Friday, February 12, 2010

California's Budget Has (Structural) Issues

A recent debate on NPR focused on the following premise: "Is California the first failed state?" The reason for the focus on California is the enormous budget deficit that the Golden State currently faces. Last July, a poll conducted by the Pew Center on Budget and Policy Priorities on states with the worst budget deficits ranked California number one with a deficit of $53.7 billion, equal to 58.8% of California's state budget. (California's budget deficit has since been trimmed to $20 billion.) While the debate proved entertaining, none of the panel of six experts mentioned a single one of the key factors that seem to be at the root of California's budget crisis.
The gorilla in the room for California's policy makers is the state's dependence on the personal income tax (PIT). While the average state receives approximately 18% of general revenue from the PIT, California received over 55% of general revenue for fiscal year (FY) 2009 from the PIT. This dependence causes dramatic budgeting problems, since the PIT has been historically volatile in California over the last thirty years. For example, a 2005 report from the California Legislative Analyst's Office found that revenue from the PIT varied by an average of 13.8% from year to year from 1992 through 2004, while sales tax revenues only varied by 4.5% over the same time period.
However, changes in government revenue are better predicted by changes in personal income, measured by the short-term elasticity of revenue to personal income. The short-term elasticity of revenue to personal income is how much of the gross fluctuations in revenue are due simply to ups and downs in the economy versus other factors. For personal income in California from 1992 to 2004, this short-term elasticity was 6.24%. Since personal income of Californian's dropped by 2.6% over the first three quarters of 2009, that translates into a drop in state revenue from the PIT of 16.2%, or $9.2 billion.
For comparison, the impact on revenue from sales tax is less dramatic. Even though the sales tax makes up 22.5% of general revenue in California's budget, the effects of reduced personal income only amount to $1.1 billion.
Another cause is California's dependence on corporate taxes, which equaled 11.6% of general revenues for FY2009. This amount is also significantly higher than that for the average state, with revenues from corporate taxes at only 2%. Since the short-term elasticity of revenue of corporate taxes is 3.33%, revenue from the corporate tax is likely to make up slightly more than $1 billion of the $20 billion deficit.
The last nail in the coffin for the California budget was put in over thirty years ago, known as Proposition 13, a voter initiative that passed in 1978 that limits local governments from raising the basis for property tax assessment to two percent per year, unless ownership changes hands, and caps the property tax rate at one percent of property value. The budget effects of Prop 13 stems from the steep drop in resale prices in California's housing market caused by the foreclosure crisis. For example, consider a home that sold for $700,000 in 2005 that went into foreclosure and sold in 2008 for $400,000. Since property taxes are capped at one percent, annual property tax revenue will drop by $3,000, and can only be raised by two percent per year until it sells, on average 7 years later. Considering the fact that 250,000 homes were foreclosed in California in 2008 valued at $107.8 billion, if you multiply this by the average drop in resale value of 35%, you have a $377 million drop in annual property taxes from 2008 foreclusures alone. According to California law, the state is required to make up any budget shortfall for local school districts, likely to total $1.5 billion over the next three years.

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