Wednesday, July 22, 2009

California's Budget: Unfortunate that I know the truth?

By my estimation, California actually closed about $15 billion of its $26 billion deficit. Maybe less. Its looks like technically they'll be able to go into the next fiscal year and resume paying their bills (assuming the legislature passes the budget bills), but its obvious this budget involves a lot of pushing the problem into future years. Consider the following:

  • According to the LA Times, the budget includes $1 billion from sale of the State Compensation Insurance Fund, but that no one thinks such a sale can be accomplished this year.
  • It takes $1.7 billion from local redevelopment districts, a move that was ruled unconstitutional just last year. According to one district official I talked to, there is nothing materially different about this year's proposal to suggest it wouldn't be struck down again.
  • The budget also borrows $1.9 billion from local governments. This would need to be paid back.
  • Another $1.2 billion will be saved by pushing payroll back one day, from June 30 to July 1. Effectively pushing $1.2 billion onto the next year's budget. But its still money out the door.
So right there, we've identified about $6 billion that isn't any kind of long-term solution. Basically I'd argue that California will start next year $6 billion in the hole.

Now ask yourself, will revenues increase?

The answer, even for someone pretty optimistic about economic growth, is clearly no. Consider the three main sources of revenue for California governments: sales taxes, income taxes, and property taxes.

The first thing to realize is that California's tax collections occur over the course of a year. So the money the state has collected for the June 2008-June 2009 fiscal year occurred during a period when the economy was declining. But what that means is that taxes collected in the early months of that period were stronger than those in the later months. For example, here is Advanced Retail Sales (nationwide) for the June '08 to June '09 period.

I drew a red line over the average for the 12-months. One might simplistically say that sales tax collection for the most recent fiscal year was based on this "average" sales level. But will the average from June 2009 to June 2010 be as high? probably not, even if the economy starts to recover. The current reading ($342 billion) is 2.7% below the average level of $352 billion. Of course, in order for the average to rise to $352 billion, the ending number will have to be double that increase, or +5.4%!

Coming out of the 2001 recession, we didn't get a year-over-year increase that strong until 2003, or about 2 years after the recession was over. Even if the recession ends today, its unlikely sales tax collections will even match last year's figures.

Income tax has a similar problem. If we assume income tax is in large part a function of unemployment, then unemployment will have to average 9.3% just to match 2008-2009's revenue figures.

Is California unemployment going to fall from 11.6% to 7% next year? Extremely unlikely. Unemployment is classically a laggard. We are more likely to see unemployment rise from here, even if the recession is almost over.

Property taxes? Same problem. In fact, maybe even worse. Assessments aren't made in real time. Unlike sales tax, for example which evolved over the course of the year, the task of re-assessing properties to reflect the current environment is an on-going thing. And obviously every new assessment is going to be lower than the previous. I've argued before than home prices are going to keep falling, at least statistically, even after the housing market has bottomed. In this piece, I argued that once transactions pick up, it will only prove that prices are in fact lower, thus making the statistical measure of home prices fall all the more. Even though I believe that transactions will show the real bottom of housing, the point is that prices keep falling for some period thereafter. As an aside, I'd think that's all the more true for commercial property, which trades even less frequently than residential property.

So if I claim that California starts out $6 billion in the hole (probably more) because of accounting scum and villainy, that isn't taking into account the near certainty that revenue will fall during the 2009-2010 period. On top of that, I'm assuming revenue will fall even if the recession is over right now. If it isn't over yet... well... I fear the worst.


Mark said...

I found your post very illuminating and I like that it focuses on the facts, you might find this video interesting.
It looks at the issue from an unbiased perspective as well.

John (Ad Orientem) said...

If you were Standard and Poors where would you be rating CA bonds right now?

Kingside said...

The hit to property taxes should be much less than the aggregate fall in property values.

Although it is the fashion of the day to criticize proposition 13 as one of the panaceas of California budgetary woes, the fact is that most real estate in California has been held for a fairly long time, and most tax assessed values are much less than current assessed values. So the fall in values alone should not have a significant budgetary impact.

California's real estate values tend to be more volatile than the rest of the country, and prop 13 actually tends to make it easier for California to make property tax revenue projections since it mitigates what would otherwise be huge swings in revenue based on changes in real estate values.

Accrued Interest said...


If I were my own ratings agency I would base the rating on the chance of a delayed payment. If they pass a budget, then I'd actually give them an "A" rating, since the odds of actually missing a payment is low. In such a system, almost every state would be AAA except CA!


Fair enough, but you can't argue that property taxes will actually rise can you? They might not plummet, but property taxes are probably the least likely area for any increase right?

Kingside said...

"Fair enough, but you can't argue that property taxes will actually rise can you? They might not plummet, but property taxes are probably the least likely area for any increase right?"

Only if they were desperate enough to somehow do away with prop 13 could you argue that there would be an increase in property tax revenues. I think that would be striking the third rail of politics out here in California, but in this increasingly populist political climate, who knows.

In Debt We Trust said...

I was talking to a friend who works in government affairs. He claims California's problems stem from a cutback in defense spending and military base closings. All those laid off machinists and technicians you know.

Interesting - balancing the national budget comes at the cost of burdening the state budgets.*

*PS The F-22 fighter project was finally scrapped this week. What a complete waste of taxpayer funds.

Tim said...

People in CA who have owned their homes a while actually pay 2% higher property taxes each year. Prop 13 allows for a 2% tax increase for those whose current property value is higher than their tax assessed values.

Have you figured this into your property tax revenue calculations?

Accrued Interest said...

Correct me if I'm wrong, but when a home is sold, the new taxes are based on the new appraisal right?

Plus if you have a 20% decline in homes (more in some areas) that wipes out a long period of rising home values. I look at Case Shiller's LA index, homes back to 2003 levels. San Diego 2002 levels. SF 2000.

So we've wiped out many years of gains. Granted many homes were bought before all this run up and they'll still get their 2% increase, but aren't we looking at a smaller and smaller Prop 13 pot?

So I agree that prop 13 is a partial offset, but if the question is "Will 2009-2010 revenues be higher?" I think the answer is still NO.

Lockstep said...

King, the flaw of your logic regarding California's prop 13 smoothing out the revenue stream is that at any time homeowners can have their house reassessed down in price if they desire. So with a 17% decline YOY in values, any person who bought after 2004 (thus underwater) will have incentive to adjust their property taxes lower.