California faces a $68 billion spending gap after tax revenue shortfall, report says

The bad financial news keeps coming for the State of California. First, the nonpartisan Legislative Analyst’s Office released a report projecting a budget shortfall reminiscent of the Great Recession. Now, that same office has released a followup report predicting a $68 billion budget gap.

The forecast comes less than a month before California lawmakers return to Sacramento to begin crafting a budget for the next fiscal year, which begins July 1. Gov. Gavin Newsom will present his proposed budget in early January.

At issue is an “unprecedented” revenue decline in the fiscal year 2022-23, which fell $26 billion below what was estimated, according to the LAO. Normally, the Legislature has a complete picture of the previous year’s revenue when it is shaping a new budget. But due to tax filing deadline extensions caused by severe winter storms, that was not the case this year.

“This creates unique and difficult challenges — including limiting the Legislature’s options for addressing the budget problem,” according to the report.

A collection of factors are at play, including a previously anticipated deficit of $14 billion and a $58 billion drop in projected revenue.

Addressing a budget gap

The Legislature will have a number of options for addressing this $68 billion deficit, according to the LAO.

Lawmakers could decide to withdraw up to $24 billion in cash reserves. It could also lower school spending to the legal minimum, cutting general fund costs by $16.7 billion. But that won’t completely close the gap.

“Even after using most or all of these solutions, the Legislature still would need to find more solutions to address the remainder of the budget problem. Other options include additional cost shifts (such as more loans from special funds), revenue solutions, and ongoing spending reductions,” according to the report.

The LAO suggested that given the scale of the problem, the Legislature should “immediately begin evaluating past spending to find monies that have been committed but not yet distributed.”

The office also warned that lawmakers will have fewer options to address multiyear deficits in the future. The state’s reserves are insufficient to cover the state’s deficits, which average about $30 billion per year.

“These deficits likely necessitate ongoing spending reductions, revenue increases, or both. As a result, preserving a substantial portion—potentially up to half—of reserves would provide a helpful cushion in light of the anticipated shortfalls that lie ahead,” the report said.

The news was greeted by Sen. Roger Niello, R-Fair Oaks, who vice-chairs the Senate Budget and Fiscal Review Committee, as the inevitable result of a “tax-and-spend majority.”

“Republicans cautioned that this level of spending would lead to greater deficits, and it would be more prudent to show restraint,” Niello said in a statement. “Unfortunately, the majority party ignored those warnings, enacting a budget in June that already projected a $14 billion deficit, even before the LAO’s new report revised the deficit to $68 billion,”

California lags in revenue growth

A big problem California faces is that it doesn’t appear there are easy ways to raise more revenue.

A new study by the Tax Foundation, a Washington group that studies tax policy, found that California had the third highest per person tax collections of any state — $9,175, in fiscal 2021. collections per household were $26,426

About one-third of total individual tax collections come from individual income, the highest per person collections in the country. California has a graduated income tax where rates go from 1% for lower income taxpayers to 13.3% for millionaires.

In other collection categories, another $2,087 was from property taxes. Other per capita taxes: $1,516 in sales taxes, $626 in excise taxes, $134 in motor vehicle license taxes, and $1,091 in business and miscellaneous taxes.

California has the nation’s highest motor fuel tax. But what’s driving the high national ranking is reliance on the income tax.

The biggest revenue declines are concentrated in California and New York, “high-tax states with intense reliance on high marginal income tax rates,” said Jared Walczak, Tax Foundation director of state projects.

“Not only are these states more vulnerable to income fluctuations among high earners—an important source of volatility—but in an increasingly mobile environment, they’re driving some of those high earners to other states as well,” he said.

Even before Thursday’s fiscal outlook report, California had lagged the country in revenue growth.

New York and California’s combined state tax revenue is up 2.9% in inflation-adjusted terms since fiscal 2019, just before the COVID pandemic, compared to 11.3 percent growth in the rest of the country.

New York has the highest per capita tax collections in the country, $10,286. Next is Connecticut at $9,458. Alaska has the lowest tax collections per capita, $4,192.