The California Non-Comeback

A version of this post originally appeared on Real Clear Policy. 

An old adage cautions, “if something seems too good to be true, it probably is.” Such is the case with the now famous, “California Comeback.” Faced with a large budget deficit, California passed tax increases on the wealthy, balanced the budget, generated a massive surplus and seemingly solved the state’s fiscal woes.

The problem? In the surplus claim, California only counts revenues that will go into the $96.3 billion budget this fiscal year. This is an increase of $9.3 billion from just two years ago. However, the state’s unfunded pension liability debt is not calculated into the budget. There are several estimates on the actual pension liability that faces California, but if California were to use the accounting standards that private companies must use, its pension debt would be about $1 trillion. This is the little secret that allows California to claim a budget surplus: ignore the state’s debt.

The other main driver of the supposed California surplus is due to a massive increase in personal income tax revenues from 2012. In fact, California’s personal income tax receipts grew by a whopping 50 percent in total collections. This anomaly will most likely never be repeated, especially not every single year for the state’s budgeting purposes.

At the end of 2012, investors faced an increased incentive to sell as much as possible and realize the capital gains before 2013 because of the increased taxes they would face from the combined effects of the Affordable Care Act and the fiscal cliff negotiations. This enormous sell-off triggered a one-time spike in state and federal capital gains and state income tax collection. Since the state of California does not distinguish between ordinary income and capital gains income, all the capital gains income is fair game for the state’s personal income tax. The pressure that investors faced to realize any capital gains before major tax increases is not exactly a common occurrence, but California has still seen fit to use revenue for creating a new budget baseline.

The major spike in personal income tax revenue in California was also due to a little known provision in the Proposition 30 tax increases that voters approved in November of 2012. Unlike the vast majority of other tax proposals that apply to the next calendar year or years in the future, California decided to retroactively raise its personal income taxes. Proposition 30, passed in November 2012, applied the new, higher tax rates to all of the personal income of Californians beginning January 1, 2012. This ex post facto confiscation of wealth left individuals and small businesses with little time to plan for the changes. The measure essentially pulled the rug out from under businesses that had already done payrolls, budgets and planning for the next year by slapping them with an unexpectedly higher tax bill. The measure did achieve its goal of significantly boosting tax revenue for the state, but it is unlikely the state will be so lucky next year since individuals and businesses can now properly plan and adjust.

Even beyond these factors, California faces structural tax problems that ensure its fiscal woes are far from solved. Over the past ten years, roughly 1.5 million taxpayers have moved out of California. This number represents a huge loss to the Golden State’s economy for years to come, and, now that California has the highest personal income tax rate in the country, it doesn’t seem like this out-of-state migration trend will turn around anytime soon.

The sleight of hand retroactive tax increase, the pressure to realize capital gains in 2012, and the ignoring of the state’s pension debt all came together to create the illusion that California had a budget surplus. However, the California budget is akin to getting an unexpected one-time bonus at work and buying a Corvette while ignoring the massive amount of credit card debt that is still owed.

Additionally, California has again fallen into the same budget trap that it has found itself in many times before. Because California relies heavily on the personal income tax to fund itself—62 percent of total revenue in 2012 came from personal income—it experiences extreme revenue volatility. California commits to spend large amounts of money during the boom times and finds a lack of funding when the personal income tax receipts inevitably shrink. This causes a perpetual funding crisis that is solved by calls for ever increasing and “temporary” taxes, which create uncertainty and further damage the ailing business climate.

This is the downward budget spiral that California has now voluntarily set itself up for once again. Tax revenues spiked this year, but what about next year or three to five years from now? The highest personal income tax rate in the nation, when coupled with a shrinking tax base, leads to a dire prognosis for California’s fiscal health in the future.

True structural tax reform is the only real hope the Golden State has left. In the latest edition of Rich States, Poor States, The ALEC-Laffer State Economic Competitiveness Index, the authors examine California’s current tax system and offer a solution to fix the problem: a flat rate personal income tax. Lowering rates and broadening the base is the cornerstone of good tax reform. While ultimately moving away from taxing income in favor of consumption taxes is ideal, it will not likely be politically feasible for California anytime soon.