California officials eyeing stock market plunge, hope it won't last

Gyrations in the stock market have taken California’s fragile finances for a ride before — when the dot-com bubble burst, when the Wall Street crash sank the national economy less than a decade ago.

So as the market continued its drop Monday, officials began glancing around for their seat belts.

More than most states, California depends heavily on taxing the wealthy, pulling about half its income tax revenue from just 1% of residents in recent years. A sustained, significant fall in capital gains could mean a return to budget crises, and the turmoil on Wall Street is a reminder of that vulnerability.

Gov. Jerry Brown’s administration isn’t ready to sound the alarm, especially since the last few years have been good ones as investment gains translated into rising revenue.

And Brown and lawmakers have taken steps to shore up the state’s defenses since the recession. They've been paying off debt incurred during down years, and stockpiling some revenue from capital gains — one of the least reliable sources of taxpayer money — in a rainy-day fund.

“The governor insisted on putting a good insurance policy in place,” said H.D. Palmer, spokesman for Brown's Department of Finance.

Still, experts have long decried Sacramento's dependence on a tax structure they say is dangerously lopsided.

“The state has done nothing to address the source of the problem, which is the tax system,” said Jeff Cummins, a Cal State Fresno political science professor.

One-tenth of the current budget’s $115 billion in general fund revenue is expected to come from capital gains — compared with 2.7% in 2009, during the depth of the recession. And Brown has repeatedly warned about the volatility of state finances, insisting on conservative revenue figures in the budget as a hedge.

Administration officials estimate that a moderate recession could cost the state $40 billion in income over three years, which would quickly wipe out the $3.5 billion that is expected to be in the rainy-day fund by next summer.

But the governor has also resisted efforts to make changes to the tax code, which probably would require making people who earn less money contribute more.

“I don't know from the political point of view that's very viable,” Brown said earlier this year.

Sen. Bob Hertzberg (D-Van Nuys), who has been working on a tax overhaul proposal of his own, said the recent stock market tumble lends urgency to the need for change.

Broadening the tax base — applying the sales tax to some services, for example — “would soften any major changes in the market,” Hertzberg said.

Stock market problems could also be felt in California’s pension funds. When investment returns don’t keep pace with goals set by state officials, taxpayers may need to fork over more money to cover the difference.

For example, in June 2014 lawmakers approved a three-decade plan for patching a $74-billion shortfall in the retirement system for teachers and other school employees. But that effort relies on hitting a 7.5% investment return; last year the fund had 4.8%, and it has had an average of 7% over the last 10 years.

There’s also the chance that technology firms will delay their initial public stock offerings. Although it’s rare that a single company is big enough to make its presence felt in California’s budget — Facebook’s IP0 in 2012 was an exception — state finances have benefited from robust activity in Silicon Valley.

Gregory Sichenzia, a founding member of securities law firm Sichenzia Ross Friedman Ference in New York, said he’s been involved in two IPOs that were recently halted because of market concerns. Sichenzia expects others would do the same if upheaval continues on Wall Street.

“I think it will hurt jobs,” he said.

Economists say California has enough strengths to help compensate for problems in the stock market at this point.

Stephen Levy, director of the Center for Continuing Study of the California Economy in Palo Alto, said he expects job growth in the state to help generate more sales tax revenue, offsetting any losses in capital gains. Over the last year, California has added more than 490,300 net new jobs.

“Port strikes didn’t derail the economy. The drought didn’t derail the economy. It’s hard to believe the Chinese stock market is going to derail the economy,’’ Levy said.

Senate Budget Chairman Mark Leno (D-San Francisco) said he’s not worrying yet, either.

“A thousand points lost in two days is attention-grabbing, but I think it’s a little early.... It’s not a trend yet.”

Here are some basic questions about the budget and stock market:

Why are the two tied?

In recent years, the state has pulled about half of its income tax revenue from the top 1% of residents, whose incomes ebb and flow with the unpredictable stock market. Even mild economic ripples can cause big waves in Sacramento.

How would a major economic downturn hit the budget?

If the next recession comes relatively soon and is relatively severe, it could cause new budget shortfalls, force cuts in government services again and derail the state's efforts to tackle some of its deep-rooted financial problems.

In short, it could present a situation like the one Brown inherited when he took office in 2011.

It's a thorny political problem for the governor, who began his final term in office in January and has been widely credited with steering the state out of a series of damaging budget crises.

He faces constant pressure from activists and fellow Democrats to increase spending on such programs as state-subsidized child care, but he has resisted adding a lot of permanent expenses that may not be sustainable.

What about Brown's "rainy day" fund?

The fund was strengthened by voters in November, requiring officials to stash away a portion of California's revenue each year. By next summer, it could contain up to $3.5 billion, according to an estimate from legislative analysts.

But if a downturn occurs then, that savings would cover only a tenth of the potential revenue loss under the governor's recession scenario.

Isn't the economy in California seen as improving?

Yes, by many measures.

The state's unemployment rate fell to 6.2% from 6.3% in June — its lowest level in more than seven years.

Technology companies in Silicon Valley have driven a lot of the state's growth in the last few years. Facebook's initial public offering in 2012 was so big that legislative analysts took the unusual step of including the company as a factor in their financial estimates.

Other areas of the economy have also bounced back.

But economists conceded that it can be hard to see downturns coming.

Times staff writer Patrick McGreevy contributed to this report.

Twitter: @chrismegerian

Copyright © 2017, Los Angeles Times

UPDATED

1:30 p.m.: This story has been updated with comments from Gov. Jerry Brown and economist Steve Levy.

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