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California’s Unsustainable Comeback


Much has been written about California’s tough economic times over the past few years. The recession that hit in December 2007 slammed particularly hard into California.

From a nonfarm employment peak in July 2007 to February 2010, California shed 1.3 million jobs—idling almost 9 percent of its workforce. It wasn’t until February 2014 that California’s employment numbers recovered to 2007 levels. Year-over-year, California employment is up 2.9 percent through April, besting the overall U.S. picture with its modest 2.2 percent gain, and even big-state rival Texas, at 2.5 percent.

California’s state government is even running a $3 billion surplus, on top of an almost $2 billion deposit into a new rainy-day fund, leading to predictable liberal twin cries: hike taxes and ramp up spending on welfare, education, and the environment. But, is California really heading into economic boom times again, or is the Golden State setting itself up for another bust?

High Tax Intake Doesn’t Mean Economic Health

A common error is that of conflating a state’s budget with the overall health of the state’s economy. A government can enjoy a surplus through any combination of spending and revenue that results in more money coming in than going out.

Politicians can spend less by reining in programs or by deferring necessary expenses, such as payments to government employee pension funds (for years, California has spent the least per capita on its roads). Conversely, revenue depends on the interaction of the tax base and the tax rate. Higher revenues can be wrung out of a shrinking economy if taxes are hiked high enough—although it will be painful and likely prolong and deepen an economic slump.

California’s heavy reliance on a highly progressive income tax makes the state subject to massive swings in revenue.

Most of California’s surplus is owed to surging individual income-tax receipts, itself driven by a rising stock market sustained by ultra-low interest rates courtesy of the Federal Reserve. From 2012 to the fiscal year 2015-16 budget currently being hammered out in Sacramento, individual income taxes are anticipated to balloon $22.7 billion to $77.7 billion, an increase of 41 percent, far outpacing economic growth. In contrast, projected sales tax receipts should be up by 23 percent.

California’s heavy reliance on a highly progressive income tax, with the nation’s highest top marginal rate at 13.3 percent, makes the state subject to massive swings in revenue as wealthy taxpayers realize capital gains or receive bonuses or stock options.

Providing further context, during the four years from June 2012 to June 2016, receipts from income taxes are anticipated to climb 41 percent and sales taxes by 23 percent, the number of people employed in California should be up by 16 percent. Add in inflation of 4 percent and a sales-tax-rate increase of 3 percent (from 7.25 percent to 7.5 percent) and the sales-tax receipt growth tracks perfectly with employment gains. The challenge is in tempering budget growth in the face of historically wild swings in the state’s income tax revenue.

So, while California appears to be back in the black, appearances can be deceiving—especially in the state that gave us Hollywood.

Gloom on California’s Horizon

A few silent threats loom over California’s happy days. First, the stock market. Sometime this year, the Federal Reserve is expected to increase interest rates. When that happens, many experts believe the market will correct as investors exit equities. Any setback in the stock market will eviscerate California’s income taxes.

Second, California has from $172 billion to $214 billion in unfunded pension and retiree health liabilities for its government employees. Government accounting standards suggest an amortization period of 30 years for this liability. Assuming California’s retirement fund, CalPERS, can meet its projected 7.5 percent return on investment, this means that state leaders would have to set aside about $7 billion extra per year for 30 years to match the years of promises politicians made to government employee unions. Further, if the stock market retrenches, many CalPERS investments will as well, which will increase the amount for which taxpayers are on the hook.

State leaders would have to set aside about $7 billion extra per year for 30 years to match the years of promises politicians made to government employee unions.

Third, Medi-Cal, California’s Medicaid program, now covers 12 million people, an increase of 2.7 million with the advent of Obamacare. The growing challenge is that this program seriously underpays doctors for their services. This low reimbursement rate discourages doctors from accepting new Medi-Cal patients, which then leads Medi-Cal recipients to bypass doctors’ offices and go straight to the emergency room. As a result, emergency rooms have seen a spike in use, the opposite of the promised effect of Obamacare’s passage. Paying realistic rates for all of that “free” health care could more than wipe out this year’s surplus.

Lastly, California still has a very weak balance sheet, with a total net position of $7.3 billion in 2014, leaving it with precious little maneuvering room in an economic slowdown. A state’s Comprehensive Annual Financial Report totals up assets, such as cash and investments, as well as state-owned infrastructure (California values its highways at $65.3 billion) and then subtracts liabilities, such as bonded indebtedness, to arrive at a total net position (retiree liabilities are separate). By comparison, the next four most-populous states reported the following total net positions in 2014: Texas, $175.6 billion; Florida, $83.4 billion; New York, $27 billion; and Illinois, -$45.3 billion.

With one in eight Americans calling California home, America benefits from a healthy California economy. California has many strengths, among them the innovation economy and rising immigration of highly talented people, often with considerable capital, from China, Taiwan, South Korea, and other Asian nations. But goodwill and location can only go so far in the face of punitive taxes, a tangled regulatory web, an anti-business lawsuit climate, and a high cost of living. This is reflected in California’s long-term employment growth, up only 7 percent in the last ten years versus Texas’ 21 percent expansion.

In good times, these weaknesses are mere annoyances for many firms doing business in California. But in bad times these weaknesses can be fatal, leading some survivors to make an exodus to the business-friendly climes of states like Texas.

That America’s weaknesses have increasingly come to resemble California’s in the past few years goes a long way towards explaining the nation’s anemic economic recovery.