The stock market's plunge amid the COVID-19 pandemic increases the risk of a revenue shock for California and other states that are vulnerable to a steep drop in capital gains.
California lawmakers and Gov. Gavin Newsom may be scrambling in May when the governor performs the annual ritual of offering a revised version of his January budget proposal.
The U.S. stock market fell 11.5% in the last week of February, a decline that continued into March, pushing it into bear territory Wednesday.
The rout continued Thursday, when the S&P 500 fell 7% within minutes of the market open a "circuit breaker" temporarily halting trading on the New York Stock Exchange.
Even as the California economy thrived, chalking up record reserves in recent years, credit analysts have cautioned that the state’s dependence on wealthier taxpayers injects volatility into the system that could result in the state losing ground gained in the years following the Great Recession.
California ranked No. 1 among the 50 states as most sensitive to capital gains in an S&P Global Ratings report released Tuesday, produced by credit analysts David Hitchcock and Geoffrey Buswick.
“A stock market correction like the one experienced last week, or an extended decline in the stock market could affect the state’s economic condition,” California State Treasurer Fiona Ma said Monday during the Los Angeles Regional Investor’s conference.
Ma included capital gains volatility resulting from a stock market correction on a laundry list of potential risks to the state’s economy in her speech that also included the coronavirus, global tensions that could trigger slowing in the national economy, a trade war and the potential for an undercount in the census for the state.
She also described as a virtuous cycle the level of reserves and the surplus resulting from actions taken by California Gov. Gavin Newsom, the Legislature and the State Treasurer’s Office.
The governor’s proposed budget would place $20.5 billion in reserves, including $18 billion in the state’s rainy day fund and $1.6 billion in the special fund for economic uncertainties.
California tops the table ranking states from most to least vulnerable to taxpayer losses in capital gains, because the state has a very high top tax rate, Hitchcock said.
About 70% of the state’s general fund revenues come from income taxes and the top 1% of taxpayers (those making more than $500,000 annually) paid 47% of total personal income tax in 2017, the last year the federal government broke out top taxpayer data, Hitchcock said.
“New York has a high tax rate, and the highest percentage of high income earners, but California has the largest number of people in terms of the percentage making over $500,000 annually,” Hitchcock said. “In California, its 33.1% of taxpayers, and 25.3% of that comes from capital gains.”
The top five states most sensitive to capital gains are California, New York, Connecticut, Massachusetts and Oregon, in that order, according to the S&P report.
Newsom and the Legislature can make adjustments during the "May Revise" to the governor’s proposed $222.2 billion budget, Hitchcock said, but they may not have the full picture on how much revenues from capital gains will be reduced come tax time.
The hit to state coffers may be delayed until fiscal 2021, when income tax due from calendar year 2020 tax returns is finalized, Hitchcock said. In the meantime, the state could see a windfall in fiscal 2020 from stock market gains in calendar year 2019, as taxes are paid during the calendar year, he said.
“I wanted to show the states that are potentially exposed to a drop in capital gains loss,” Hitchcock said. “It’s easy to overestimate the amount of capital gains on an ongoing basis, because of the lag in information coming from the federal government estimating capital gains.”
So, the state could be making budget decisions this year without knowing the full effect of this year’s stock market volatility on capital gains.
From Dec. 31, 2008, considered the bottom, to Dec. 31, 2019, the stock market grew 258%, Hitchcock said.
Credit analysts and the Legislative Analyst’s Office have said in recent years even a $20.5 billion reserve like that in the governor’s proposed budget may not be enough.
The level of budget reserves the state has maintained historically raises questions about whether policymakers have done enough to prepare for a recession, Gabriel Petek, the state’s legislative analyst, wrote in a report in mid-February, before COVID-19 was a factor.
“Our office is on record that while the state has made significant progress, considerable uncertainty remains,” Petek wrote. “Not least are signs of slowing economic growth and risk from draft federal regulations regarding the types of fees and taxes the state can levy on healthcare providers.”
He recommended the state adopt a system of planned operating surpluses as a preemptive fiscal defense against a recession based on the length of the economic expansion.
The UCLA Anderson Forecast downgraded the outlook for the nation and California as the COVID-19 epidemic took a toll on economies worldwide.
The forecast, expected to be delivered as part of a half-day conference Wednesday at the University of California, Los Angeles, was canceled. It will be recorded, and distributed later on video.
A two-quarter hit to gross domestic product is expected, according to the forecast, although uncertainty regarding COVID-19 means the length and depth may be worse.
“We are assuming a two-quarter hit to real GDP growth in the second and third quarters of this year, with very modest increases of 1.3% and 0.6%, respectively, compared to the 2%-plus growth we previously forecasted,” Shulman said.
The relative strength of the California economy will buffer the initial overall impact, but trade, transportation and travel will see negative effects from the health crisis, according to the Anderson Forecast.
“What makes COVID-19 different from prior epidemics of SARS (2002-03), MERS, (2012) and the swine flu of 2009-10, which killed 12,500 Americans, is that although maybe fatal, it is potentially far more contagious,” wrote David Shulman, a senior economist with the UCLA Anderson Forecast. “It is the contagious nature of COVID-19 that triggered the economic shutdowns that have become so disruptive to the global economy. Remember, China is far more integrated into the global economy than it was during the SARS epidemic.”
Shulman called the forecast the "midpoint between the coronavirus having a very minimal effect to it causing a full-blown recession."
Pointing to public statements by executives at the ports of Los Angeles and Long Beach, who note declines in container traffic and labor levels, Anderson Forecast Director Jerry Nickelsburg wrote: “Fewer goods than expected this time of year are coming into the ports, and the logistics industry is already feeling the pain.”
It is challenging to fully incorporate the impact of the outbreak into the forecast given the epidemic is in its early stages, Nickelsburg wrote
“As with the U.S. Forecast, the first three quarters of 2020 will be weaker than previously believed for California, with the third quarter the weakest,” he wrote.
