Reliance on income taxes threatens California’s budget

from Dan WaltersCalMatters

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California lawmakers are facing a fifth straight budget in which spending will outstrip revenue, amid warnings of multibillion-dollar deficits stretching into the future unless they cut crime or raise revenue.

Legislative analyst Gabe Petek, c his review of Governor Gavin Newsom proposed budget of $349 billion for 2026-27says deficits have totaled $125 billion over the past four years and “have persisted even as the economy and state revenues have grown, underscoring that the problem is structural, not cyclical. Taken together, these trends raise serious concerns about the state’s fiscal sustainability.”

The proposed budget calls for $227 billion in general fund revenues and $248 billion in general fund expenditures. Newsom has promised that when the budget — his last as governor — comes up in May, he will not only close his deficit, but also address ongoing deficits. Petek and Newsom’s Treasury Department projects them in the range of $20 billion to $35 billion a year.

How Newsom would do this while opposing major tax increases has yet to be revealed. Meanwhile initial hearings in both legislative houses involved speculation from members on how the budget can be balanced, including sharp spending cuts and tax increases.

The hearings also saw renewed interest in another factor from years past: volatility.

Sen. Jerry McNerneyStockton Democrat, who chairs the Senate Revenue and Taxation Committee, noted that the state’s main source of revenue from personal income taxes can vary widely from year to year, making them difficult to reliably predict.

“I think it’s time for a statewide discussion about how to even out this volatility, even though those are tough conversations — it’s been noted, it’s been tried before,” McNerney said.

The proposed budget projects that personal income taxes would provide 68 percent of general fund revenue, with high-income taxpayers paying the majority of those taxes. Wealthy Californians derive much of their income from capital gains, which can vary widely from year to year depending on how their investments perform.

The volatility factor has the greatest effect on the budget during periods of economic uncertainty, when investment earnings fluctuate significantly. During past recessions, California has experienced revenue declines of up to 20%.

California budgets became dependent on relatively few high-income taxpayers over the past four decades as income taxes surpassed sales taxes to become the most important source of revenue.

Income taxes exceeded sales taxes for the first time in 1983. The gap has steadily widened since then, with detailed diagram in the budget supplement reveals. The progressive structure of the income tax system ensures that high-income taxpayers provide the majority of its revenue.

The Great Recession that hit California in 2007 added to the volatility factor. Then-Gov. Arnold Schwarzenegger and legislative leaders created a blue-ribbon commission to recommend steps to make revenue more predictable. Months of hearings followed, and a sharply divided commission finally recommended reducing the state’s reliance on income taxes and replacing it with a revised sales tax that would cover more transactions.

The report was never taken seriously. When Jerry Brown succeeded Schwarzenegger in 2011, he defended “dark days” reserves that, he said, would cushion the impact of volatility during economic downturns.

During the past four years of chronic deficits, however, Newsom and lawmakers have used those reserves to cover gaps even though there has been no recession, breaking promises to preserve them.

“We’re not going to touch those reserves,” Newsom said three years ago. “We are in a very volatile moment.”

Petek warned of a possible downturn – with big drops in revenue – if the AI ​​stock market boom subsides. This happened in 2000 when the dot-com boom exploded.

This article was originally published on CalMatters and is republished under Creative Commons Attribution-NonCommercial-No Derivatives license.