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California Warned to Prepare for Fiscal Fallout From Pandemic

California has spent years building up a $21 billion “rainy day” fund to help ride out the next economic slump, but its ability to withstand a pandemic-triggered downturn hinges largely on an unknowable factor.

(CN) – California has spent years building up a $21 billion “rainy day” fund to help ride out the next economic slump, but its ability to withstand a pandemic-triggered downturn hinges largely on an unknowable factor.

No economist or budget analyst can predict how long businesses will stay closed or people will be ordered to stay home to combat the spread of the novel coronavirus Covid-19. But that is precisely the variable that will determine if California can avoid shrinking the size of its government, according to economics experts and budget analysts.

“It really depends on how long we shut down the system,” said Ludwig Chincarini, finance professor at the University of San Francisco.

In a report released Wednesday, the nonpartisan Legislative Analyst’s Office warns a downturn lasting more than two months could pose significant challenges to the state’s budget and force California to start cutting government spending.

“With regard to the broader economy, the odds of a recession have increased substantially within a short period of time,” Legislative Analyst Gabriel Petek wrote in his report.

With the fifth largest economy in the world, California boasted a $3.1 trillion GDP in 2019. But new economic forecasts predict the state’s GDP growth could drop to “near zero or negative” between April and June 2020, according to Petek.

Despite this gloomy prognosis, Assemblyman Phil Ting, who chairs the Assembly Budget Committee, insists the state’s penchant for pinching pennies in recent years will enable California to overcome the impending crisis.

“We’ve been very disciplined in trying not to overcommit to new programs and spending for situations like this,” said Ting, a San Francisco Democrat, in a phone interview.

Ting says the state stands ready to dip into its $21 billion reserve fund to protect social safety net programs that millions of Californians rely on and to avoid the devastating budget cuts that occurred following the 2008 recession.

But with about $12 billion in tax revenue projected each month, a severe drop in tax proceeds could deplete that $21 billion reserve account in a matter of months.

“I would brace for the worst,” Chincarini said. “You want to prepare for bad scenarios. It’s prudent management.”

Jerry Nickelsburg, a UCLA economics professor and director of the school’s Anderson Forecast for economic projections, takes a more optimistic view on the state’s ability to weather the storm. He believes actions taken by former California Governor Jerry Brown and current Governor Gavin Newsom have left the state better prepared to handle an economic slump than any other time in recent memory.

In 2014, Brown was instrumental in getting voters to approve Proposition 2, which requires the state put aside at least 1.5% of general fund dollars each year. Half the money goes to pay down debt. The other half goes to the state’s “rainy day” reserve fund.

In his most recent budget proposals, Governor Newsom also avoided creating new ongoing spending commitments, instead opting for one-time funding to hire teachers, increase tax breaks for working families and put billions toward new housing and homelessness.

Nickelsburg says that combination of austere measures has helped prepare California for an inevitable decline, which Newsom predicted in his most recent budget proposal would likely come soon after a historic 10 ½-year run of economic growth.

“The state is in a much better position today than it has been in the past to address the downturn in revenue in the general fund,” Nickelsburg said.

A “rainy day” fund is especially crucial for ensuring California can withstand an economic slump because unlike the federal government, states cannot borrow money for general expenses. They can only borrow for capital projects like renovating schools and improving roadways, explained Leonor Ehling, executive director of the Center for California Studies at California State University, Sacramento.

“We can’t sell bonds to pay for our ongoing expenses,” Ehling said. “The federal government can do that, which is why it’s so important in a recession that the federal government provide infusions of cash to help the economy.”

California’s progressive tax code, which makes the wealthy pay higher tax rates, can also serve as a kind of double-edged sword during times of economic upheaval. California has the highest uppermost tax rate for capital gains, the term for profit on the sale of stocks, bonds and real estate.

“It’s a kinder tax burden on working families and people who don’t make as much, but it also makes us more reliant on more volatile tax revenues,” said Ehling, who previously worked in various roles for the California Legislature, including for the Senate Research Office and Assembly Budget Committee.

Governor Newsom projected tax revenues from capital gains of about $30 billion in the 2019-20 and 2020-21 fiscal years, according to the Legislative Analyst’s Office. A preliminary study by that office found “a very high likelihood” that capital gains income will fall several billion dollars short of those projections.

Perhaps anticipating this and other strains from coping with the pandemic, Newsom sent a letter to congressional leaders Thursday seeking $1 billion in federal funding "to support our coordinated Covid-19 response and pandemic surge planning and implementation." He also asked President Donald Trump to immediately deploy the USNS Mercy Hospital Ship to the Port of Los Angeles through at least September to handle what he says could be 25.5 million infections statewide if mitigation efforts fail.

Despite major challenges and risks threatening California’s fiscal health, Ehling believes a competent government and multifaceted economy will go a long way in helping the state weather a potentially prolonged economic downturn.

“The positives are that we have a functioning government,” Ehling said. “We’ve got a diverse economy, a big economy. We’re probably in a much better situation than other states which are smaller and less diverse. We’re the fifth largest economy with a GDP of about $3 trillion. We’ve got a lot of advantages so that’s the positive.”

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