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Wednesday, Feb 28, 2024

The Impact of a Recession on State Coffers

A recession in 2023 would have a significant impact on California’s budget, potentially moving it deeply in the red.

To understand how it’s possible for the budget to deteriorate so quickly, it’s important to understand that California’s currently budgeted “surplus” for the 2022-23 fiscal year of $8 billion is not really a surplus.

Since it includes a balance (surplus) of $22 billion from the prior 2021-22 fiscal year and effectively treats it like current revenue, the 2022-23 budget is actually in a deficit.

Excluding the prior year’s surplus, total general fund budgeted revenues and transfers in 2022-23 of $220 billion compared to $234 billion in expenditures, leaving a deficit of $14 billion. This argument isn’t simply over semantics. If no balance (surplus) exists at the end of the current fiscal year, the state will find a revenue shortfall of $22 billion in revenues in its 2023-24 budget.

To cloud matters even more, the prior budgetary year, especially 2020-21, was positively affected by sharp infusions of one-time COVID-19 federal relief aid. How much COVID-19 relief is still affecting revenues in the 2022-23 budget is anyone’s guess, but all lagged COVID-19 payments are likely to end by December 2024. Given all the confusion, we’re reminded of Walter Scott’s famous line, “Oh, what a tangled web we weave.”

So let’s try to make the analysis as simple as possible by accepting at face value the state’s current 2022-23 budget that calls for a “surplus” of $8 billion by the end of June 2023. This surplus is based on total general fund revenues and transfers (including the 2021-22 surplus of $22 billion) of $242 billion and expenditures of $234 billion.

If a recession occurs next year, its impact on the state’s coffers will most significantly hit tax revenues from personal income taxes and capital gains. In the current 2022-23 budget, personal income tax revenues of $138 billion represent 62% of total budgeted revenues of $223 billion. Capital gains revenues of $23 billion represent 10% of the total. The combined total of personal and capital gains tax revenues, therefore, represents 72% of the state’s budgeted revenues.

In 2001-02, the share from these two taxes was a significantly lower 54%. The growing dependence on these two tax sources presents formidable challenges in accurately budgeting state revenues.

As shown in Chart 1, annual percentage changes in personal and capital gains tax revenues are highly volatile, especially during recessionary periods. The 2001 recession led to a 17% decline in personal income tax revenues and a 58% decline in capital gains tax revenues during California’s 2001-02 fiscal year.

Similarly, during the 2008-09 fiscal year, the Great Recession of 2007-09 led to a 20% decline in personal income tax revenues and a 57% decline in capital gains revenues during the 2008-09 fiscal year.

If a recession next year has, on average, the same percentage impact on personal and capital gains tax revenues during next year’s 2023-24 fiscal year, personal income tax revenues would decline by $25 billion, and capital gains revenues would drop by $13 billion. That’s a total decline of $38 billion or about 16% of the 2022-23 fiscal year’s total expenditure budget of $234 billion. It’s likely, though, to be considerably more. Other tax sources like sales and use taxes, as well as corporate taxes, will also decline in the face of recessionary forces.

It might be argued that the state is captive to national economic forces and can’t do very much about a recession. That doesn’t mean, though, that the state can safely ignore the possibility of a recession happening, particularly given the potential impact it will have on its budget.

So rather than simply going about the business of preparing the 2022-23 budget as if no headwinds might occur, it should include a large reserve fund. In fact, the current 2022-23 budget includes a “Special Fund for Economic Uncertainties” in the amount of $3.5 billion.

The upcoming 2023-24 budget should continue that practice but significantly increase its magnitude. By what amount?

Answering that question is a bit complicated. As we pointed out earlier in this article, the state included its previous year’s surplus of $22 billion in the current year’s budget. But the current year’s budget only includes a projected surplus of $8 billion. That’s a shortfall of -$14 billion going into the 2023-24 budget year ($8 billion less $22 billion).

When that shortfall is added to the projected recessionary decline of $38 billion, the total shortfall in the 2023-24 budget is $52 billion. As shown in Chart 2, total general fund revenues would decline from $242 billion in 2022-23 to $190 billion in 2023-24. That drop of $52 billion represents a 21% decline in total revenues.

Setting up a “special fund” in the amount of $52 billion will strike most of our public servants in Sacramento as draconian, to say the least. It should be noted, however, that general fund expenditures increased from $139 billion in 2019-20 to $243 billion in the current 2022-23 fiscal year. That’s a whopping increase of $104 billion or 75% in the general fund in a scant three fiscal years. In the face of such a sharp increase in spending, holding back enough discretionary spending to create a meaningful “special fund” seems doable. And if not $52 billion, maybe $25 billion?

But who knows? Perhaps the Federal Reserve will finally succeed in bringing rampant inflation under control without a recession. Although that’s never happened before, maybe this time, the Fed will get it right. If it does and the state’s monthly tax receipts stay on budget, the “special fund” reserve can be released over the course of the year. Our lawmakers in Sacramento, however, should not bank on this rosy scenario. As we’ve learned, “Hope for the best and plan for the worst.”

Such prudent fiscal oversight on the part of our state government may be too much to realistically expect, but one can always dream.

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