With New Deficits Looming, California Will Weigh its Options for Allocating a Large Revenue Windfall

As of spring 2020, a near consensus held that economic fallout from the coronavirus disease 2019 pandemic would inflict a massive fiscal shock on California. Policymakers adjusted accordingly, adopting the 2020‑21 budget on a series of cautious assumptions that reflected a new and arguably warranted pessimism. To date, however, the recession has had a muted effect on tax collections while the surge in demand for state-funded safety net services has been less than anticipated. Largely as a result of these better-than-budgeted trends, we estimate in our recent report, The 2021‑22 Budget: California’s Fiscal Outlook, that a sizeable revenue windfall is taking shape. The magnitude of this unexpected windfall is such that it could produce an unprecedented near-term budget surplus. Looking ahead, however, we also identify the emergence of a new ongoing deficit beginning in the budget year (2021‑22). This fiscal gap persists and widens through the remainder of our outlook period (2024‑25).

Higher than budgeted revenues also result in a substantial current-year increase in the constitutional funding guarantee for the state’s public schools and community colleges (K-14) under Proposition 98. However, whereas a similar near-term windfall on the non-Proposition 98 side of the budget is followed by deficits, the fiscal outlook for the schools remains favorable through the outlook period. A new supplemental payment to the schools, instituted in the 2020‑21 budget, contributes to strong projected funding growth for K-14 education. After accounting for cost-of-living and other baseline adjustments, we estimate that the Legislature will have increasing amounts of funding available for new K-14 commitments over the outlook period. On the non-Proposition 98 side of the budget, given that our outlook anticipates a large windfall concurrent with nascent operating deficits, it will be important for the Legislature to balance its fiscal priorities in the coming budget cycle. Our core recommendations include suggesting that lawmakers (1) allocate roughly half of the windfall to restoring budget resilience, (2) use the other half on one-time activities related to mitigating the effects of the pandemic, (3) refrain from adding new ongoing commitments, and (4) consider making at least some progress toward reducing the ongoing deficit. We also think the Legislature should reassess the new Proposition 98 supplemental payments after reviewing both its education and non-education budget priorities.

Three observations in particular guided development of our recommendations. First, the revenue windfall is a one-time occurrence. Whereas the 2020‑21 budget was built on the assumption of a widely anticipated plunge in revenues, actual tax collections largely have continued apace. This difference between lower revenues in the current budget and our newly updated—and higher—revenue estimates for the current year explains the one-time nature of the windfall. We do not characterize the state as being in a surplus situation because in most years of the outlook, including the budget year, we project that revenues will be below expenditures.

Second, it turns out that the recession’s harshest effects, including severe job and income loss, are falling disproportionately on the state’s less-educated and lower-wage workers. In contrast, high-income Californians have fared much better. Not only did this latter group experience less job loss, an unexpectedly strong rebound in equity markets further buoyed their incomes. Because this group accounts for a large portion of the state’s tax revenues, tax collections proved to be somewhat insulated from the initial downturn. In fact, our revenue estimate for 2021‑22 now is very similar to what the Governor projected in his January 2020 (pre-pandemic) budget proposal. However, the pandemic’s disparate effects on the state’s higher- and lower-wage workers also inform our recommendation to consider allocating half of the windfall to pandemic relief.

Third, the structural deficit, which initially appears in the budget year at a few billion dollars, grows to around $17.5 billion by 2024‑25, and warrants legislative attention. While demands on the state’s safety net programs have been lower than expected this year, we anticipate that caseloads will begin to rise in the years to come. In addition, the state committed to materially higher spending on K-14 education when it adopted the aforementioned supplemental payment to schools as part of the 2020‑21 budget. These and other cost drivers put the state’s expenditures on a steepening trajectory. Meanwhile, in a shadow cast forward by the pandemic-induced recession, we expect both the economy and tax revenues in the years ahead will grow more slowly than before. This mounting fiscal pressure within the context of an expanding economy is a disquieting hallmark of an underlying structural problem.

Allocating the Windfall
—Restoring Budget Resilience

In the upcoming budget cycle, there are three reasons why the Legislature may want to consider dedicating about $13 billion, or about half of the anticipated windfall, to restoring the state’s fiscal resilience. The first recognizes that replenishing reserves, repaying internal borrowing, and restoring supplemental pension payments—which together represent the lion’s share of the state’s budget resilience—all are one-time resource commitments. Restricting the use of a large one-time resource for one-time purposes, such as rebuilding budget resilience, would be in well-advised agreement with public finance theory. The alternative—funding ongoing expenditures with a one-time resource—would worsen the state’s oncoming structural imbalance.

Second, rebuilding budget resilience is crucial to ensuring that the state can maintain its safety net programs when they are needed most—in times of economic stress. Consider the most recently completed budget process. From January to May 2020, projected tax revenues for the upcoming fiscal year (2020‑21) underwent an unprecedented $42 billion downward revision. Within just a few weeks, the budget process was upended from a discussion about how to allocate a surplus into the much less welcome task of solving a large anticipated deficit problem. Moreover, the situation presented the Legislature with a difficult dilemma. On one hand, revised estimates indicated that tax revenues would be insufficient to cover the state’s commitments. On the other hand, preservation of key safety net programs, which assumed an increasingly mission-critical role given the unfolding public health and economic crises, had become more important. Ultimately, the Legislature was able to sustain these programs while balancing the budget, but only by accessing reserves and other forms of fiscal flexibility. To a significant extent, the Legislature deserves credit for its prior multiyear commitment to building budget resilience following the Great Recession. Elevating budget resilience as a fiscal priority again now may seem premature considering the unresolved pandemic and still-high unemployment rate. On this point, however, it is worth remembering that when the state commenced its prior budget resilience efforts in 2012, its recovery from the Great Recession was incomplete.

Finally, there is some urgency to rebuilding the state’s budget resilience in the upcoming budget cycle. Recall that the windfall is the difference between the lower revenues assumed in the current budget and actual (considerably higher) tax collections. There is no basis for expecting this dynamic to repeat. Furthermore, given the impending structural imbalance, it is unclear when another opportunity to meaningfully restore the state’s budget resilience will present itself.

Allocating the Windfall
—Pandemic Response

Alongside the restoration of budget resilience, the Legislature could direct the balance of the windfall—potentially around $13 billion—to a more robust pandemic counteroffensive than was feasible in the spring. These one-time resources would be particularly well-suited to provide near-term mitigation of various public health, economic, and educational harms caused by the pandemic. Our office stands ready to provide analytical assistance to the Legislature as it considers its options on this front.

Consider Proactive Steps to Address Oncoming Operating Deficits

Regarding the structural deficit, our twofold recommendation—to avoid new ongoing commitments and make some initial progress in shrinking the projected problem—would be a good start. Most likely, in the coming years the Legislature will have to consider policy changes to reduce expenditures or increase revenues. While our forecast is susceptible to error, especially given the extraordinary economic uncertainty that exists, we think the revenue growth needed to eliminate the deficit naturally is unlikely. However, the gathering one-time windfall provides a crucial advantage. Prudently managed, this fiscal cushion can buy time for the Legislature to phase-in policy changes while simultaneously allowing it to protect legislative priorities.