Whether or Not to Tap Reserves to Solve Estimated Budget Problem Emerges as Key Fiscal Decision Facing California’s Legislature

Through the final months of the 2023-24 budget process, California’s Legislature will make numerous important decisions regarding the allocation of state resources in the context of a budget problem. Few choices will be as consequential for the state’s medium-term fiscal outlook as whether or not to draw upon its budget reserves to close a projected deficit. On the one hand, reserves offer an expedient solution to the problem. At $27 billion, the state’s discretionary reserve balances are roughly equivalent to the size of the deficit as estimated in January. (The state also has an additional nearly $10 billion in reserves that it can use specifically to supplement constitutionally required funding for schools and community colleges.) On the other hand, our office maintains that the economy is at a heightened risk of going into a recession, which could cause the state’s budget problem to metastasize. Holding all else equal, if the economy were to enter a recession, it would be better to do so with flush reserves. The decision of whether to draw upon reserves, therefore, hinges on the Legislature’s assessment of the state’s current fiscal structure and economic outlook. Unpacking the situation on both fronts points to the guidance our office has provided, which, unless the situation substantially worsens, is to consider solving the problem without using reserves.

Regarding the fiscal situation, consider that the state’s now-strained budget condition is the other side of its recent revenue boom more than it is an outright downturn. Throughout the pandemic period, the state experienced a several-year period of extraordinary General Fund revenue growth. Revenues increased by nearly 30 percent in 2020-21 and another 20 percent in 2021-22. In the course of allocating the historically large surpluses generated by the revenue surge, General Fund spending increased commensurately. Whereas for the first two decades of this century expenditures averaged 5.9 percent of total personal income, they climbed to a four-decade high of 8 percent in 2022-23.

Neither recent revenue trends nor the elevated spending level they supported were expected to represent a new normal, however. That is why the Legislature allocated the vast majority of the surpluses to one-time purposes and temporary spending phased in over several years. It is notable that even now, anticipated revenues for 2023-24, while down from their peak, remain 20 percent higher than the pre-pandemic level on an inflation-adjusted basis. Yet, the state nevertheless faces deficits in the budget year and beyond. The implication is that as prudent as the one-time and temporary spending allocations were, General Fund spending remains too high relative to revenue performance typical of historic norms. At the same time, we have estimated that revenues are much more likely to be sufficient to cover the state’s baseline commitments—which are expenditures stripped of the one-time and temporary allocations. Therefore, the question is whether reserves should be deployed in order to sustain unusually high levels of spending commitments predicated on a cyclical peak in revenues. The alternative would be to solve the currently estimated budget problem without tapping reserves, which we have indicated is possible by curtailing previous temporary spending allocations. The main benefit of this approach is that it would preserve budget flexibility in case the economy were to enter a downturn.

Beginning in May 2022, our office estimated that the economy was at a heightened risk of recession occurring within the next two years. Our assessment was based on certain leading economic indicators and financial market correlations. For example, the simultaneous occurrence of very low unemployment (below 4 percent) and high inflation (above 4 percent) has, for the past 70 years, always preceded a recession within two years. Although inflation, as measured by the consumer price index, appears to be trending down from the recent peak of 9.1 percent in June 2022, as of March, it remained 5 percent, or 2.5 times the Federal Reserve’s (the Fed’s) target. This suggests that the Fed may have more inflation-fighting work to do. The Fed’s continued efforts to lower inflation by raising the Fed funds rate has the effect of cooling the economy, which inherently raises the odds of a recession. As a potential precipitating factor to recession, tighter monetary policy can also reveal financial system vulnerabilities. Recent stress in the banking sector illustrates the point and even if the turmoil largely has subsided, these events could potentially contribute to more constrained credit conditions.

In addition to gauging the risk of recession, the type of recession that could unfold, if there is one, will matter. Looking back, some recessions, such as the early 1990s recession, have been harsher economically for the state as a whole than they have been from a state budget standpoint. Other downturns, such as the 2001 so-called dot-com recession, had severe fiscal implications while inflicting somewhat milder economic damage. The 2008 Great Recession had brutal effects on both the state’s economy and budget. Due to its origins in the technology sector, the best analog for the current situation might be the 2001 recession. We have attributed some of the weaker-than-expected personal income withholding tax collections so far to a steep 84 percent decline in initial public offering (IPO) activity in 2022. Given that many IPOs in recent years have been among technology-related firms, the ongoing slowdown in that sector combined with more restrictive access to credit going forward is cautionary. If the economy enters a recession, the possibility of a sharp downward revision to revenue estimates—we have estimated by as much as $30 billion to $50 billion—cannot be dismissed.

A final complication is the state’s conformity to the federal Internal Revenue Service rule change that, as a response to the January floods, delayed the 2022 tax filing deadline to October from April. Incomplete tax collections data in April could contribute to a substantially larger revenue forecast error. If the budget were inadvertently built upon overestimated revenues, chances become greater that midyear corrective budget adjustments will be necessary. In that scenario, flexible budget options of the kind afforded by reserves are at a premium.

In his 2021 book, The Resilient Society, Princeton University economist Markus Brunnermeier argues that for governments, being frugal in good times is what provides extra spending capacity—resilience—in bad times. From a cyclical standpoint, it is difficult to describe the present moment as constituting bad times with an unemployment rate hovering at near its historic low. According to Brunnermeier’s framing, therefore, using the reserves to solve the currently estimated problem could be premature, if not risky. We hasten to add, however, that our guidance is not meant to suggest that reserves should be deemed off limits regardless of circumstances, for example, in the event that deteriorating economic conditions result in new projections showing a larger budget problem that cannot be solved without encroaching on the state’s core operations. In that case, the state’s reserves could be key to sustaining the state’s safety net through a challenging economic period.