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California: Mediterranean Climate, Mediterranean Budget

May 11, 2010

By Josh Barro

If you doubted that California’s fiscal picture could get any bleaker, see last week’s revenue notice from Controller John Chiang. He announced that California had missed its April tax revenue target by 26%, or $3.6 billion.

The announcement more than wiped out four months of ahead-of-plan tax receipts in the state, and dashed legislators’ hopes that strong tax receipts would eat away at the state’s $20 billion budget gap. As a result, California’s need to bring revenues and expenditures into line has become more urgent than ever. The handful of other states that have already reported April revenue figures are generally also showing shortfalls, though not quite at this level of severity.

April is the most important month of the year for state tax collections. Because tax returns are filed in April, it’s a month when many people remit taxes due on non-wage income. Taxpayers subject to tax increases (as most high income Californians were in 2009) can also generally wait until April to pay their added liability without penalty - leading to a payment lump.

For these reasons, California anticipated that it would take in over 15% of all Fiscal Year 2010 taxes in April, nearly double the typical monthly share. But total collections for the month were just $10.1 billion, not $13.7 billion as expected.

The shortfall is largely attributable to personal income tax (PIT), where the state fell $3.1 billion short of plan in April; as a result, PIT revenues are $2.2 billion below plan for the fiscal year (6%). Corporate tax and sales tax receipts are still above expectation, but PIT provides by far the largest portion of California’s revenues: over half the general fund.

The state’s finance department has offered three preliminary explanations for the below-expected PIT receipts. One is that California small businesses suffered more in 2009 than expected - small business income isn’t subject to withholding and is therefore harder to track than payroll income. A second is that more people than expected carried forward investment losses from the stock market bloodbath in 2008.

The third explanation is that many taxpayers voluntarily paid their taxes earlier than required, which would explain the stronger-than-expected receipts in the first three months of 2010 followed by poor April performance. (This behavior sounds illogical, but taxpayers owing money to California may have chosen to file early because they were due federal refunds.)

This last story would mean that stronger-than-expected receipts from December through March were in significant part a mirage, not reflecting higher incomes and tax liabilities but merely meaning that taxpayers were paying earlier than required. But lawmakers relied on those apparently strong receipts to make policy decisions, including Chiang’s choice to cancel a planned delay in sending tax refund checks, as it appeared the state would not need to hoard cash.

As previously noted, other states have also fallen short of their projected April revenues. New Hampshire missed its projection by 15%, due to weak receipts from business taxes and taxes on dividends and interest. Kansas was off by 10%, Mississippi 9%, and Indiana 5%. Massachusetts was off significantly, too, but the state revenue department claims that widespread flooding pushed some expected April receipts into May.

Most large states haven’t reported their revenue figures yet, but if the early reporting states are any indication we can expect bad news from New York, New Jersey, Pennsylvania and others.

These weak revenue figures will remind states that they cannot necessarily just “grow” out of budget deficits, but will have to take affirmative gap-closing measures. That’s starting now - Indiana Governor Mitch Daniels already ordered another round of spending cuts in response to his state’s weak April revenues. Other states will have to follow suit.

If there is any “silver lining,” it is that states are likely to see a revenue reprieve next year. Tax changes at the federal level (including higher capital gains tax rates to come in 2011, and a one-time opportunity for taxpayers to convert traditional IRAs to Roth IRAs) should cause a surge in taxable income in late 2010, which will pump up state revenues in the first quarter of 2011.

But states must remember that the rise will be temporary - in fact, taxpayers’ actions to convert IRAs and bring capital gains forward will shrink the tax base in 2011 and beyond. It is typical for state revenues to lag the overall economy in recovering after a recession, so states should not treat positive jobs numbers or a temporary boost in tax revenues as signs they can avoid fiscal adjustments.

No state has more work ahead than California, whose leading revenue shortfall comes on top of a yawning structural deficit. Indeed, the Golden State has been in a state of budget ‘crisis’ at least for the last seven years, continually responding to budget gaps with temporary fixes and accounting gimmicks instead of real reform.

California’s permanent budget crisis stems from institutional failures. Ballot measures have made it nearly impossible to raise taxes or cut spending, and have cemented the idea in voters’ minds that they can get government services without paying for them. The state has repeatedly failed to reform its inefficient tax code (which relies too much on highly volatile taxes on high-income people, and not enough on property taxes) or to tackle the problem of runaway public employee compensation.

This is unsustainable. California’s rickety finances have already earned it a S&P general obligation bond rating of A-, lower than any other state and equal to Portugal.

The trouble with California is that it has a Mediterranean budget to match its Mediterranean climate. April’s numbers show that rosy tax receipts aren’t likely to improve matters any time soon. Like any Mediterranean EU member, California desperately needs an aggressive fiscal adjustment if it is to remain solvent

Original Source:



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