State revenue is increasing at historic rates and could result in a $31 billion dollar surplus to allocate in next year’s budget process, and the state constitution’s spending limit “will constrain how the Legislature can allocate the estimated surplus,” the Legislative Analyst’s Office (LAO) reported November 17. The spending limit will be “the key issue” in the 2022-23 budget, the analyst stated.

The windfall can be attributed to $28 billion in increased revenue from tax collections as well as federal funds received under the American Rescue Plan Act (ARPA). From September 2020 to September 2021, revenue from income, sales, and corporate taxes grew 30 percent, the fastest rate in at least four decades, the LAO reported. Additionally, California received $27 billion under the ARPA, and those funds are being used to offset general fund costs and cover additional spending.

The LAO defines the surplus as “the difference between projected revenues and spending under current law and policy.”

“Consequently, the surplus reflects our assessment of the budget’s capacity to pay for existing and – potentially – new commitments,” the LAO added.

The spending limit, which requires the state to return money to taxpayers and dedicate more funds to schools if revenue is above a prescribed amount over two consecutive years, will come into play again this year, the LAO said. Approved by voters in 1979 and modified in subsequent elections, Article XIIIB of the state constitution (known as the Gann Limit in honor of sponsor Paul Gann) establishes an appropriations limit on the state and most types of local governments based on appropriations from tax revenue, and requires a surplus to be distributed to taxpayers by a reduction of “tax rates or fee schedules.”

The Department of Finance is responsible for annually using a three-step process to determine whether the limit has been reached: calculate the spending limit (based on prior spending adjusted for population and economic growth); determine the amount of appropriations subject to the limit (appropriations that are not subject to the limit include subventions to local governments, debt service, federal and court mandates, qualified capital outlay projects, and certain emergency spending); and determine the room (if any) left for additional spending.

The LAO estimated that the state will need to allocate roughly $14 billion – “for example by spending more on capital outlay or making taxpayer rebates and school and community college payments” – to stay under the appropriations limit for 2020-21 and 2021-22.

The 2021-22 budget addressed the spending limit by including approximately $12 billion for stimulus payments targeted to lower-income Californians – described by Governor Gavin Newsom as “the largest state tax rebate in American history,” although many of the recipients had no personal income tax liability under the state’s progressive tax structure.

Actions to get appropriations under the limit “would be prudent in early 2022,” the analyst stated, adding: “Given the potential magnitude of the requirement, if the Legislature wishes to meet it with lower tax revenues or spending on excluded purposes, early action would be prudent. If, however, the Legislature preferred to meet the requirement with taxpayer rebates and school and community colleges payments, the state would have two years to make these payments, as allowed by the Constitution, and early action would not be necessary.”

The analyst predicted that the Newsom administration will have different revenue estimates, and thus a different estimate for the spending limit.

California’s budget reserves likely will not reach pre-pandemic levels when measured as a percentage of total revenue, the analyst projected.

“The balance of the state’s constitutional reserve, the Budget Stabilization Account (BSA), would grow to about 10 percent of General Fund revenues and transfers ($21 billion) under our revenue estimates,” the LAO stated. “In particular, under the constitutional rules of Proposition 2 (2014), the state would be required to deposit about $4 billion in the BSA in 2022-23 and make net true up deposits of $1 billion. Although this represents an increase relative to the 2021-22 enacted level, the balance of the BSA would remain below the pre-pandemic level of 11 percent of revenues.”

The $21 billion projection is not inclusive of all state reserve funds. Two funds – the Safety Net Reserve and the Special Fund for Economic Uncertainties – were not included because their levels “largely will be determined by discretionary choices made by the Legislature,” the LAO stated.

Inflation “presents a number of issues for the state budget,” the analyst added. It could lead to higher revenue collections due to higher wages, but “also could create instability in financial markets or the economy broadly, which could depress revenues.” On the spending side, higher inflation can result in higher costs, “for example for interest on the unemployment insurance loan from the federal government, and bond debt service,” and “creates pressure for the state to increase spending, for example on cash assistance or employee compensation.”

John Fensterwald, a respected commentator on education issues through his EdSource website, said the LAO’s report “usually is an accurate annual preview of the governor’s state budget released in early January,” and under the LAO’s projection, K-12 schools and community colleges “can expect an additional $20 billion in 2022-23, which will follow a record level of funding this year.”

The LAO report showed that all three of the state’s major taxes brought in far more money than projected in the budget enacted this summer:

  • “Personal income tax revenue totaled $127.7 billion in 2020-21, 29 percent above 2019-20. This trend of strong growth has continued so far in 2021-22. For example, withholding collections so far in 2021-22 have been 22 percent above the same months in 2020-21 and 32 percent above the same months in 2019-20. Similarly, September 2021 estimated income tax payments were up more than 50 percent over September 2020.”
  • “State revenue from the corporation tax increased from $14.3 billion in 2019-20 to $22.0 billion in 2020-21. Not only has the strongly positive trend in cash collections been sustained so far in the current fiscal year, the trend appears to be accelerating. As of October 2021, net corporation tax cash collections for the year-to-date were 48 percent above the budget act projections.”
  • Sales and use tax revenue is up significantly, and the LAO reported that “California taxable sales have followed roughly similar patterns to U.S. retail sales: plummeting in Spring 2020, recovering quickly in Summer 2020, and growing dramatically in the first half of 2021.” The California Department of Tax and Fee Administration reported November 16 that California businesses reported a record high of $216.8 billion in taxable sales during the second quarter of 2021 – a 38.8 percent increase over the same period last year and 17.4 percent from the pre-pandemic second quarter of 2019.

Breaking down the sales and use tax numbers, the CDTFA reported that clothing stores saw the most significant increase in taxable sales (a 144.5 percent increase from the second quarter of 2020 to the same period in 2021), food services and drinking places (including restaurants, bars, and food trucks) saw an 81.1 percent increase in taxable sales, and gasoline stations reported a 77.8 percent increase. When compared to pre-pandemic levels of the second quarter of 2019, furniture and home furnishing stores saw the highest increase at 27.9 percent; building material, garden equipment, and supply stores saw a 26.8 percent increase from pre-pandemic levels; and some industries, including restaurants, bars, and gas stations, have not rebounded to pre-pandemic levels.

Some of the increase in sales tax revenue is attributable to inflation driving up the consumer prices upon which the tax is based.