures is likely greater than it is of overestimating them. The outlook represents our best estimate of future expenditures but, inherently, we cannot account for unanticipated events, most of which introduce higher, rather than lower, costs.

• Finally, uncertainty is not confined to the expenditure side; revenues are also susceptible to missing the forecast. For the 2019‑20 budget, the most volatile revenue sources—capital gains and corporation taxes—are what drove revenue higher in our May outlook relative to November. Our revenue outlook also incorporates the administration’s assumptions about the revenue effects of conforming to federal tax law. These estimates are highly uncertain, both in the budget window and in the subsequent years of our outlook.

Building an operating surplus into the state’s fiscal plan can help offset the general tendency of margins to erode over time. Therefore, while the state’s currently strong budget condition suggests it can accommodate some new ongoing spending commitments, we suggest the Legislature treat the Governor’s proposed level as an upper limit.

Larger Discretionary Reserves Are Warranted at This Time

Our other central recommendation is for the Legislature to consider making larger discretionary deposits to budget reserves. Large budget reserves are a crucial buffer against more significant fiscal stress that occurs in recessions or when there is a large stock market correction. The economic forecast serving as the basis of our fiscal outlook assumes consistent, albeit slowing, growth through 2023. By then the expansion would have entered its 15^th year if our expectations hold. While it is possible that the economy will avoid a recession for this long, it would be unprecedented. And in the event there is a recession, we have estimated that the state requires reserves in the range of $20 billion to $40 billion to withstand its fiscal effects without enacting major spending reductions, tax increases, or cost shifts. Based on our revenue outlook, the state’s total reserves in 2019‑20 would equal $20.2 billion, high from a historic perspective, but still at the lower bound of the prudent range.

The significance of hard-to-predict capital gains in California’s tax base is another reason to build larger reserves. The May Revision assumes that in 2019‑20, approximately 10 percent of General Fund revenues will come from personal income taxes assessed on capital gains. In a recent scenario analysis, we ran simulations to gauge how likely it is the state would meet its capital gains revenue estimates based on historic stock market performance. For 2019‑20, capital gains-related revenue was either above or below expectations by more than $1 billion in 79 percent of simulations. By 2022‑23, capital gains revenue was either above or below the estimate by more than $1 billion in 82 percent of simulations. Simply put, if the past is any indication, it is highly likely that capital gains revenue will materially differ from our current estimates. Our simulations also illustrated how the range of potential outcomes widens when looking further into the future. For instance, by 2022‑23, our scenarios ranged from $4 billion at the low end to $23 billion at the high end. Both the uncertainty and magnitude of these potential revenue swings in California’s budget argue in favor of larger discretionary reserves.

The composition of personal income in 2019 provides another reason for larger discretionary deposits than what the Governor proposes in the May Revision. Whereas in a typical year, California-based companies make initial public offerings (IPOs) worth about $30 billion of market capitalization, 2019 has already seen IPOs with $150 billion in market capitalization. The most immediate effect of IPOs on state tax revenues is in the personal income tax from wage withholding—in particular, from the newly public companies’ vesting of their restricted stock units. Proposition 2, which establishes rules for mandatory reserve deposits, includes a provision that captures surging capital gains-related tax revenues. However, because withholding revenues are not subject to this feature of Proposition 2, the state treats the surge in IPO-related revenue as regular personal income tax revenue despite otherwise exhibiting capital gains-like characteristics. Consequently, although we acknowledge it comes at the expense of spending capacity—imposing difficult choices on the Legislature—we believe a larger discretionary deposit to the state’s budget reserves is justified this year.

Now Is the Time for Countercyclical Fiscal Policies

With the economy and state tax revenues likely nearing the peak of the current cycle, now is the time for California to robustly engage its countercyclical fiscal policy options. Given the Governor’s proposed level of new ongoing spending and budget reserves, California is poised to enter 2019‑20 prepared for a mild recession, but only just. In its final budget deliberations, we recommend that the Legislature acknowledge upfront the full ongoing costs of its policy commitments (for example, reject the proposed sunsets). Beyond that, we suggest that the Legislature be selective and exercise caution with regard to any additional new ongoing spending and consider making larger discretionary reserve deposits.