Governor Brown's Gift to His Successor - Or Was It?

Governor Jerry Brown left his successor in office, Gavin Newsom, a great gift: a balanced budget with a several billion-dollar operating surplus and a $15 billion rainy day fund to boot. Governor Newsom is the first California Governor in over 40 years to be the recipient of such a gift from his predecessor. How did Jerry Brown do it? Was it luck or great fiscal management?  Well, Governor Brown was clearly listening to his Director of Finance and he deserves a lot of credit for that. In any administration, the Governor is the last voice of reason to put the kibosh on profligate spending because the legislative branch has an insatiable appetite to spend. It is just the way they are wired. The Sheehy Strategy Group has seen multiple Governor’s from both parties play the “adult in the room” role with a profligate legislature.

Did Arnold Schwarzenegger Mishandle State Finances?

Governor Davis failed to listen to his Director of Finance and well, we all know what happened to him. But in addition to drawing the line on spending, Governor Brown did in fact benefit from numerous cuts that were made by his predecessor Governor Schwarzenegger who had the unenviable task of managing the state’s finances through the great recession after having cut a major revenue source (Vehicle License Fees or VLF) as a fulfillment to his 2003 campaign promises to do so. Schwarzenegger fulfilled an important campaign promise in cutting the VLF, but in so doing, he blew a large hole in the state budget that only became exacerbated in the great recession. Schwarzenegger of course was a Republican dealing with an overwhelmingly Democratic controlled Legislature. They failed to see eye-to-eye on many things including on how to balance the state budget. Democrats were still furious that Schwarzenegger had figured out how to bypass them and cut the VLF unilaterally through administrative fiat.  Sheehy Strategy Group believes that former DOF director Mike Genest and his Department of Finance deserves the credit for that ingenious scheme. But when the recession hit California really hard, Schwarzenegger did not want to raise taxes and California Democratic lawmakers did not want to cut funding for schools and the social safety net. The result of all that was a double-digit budget deficit turned over to Jerry Brown. To be fair to Governor Schwarzenegger, he did get some of the difficult but necessary reductions in education, health and welfare programs he needed to balance the budget. These cuts carried forward to help Governor Brown balance the state’s General Fund going forward during his eight year tenure.

Did Jerry Brown Have The “Midas Touch”?

Governor Brown not only was helped from some of the cuts negotiated by his predecessor, he  also had good timing because he  benefitted from three other significant events, including one largely of his own making: (1) the end of the great recession; (2) strong stock market performance that has increased capital gains and is driving a revenue bonanza for the state; and (3) passage of Proposition 30, a general tax increase that raised both sales tax and personal income tax rates in California. Governor Brown said repeatedly during his 2010 election campaign that he would neither sign nor support a general tax increase without a vote of the people. In uncharacteristic fashion compared to many politicians, he kept his word. Once in office, he led an initiative campaign after cutting a deal with the California Teachers Association and the “fix” was in. Proposition 30 passed in the November 2012 election on a 54 percent to 45 percent vote margin. It raised top PIT bracket payers in California by 3 percent to 13.3 percent on personal income. It also raised the state’s general sales tax by 0.25 percent to 7.5 percent. After passage of Proposition 30, California became one of the highest taxed states in the country. Some say that fiscal stability in California came on the backs of the “uber wealthy” who the voters gladly “soaked” in Proposition 30. The sales tax increase was allowed to sunset after four years, at the end of 2016, but the PIT tax increase was extended in a subsequent ballot proposition 55. Once again Governor Brown campaigned for Proposition 55 in 2016 where the voters once more “soaked the rich” and extended the PIT increases on the uber wealthy another 12 years (essentially making them permanent).

Time to Pop Champagne Corks and Celebrate Fiscal Stability?

Despite the multiple balanced budgets, we got from Governor Brown and the Legislature, the Sheehy Strategy Group identifies serious risks that threaten the state’s new found fiscal stability and budget surplus. The spike in capital gains tax revenues collected from the uber wealthy will not last forever. But in the meantime, it primes the pump of the spending lobby. The pressure to increase state general fund expenditures is enormous and legislators are inclined to expand existing programs and create new ones. Many in the state’s capitol tend to see the budget surplus as an opportunity to achieve their policy and spending agendas. There is tremendous demand for new spending in health care, providing additional services to undocumented immigrants, providing universal pre-school to all children, major housing development incentives and low-income housing subsidies and the multibillion-dollar costs of firefighting and preventing future conflagrations – just to name a few budget cost pressures. As if these threats were not enough to cause panic at the California Department of Finance, you add in hundreds of billions of dollars in long-term pension and retiree health liabilities (see figure 1), and well, don’t forget that there is the looming threat of the next recession and throw in changes in Federal law that could cost the state billons in higher costs and reduced revenues and you have a real fiscal monkey wrench in California finances.

(Figure 1 - CA DOF)

It does not take much imagination to quickly see how the “all is rosy” forecast could be severely disrupted by these serious storm clouds threating the fiscal smooth sailing we have experienced for the last few years.

Are California Finances Controlled by Only a Few Uber Rich?

California’s fiscal history is riddled with budgets that made permanent obligations of both spending increases and tax cuts based on temporary revenue increases driven by capital gains. After these spikes in revenues disappeared, as they always do, the state was forced to cut programs and raise taxes.

(figure 2, CA DOF)

The Sheehy Strategy Group sees that this danger is exacerbated by the fact that seventy percent (70%) of all general fund revenues come from the PIT (see figure 2) and 50 percent of all PIT collected in the state come from the top 1 percent of taxpayers (an extremely important, but small population). So, when this handful of highly affluent individuals gets a financial cold, the state budget gets a severe case of influenza – or worse. And that is what happened to previous governors when the capital gains tax bubble burst – they had a fiscal roller coaster on their hands (see figure 3).

(figure 3 – CA DOF)

So, the combination of all these factors should leave no doubt that the state’s modest surplus must be carefully guarded, or fiscal ghosts of budgets past will haunt California. It should be clear to see that maintaining the new found fiscal stability will require considerable restraint, smart policy and economic momentum. The $15 billion “Rainy Day Fund” created by Proposition 2 and funded by Governor Brown and the Legislature will help reduce fiscal heart burn when the recession comes, but it will be a “drop in the bucket” if we end up with a $40 billion budget problem as Governor Schwarzenegger had to deal with. The CA DOF says even a “mild” recession would blow a $25 billion hole in general fund revenues thus totally consuming the rainy day fund and then some (see figure 4).

(figure 4 – CA DOF)

Conclusion

The Sheehy Strategy Group acknowledges that California government has made impressive progress in the last eight (8) years on its financial stability. Governor Brown and the Legislature deserve a lot of credit for making smart fiscal moves. They have also benefitted significantly from the national and state economies rebounding from the great recession, massive stock market gains since the 2016 election as well as tax payers’ willingness to increase taxes on the uber wealthy. State policy makers need to resist the temptation to “spend it all” in one year and instead plan for the future. They must not make the tax burden any worse on the uber wealthy and thereby accelerate their departure from California (rich people can move easily).  If they resist these temptations, then California can experience balanced budgets and fiscal stability into the future. Governor Newsom will be wise to listen to his Director of Finance – listen very carefully. He must be willing to use the “blue veto pencil” and just say “no” to profligate spending proposals that could sink his governorship into the same hellish morass as his predecessors.