California budget nightmare

in 1970 California took in 28 percent of state revenues from personal income taxes. Today, the state pulls in 52 percent from personal income taxes. Massive shift to service oriented state.

The problems for the California state budget are deep and significant and will provide fodder for another politically charged year. California faces a $19 billion budget deficit brought on by falling fund revenues and expenses that still reflect a time of better days. The Governor last week announced that 200,000 state employees would see their wages cut to the minimum of $7.25 (that is, for the exception of practically every group with special benefits so the number dwindles to a handful). The act in itself is merely a political move since pay will be retroactive once a budget is enacted. Yet this is how the gimmicks are played in California. There was also a recent focus on state benefit debit cards being used at strip clubs and casinos although this only reflected a tiny fraction, less than 1 percent of 1 percent of 1 percent this is how the state handles priorities and sensationalizes pennies to ignore the dollars.

The real issues are deeper and no one in Sacramento has come to the table with solutions. First, let us look at the general revenues of California:

The largest source of revenues for the state comes from personal income taxes. This wasn’t always the case. Over half of all revenues come from personal income taxes (52%). With the California unemployment rate at over 12 percent (real unemployment + underemployment is closer to 23 percent) the amount of payroll taxes has plummeted. Sales taxes, which indirectly benefitted from the extraordinary California housing bubble, have now fallen drastically as well. If we go back to even the 2008 fiscal year, we will find that sales taxes came in at $35 billion. Today they stand at $25 billion (a drop of 28 percent). This is to be expected given the high dependence of California on all things housing related.

If we want to examine the decline in the trend, let us look at housing sales at different points and time in the state:

Now this is an interesting chart showing how quickly things changed for California. From 2000 to 2006 the pattern was very clear and held steady. What you need to remember is that during this time, the vast majority of home sales (90+ percent) were organic home sales. That is, these were not distress sales. So each home sold, in many cases also generated another buy. For example, say a family was selling their starter home and moved up to a bigger place. This churn produced new taxes each time (i.e., new assessment on the property, taxes on sales commission, spending from new income etc). Today close to 40 percent of all homes sold were foreclosure resales. This number has trended lower but the amount of funds being generated are much lower.

We also need to remember that the median home price in the state fell from over $500,000 to $250,000. So commissions just by the price cut were halved. This is reflected in spending but also the unemployment rate in the state which is still very high. If we look at select sectors we see clear signs of a minor depression:

Constructions jobs have fallen by over 30 percent from their peak. The finance sector in the state has lost close to 200,000 jobs from the peak. These were high paying jobs based on the housing bubble. Since we know that option ARMs paid good commissions and half are here in the state, how much money in commissions was generated during this past decade? These loans are not coming back and prices are not going to the peak level so structurally the state needs to find other income sources to plug the budget. But the question is, where is this money going to come from?

The state is left with two roads to travel. In one, they can increase taxes to raise revenues but raising taxes without surgical precision will cut deeper into the economy. You can cut more into the budget but this also will cause pain in the real economy since the private sector in the state isn’t hiring at all. In the end, these are the questions California state leaders will need to wrestle with in the summer. Yet the fact that we are already late once again and the gimmicks are out, we know that it is going to be another long and drawn out summer.

People don’t usually pay attention to longer term trends. Yet these happen slowly and progressively. Look at how the California tax structure has changed over the last 40 years:

What does the above shift account to? A large part of the shift occurred because California shifted to a large service oriented state. Many of these services are not taxed through the sales revenue channel. The housing bubble was the perfect culmination of this all. A large portion of the state income shifted from those in the industry churning home sales at higher and higher prices. Yet this was unsupportable and that is why the state finds itself in deeper problems than many other states. No doubt, this recession is impacting the country but few states have the deep structural problems that California will be facing going forward.

The state has increased spending in many areas:

Interesting to see how much money now goes simply to service current debt. Some areas grew way beyond the normal rate of inflation (i.e., corrections, infrastructure debt service , etc) and this has caused spending to jump off the charts. Much of this was hidden with a once in a generation housing boom but now with that gone, where will the money come from? That is the major question that will need to be answered in the second half of 2010.