- We believe the governor's fiscal 2024 budget, as proposed, would largely maintain structural budget balance, although, state-projected revenues could prove optimistic; the California Legislative Analyst's Office forecasts slightly lower fiscal 2024 revenue than the governor's proposal, and neither the office nor the governor anticipates a recession
- The governor's executive budget proposal identifies a $22.5 billion potential general fund budget gap over the next year and a half, which would mostly be closed through reduction of previously approved one-time spending, spending delays, and shifting costs to other state funds
- The governor's proposal would spend down significant amounts of unreserved fund balance, but still increase the restricted budget stabilization fund slightly to $22.4 billion (10.0% of proposed general fund expenditures) in 2024, while at the same time paying down about $1.9 billion of long-term pension and other postemployment benefit liabilities
- While the executive budget forecasts substantial operating deficits throughout its five-year projection, these deficits would be eliminated or reduced to relatively small levels if what the state self-identifies as one-time spending is netted out. The state currently counts $32.4 billion of one-time spending in fiscal 2023, before proposed adjustments
The governor's executive budget proposal for the fiscal year ending June 30, 2024, forecasts $29.5 billion lower revenue during combined fiscal years 2023 and 2024 than assumed in last year's enacted fiscal 2023 budget. Fiscal 2024 general fund revenue and transfers are now projected at $211.1 billion, compared with $233.6 billion of projected 2024 revenue when the fiscal 2023 budget was adopted. The new 2024 executive budget estimates a $22.5 billion budget gap will need to be closed, including fiscal 2024 and the remaining months of fiscal 2023. This gap incorporates the lower revenue forecast and the state's estimate of ongoing program costs projected into fiscal 2024, plus what the state Legislative Analyst's Office (LAO) estimates as about $2 billion in new discretionary spending. The governor's department of finance will release an updated revenue forecast and budget proposal in May, after key April income tax collections have been received.
A major contributor to the lower revenue forecast is lower-than-expected capital gains tax as a result of recent stock market losses. S&P Global Ratings believes California is the state most exposed to capital gains tax fluctuations (see "Market Volatility Has Varying Impact On U.S. States’ Capital Gains Tax Exposure," published March 10, 2020), as a result of the state's steeply progressive income tax and its dependence on top taxpayers (the top 1% of taxpayers contributed 49% of total personal income tax in calendar 2020). Top taxpayers, such as those in Silicon Valley, receive a significant amount of their income from capital gains. The state projects capital gains tax will decline from 12.3% of general fund revenue in fiscal 2022, to an estimated 9.2% in 2023, and 8.3% in fiscal 2024. Following the Great Recession in 2009, capital gains tax fell to only 3.4% of general fund revenue.
The most recent monthly revenue report from the California Department of Finance indicates that through November 2022, state general fund revenues were $1.1 billion, or 1.8% above budgeted fiscal 2023 levels. However, this includes an estimated $5.7 billion bump-up in revenue, due to the timing of a Pass-Through Entity Elective Tax credit, compared with last year, and does not incorporate the upcoming important April collection period when the 2022 tax year income tax filing deadline comes due.
Structural Budget Balance
We believe the state's projected operating deficits would show near structural balance if what the state identifies as one-time spending were netted out. California identifies $32.4 billion of one-time spending in fiscal 2023, not including the governor's proposal for a $4.2 billion reduction in fiscal 2023 one-time spending.
We calculate that netting out state-identified one-time spending would leave a fiscal 2023 estimated operating deficit of $1.3 billion, or a small, negative 0.6% of general fund expenditures (see table). The governor identifies $27.8 billion of previously enacted one-time spending in fiscal 2024, which he proposes to reduce by $12.6 billion.
|California--Fiscal 2024 Executive Budget Multiyear General Fund Projection|
|Fiscal year-end June 30|
|Revenues before transfers to the budget stabilization account||210,503||211,085||213,412||217,099||226,327|
|Net operating surplus as % of expenditures||(12.3)||(5.6)||(4.0)||(3.6)||(1.4)|
|California's breakout of prevously enacted one-time expenditures included above||32,414||27,785||13,873||8,242||0|
|California's breakout of proposed executive budget reductions in one-time expenditures||(4,188)||(12,631)||(4,603)||(2,196)||0|
|Net one-time expenditures as % of expenditures||11.8||6.8||4.2||2.7||0.0|
|Net operating surplus excluding proposed net one-time spending from expenditures||(1,347)||2,625||344||(2,123)||(3,130)|
|Net operating surplus excluding proposed net one-time expenditures as % of budget||(0.6)||1.2||0.2||(0.9)||(1.4)|
|Transfer (to)/from budget stabilization fund||(1,620)||(911)||(344)||(627)||(879)|
|Special Fund for Economic Uncertainties balance||17,245||3,805||(5,465)||(14,261)||(18,269)|
|Safety net reserve balance||900||900||900||900||900|
|Public School Stabilization Account balance||8,108||8,473||8,473||8,473||8,473|
|Budget Stabilization Account Balance||21,487||22,398||22,742||23,369||24,248|
|Total reserves as % of expenditures||19.9||15.9||12.0||8.2||6.7|
|*Does not include reserve for encumbrances. Source: State of California.|
Netting out proposed one-time spending in 2024 would leave a small fiscal 2024 operating surplus of 1.2% of expenditures, even while total reserves would be reduced by $12.2 billion, primarily due to the remaining amount of one-time spending. Total reserves would decrease from $47.7 billion to $35.6 billion at fiscal year-end 2024, or 15.9% of general fund expenditures, which we consider still strong.
State out-year forecasts beyond fiscal 2024 depend on a number of assumptions about future spending and legislative action. Some of the state's out-year assumptions, however, may not be realized or may be difficult to implement. For example, California proposes to withdraw a previously assumed $3 billion inflation adjustment in fiscal 2024, but also projects withdrawing combined future inflation adjustments in fiscal years 2025 and 2026 of $7 billion. In addition, the state does not project a recession, which, due to its progressive income tax rates, could erode revenues quickly. The state LAO projects slightly lower revenue than the state Department of Finance (DOF) in fiscal 2024. In particular, the DOF sees the economy recovering more slowly in the out-years, but more quickly in the short term.
We calculate, based on state projections, an out-year operating deficit in fiscal 2025 of 4.0% of general fund expenditures (see table), which would turn into a small operating surplus of 0.2% if all projected one-time expenditures were excluded. However, the state is projecting that there would still be $9.3 billion of net one-time expenditures in 2025, leading to a negative $5.5 billion balance in its unreserved Special Fund for Economic Uncertainties (SFEU) at fiscal year-end 2025. Such a negative balance would need to be closed in the 2025 budget, either by fewer one-time expenditures, or other adjustments. A similar story occurs in projections for the following two years, with the state projecting small out-year operating deficits even without one-time spending, and an increase in the projected negative unreserved fund balance to negative $18.3 billion by fiscal 2027. This will not occur, because the state will need to balance each year's budget at time of adoption. However, the size of the projected out-year operating deficits appears relatively modest, with an out-year operating deficit of negative 1.4% of projected expenditures in fiscal 2027. Deficits of that amount should be solvable, assuming state assumptions prove accurate.
Budget Gap-Closing Actions
The fiscal 2024 executive budget gap of $22.5 billion, which would be left over after a proposed planned spend-down of $13.4 billion of reserves available in the SFEU, would be closed by actions that include:
- $7.4 billion in delayed spending to a future year, including delays in higher education, health care, and broadband spending;
- $5.7 billion in spending reductions and pullbacks from previously planned increases, including withdrawals of a previously planned $3 billion inflation adjustment in fiscal 2024 and a $750 million principal payment on federal unemployment trust fund loans;
- $4.3 billion of cost shifting from the general fund to other special funds, such as $1.5 billion in zero-emissions vehicle costs switched from the general fund to the greenhouse gas reduction fund, and $500 million in transportation-related costs shifted to transportation-related special funds. In addition, California will resume bond financing on certain infrastructure projects, which it had started doing on a pay-as-you-go basis;
- $3.9 billion of spending reductions that would be subject to a "trigger" that would restore the spending if revenues are projected by January 2024 to be sufficient to restore them. The largest trigger reduction would consist of $3.1 billion in climate change- and transportation-related items;
- $1.2 billion in new revenue and borrowing, including $850 million in loans provided from special funds to the general fund about $350 million of new revenue-related solutions, such as reauthorizing a managed care organization tax (which requires federal approval).
Despite the gap-closing measures, the governor proposes continuing to expand various new initiatives from the previous year. These include further expanding pre-K education, childcare programs, universal school meals, increasing access to state institutions of higher education, and Medicaid eligibility for undocumented immigrants. Previously enacted budgets for fiscal years 2022 and 2023 increased planned climate change-related spending to $54 billion over five years (which includes drought resiliency); the governor proposes reducing this to $48 billion, which still represents a significant increase above pre-2022 planning. The executive budget proposes maintaining the $10.2 billion in spending on homelessness allocated in fiscal 2023, while previously expanded housing programs would be cut by $350 million in the general fund under proposed trigger reductions.
Proposition 2, passed in 2014, mandates that a certain portion of excess capital gains tax be put first toward reserves, then infrastructure and a paydown of long-term liabilities once the budget stabilization hits its maximum 10% level. This drives a small deposit to the state's budget stabilization fund in 2024 and will mandate a small infrastructure payment, as well as requiring a $1.9 billion paydown in long-term liabilities in fiscal 2024, proposed to be spent mostly on pension funding obligations and a small other postemployment benefit (OPEB) paydown.
Major General Fund Spending Categories
K-14 school spending remains the biggest category of state spending, as mandated by California's Proposition 98, passed in 1988, with 36% of proposed fiscal 2024 general fund spending, an increase of 3.4% in dollar amount from fiscal 2023. After K-14 school spending, health and human services spending comes next, at 32% of general fund spending, and with a bigger increase of 10.3% in dollar amount.
Along with debt and OPEB spending, these two large spending categories may be relatively hard to control, and could limit the state's ability to make cuts once one-time spending no longer exists in the state budget. Therefore, we believe California was prudent in allocating previous surges in revenue toward one-time spending that could be later dialed back to preserve structural budget balance. Once these spending items no longer exist, the state may find future budget-cutting more difficult, particularly as it is not currently forecasting a recession, which may be optimistic.
In previously more stressful years, the state has sometimes met cyclical revenue weakness by reducing school spending, technically meeting its Proposition 98 yearly mandated school spending requirement by deeming the reduced school payments as a cash receivable due from a future year, with such school "loans" reaching a peak of $12.5 billion in fiscal 2021. As times improved, these school loans were eventually paid off, and none currently exist, providing some budget flexibility to fall back on, if necessary.
One spending area that is relatively discretionary is higher education, at 10% of proposed total general fund spending in fiscal 2024, a 2.3% decrease from fiscal 2023. In another area, corrections and rehabilitation, the state has also benefitted financially from long-term declines in the prison population. Corrections and rehabilitation are proposed at 7% of general fund spending.
Previous budgets planned for approximately $54 billion over five years to advance the state's climate change agenda, which the governor proposes to scale back to $48 billion, partially offset by shifts to other fund sources. Most of these cuts are included in the governor's proposed fiscal 2024 trigger reductions, so that if there is sufficient general fund money in January 2024, these reductions would be restored. They include a cut of $2.5 billion from the general fund in various zero-emission vehicle programs, offset by a $1.4 billion shift to cap and trade funds and possible receipt of new federal funds. Total multiyear zero-emission vehicle related spending includes $8.9 billion for zero-emission vehicles, including targeted investments for disadvantaged and low-income communities. The previous budgets also committed $8.7 billion over multiple years to support drought resilience, which the governor proposes reducing slightly to $8.6 billion.
The LAO counts about $2 billion of new discretionary spending in the governor's 2024 budget proposal, mostly for expansion of health care programs and cash financing of various capital outlays.
Additional Budget Risks
The state is not forecasting a recession. S&P Global Economics forecasts a mild recession in the first part of this year (see "U.S. Business Cycle Barometer: Constrained By Tight Monetary Policy And Global Slowdown," published Jan. 25, 2023). Should a recession develop, the state's May executive budget revision may have to be adjusted significantly, and budget gap-closing may become politically difficult. The California LAO forecasts slightly lower revenue than the state does, but also does not forecast a recession.
The legislature may wish to spend more than the governor does. However, to access the budget stabilization fund, the governor would need to proclaim an emergency, in addition to certain economic triggers required for use of the stabilization reserve. At this point, we do not expect use of the stabilization fund unless a recession develops, but it becomes much more likely if one does develop. The proposed spend-down of the available unreserved SFEU balance to $3.8 billion from $17.2 billion would leave mostly restricted reserves available to meet a steeper downturn, although these remain considerable.
California's out-year forecast projects a gradual drop in capital gains tax back to the long-term average percentage share of contribution to the general fund, but, as always, stock market activity remains unpredictable, and the state's dependence on top taxpayers has been consistently high over the years. The state believes that neither its high top marginal tax rate, nor individual legislators' calls for higher tax rates or a wealth tax, have resulted in significant migration of top taxpayers out of state, and the number of taxpayers paying its additional tax on those making more than $1 million per year has been climbing in recent years. Nevertheless, this will likely remain a risk due to California's highest top marginal personal income tax rate in the nation at 13.3%, more than two percentage points higher than the next highest state.
State Fiscal Position Is Still Better Than In Fiscal 2021
Overall, California's financial position is in better shape than it was in fiscal 2021, when it had to resort to substantial "school loans" from future years to meet budget requirements. Recent financial strength stems in part from strong stock market returns and the associated boost in top taxpayers' incomes. Substantial economic risks remain to the state budget should the economy enter into a recession due to the volatility of California's income taxes, and the difficulty in reducing spending further once one-time spending is no longer present. Economic results in the next six months will determine how smoothly the fiscal 2024 annual budget process runs, or whether the state will experience stress when the final placeholder budget is adopted in June, with specific line-item budget trailer bills typically not adopted until July.
This report does not constitute a rating action.
|Primary Credit Analysts:||David G Hitchcock, New York + 1 (212) 438 2022;|
|Oscar Padilla, Dallas + 1 (214) 871 1405;|
|Ladunni M Okolo, Dallas + 1 (212) 438 1208;|
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