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Are California's High Budget Reserves A Bare Minimum?

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Are California's High Budget Reserves A Bare Minimum?

Highlights

- Despite eight years of an improving budget position, California remains vulnerable to significant fiscal stress in a recession.

- A volatile revenue structure is California's primary fiscal risk factor.

- Constitutional funding formulas dictate major general fund expenditures and can stabilize budget imbalances automatically.

- Historically large budget reserves provide a significant one-time buffer to unanticipated revenue shortfalls.

- Budget stabilizers plus reserves could enable the state to weather a downturn.

Oct. 23 2018 — Eight years of strong budget management simultaneous with an expanding economy, booming stock market, and (for six years) tax increases on its high-income taxpayers have dramatically strengthened California's budget position. Compared with most states, California has assembled one of the strongest fiscal recoveries of the post-recession period. Despite this, S&P Global Ratings found, in a recently completed evaluation of the U.S. states' fiscal preparedness for the next recession, that California remains vulnerable to significant fiscal stress in a downturn. This seeming contradiction reflects the effects of the state's tax structure and its well-documented propensity for revenue volatility.

While this numbers-based scenario analysis is useful as a starting point, it cannot easily incorporate the role of budget management to a state's credit profile and thus paints an incomplete picture. Moreover, in California's case, major funding decisions are the province of constitutional formulas. When tax revenues decline, such as in a downturn, the formulas automatically provide spending relief and, from a budget balancing standpoint, work to the state's advantage. Taking these estimated savings into account, we believe California may be approaching a fiscal position that would enable it to weather a downturn without experiencing severe budgetary distress. However, we expect its ability to do so will remain contingent on the recent structural orientation to state fiscal policy enduring through the transition to a new administration.

More than one-third of the way into the current fiscal year, there is little evidence to suggest a recession is imminent. The economy continues to create jobs at a robust pace, averaging 228,000 new payroll jobs per month in 2018 through September. In California, tax revenues were running ahead of the budget forecast by $1.03 billion, or 3.8% during the same time period. Personal income tax receipts were leading the way, at $990 million, or 5.3% above the budget assumption through September. Strong year-to-date tax collections are consistent with S&P Global's economic forecast for the expansion to continue. Currently, our economists place the odds of a recession occurring within the next 12 months at a low 10% to 15%. In prior cycles, California's tax receipts have functioned as something of a leading indicator. In July 2007, six months before the official start of the Great Recession, the state's sales and use tax collections unexpectedly fell short of its forecast by $465 million, or 34.2%. These revenue shortfalls tipped California's general fund into a cash deficit (initially financed by loans from internal state funds), where it would remain for 69 months. Personal income taxes also missed the mark, though by a narrower margin of $165 million or 5.5%. Therefore, rather than a prediction, our scenario analysis is more akin to a risk management exercise, offering an assessment of the states' capacity to withstand the fiscal effects of hypothetical economic stress that is already underway.

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