State Budget

State Could Face $25 Billion Deficit, Analyst Warns

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California could face a $25 billion operating deficit in the 2023-24 fiscal year if current spending levels remain unchanged, according to a November 16 report by the Legislative Analyst’s Office (LAO).

“Under our outlook, the Legislature would face a budget problem of $25 billion in 2023-24,” the analyst wrote, defining a “budget problem” as the situation “when resources for the upcoming fiscal year are insufficient to cover the costs of currently authorized services.”

The analyst added: “The budget problem is mainly attributable to lower revenue estimates, which are lower than budget act projections from 2021-22 through 2023-24 by $41 billion. Revenue losses are offset by lower spending in certain areas. Over the subsequent years of the forecast, annual deficits would decline from $17 billion to $8 billion.”

The report marks a major change from roughly one year ago, when the state had a projected operating surplus of nearly $100 billion, but the analyst noted that the state has significant reserves.

“The $25 billion budget problem in 2023-24 is roughly equivalent to the amount of general-purpose reserves that the Legislature could have available to allocate to General Fund programs ($23 billion),” the analyst wrote.

“While our lower revenue estimates incorporate the risk of a recession, they do not reflect a recession scenario,” the analyst cautioned. “Based on historical experience, should a recession occur soon, revenues could be $30 billion to $50 billion below our revenue outlook in the budget window. As such, we suggest the Legislature begin planning the 2023-24 budget without using general purpose reserves.”

The Department of Finance recently reported that state revenue for the first quarter of the 2022-23 fiscal year was 11.1 percent below the amount projected in the budget approved in June. Personal income tax collections were $4.7 billion below forecast and sales and use tax revenue was $281 million below forecast.

On November 17, the LAO reported that October revenue was unexpectedly high, but added a disclaimer that this was not a sign of a long-term rebound in revenue.

“October collections from the state’s ‘big three’ tax revenues – personal income, corporation, and sales taxes – came in far ahead of Budget Act assumptions,” the LAO wrote. “Collections totaled $10.7 billion, whereas the Budget Act assumed $3.7 [billion]. This entirely erased the underperformance of recent months, putting big three collections up $2.1 billion for the fiscal year to date. These unexpectedly high October collections, however, are not indicative of better-than-expected revenue performance for 2022-23. In fact, a closer look at the collections data shows the recent trend of weakening continued. The October variance instead arises from a timing issue related to the newly created elective pass-through entity (PTE) tax.”

The analyst continued: “The administration anticipated a large amount of income tax refunds ($9.7 billion) would be paid in October, related to delayed claiming of credits for elective PTE payments for tax year 2021. However, only a small fraction ($2.1 billion) of the assumed refunds materialized in October, as it turns out the majority of taxpayers already had made timely claims of their credits back in April. The result is an artificial boost of $7.6 billion to the October collections total, which is not indicative of underlying revenue performance. The October numbers instead tell us that 2021-22 (a year in which the state saw historically high revenue growth) was even stronger than previously assumed.”

In addition to safeguarding reserves for use if a recession hits, the analyst recommended that the Legislature use the first months of 2023 to “question the administration about the implementation and distribution of recent augmentations,” noting that more than $36 billion in one-time and temporary spending was approved in the 2022-23 budget.

“If augmentations have not yet been distributed, the Legislature has an opportunity to reevaluate those expenditures,” the analyst stated. “Moreover, in light of the magnitude of the recent augmentations, programs may not be working as expected, capacity issues may have constrained implementation, or other unforeseen challenges may have emerged. To address the budget problem for the upcoming year, these cases might provide the Legislature with areas for pause, delay, or reassessment.”

Lawmakers will return to Sacramento on December 5 to take the oath of office and begin the first year of the new two-year session. Governor Gavin Newsom has announced that he plans to call the Legislature into a special session, also beginning December 5, to consider a “windfall profits tax” on the oil and gas industry.

The governor is required to propose a 2023-24 budget by January 10, marking the official beginning of the annual budget process. A revised budget is required in May, to account for April tax collections and other changes since the beginning of the year. The Legislature must send a budget bill to the governor by June 15 or forfeit pay, and the new fiscal year will begin July 1.

In other budget-related news:

State Pension Systems Report Massive Losses. California’s two largest government employee pension systems – the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS) – recently reported that they experienced substantial losses for the second half of the 2021-22 fiscal year.

CalPERS reported a 7.5 percent loss and CalSTRS reported a 3.3 percent loss for the fiscal year.

Both systems had released investment return data earlier this year, but recently released updated figures. The pension systems noted that private equity and real asset performance figures are reported on a three-month lag, requiring the agencies to update figures every year when new data is released.

The updated figures are grimmer than the original reports, which pegged the losses at 6.1 percent for CalPERS and 1.3 percent for CalSTRS.

CalPERS closed its fiscal year with a portfolio value of $439.4 billion, and CalSTRS closed the year with a portfolio value of $300.1 billion.

“As with other institutional investors, our private assets were not spared from the impacts of global turmoil and domestic economic volatility,” CalPERS Chief Executive Officer Marcie Frost stated. “While the final numbers are informative, we remain focused on long-term performance and our members can be confident that their retirement is safe and secure.”

For the 2020-21 fiscal year, CalPERS reported a 22.4 percent return and CalSTRS reported a 25.6 percent return.

Since California’s government employees receive defined benefits upon retirement, poor performance by the retirement funds ultimately leads to greater costs for taxpayers, as tax dollars must be used to continue paying pensions at the legally required rates.