California’s tax revenue shortfall a preview of potential challenges in other states

Many of the slew of bills California Gov. Gavin Newsom (D) recently vetoed, such as legislation that would have required school districts to offer full-day kindergarten, came with the same explanation.

“With our state facing lower-than-expected revenues over the first few months of this fiscal year, it is important to remain disciplined when it comes to spending, particularly spending that is ongoing,” the veto messages say.

California may be the only state where revenues are coming in lower than expected. Elsewhere, tax collections this fiscal year, which for most states began July 1, are still surging above the estimates lawmakers used to plan state spending.

Still, state lawmakers nationwide are bracing for tax revenues to decline as the economy stalls. And as the Federal Reserve hikes interest rates, the stock market slumps and the war in Ukraine drags on, some fear the economy is on the brink of a recession.

States are better prepared for a downturn than they were in the past, as they’ve been able to use the past few years of revenue growth to build up budget reserves and pay down debt. But a recession could potentially force state leaders to abandon plans for new spending or cut funding for certain services.

California collected about $2 billion less in tax dollars than expected since July 1, an 8.4% shortfall. It also ended last fiscal year with about $2.2 billion less than anticipated.

By comparison, tax revenues in Washington State since June have come in $113.4 million higher than expected, a 1.7% difference; Indiana revenues beat expectations by $200 million, or 7.4%, in July and August; and Arkansas revenues beat expectations by $46 million, or 4.4% over the same period.

Nationally, low unemployment, rising wages and the rising cost of goods are helping to buoy tax revenues. California officials say their lower-than-expected tax collections in recent months are most likely driven by the state’s wealthiest residents paying less in taxes than anticipated.

“We think some of the weakness that we’re seeing with the income tax, in particular, probably is more tied to financial markets — both directly and indirectly,” said Brian Uhler, deputy legislative analyst for economy, taxes and labor at the California Legislative Analyst’s Office, which advises the Legislature.

California’s budget is particularly vulnerable to stock market swings as it relies heavily on income taxes paid by wealthy residents. Many of those people earn a large share of their income from stock options, capital gains and other income tied to financial markets.

“The fortunes of a relatively narrow band of taxpayers in California can have a significant, outsized effect — up or down — on our revenue,” said H.D. Palmer, deputy director for external affairs at the state Department of Finance.

The state drew almost 45% of its personal income tax money in tax year 2019 from just the top 1% of filers, according to the agency. Last fiscal year, when the stock market was booming, the agency estimates capital gains income comprised almost 13% of all general fund tax revenues.

Palmer also noted that California-based tech companies and startups have laid off workers in recent months. Those layoffs could also have driven down personal income tax payments, he said.

Other states with a similar tax structure, such as New York and Connecticut, will also feel the stock market slowdown. But so far, the impact beyond California is murky.

New York’s fiscal year began April 1. Since then, the state has collected about $2.4 billion more than budget writers expected, almost entirely due to strong personal income tax payments, according to data provided to Pluribus News by the state Comptroller’s office.

Gov. Kathy Hochul’s (D) administration is currently expecting a $2.3 billion general fund surplus for this fiscal year (New York’s budget this year was $220 billion).

Still, the New York Division of the Budget is expecting income tax receipts to ultimately come in lower this fiscal year than last year. And it’s expecting a $310 million budget gap in fiscal 2024, due primarily to flagging revenues.

“We’re expecting a number of different tax revenue streams to go down for the next fiscal year, and the year after that,” said state Sen. Liz Krueger (D), who chairs the New York Senate Finance Committee.

Krueger said she doesn’t see any reason for panic, but she’s glad the legislature this year moved to bolster the state’s rainy-day fund.

“You never know when a rainy day is going to happen in annualized budgeting,” she said. “So we may need that sooner than later.”