California Confronts the Gap
— John Hallacy
The state has a long history of closing budget gaps. This time should be no different. The reasons for the gaps vary over time. This time is different due to the delay in tax collections in the state to November of 2023 due to the climate change induced events that had taken place. What is the same factor this time is that capital gains declined appreciably in 2022 into 2023 due to the downturn in the markets. The turnaround for the markets did not take place until late 2023.
Ratings: Strong Liquidity
S&P maintains its AA- stable rating in its recent review. The analysts note the changes in the financial posture in this cycle. Softness in key revenues particularly in PIT command attention in the review. However, it is highlighted how volatility has been present over the long haul. On a positive note, the analysts value the strong liquidity and the sound reserves as required under Prop 2 as real strengths for the state in the credit profile. On the economic front, S&P acknowledges the strong wealth and income indicators for the state. There is some emphasis that there will be a slowing of economic growth in 2025. Despite a strong balance sheet, the raters suggest that the state needs to continue to strive for structural balance. The analysts continue to be concerned about the lateness of the audit. Other concerns include Pay as You Go OPEB funding and Initiative 1935 that has not qualified for the ballot at this point. In conclusion, the economy is viewed by S&P as strong and the financial management is up to the task.
Moody’s has maintained its Aa2 rating with a negative outlook. The primary rationale for the negative outlook is due to a weakened and uncertain revenue environment for the state in their view. The analysts also note an above average leverage and elevated fixed costs. Alternatively, Moody’s also cites strong reserves and ample liquidity.
Fitch maintains an AA stable rating on the state. The raters focus on a robust economy and cyclical revenue growth. Management is cited as having a strong ability to manage over the cycle. Despite elevated current budget challenges, the analysts believe that the state retains a strong gap closing ability. They cite some limitations from the requirements of Prop 98 but note how those requirements ratchet up and down with the revenue performance. Fitch is cautious about the future course for reserves. The analysts will monitor how well the state is able to rebuild financial resilience over time. Fitch is the only rating agency that describes the state’s ESG score as credit neutral. The rating agency also characterizes the long-term liabilities as moderate.
Mind the Gap
The gap in the 2024-2025 budget (or FY 25) is forecasted at $37.9 billion. The approach being taken to close the gap is to draw on the state’s sizeable reserves and to cut spending. With the top bracket for the income tax already at 13.3% there really is no leeway to impose additional increases in the rate. The top three revenue sources of the personal income tax, sales and use tax, and the corporate income tax account for approximately 90% of General Fund revenues.
Approximately half of the Proposition 2 imposed Budget Stabilization Account (BSA)or $12 billion will be drawn down for this purpose. The remaining BSA will stand at $11.1 billion. (The state estimates that the BSA will be increased to $17.6 billion by FY28.) In addition, due to the declaration by the Governor of a “fiscal emergency” the mandated transfer under Prop 2 of $2.1 billion will not be made in the FY25 budget.
Other gap closing measures include a variety of actions. Expenditure cuts of $8.5 billion will be made. Miscellaneous revenues and internal borrowing will account for $5.7 billion. Other tactics include a spending delay of $5.1 billion, a shift of General Fund expenses to Special Funds of $3.4 billion, and deferment of certain expenses to the FY26 budget of $2.1billion.
Revenues in budget year 2025 are estimated at $214.7 billion including the BSA transfer. Expenditures in 2025 are estimated at $208.7 billion including the proposed expenditure cuts. Total reserves at the end of FY25 are forecasted at $18.4 billion or a significant 8.8% of expenditures.
Despite the size and scope of the gap, the state continues to have sound creditworthiness to service its debt. The General Fund debt ratio or debt service to budget is estimated at just 4% in FY 25. The state has $70 billion of general obligation bonds and $7.8 billion of lease debt outstanding that by most measures is considered a reasonable amount given the size and the needs of the state. Pension liability and OPEB exposure is large. Pension liability is being funded on a regular actuarial basis and catch-up funding has been provided. OPEB liability is on a pay as you go basis.
The state’s population is just under forty million. Forecasts for population growth are in the low single digit range. The state did experience a small net outmigration of 144,000 in 2023. Some high-net-worth individuals have left the state but the numbers are relatively small in scope. California personal income is among the highest at 117.7% of the national average at $77,036. Wage growth is forecasted at 3.4% in 2024 and is forecasted at 3.7% in the outyears. Personal Income Tax growth is estimated slightly higher at 4.8% in the outyears especially as markets continue to recover as rates moderate.
The state faces a number of challenges and opportunities on the economic front. The economy is considered to have the fifth largest GDP in the world at $3.6 Trillion. The outlook is for slower job growth but this forecast has not fully considered all the possibilities of job creation in the Artificial Intelligence field. The unemployment rate is running about 1% over the national rate and is expected to increase marginally to 5% in the outyears. Inflation in the state is running about 1% higher than in the nation. The higher level is attributed to higher housing and energy costs. The median sales price of a home peaked at $893,200 in May, 2022. A more recent reading put the level at $822,200 in November, 2023. The change is largely due to the changes in mortgage rates. Housing permits are expected to increase from 119,000 per year to 126,000. Housing affordability has been an issue in the state for some time. Both the state and some of the localities have sold bond issues to produce more housing beyond the standard programs that are in place. On the energy front, the state’s early transition to alternative energy sources and exposure to wildfires among other factors has caused greater prevailing power costs. Given the emphasis on moving away from fossil fueled energy sources, there is not much relief on the rate front expected over time.
Another challenge over time is the MediCal (Medicaid) caseload of 14.8 million. In FY25, $156.6 billion is estimated to be appropriated for MediCal with $35.9 billion of the total being funded by the General Fund. The MediCal eligibility is to be revisited in July of 2024.
The state is estimating $331 million will be required to pay interest on its unemployment liability to the federal government. Approximately $231 million of the total is being paid from the General Fund. As interest rates decline, the state may consider alternatives to address any net liability after federal forgiveness.
At this point, the next event that will be significant is the release of the May Revision in early May. This report will include the last best forecast for economic indicators and other factors anticipated for FY25. With the markets recovering and potentially rallying even more after attaining all-time highs, it is not unreasonable to think that the amount of revenues from capital gains may be adjusted upwards from the 8% of revenues level. Personal income and sales and use taxes may also benefit from additional wealth creation.
Currently, the outlook and creditworthiness of the state remain stable. There is always a possibility that the anticipated gap could widen. Revenues may turn out to be more positive but the expenditure side requires more discovery. The recent transaction was well received by the market.
