Menu
Tax Notes logo

Will California Beg, Borrow, or Steal?

Posted on July 20, 2020
William Hays Weissman
William Hays Weissman

William Hays Weissman is a state and local tax practitioner in California.

In this installment of Taxing Times, Weissman discusses California’s $54 billion budget deficit and how the state will fill the hole.

There is an old expression: to beg, borrow, or steal. The phrase is used to imply getting something you want or need by any means possible. It usually does not mean a combination of the three options in the literal sense, unless you are talking about government.

California is a case in point. According to Democratic Gov. Gavin Newsom’s May revised budget, California is facing a $54 billion deficit, a rather dramatic swing from a budget surplus of $5.6 billion only a few months earlier. The deficit is more than three times California’s $16 billion rainy day fund, and nearly 37 percent of its total general fund spending. In other words, the hole is substantial. The $54 billion deficit is calculated based on an estimated $41 billion revenue loss, $7 billion increase in Medi-Cal and related health services, and approximately $6 billion in spending related to COVID-19.1

The $54 billion question: How will California fill that hole? The answer seems to be through a combination of begging, borrowing, and, perhaps, stealing.

First is begging. On May 11 Newsom, along with the governors of Colorado, Nevada, Oregon, and Washington — together known as the Western States Pact — requested $1 trillion in additional funding from the federal government. They probably should not hold their breath. President Trump has said he opposes what he calls blue state bailouts, commenting: “You look at Illinois, you look at New York, look at California, you know, those three, there’s tremendous debt there, and many others. I don’t think the Republicans want to be in a position where they bail out states that are, that have been mismanaged over a long period of time.”2

There are some data to suggest that sending the states funding would aid the larger economy, as occurred with the Obama administration’s American Recovery and Reinvestment Act. However, unsurprisingly even if somewhat disappointingly, politics prevents Republicans from agreeing to federal spending that might benefit Democrats, as Trump acknowledges.3

Then there is a question about whether the begging is really needed. Between May and the end of June, the economic situation appeared to improve. Newsom’s estimate of a 25 percent unemployment rate turned out to be off by about 40 percent. Many states’ economies are improving with reopening, albeit slowly and with uneven results. All we really know is that it is probably too early to tell where the economy is really headed.

Second is borrowing. Newsom’s budget calls for borrowing just over $4 billion from special funds.4 The May budget revision acknowledges that California faces $167 billion in unfunded pension obligations. While California has been working over the last few years to reduce that liability, in the current crisis the governor proposes to redirect a $500 million general fund supplemental pension payment and suspend payments to the California Highway Patrol’s retirement plan.5 The state will also suspend rate increases to the California State Teachers’ Retirement System, saving $1.8 billion over the next three fiscal years. Further, the state proposes raiding $754.2 million from the State Project Infrastructure Fund and using it for general fund purposes.6

Unfortunately, all this begging and borrowing will not be enough for California to fill its budget hole. So third, it may have to “steal” even more of its residents’ wealth and income. It has numerous options for doing so.

One way to steal is to impose new taxes that take Californians’ hard-earned wealth. For example, in 2019 Sen. Scott Wiener (D) introduced S.B. 378., which would have reinstated California’s inheritance tax, eliminated by initiative in 1982, by imposing an estate tax of 40 percent on the net value of a decedent’s estate in excess of $3.5 million, with a credit for all federal estate taxes paid on the estate, set to begin January 1, 2021. The bill failed to advance in the Senate and did not get a floor vote, effectively killing it for now.

The problem with this option is that even if it had been enacted, the bill would not have been very helpful because the tax revenues from an inheritance tax were dedicated to the Children’s Wealth and Opportunity Building Fund. The fund was created to pay for “programs and services that directly address and alleviate socio-economic inequality and build assets among people who have historically lacked them, including helping low income children build wealth through savings accounts.”7 So stealing residents’ inheritance probably will not do much to fill up the general fund because it cannot be directed wherever the revenues are needed most.

California is known as a high-tax state. One tax, however, is remarkably reasonable by comparison to others: unemployment insurance tax. Because of COVID-19, California had a record 15.5 percent unemployment rate in May.8 Back in 2007, A.B. 651, introduced by Assembly member Sharon Runner (R), would have amended California Unemployment Insurance Code section 930 to read:

930. ‘Wages’ does not include remuneration in excess of seven eleven thousand two hundred fifty dollars ($7,000) ($11,250) paid to an individual by an employer during any calendar year, with respect to employment.

With that simple change, the tax California employers pay for their employees would have increased about 60 percent. This bill did not pass either, and California has kept its $7,000 wage base limit for decades.

Like the failed inheritance tax, an increase in the unemployment tax is a mixed bag because while it might help shore up California’s depleted unemployment insurance fund, it might also cause more businesses to either go under or move out of the state, actually exacerbating the unemployment funding problem. So this kind of robbing Peter to pay Paul might not be a great solution either.

Another strategy is to raise taxes indirectly. California is taking this approach by temporarily suspending the use of net operating losses and limiting some tax credits. By reducing the expenses against revenue, the state artificially increases net income subject to tax (that is, profit), anticipating several billion more in revenue. These changes are temporary, but California has been down that road before too.

In 2012 California imposed “temporary” sales and use tax and personal income tax increases via Proposition 30. The income tax increases were needed because California had the nation’s third highest unemployment rate, at 10 percent, and a $25 billion budget deficit. The personal income tax increase was set to expire in 2018, but in 2016, when the unemployment rate was only 4.4 percent and the state had a budget surplus, California decided to extend the temporary personal income tax increase until 2030 via Proposition 55, resulting in the nation’s highest marginal rate of 13.3 percent. The problem with this theft is that the “temporary” personal income tax increase still exists and will for years, so all the state can do is raise taxes even higher, even if for the same “temporary” period. The public might end up with temporary tax fatigue and decide a 16 or 17 percent personal income tax rate is not worth it, especially when the state and local tax deduction on federal taxes is limited to $10,000.

There is already evidence that the current temporary tax increases are not worth it. In the National Bureau of Economic Research working paper “Behavioral Responses to State Income Taxation of High Earners: Evidence From California,”9 the authors found that there were indeed behavioral responses to the temporary tax increases imposed by Proposition 30 that included both moving out of California and reporting less income. The authors speculated that the reason less income was reported could be for a variety of reasons, including that the rich simply chose to work less if they just have to hand over all their money to the government. What they did explain is that the wealthy’s response to increases in taxes resulted in about 45.2 percent of anticipated windfall tax revenues being eliminated.

So, based on at least some research, imposing higher temporary income taxes, employer taxes, and inheritance taxes is likely to result in high-net-worth Californians and their businesses either generating less income, leaving the state altogether, or, more likely, some combination of both. That does not bode well given that California gets nearly 70 percent of its revenue from personal income taxes (including business income from passthrough entities), and particularly given that the wealthiest 1 percent of Californians pay about half of all income taxes.10 In fact, in 2016 over $1 billion in personal tax revenue came from one ZIP code: 94301 in Palo Alto.11 With all those tech employees working remotely from all over the world during the pandemic, maybe never to return, California faces a much more serious long-term revenue crisis.

Of course, there is one other option, which California will also be forced to use: spending cuts. Some would also call this stealing — stealing the funds necessary to help the poor, educate our young, pay for our roads, and so forth. Part of Newsom’s $54 billion deficit is actually the result of spending increases set to take place July 1 with the new fiscal year. As a result, Newsom proposes canceling $6.1 billion in spending expansions for Medi-Cal and the University of California and California State University systems, thus stealing needed funds from the young and the old.12

Then there are the actual spending cuts (rather than merely not increasing funding). California is required by Proposition 98 to make minimum spending commitments to K-12 education based on a formula that is tied in part to general revenue and personal income. COVID-19’s impact is estimated to be about $19.9 billion in funding for K-12 education.13 The Legislature does not appear to like Newsom’s proposed cuts, or the way the governor has appeared to act by fiat in making all decisions about how California will weather the pandemic, and is pushing back with its own priorities.14 What ultimately happens will largely be tied to factors neither the governor nor Legislature control: the scope of the infections and their impact on the healthcare system, which in turn is what is affecting the broader economy that force workplace shutdowns.

No one knows what the future holds, in California or anywhere else. The best hope is that the pandemic can be managed in a way that does not further hold the economy hostage. California appeared to be doing quite well before pandemic hit the state hard in March, but that merely masked numerous festering structural problems, including steeply progressive tax rates that are too reliant on a narrow base of taxpayers via the personal income tax and massive unfunded pension liabilities, among others. Regardless, until the economy is doing well enough to once again cover up its structural defects, California will beg for what it can get, borrow what it can, and steal what the public allows.

FOOTNOTES

2 Ebony Bowden and Steven Nelson, “Blue-State Coronavirus Bailouts Are Unfair to Republicans, Trump Says,” New York Post, May 5, 2020.

3 Michael Grunwald, “Why Politics Keeps Tanking a Bailout Idea That Works,” Politico, June 1, 2020.

4 California Department of Finance, California Budget 2020-21, May Revision, at 3-4.

5 Id. at 120-121.

6 Id. at 134.

8 California Employment Development Department, “California Unemployment Rate Rose to Record 15.5 Percent in April” (May 22, 2020).

9 Joshua Rauh and Ryan J. Shyu, “Behavioral Responses to State Income Taxation of High Earners: Evidence From California,” NBER Working Paper No. 26349 (Oct. 2019).

10 Lin, “The Open Secret About California Taxes,” CalMatters, May 8, 2018.

11 Melanie Mason, “State’s Fortunes Rise and Fall With the Wealthiest,” Los Angeles Times, Sept. 23, 2018.

12 Supra note 4.

13 Id. at 33-45.

14 Laurel Rosenhall, “‘Mutually Repugnant’: Gov. Newsom and Lawmakers Pursue Budget Compromise,” CalMatters, June 7, 2020.

END FOOTNOTES

Copy RID