October 2001

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State Budget 

David R. Doerr is chief tax consultant for the California Taxpayers’ Association and author of California’s Tax Machine – A History of Taxing and Spending in the Golden State. He was chief consultant to the Assembly Committee on Revenue and Taxation for 24 years, until mid-1987.

Rotten luck! The warranty on my crystal ball just expired as the device has become so cloudy as to be inoperable.

Recent reports have the state budget’s General Fund in serious trouble, with estimates that this year’s spending plan may be $3 billion to $5 billion in the red and the 2002-03 budget deficit, through June 2003, running off the charts.

The public should take these estimates with the proverbial grain of sodium chloride. Under current conditions, no one can predict the dollar impact of today’s fiscal ups and downs on this year’s or next year’s state budget with much more certainty than you or I.

Fiscal developments were not promising even before September 11. As passed and signed by the governor, the current state General Fund budget was balanced only by using prior year surpluses of $3.5 billion. Because of the use of surplus funds to balance this year’s budget, the Legislative Analyst’s Office estimated that the projected operating deficit for 2002-03 was $4 billion.

Things have gone from bad to worse. Through July and August, because of the lingering effects of the energy crisis and the collapse of many dot-com businesses, General Fund revenue fell $142 million below last May’s estimates. The economic toll of September 11 has further eroded state revenues. The Department of Finance reported that General Fund revenues for July through September were $608 million below forecast. For September alone, the shortfall was $468 million.

As a result, the 2002-03 budget faces a triple-whammy : (1) Because of the use of the prior year’s surplus to balance this year’s budget, a $4 billion structural deficit for 2002-03 was expected even before recent problems emerged; (2) revenue projections for 2002-03 now will very likely be lower than had been expected, to support current spending levels, and (3) the red ink in this year’s spending plan will be carried into 2002-03. The size of the hole facing state budget writers could be anywhere from $5 billion to $20 billion.

Complicating matters is the governor’s budget-balancing assumption that revenue bonds will be sold to replenish the General Fund for tax dollars spent earlier this year to buy electricity.

What’s the likely scenario for next year? Based on recent history, when the state has faced a budget deficit in an election year with the governor on the ballot, the probability of a tax increase is remote. (While Governor Davis has not formally announced his candidacy for re-election as of this writing, he has raised a considerable amount of money for such a campaign.)

A quick history lesson: In 1958, Governor Goodwin Knight dipped into “rainy day” funds established by his predecessor, Earl Warren, to balance the budget. Governor Pat Brown, facing an election-year deficit in 1966, instituted “accrual accounting” and left the problem for his successor (Ronald Reagan). Pat Brown’s son, Governor Jerry Brown, raided public employee retirement accounts, eliminated some local subventions, accelerated collections of state taxes, and projected an economic upturn to cover the 1982 deficit.

While the state may be facing its worst budget crisis in recent memory, local government revenues should fare better than state revenues, thanks to Proposition 13. Why?

The state has built its revenue structure on highly visible and volatile taxes. The state’s primary tax source, the personal income tax, is the most progressive in the nation, with a strong component of income from capital gains and stock options. This makes the tax terribly sensitive to economic conditions and unreliable in difficult economic times.

Most local governments should be able to weather the economic storm. Those with utility user taxes can expect revenue increases that should offset weaknesses in hotel/motel room taxes and sales taxes.

However, it is primarily the property tax that should keep local entities afloat. The virtues of Proposition 13 are coming home to roost. While the benefits to homeowners of this 1978 property tax-cutting ballot initiative are well known, it also acts to stabilize local revenues in hard times. The acquisition-value assessment system is a wonderfully ingenious counter-cyclical fiscal device. In good times, it moderates what would otherwise be explosive revenue growth. In bad times, it cushions the revenue impact of declining property values.

For example, suppose a property worth $500,000 is sold for $400,000 due to a decline in property values. It is likely that the acquisition-based assessed value of the property (its Proposition 13 value) is below $400,000. So on a “change of ownership,” the taxable value of the property will actually go up, generating additional property tax revenue. Even the assessed value of properties that do not change ownership can increase by 2 percent annually as a result of Proposition 13.

During the last economic downturn in 1991, property tax revenue increased by $1.3 billion over 1990, and continued to grow, at a slower pace, in 1992, 1993, and each year thereafter.

From past experience and the fact that state tax increases require two-thirds votes of the Legislature, taxpayers should be able to breathe easy. Also, most economists agree that tax increases in hard times would hamper economic recovery.