California’s final budget could have "favorable credit implications" depending on how it spends its record-breaking $97.5 billion surplus, S&P Global Ratings said.
S&P analysts suggested in a report this week that a ratings upgrade could be on the horizon if the state plays its cards right and economic forces align in its favor.
“We believe what the state does with the extra revenue in the final enacted budget could have important credit implications for the state,” S&P analysts Hitchcock, Oscar Padilla and Ladunni M Okolo wrote in Wednesday’s report.
Gov. Gavin Newsom’s
The Democratic governor would also dedicate $6.2 billion to reducing long-term debt obligations through refunding and shifting $2.7 billion in planned issuance of lease revenue bonds for capital projects to pay-go.
The state has held a positive outlook from S&P since September 2021, a position that signals there is at least a “one-third chance” that the rating could be upgraded over the two-year outlook period that ends in 2023, said David Hitchcock, senior director.
If S&P analysts believe that state finances will be structurally balanced over the next few years, there is the possibility of an upgrade, Hitchcock said.
S&P’s AA minus rating is one notch lower than both Fitch's AA and Moody's Investors Service's Aa2. They both
Lawmakers could alter Newsom's budget course with big plans for multi-year spending and the massive surplus is tempered by the potential for spending restrictions from the Gann spending limit voters approved in 1979, which requires surplus money be returned to taxpayers if revenues exceed a set ceiling.
The surplus also gets carved down to a still substantial $49.2 billion for discretionary spending after constitutionally mandated spending on education, reserves and long-term liabilities are counted.
Leaders of the state Senate and Assembly, all Democrats, unveiled a placeholder budget Wednesday night. It's a practice they have adopted in recent years where they release an outline of their budget revisions spotlighting major policy decisions a few weeks ahead of the June 15 budget deadline for approval by the entire Legislature.
The main difference between their plan and Newsom's appears to be a renewed push to return nearly $10 billion directly to taxpayers in $200 payments, rather than employing the $400 per car gas tax rebate Newsom has offered as the mainstay of his refund package.
Lawmakers plan would include $8 billion in rebates for most taxpayers, $1.3 billion in aid for small businesses and nonprofits and $400 million to expand assistance for impoverished Californians. They also included $40 billion in across-the-board infrastructure spending.
"Our state's wealth needs to work for Californians and that's exactly what we have ensured with this agreement," Sen. President pro Tempore Toni Atkins, D-San Diego said in a release.
The
Unlike previous years, their budget agreement did not include Newsom, also a Democrat, signaling further budget battles among Democrats. He has line-item veto power meaning he could eliminate any appropriations from the budget.
Newsom spokesman Anthony York said the governor's budget does more for California's while being more fiscally prudent.
“The legislative proposal creates more long-term spending obligations for the state, does not pay down long-term debts and puts less in the state’s rainy-day fund than the Governor’s budget blueprint,” York said. “The governor is committed to an on-time and fiscally responsible budget."
Newsom’s proposal would spend 94% of the $49.2 million in discretionary revenue on
The substantial one-time spending “could have favorable credit implications, as it could help mitigate the twin risks of either a revenue pullback, or even higher revenue growth causing the state to reach its constitutional appropriation limit,” S&P analysts wrote.
Much depends on what transpires between now and Newsom's July 1 deadline to sign a budget in time for the new fiscal year.
Fitch analysts “anticipate details of the enacted budget will vary from the governor’s plan; but, as in recent years, the general approach of limited recurring spending growth, focus on one-time actions, and restoring resilience will likely carry through,” they wrote.
“This analysis reinforces the fact that Governor Newsom has put forth a prudent budget that plans for the future while addressing some of our state’s most pressing, immediate challenges," a governor's spokesman said of Fitch's report.
Fitch estimated that the governor's May revised budget only added $3 billion of ongoing spending, including expanded access to healthcare, to address extreme weather, invest in public safety and combat homeless. Even with the increases, the multi-year forecast, which incorporates an added inflation adjustment beginning in 2023-24, is structurally balanced.
Likewise, lawmakers state in the initial pages of their document they emphasized one-time spending.
The placeholder budget of just over $300 billion, for an estimated $235.5 billion in general fund spending,
But lawmakers have been advancing a proposal to spend $100 billion over 10 years on housing programs to mitigate the state’s high home prices, and they have also been discussing costly healthcare reforms that could result in ongoing spending, Hitchcock said.
“We want to look at the final budget,” Hitchcock said.
If the final product maintains structural balance over the next few years, there is the possibility of an upgrade, he said.
But there are a lot of uncertainties in a state that faces challenges including being the state most dependent on capital gains taxes in the nation as the stock market falls, the Gann limit and potential programmatic legislative spending to reduce inequities.
Not to the mention the economic headwinds confronting all states.
California is well-positioned to ride out the economic uncertainties, according to the report from Fitch Ratings analysts Karen Krop and Bryan Quevedo, but there are many.
These uncertainties, creating hiccups in everyone’s economic outlook, are the war in Ukraine, inflation and the stock market decline, Krop said.
“California’s current year revenues for 2022 are incredibly strong, but even in the May budget revise the [Newsom administration] noted their expectations for growth are tempered by those uncertainties,” Krop said.
“Things may look really good in 2022, but we have to be cognizant that there are headwinds for 2023,” she said.
In addition to larger economic forces, the state's dependence on capital gain taxes is near the same level as it was ahead of the the dot.com crash of 2000, Hitchcock said.
The Department of Finance estimated in January’s budget proposal that 11.8% of revenues for fiscal 2023 came from capital gains and 12.8% for 2022, Hitchcock said. In fiscal 2001, the capital gains tax hit a high of 14.8%, reflecting the calendar 2000 dot.com bubble, he said.
In the last recession, capital gains tax fell to 3.4% of total general fund revenue growth, according to an S&P report released in January. The exposure to high capital gains tax is in part due to the fact that 1% of taxpayers contributed 47% of personal income tax in 2017, and an above average portion of these individuals income is derived from capital gains, according to the report.
“The forecast depends on a balance of just strong-enough revenue growth to meet ongoing programs, but not so much revenue that it would trigger the state’s constitutional Gann appropriation limit,” S&P analysts wrote in Tuesday's report.
The Legislative Analyst’s Office
“The state needs a “Goldilocks forecast of not too little revenue growth, but also not too much — or high inflation that raises the Gann limit,” S&P analysts wrote.
The deficit forecast by the LAO comes into play because of the combination of state constitutionally mandated spending on education and a requirement to put money into reserves and pay down liabilities that could be triggered at the same time that the state has to return money to taxpayers if the Gann limit is hit.
The LAO
California has the distinction of being among the states with some of the wealthiest residents, but also a significant number who are the nation’s poorest.
One-third of the people in California are on Medicaid, a federal and state program that pays for healthcare for people below a certain income threshold.
“There is more income inequality than other states,” Hitchcock said. “The people on Medicaid are also not paying any tax, which means the people paying taxes are paying a lot at a high tax rate.”
The volatility wrought by the state’s dependence on capital gains and other factors makes it unlikely it could see a boost from Fitch.
“They are in the middle of the double-A category,” Krop said. “Volatility in revenues is definitely an issue. While they have built their reserves higher than they have ever been, they would have to be significantly higher than what they have, but I don’t know what that number would be.”
The state currently has $23 billion in its budget stabilization fund, which is considered full funding at 10% of revenues and allocates $10.4 billion to other operating reserves, Fitch analysts wrote.
