California Is In Great Financial Shape…And Headed For An Epic Crisis

California Governor Jerry Brown inherited a $27 billion deficit from Arnold Schwarzenegger eight years ago. This month he’s leaving his successor a $13.8 billion surplus and a $14.5 billion rainy day fund balance. Pretty good right? Approximately 48 other governors would kill for those numbers.

Unfortunately it’s all a mirage. California, as home to Silicon Valley and Hollywood, lives and dies with capital gains taxes. In bull markets, when lots of stocks are rising and tech startups are going public, the state is flush. But in bear markets capital gains turn into capital losses and Sacramento’s revenues plunge. Put another way, the state’s top 1% highest-income taxpayers generate about half of personal income taxes. When their incomes fall, tax revenues crater.

That’s happening right now, as tech stocks plunge, IPOs are pulled and billion-dollar unicorns endure “down rounds” that shave major bucks from their valuations. So if this is a replay of the 2008-2009 bear market, expect California’s deficits to return to the double-digit billions.

But that’s not the real problem. Those currently-rosy budget numbers are only rosy because they omit the unfunded liabilities of public sector pensions, which are almost supernaturally large. Consider just Los Angeles’ schools:

Can we prevent the LAUSD budget crisis from taking down the California state budget?

(SGVT) – Even as its teachers consider going out on strike, the Los Angeles Unified School District’s budget clearly is in crisis. The problem is so big it might wipe out whatever surplus the roaring California economy might generate in 2019 – and then some.

The LAUSD just released its Comprehensive Annual Financial Report, or CAFR, for the fiscal year ending June 30, 2018. As I have been predicting, the LAUSD’s new CAFR doubled the size of its negative Unrestricted Net Position (UNP), the best number I’ve found for judging financial soundness. The reason was, for the first time, municipalities are now required to include unfunded liabilities for retiree medical care on their balance sheets.

The unrestricted net deficits for 2016 and 2017 were $10.5 billion and $10.9 billion, respectively. For 2018 it is $19.6 billion, or 80 percent higher! That’s what a $15 billion obligation will do when it’s recognized.

In bureaucratic language, the CAFR itself explained, the negative UNP “is largely the result of net other postemployment benefit (OPEB) liability and net pension liability for various retirement plans.” They blamed this transparency on the recent accounting standard they just implemented.

And here’s where it gets even more interesting. This fiscal implosion is about to collide with a wave of incoming liberal governors who have big plans for using the public budget to address society’s ills:

The Blue State Challenge

(Wall Street Journal) – Democratic dominance means they now have to pay the union bills.

Democrats received a mixed blessing in November when they seized complete control of state governments in California, Connecticut, Illinois and New York. They now own responsibility for fixing the dysfunctions of liberal governance even as the left wants more spending and taxes.

Anti-Trump furor helped Democrats retake the governorship in Illinois and augment legislative majorities in California, Connecticut and New York. Democrats picked up 12 seats in the Connecticut House and six in the Senate where control is split with Republicans. Democrats in New York flipped eight Senate seats and won a legislative majority for only the third time in 50 years.

With legislative supermajorities, liberals in California can raise taxes without GOP votes and in Illinois place a progressive tax on the ballot as unions have long wanted. Democrats campaigned on more spending—for schools, roads, child care, you name it. But Illinois and Connecticut are spilling red ink while the progressive tax-and-spending structures in New York and California are profiting from the Trump economy while storing up future trouble.

Illinois is forecasting a $1.2 billion deficit next year and has accrued $7.5 billion in unpaid bills despite a $5 billion income and corporate tax hike in 2017. Pensions consume 25% of state revenue, up from 10% a decade ago, yet are still only about 40% funded. Chicago is leaning toward insolvency as pension costs have doubled in a decade.

While New York’s fiscal problems are less glaring, its taxpayer flight is also ominous. The state lost a net $8.6 billion in adjusted gross income in 2016 as high-earners fled for lower-tax climes. Growth has stalled upstate—half of upstate metro economies have contracted over the last five years—as residents have moved.

New York City has benefited from its finance industry and cultural attractions, but even its economy has grown only half as fast as the rest of the country. Roads and subways are in disrepair as politicians have neglected public works to boost pay and benefits for their union friends.

New York, by the way, is the other state that lives and dies with stock prices. In a bear market, Wall Street lays off tens of thousands of analysts, investment bankers and traders, who promptly stop paying taxes.

The last recession/bear market was tough on state budgets. The next one, with debt much higher and unfunded liabilities off the charts – will be brutal.

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