Another economic dip coming?

JUNE 21, 2010

By JOHN SEILER

Here’s something Meg Whitman and Jerry Brown should be debating.

As the California budget is haggled over by the governor, Legislature and the powerful government unions, one thing everyone assumes is that the California economy will gradually improve. That it will keep lifting its head out from the mire of the 2007-09 recession. Gov. Arnold Schwarzenegger’s May Revise of his fiscal 2010-11 budget proposal observes that “there continue to be signs the economy is slowly improving.” And:

The national and California economies improved between the Governor’s [January] Budget and the May Revision. … In fact, the good signs are coming at an increasing rate, especially in the national economy….

Based on better than expected indicators that have been released since the Governor’s Budget forecast, most notably GDP growth in the final quarter of 2009 that was much stronger than anticipated, the outlook for the national and state economies is more positive, but remains cautious.

But the proposal does caution that, “Despite these positive developments, the recovery remains fragile.”

However, what if even these cautious statements are not cautious enough? When working on a budget, a prudent family or business takes into account the possibility of economic calamity. Such a family or business saves a decent amount of money in a “rainy day” fund. And even in modestly bad times, it sharply cuts expenditures well below income to insure that debt is not accrued that will severely damage, or even bankrupt, the family or business.

In recent decades, California has never taken such precautions. Even when times were good and the tax money was rolling in, as during the dot-com boom of the late 1990s or the real estate-boom of the mid-2000s, instead of saving some money for use during a recession, virtually all the surplus tax money collected was spent on increasing the budgets of state agencies and pension spiking. No “rainy day” fund ever was funded.

Because there will be no cushion should the second half of a “double dip” recession hit within the next year or too, it’s worth contemplating what will happen.

Recession Part Two in 2011?

Some of our best economists are warning that 2011 well could bring a renewed recession. Even if they are proved wrong – as everyone hopes will be the case – prudent budget crafting should take into account their warnings.

Because most of President Bush’s 2003 tax cuts expire in 2011, economist Arthur Laffer is forecasting a major recession. Laffer is the head of Laffer Associates. Formerly located in San Diego, it recently relocated to Nashville, Tenn., to escape California’s high taxes. In particular, the 10.55 top California income tax rate compares badly with Tennessee’s 0 percent. Laffer helped craft Proposition 13, the 1978 property tax cut measure in California, and President Reagan’s tax cuts – both of which formed the foundation of  30 years of California prosperity.

In the June 6 Wall Street Journal, Laffer wrote:

On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply. President George W. Bush’s tax cuts expire on that date, meaning that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. Lots and lots of other changes will also occur as a result of the sunset provision in the Bush tax cuts.

But hasn’t the economy been growing since the middle of 2009, when the recession ended? Yes. But the reason is that taxpayers, anticipating getting hit with the 2011 tax increases, are squeezing as much economic growth and profit into the months before then.

Here’s the scary part. Laffer explained:

Now, if people know tax rates will be higher next year than they are this year, what will those people do this year? They will shift production and income out of next year into this year to the extent possible. As a result, income this year has already been inflated above where it otherwise should be and next year, 2011, income will be lower than it otherwise should be.

In a discussion with me, Laffer also used an analogy to a sale, which I’ll adopt for our purposes. Suppose a store offers a 25 percent-off sale for the July 4 weekend, which is coming up. Predictably, sales and profits will rise that weekend. But the day after the sale ends, sales and profits will be lower than usual.

For a government, lower income by businesses and citizens means a recession. And it means a lower tax base, leading to fewer taxes collected – and a bigger state budget deficit.

California tax cuts

It’s true that Gov. Schwarzenegger’s record $13 billion in tax increases of 2009 expires next year – assuming he and the Legislature don’t extend the tax increases another year to close this year’s $19 billion budget deficit.

But even assuming the tax reductions go into effect in California, they won’t be big enough to discourage people and businesses from leaving for tax havens such as Texas. Consider:

In 2011, the top federal income tax rate will zooms from 35 percent to 39.6 percent. For a Californian in the top tax bracket, that means tax rates of:

In 2010: 45.55 percent (35 percent federal plus 10.55 percent state) – current marginal tax rate.

In 2011: 49.9 percent (39.6 percent federal plus 10.3 percent state) – marginal tax rate next year, in 2011, a 4.45 percentage-point increase.

In 2011 – moving out of California: 39.6 percent (39.6 percent federal plus 0 percent state) –  marginal tax rate if you move to Washington, Texas, or some other state with no state income tax.  That’s a 5.95 percentage-point overall tax cut, even after the federal tax increase.

The meaning for California

In my call to Dr. Laffer, I asked him about how the federal tax increases directly would affect California. “California is a part of the United States, and will be affected directly as a consequence,” he told me. “The higher tax rates will make California more vulnerable than most other states – although not all of them.”

As I noted in a previous CalWatchDog.com piece, a study Laffer conducted with the American Legislative Exchange Council (ALEC) included California in the category “States That Do Everything Wrong.” Other states in that category were New York, Michigan and New Jersey. Since then, rookie New Jersey Gov. Chris Christie has been cutting budget waste and taxes. So perhaps it will drop out of that dismal group.

“People don’t work to pay taxes,” Laffer continued. “They work for what they take home after paying taxes. States with the highest tax rates will be the most disadvantaged. California is right at the top of that pile. States with the most debt will be especially burdened.”

For his ALEC study, Laffer came up with the “Moving Van Effect,” gauging how many people were moving out of one state to another state. California saw 1.4 million leaving the state between 1999 and 2008, second worst after New York’s 1.7 million leaving.

Laffer said he expects California to maintain a high Moving Van Effect. “California economy is not where anyone wants to be if they care about economics.”

Still a great place…

I got more perspective from David Zetland, Wantrup Fellow in Natural Resource Economics and Political Economy at the University of California, Berkeley, and editor of the Aguanomics.com Web site on water policy. “As goes the nation, so goes California,” he told me of what would happen if the economy tanks in 2011. “Besides the obvious (lower tax revenues, higher unemployment), there will also be an Uh-oh effect – people will really dig in and cut back on spending, to make sure that they do not end up on the streets.”

As to whether a renewed recession would encourage more jobs to leave California, he replied, “Yes and no. Maybe the government will realize that reform is necessary. If there’s no change, then existing ‘hanging on’ businesses may call it quits or leave the state.”

As to how big the state budget deficit might get in another recession, he said it was difficult to speculate. But it could get “bigger, and maybe much bigger. Falling income taxes and rising expenses are an ugly pair. If you need a number, try $25 billion.”

He also doesn’t think a new recession would be a spur to more Californians leaving. The question, he said, is: “Will there be more jobs elsewhere, i.e., will other states recover faster? If not, and housing prices drop again, then they will either be trapped in houses (underwater) or able to afford cheaper houses. Moving is financially and emotionally costly, so people will not leave unless things are obviously better elsewhere. And others will fill their places. California is still a great place, government aside.”

John Seiler, an editorial writer with The Orange County Register for 19 years, is a reporter and analyst for CalWatchDog.com. His email: [email protected].