California’s budget whiplash: From a record-setting surplus to a massive shortfall in one year

California collects taxes to fund state programs. The kinds of taxes the state relies on to fill its coffers has changed over time, and that has increased revenue volatility. The state’s major revenue sources have shifted from retail sales and use taxes making up the bulk of major revenue to personal income taxes.

Here is a breakdown of some of the major revenue sources:

Personal Income Tax

California has a progressive income tax, where the state’s top earners pay at a higher rate and provide a bulk of that tax revenue. Over the years, income taxes have become the largest major source of general fund money. Capital gains — money made from investments such as stocks — is also taxed, but that stream of revenue is highly volatile. We’ll talk more about that in a moment. 

Corporate Tax

There is a flat 8.84% tax on the gross taxable income of businesses and corporations doing business in California, excluding some types of business such as sole proprietors and partnerships. Other rates apply to certain types of businesses, such as financial institutions. 

Starting in the 2021 tax year, Californians who are shareholders of S Corps. or who have business partnerships could pay into a newly created tax, which effectively allows them to get income tax credits. This has shuffled what could have been income tax revenue into corporate tax revenue as far as the state is concerned, while allowing those individuals to get around federal deduction limits on state and local taxes passed in the Trump administration. 

Retail Sales and Use Tax

This tax covers the purchase of most physical merchandise — including vehicles — regardless of whether the merchandise was bought at a physical store in California or an out-of-state retailer. While the current statewide sales and use tax rate is 7.25%, that rate can be higher depending on additional taxes levied by cities and counties. Of all the major revenue sources, this one continues to shrink over time.

When Gov. Gavin Newsom was asked to explain how the state has a record surplus one year and has to make budget cuts the next, he answered “progressive taxation.” He was referring to the way California’s tax law is structured so that wealthy residents pay far more than anybody else. In fact, the top 1% of income earners paid nearly half of all personal income taxes in 2021, according to the governor’s recent budget proposal.

And the state relies heavily on capital gains — the profit a person gets when they sell stock for a higher price than they bought it for — of those wealthy folks more than ever. In 2021, a record-setting year for the stock market, capital gains accounted for 11.3% of personal income in the state. That’s good when the financial markets are doing well, but shocks to the income of this relatively small group of taxpayers can have a significant impact on the state’s revenue.

In putting together a budget, legislators pay attention to the end-of-the-year balance — the difference between expenses and available tax revenue and the previous year's ending cash on hand. The state has a budget surplus when the difference is positive and a deficit when it's negative. That number is usually a big number, but small relative to the overall budget. But that all changed with the COVID-19 pandemic, as emergency expenses soared along with tax revenue and federal assistance. The average ending balance from 2006 through the 2019-20 fiscal year was a surplus of about $2.8 billion; for 2020 through 2022-23 it was more than $37.5 billion.

In 1979, voters approved a limit on how much money the state can spend each year — beyond how much is in its bank account. Proposition 4 created the state’s spending limit, sometimes called the “Gann Limit,” which says that if the state’s tax revenues increase too quickly for two consecutive years, the government has to either change tax rates, reduce spending or give taxpayers a rebate. The check-cutting isn’t triggered often, but it was the reason thousands of California families making as much as $75,000 a year got Golden State Stimulus checks in 2022 so that the state wouldn't exceed the Gann Limit in 2020-21 and 2021-22 fiscal years.

Since voters enacted Proposition 98 in 1988, the state is required to fund K-14 education at a minimum level based on which of two tests is higher — about 40% of general fund revenue for the year, or the previous year's Prop. 98 funding, adjusted for student attendance and the per capita income of Californians. How much general fund revenue needs to be spent is based on how much money school districts receive from local property taxes: More property tax revenue means less general fund money is required to provide the minimum level of funding. 

What does this mean in the context of revenue volatility? 

It means each year, some portion of the general fund will have to go toward making up what local property taxes can't provide for school funding. And that amount is tied to other complex factors that can make budget planning difficult and lock out a chunk of revenue from being spent on other priorities, including plugging budget holes. 

And the formula for determining the minimum level of K-14 education funding keeps changing as new requirements are added. For example, voters passed Proposition 28 last year, which guarantees an additional 1% of what Prop. 98 provides toward arts and music education. That's estimated to be an additional $941 million in this year's budget.

There are a few ideas floating around to help stabilize general fund revenue through new taxes, or the modification of existing tax relief. 

“Split roll”

Proposition 13, approved by voters in 1978, established rules on how and when residential, commercial and industrial property can be assessed to determine how much in taxes is owed to local governments. Prior to this, local property taxes paid a larger share of K-14 education, but after the passage of Prop. 13, it fell on the state to offset spending, particularly after Prop. 98 was approved by voters ten years later. 

While property values across the state have been climbing for decades, local governments don't capture that value through taxation for homeowners who sit on their property. If you bought a home in 1990 and never left, you are paying property taxes based on the assessed value that year even if the house is worth, say, three times as much today. 

One solution to relieving the funding pressure put on the state's general fund to pay for K-14 education is by assessing taxes on most commercial and industrial properties based on market value, essentially removing the tax relief Prop. 13 offers them. This is called "split roll" and a recent attempt to have voters pass this lost by 3 percentage points in 2020. If it passed at the time, large commercial and industrial entities could have provided an estimated $6.5 billion to $11 billion a year for local governments and school districts, a boon that surely could offset Prop. 98 spending from the general fund. 

Service taxes

In 2016, then-State Controller Betty Yee published a comprehensive report exploring alternative tax reforms to generate new income. One proposal called for expanding the state's sales and use tax to include services, such as going to the doctor, using an accountant's services, or getting your hair done. Since more and more of the economy relies on services, the current sales tax regime was seen as outdated. 

This was proposed by then-state Sen. Robert Hertzberg, and it could have generated an estimated $10 billion a year in additional revenue. It didn't pass, but Hertzberg continued to push the issue for years, albeit in different ways. Ultimately, none of the proposals panned out.

Changing spending habits

Due to how volatile revenue has become, how the state spends money has also changed in two important ways. One is a focus on one-time spending obligations instead of multiyear spending on state programs. This was a tactic used during the last budget negotiations, where the state was flush with cash.

Another approach is the state's rainy day fund, basically a voter-approved savings account the state is required to invest in each year to weather an economic downturn when it inevitably happens. This became popular after the Great Recession saw deep program cuts when the state was facing down deep deficits.