Will California's Budget Woes Have a Hollywood Ending?

As states begin annual budget planning, the national spotlight may shift to challenges in California. After hinting in January of a $22.5 billion deficit, the world’s fifth-largest economy last week raised its estimate to $31.5 billion. Governor Gavin Newsom and the state legislature are now ramping up to debate steps to balance its budget in time, from tapping reserves to slashing program funding.

Since the fates of so many municipal issuers across California depend on the state’s financial integrity, unfavorable budget news naturally weighs on muni investors’ minds. But we think the situation isn’t so dire. Overall, states are in excellent fiscal health, California included, with the ways and means to skirt economic speed bumps and even a possible recession.

Budget Shortfalls in Focus

After years of fiscal improvement and economic expansion following the global financial crisis, California has only recently begun to project fiscal setbacks.

Capital gain taxes are an important source of revenues, but 2022’s market volatility and a slowing economy significantly crimped investor returns. Personal income taxes are another key contributor, but widespread layoffs across the tech sector have weighed on those too. Tax-filing extensions for winter flooding victims are also making next year’s revenue estimates harder to pinpoint.

But California’s balance sheet remains strong, as does its ability to keep it that way. By one measure, the state has steadily lightened its debt burden as it relates to important economic indicators. In fact, its outstanding bond debt as a percentage of personal income is half of what it was over a decade ago (Display). Moreover, California has a record $37 billion in available reserves, not to mention a variety of budget maneuvers it can use to fill the gap.

Multiple Budget Solutions Will Share the Stage

We’re encouraged by both California’s record reserves heading into economic headwinds and the fact that Newsom proposed to largely leave them untouched. Reserves can ease the pressure to make politically difficult decisions, like spending cuts or tax increases. They also help fend off unfavorable actions like shortchanging contributions to pension funds or deficit borrowing, which can hurt credit quality. And just having the fund available can create a more stable funding environment for cities, counties and school districts that rely on the state for support.

We think Newsom’s ideas are relatively easy to implement and, while he can’t please everyone, he likely has the political clout to push through a final budget that closely resembles his proposal. For instance, he suggests delaying some expenditures to subsequent fiscal years, without canceling them outright.

Drought-mitigation funding, for instance, can wait, Newsom argues, thanks to the historic rainfall last winter creating a wetter fire season. Other maneuvers include modest revenue increases, recapturing certain unspent funds, shifting some capital funding at state colleges to bond issuances and delaying certain project funding until the taxes earmarked for them are received.

If a recession eventually strikes, budget decisions will certainly get more complicated. In fact, Newsom estimates that a moderate recession could add another $40 billion to next year’s deficit. But we believe California has what it takes to make timely, decisive adjustments and maintain its credit quality. This isn’t the 2008 financial crisis, when partisan legislative infighting led to budget gridlock that sank the state’s rating to BBB. Today, only a simple majority—which we think Newsom can muster—is required to pass a budget.

California also has access to a wide range of internal liquidity. That is, there’s more than $90 billion—nearly three times the projected deficit—considered borrowable across government agencies. Moreover, California has broad sovereign power to raise revenues or cut expenses—whatever it takes to keep the state solvent.

Mass Exits and Other Long-Term Influences

Looking beyond this near-term episode, we think some longer-term trends bear watching. For example, 2022 marked its third consecutive population loss for the state. However, outmigration hasn’t affected the state’s contribution to national economic output, which is holding at around 14% (Display right). 

Other influences that will play into California’s long-term fiscal integrity are extreme weather, wildfires and other natural catastrophes. Meanwhile, competition for workers and industries, especially technology companies, from tax-friendlier states like Texas and Arizona will likely continue to siphon high-paid talent and tax dollars. Also recently added to the mix are reparations initiatives, which, if approved, could cost the state $800 billion overall. These are important economic challenges that will likely play out over the coming decades. However, California has worked through past challenges with fiscally prudent decisions that have now well positioned it to meet these new ones.

The closing scene in California’s budget deficit story is weeks away. But we think the state’s sound financial condition­—and a raft of solutions at its disposal—should make for a satisfying ending for investors.