Brown Budget Flies to Fantasyland

MAY 24, 2011

By WAYNE LUSVARDI

There is a children’s fairy tale about a Sacramento government accountant for the State of California who takes his new poor stepdaughter all the way to Orange County to go to Disneyland for the first time. When she gets to Fantasyland, she becomes fascinated by the story of Cinderella, where the pumpkin turns into a golden coach.  Whereupon she asks her step dad: “When the pumpkin turns into a royal golden coach, would that be classified as income or a capital gain?”

Something like this fairy tale joke is happening in real life with California Gov. Jerry Brown’s May Revision of the Governor’s Budget.  Brown has surprisingly announced a $6.6 billion jump in tax revenues, which is enough to plug a fourth of the projected annual budget deficit. Brown and Controller John Chiang are mostly silent about the source of the increased revenues and allude to an economic recovery.

But the bad news not being reported in the headlines and news broadcasts is that the newfound tax revenues are not from rising income or sales taxes, but apparently from capital gains taxes. A capital gain is the increase in value of a stock or real estate that you realize when you sell it.

The Golden State can have its golden coach but the wheels are still made out of pumpkins. California is still living in a budget Fantasyland.

Controller’s Report

Whether you’re an accountant or a little girl, if you’re interested in California’s budget numbers do not go to the Governor’s Revised May Budget.

Instead, go to the State Controller’s Office Report for April 2011. There you will find that it is true that income tax receipts are up for the fiscal year to date from July 2010 to April 2011. But April is when income taxes are due.  And the spike in tax revenues is mostly due to a one-time payment of capital gains taxes by investors selling stocks and/or real estate.

For those curious stepchildren and other California citizens, the real tale of the economy is told in sales tax receipts, which are up a mere 0.9 percent.  If you take out your calculator and adjust for inflation, sales taxes are actually less than a year ago, when California and the United States were officially in “recession.”

Total income taxes received up to April were $7.5 billion. But in April 2007, before the bursting of the Real Estate Bubble, income taxes were $7.9 billion. California still doesn’t know whether it is turning into a golden coach or back into a pumpkin patch.

Robert Frank of the Wall Street Journal warns that dependence on capital gains is how states like California got hooked on dope in the first place. Frank describes the jump in revenues as a tax fluke driven by investors selling stock to avoid higher capital gains tax rates for the 2011 tax year, as well as due to Roth IRA rules. So much for the “tax the rich” mantra. The rich are already saving California via the “evil” stock market. Frank writes:

Now, stock markets have recovered and so have the rich. It follows, therefore, that as the incomes of the rich are soaring again (all those Facebook billionaires and hedge-funders), so are their tax payments.  As go the rich, so go the states. (That is simply fact: This is not to argue for lower or higher rates on the rich.) Add to this the fears last year of higher capital-gains tax rates — which induced the rich to sell extra stock so they don’t have to pay more later — as well as Roth IRA rules and you get a new bulge in tax revenue.

The good news is that the revenue boom will continue — as long as stock markets hold. The bad news is that just as governments failed to recognize their dependence on the rich in good times, and failed to prepare for a bust, they have been too slow to realize the rebound of the rich in good times. Now they find themselves drastically missing their budget projections.

And rest assured, this boom in tax revenue from the rich will end just like the last one. And governments won’t be ready.

Brown’s Tax Increases

For the above reasons, this is why Gov. Brown is still pushing for the continuation of a 1 percent temporary premium on the state sales tax rate and higher DMV vehicle license registration fees.  But he needs to better control expenditures than raise revenues (read below).

Gov. Brown’s Revised May Budget is a pumpkin pie of mushy assumptions.  Brown’s budget team assumes that revenues will increase by 7.3 percent annually from 2012 through 2015.  This is based on the experience where there has been revenue “bounce” after recessions.

There has been discussion on the Calwatchdog.com website about a “worst-case” scenario where the State budget might fall to, say, $60 billion from about $85 billion.  Under such a scenario, the state would likely have enough money to pay pensions, bond payments, and mandated public schools under Proposition 98.  But after that, everything else in the state would have to shut down.  It would not be a bond default, pension fund default or system-wide school closures. But it would otherwise be a technical default as to providing other services, many but not all of which are planned to be shifted to local governments under what is called “realignment.”

In the chart below, this writer took Gov. Brown’s revised May 2011 Budget and tried to reconstruct his forecast.  Brown forecasts revenues growing 7.3 percent per year through the 2014-15 fiscal year (Line “a”).  But when you take his revised forecasted deficits over that same time period, it shows that he would be increasing expenditures by 5.3 percent per year (Line “b”).

Inflation, measured by the Consumer’s Price Index (CPI), has been running 3 percent a year.

And by the Producer’s Price Index (PPI) has been running 4.8 percent in California. Even using the 4.8 percent inflation rate, expenditures would exceed inflation by $72.2 billion over four years (Line “e”).

Either there is something wrong with Brown’s budget numbers, or they aren’t clear enough to reconstruct.

GOVERNOR’S MAY REVISED 2011-2012 STATE BUDGET (in billions)
Year	2009-2010	2010-2011	2011-2012	2012-2013	2013-2014	2014-2015	Percent Per Yr.
a. Revenues	$84.5	$91.9	$96.8	$105	$110.6	$119.5	+7.3%
b. Expenditures	$122.23	$92.2	$106.4	$115.3	$120.8	$129.1	+5.3%
c. Deficit per Brown			-$9.6	-$10.3	-$10.2	-$9.6
REVISED BUDGET EXPENDITURES ADJUSTED FOR INFLATION BY PPI
d. Expenditures  Frozen + PPI		$84.6	$92.9	$97.4	$102.1	$107	+4.8%
e. Indicated Expenditure Increase Over Inflation			$13.5	$17.9	$18.7	$22.1	+18%

Another Revenue Drop?

Certainly, it is not beyond question that there could be another large drop in revenues due to a world war, terrorism or a movement on the San Andreas Fault.  Jerry Brown has proposed to set aside $1 billion for an emergency reserve, instead of spending like a drunken sailor, as the recent past legislatures have done.

As Robert Frank of the Wall Street Journal writes: “it’s not just volatile revenues, it’s volatile expenditures.”  The budget game that government often plays is to try to keep the eye of the public on revenue declines and not on reduced expenditures as well.  Government budgeters like to keep your eye focused on revenues like a moth is hypnotized to a flame.  The hidden assumption often is that expenditures are constant and untouchable.

As best this writer can tell, Brown’s budget team has disclosed expenditures, but in a very fuzzy way. And once you try and replicate their spending numbers, it appears that expenditures largely exceed inflation.

Borrowing a phrase from comedian Robin Williams, except for a new line item tweak to put money aside for a rainy day, California’s state budget continues to be “Disneyland restaged by Dante.”