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.

Fiscal 2019 Budget Position As Enacted

The condition of California's budget is now such that it offers the state some fiscal cushion to work with in the event of unanticipated economic stress. The state entered fiscal 2019 in a strong position, carrying in a balance of $8.5 billion from fiscal 2018. Of this, $7.3 billion, or 5.8% of fiscal 2018 expenditures, was in the state's special fund for economic uncertainty. Together with $133.3 billion in anticipated fiscal 2019 revenues after transfers, the state has $141.8 billion in budgeted resources to fund $138.7 billion in expenditures for a budget surplus of $3.1 billion. Nevertheless, the governor's Department of Finance reports an anticipated operating deficit for the 2018-2019 fiscal year. An operating deficit (or surplus) is a measure of the state's current year revenues and funding commitments without regard to its beginning balance. Taking current year revenues of $137.7 billion and deducting transfers of $4.4 billion leaves the state with $133.3 billion in net general fund revenues. Comparing net general fund revenues to its budgeted expenditures of $138.7 billion results in an operating deficit of $5.4 billion. Among the transfers, however, is a $2.6 billion supplemental deposit (on top of the Proposition 2 formula-determined $1.7 billion transfer) to the state's budget stabilization account (BSA, or rainy day fund). A growing BSA balance provides confirmation that in this instance, a reported operating deficit does not indicate fiscal stress.

This description of California's fiscal 2019 baseline budget condition above may even understate its actual fiscal capacity. Constitutionally encoded formulas (in Propositions 2 and 98) determine the allocation of major portions of general fund revenues each year. Crucial to considering California's fiscal condition when revenues decline, such as in a recession scenario, there is a corresponding reduction in spending levels mandated by the state's constitution. The Legislative Analyst's Office has characterized the dynamism of the Proposition 2 and 98 funding requirements as "automatic stabilizers" in the state's fiscal structure. On the other hand, there is reason to believe California's susceptibility to experiencing revenue volatility has only increased in recent years.

Chart 1

Exploring The Origins Of California's Fiscal Volatility

California is susceptible to boom-and-bust budgetary cycles--a byproduct, in our view, of it being a high-income state with a progressive income tax regime plagued by an above-average poverty rate. During stock and technology sector booms, soaring capital gains incomes and bonuses accrue disproportionately to those at the top of the income spectrum. As of tax year 2016, for instance, the adjusted gross income of the top percentile—which took home 23.9% of the total—had increased 35% since 1997, far greater than other segments of the income distribution. Being subject to the state's progressive personal income tax schedule, however, the top one percent of income earners also paid an outsized 46% of total personal income taxes that year. And while the heavy reliance on high-income taxpayers can turbocharge tax receipts in goods years, there is a downside corollary to linking revenue performance to financial markets. After surging by 28% in fiscal 2000 at the height of the dot-com boom, California's personal income tax receipts plummeted 26% just two years later when technology industry valuations faltered. These swings mirrored trends in capital gains income itself, which nearly doubled between 1998 and 2000 before falling steeply (72%) over the subsequent two years.

Chart 2

In a slowdown, the repercussions of declining stock prices and smaller bonuses among California's upper income strata ripple throughout its real estate market and broader economy. Reduced demand for construction and service sector workers causes unemployment in these lower-wage sectors to rise. As job and income losses mount, the state's Medicaid program, Medi-Cal, sees caseloads swell along with demand for other social services. California's high per capita personal income translates to a fiscal disadvantage under the federal funding formula that determines the state's eligibility for Medicaid matching funds. In fact, California's 50% Medicaid matching rate is the federal minimum. Countercyclical demand for social services is not unique to California, though its low federal match rate and revenue volatility conspire to virulent fiscal effect in times of economic stress.

A Byzantine Maze Of Budget Rules That Help And Hurt Fiscal Stability

Although California's economic structure is a fundamental source of its cyclical budget performance, several policy changes over the years have unintentionally exacerbated the state's fiscal instability. Other policy changes have pushed in the other direction, though often addressing the effects more than the cause of its volatile revenue base. There are even policies that have countervailing effects on the state's finances, helping to solve fiscal imbalances while adding to its propensity for instability.

Policies that likely increase the state's fiscal instability:

• Propositions 13 and 98 have had the effect of shifting and centralizing the financing of portions of local government services and education from local property tax bases to the state and its more volatile income and sales tax bases;
• Motor vehicle license fee (MVLF) rollback of 2003 reduced a local government revenue source. In place of the foregone MVLF revenue, local governments received a share of property tax revenues that previously were a source of funding for school districts. Under Proposition 98, the general fund automatically backfills to school districts the redirected property tax revenue. In fiscal 2019, the cost to the general fund of providing this backfill, which subsequent constitutional amendments made permanent, is approximately $8.5 billion;
• Public safety realignment of 2011 redirected state sales tax revenue to local governments, totaling an estimated $7.4 billion in fiscal 2019, increasing the general fund's reliance on the personal income tax; and
• Personal income tax provisions of Propositions 30 and 55 have increased the general fund's reliance on the personal income tax to 71% in the fiscal 2019 budget from 53% in fiscal 2011 (before Proposition 30).

Policies with a beneficial effect or with provisions that benefit general fund budget condition:

• Proposition 98 establishes the minimum funding guarantee for education based in part on general fund revenues and thus offers spending relief when revenues fall;
• Dissolution of redevelopment agencies in 2011 freed up property tax revenues as a source of funding for school districts saving the state general fund an estimated $1.6 billion in fiscal 2019;
• Public safety realignment of 2011. Redirecting sales tax revenue to local governments lowers the general fund revenue base on which Proposition 98 funding is partly determined. This effect produces $3.0 billion in estimated general fund savings in fiscal 2019;
• Propositions 30 and 55 increase the state's general fund revenue by an estimated $8.3 billion in fiscal 2019; and,
• Proposition 2 requires that 1.5% of annual general fund revenue and capital gains-related income tax revenue above 8% of general fund tax revenues (net of the amount that must go toward funding the state's share of the Proposition 98 minimum guarantee) must be deposited into the budget stabilization account. In our view, Proposition 2 discourages budgeting to revenue spikes and thus promotes structural fiscal alignment.

As noted, some of the policies cut both ways, providing the state with additional revenue or offering expenditure savings, while also increasing its reliance on the volatile personal income tax. Furthermore, because California is a highly active voter-initiative state, future ballot measures with fiscal implications are always possible.

The tax increases of Proposition 30, though passed in 2012, were not just part of the state's solution to its then-recent budget crisis. They also represented a response to its underlying structural deficit dating to 2003. As mentioned, rolling back the MVLF resulted in higher general fund expenditures, increasing pressure on the state's finances. Around the same time, the state began deferring school aid disbursements in order to achieve one-time budget savings, signaling the presence of a structural deficit. Although the deficit and the state's reliance on deferrals would explode with the onset of the Great Recession, we trace its origins to the 2003 MVLF rollback. In a relationship that persists to this day, revenue ($8.3 billion) in fiscal 2019 from Propositions 30 and 55 offsets—almost exactly—the general fund cost ($8.5 billion) associated with the foregone MVLF revenue.

California is also at a disadvantage when its tax revenues begin falling short of the budget forecast because of its limited institutional capacity to make midyear fiscal adjustments. There is minimal executive authority for the governor to unilaterally restrict spending or impose allotment reductions after the budget takes effect. The main line of defense is the state's special fund for economic uncertainty and—if the governor declared a financial emergency—the ability to draw down up to half the balance in the budget stabilization account. Unless the governor invoked his authority to call a special session focused on addressing the fiscal emergency pursuant to Proposition 58, however, the budget gap would roll into the proposed budget for fiscal 2020. If the revenue falloff were severe enough to precipitate intra-year liquidity pressure, we expect the governor would call a special session to address the fiscal emergency.

Responding to projected fiscal stress did become easier beginning with fiscal 2011, however. In 2010, voters approved Proposition 25, which provides the legislature with the authority to adopt annual budgets with a simple majority vote. The previous two-thirds majority vote requirement, which still applies to tax and fee increases, led to protracted budget stalemates. Late budgets were especially common in deficit years as negotiations sometimes dragged on for a month or more into the new fiscal year. Delayed budget adoption resulted in periodic funding crises and, in our view, inflicted damage on the state's credit quality by interfering with its ability to manage its cash flows in a conventional manner. Since the passage of Proposition 25, the state has not begun a fiscal year without an enacted budget in place. This includes fiscal years 2012 and 2013, when the state was facing large projected budget deficits.

A Closer Look At California's Stress Test Results

In our simulation, general fund tax revenue would fall short of what the enacted budget assumes by $19.5 billion or $24.3 billion in our moderate and severe scenarios, respectively, during the first year of a recession. Illustrating its propensity for revenue volatility, California's 14% revenue miss in our recession scenario assuming moderate fiscal effects exceeds the estimated shortfalls of all but five states. Of those, most have economic bases tied to highly cyclical oil extraction and energy production more broadly. In the severe scenario, California's revenue shortfall is 18% of what is budgeted, ranking it worse than all but three states. Its deterioration from fifth to third largest in the rankings of estimated state revenue shortfalls reflects that compared with other states, California's revenues are more elastic. In other words, harsher assumptions produce ever-larger estimated revenue shortfalls.

On the spending side, falling incomes and rising unemployment would correspond with growing Medi-Cal caseloads, which exerts upward pressure on state expenditures. We estimate that in the first year of a recession, state general fund-support Medi-Cal expenditures could increase by 7.4%. This would cause Medi-Cal costs funded by state resources to increase by $1.7 billion, to $24.7 billion from $23 billion.

California's revenue shortfall and increased Medi-Cal spending pressure cause a combined $21.3 billion or $26 billion of fiscal shock in the first year of a recession in the moderate or severe scenarios, respectively. Even after eight consecutive years of improving finances, the state's budget reserves equal just 78% and 64% of the moderate and severe fiscal shock scenarios.

As mentioned, however, California's constitution offers some offsetting relief because of how Propositions 2 and 98, in particular, employ formulas partly tied to general fund revenues to mandate spending or transfers. Most significant is Proposition 98, which establishes the funding level (often referred to as the "minimum guarantee") for public education spanning kindergarten through community. For fiscal 2019, the general fund budget includes $54.9 billion in Proposition 98 expenditures, equal to 41% of total general fund outlays. We estimate that if general fund revenues went into a decline similar to our stress scenario, the state's general fund portion of the minimum guarantee would also fall. In our moderate fiscal stress scenario, the minimum guarantee would decline by $8.2 billion, to $46.7 billion. In the severe case, the minimum guarantee would fall by $10.2 billion, to $44.7 billion. (We note that while the reduced minimum guarantee may provide fiscal relief to the general fund, it would impose a substantial financial burden on public school districts.)

In addition, Proposition 2 requires annual transfers of general fund tax revenues into the BSA and an equal be used to retire on an accelerated basis certain eligible debts and liabilities. Similar to Proposition 98, in the event that general fund revenues are lower than anticipated, the state's obligations under Proposition 2 also decline. For fiscal 2019, the general fund budget includes $1.7 billion of required deposit to the BSA with a like amount set aside for debt repayment. In effect, Proposition 2 reduces discretionary spending capacity by $3.5 billion in fiscal 2019. Proposition 2 is also complex and entails true-up or true-down provisions based on final actual revenues in prior years. Taking into account a small true-down adjustment in fiscal 2019, the combined required BSA deposit and debt repayment equals about 2.6% of general fund tax revenues. Applying this percentage to our recession scenario revenues, we estimate that the state's required setasides under Proposition 2 would decline by $600 million or $700 million, respectively, assuming moderate or severe fiscals stress.

Absent other budgetary adjustments, the net operating deficits after adjusting for the offsetting effects of these formulas are $12.5 billion and $15.1 billion in the moderate and severe scenarios. In the event of a downturn, we assume the first line of defense against an emerging revenue shortfall would be use of the fiscal 2019 general fund beginning balance. At $7.3 billion (net of the reserve for encumbrances), the beginning balance would cover all but $5.2 billion or $7.8 billion of our moderate or severe recession scenario deficits.

Historically High Reserves Are A Crucial Backstop

In our simulation, comparing California's reserves to its estimated revenue shortfall in a recession scenario, accounting for the effects of key constitutional provisions is transformative. The fiscal offsets shrink the residual estimated deficits in either scenario (moderate or severe) to less than the balance in its BSA ($9.4 billion) at the end of fiscal 2018. Proposition 2, which established the BSA provisions, allows that only up to half the balance held in the BSA may be spent in the first year of a recession. Therefore, lawmakers would likely address the residual fiscal gap as part of the fiscal 2020 budget, unless the governor convened a special session. A downturn and equity market selloff would also cast a multiple-year shadow on state finances insofar as it resulted in lower pension funded ratios that necessitate higher future contributions.

Chart 3

According to our analysis, therefore, a recession would strain the state's finances, but its efforts in recent years at shoring up its finances have paid off. Underscoring the importance of discretionary budget policy, however, accumulating its current reserves required California to set aside significant amounts of revenue above what the constitution mandates. Consequently, our scenario analysis demonstrates that California's budget reserves, while now at record balances, may also be at something of the minimum necessary for it to withstand a recession.