Just three years after taking office and inheriting a $26.6 billion budget deficit, Governor Brown now has a projected general fund SURPLUS of more than $5 billion. It may be more, depending on how you count it, and the amount of cash received between now and May, when the economic forecast and budget is revised and finalized. Year to year revenue growth of the $100 billion general fund is projected at 6% or $6 billion dollars, but December estimates are already $2.3 billion higher than previously projected. Under current estimates, the year-to-year gaps between spending and revenues have been erased for the foreseeable future. Strong stock market performance is driving significant increases in capital gains and this is driving a revenue bonanza for the state of California. The stock market surge, combined with the November 30, 2012 passage of Proposition 30 that raised personal income tax (PIT) by 3% on the wealthiest taxpayers in the state, is responsible for this surplus. Top PIT bracket payers in California now pay 13%.

What Does History Tell Us? The state’s fiscal history is riddled with budgets that made permanent spending increases and tax cuts based on temporary revenue increases driven by capital gains. After these spikes in revenues disappeared, as they always do, the state has been forced to cut programs and raise taxes.  This boom bust cycle is exacerbated by the fact that 2/3’s of all general fund revenues come from the PIT and almost 50 percent of all PIT collected in the state come from only one percent of the taxpayers.  So when a handful of highly affluent individuals gets a financial cold, the state budget gets a severe case of influenza – or worse. And that is what happened to previous governors when the capital gains tax bubble burst – they had a fiscal roller coaster on their hands.

Despite the recent improvements in California’s budget situation, there remain a number of major risks that threaten the state’s new found fiscal stability, including billions remaining in budgetary debt, hundreds of billions of dollars in longer term liabilities for unfunded state employee retiree health care and pensions, as well as demands for new program spending. In addition, a quarter-cent sales tax increase under Proposition 30 will expire at the end of 2016, and the higher income tax rates on the state’s wealthiest residents will expire at the end of 2018. The combination of the fleeting capital gains surge and the temporary Proposition 30 revenues should leave no doubt that the state’s current surplus must be carefully guarded or fiscal ghosts of budgets past will haunt California.

So, What Can We Expect Out of Sacramento in 2014?  Governor Brown introduced his state budget on January 9, 2014 and provided a road map for the Legislature to follow for what the Governor believes will keep the state finances on track. His plan includes fully funding all current state government commitments to education, health and welfare, public safety and environmental and natural resources programs. He also proposes some modest restorations of previous cuts in health and welfare and education spending. In addition, he proposes to take the projected $5 billion surplus and pay off bond debt early & build a rainy day fund ($3.2 billion), increase discretionary higher education spending ($1.2 billion), prepay various state loans, pay down deferred maintenance costs in various areas like transportation and state parks as well as addressing other state liabilities. The key element to the Governor’s surplus allocation proposal is to make each one of the initiatives “one-time” in nature and not commit the state to on-going future spending it cannot afford.

The pressure to increase state general fund expenditures is enormous and the majority party in the Legislature is inclined to expand existing programs and create new ones. Many in the Capitol tend to see this temporary budget surplus as an opportunity to achieve their policy and spending agendas. For example, on January 7th, 2014 the Senate majority caucus introduced legislation that would make all four-year-olds in the state eligible for pre-kindergarten classes. This proposal, when fully phased in, will cost the state over $1 billion annually in new general fund spending.  It is these types of new spending commitments, made when times are good, that drives the fiscal roller coaster of boom-bust cycles in state budgets.

How Does Governor Brown Avoid Repeating History?  Maintaining the new found fiscal stability will require considerable restraint. There are numerous risks, each of which could hit the state’s budget to the tune of hundreds of millions, or billions, of dollars. These include the threat of future recessions, changes in federal spending policy, on-going litigation related to redevelopment and other programs, and so on. As part of his 2014-15 budget plan, the Governor has proposed to put a constitutional amendment on the next ballot. It would divert peak capital gain revenues, like we have had in the past and which are currently projected, away from the general fund and deposit them instead into a rainy day fund so legislators and future governors could not commit them to ongoing program spending. It would make sure the funds stayed in the rainy day account unless and until it was actually “raining” and California needed the funds to stabilize the budget in times of economic downturn. This proposal, like previous attempts made by past governors, will be subject to being “watered down” by the various spending interests in the Capitol that do not favor additional controls on spending. It will be a fiscal battle with very high stakes. We believe the most likely scenario is that the current surplus of around $5 billion will grow even more before budget negotiations are completed. This will likely increase pressure on the Governor to cave in to more permanent spending demands by the Legislature.

Governor Brown will have to use all of his political and negotiating skills to avoid history repeating itself.