California finance department spokesperson explains how state went from record budget surplus to possible $25B deficit

California is no stranger to economic booms and busts. But 2022 may be a prime example of how quickly and drastically the state's fiscal outlook can change. 

Earlier this year, a historic projected budget surplus of nearly $100 billion allowed Governor Gavin Newsom and the Democratic-led Legislature to expand government programs and financial assistance. 

But a report released by the nonpartisan Legislative Analyst's Office forecasted the state could be faced with a nearly $25 billion "budget problem," an estimate they say is the weakest revenue performance California has seen since the 2008 Great Recession. 

After 2 years of massive surplus, California is facing a $24B budget deficit

This report is only a projection, but how did the state's fiscal outlook change so drastically in just one calendar year? Does it mean a recession is on the horizon? 

To help us unpack all of this, CapRadio’s Insight Host Vicki Gonzalez sat down with H.D. Palmer, who heads the California Department of Finance. The department works with the governor’s office to prepare the state budget every year. Newsom must present the first version of his budget proposal by Jan. 10. 

This interview has been edited for length and clarity.

Interview highlights

On how the state came to a budget shortfall after the governor described last year’s surplus as “without precedent”

He did — and rightfully — shine a light on the fact that our fortunes have been such, our economic growth has been such, our recovery from the COVID recession has been such that we were blessed with a significant surplus. But if you go back to the governor's forecast in his revised budget in May, he said there are a lot of flashing lights out there in the economy. There's a slowdown ahead and we need to be mindful of it. 

So the governor, when he was noting our surplus, said this isn't going to go on forever. In the past in California, when we've been in good times, the governors and legislatures have thought, ‘this is going to go on forever and we can continue budgeting.’ In doing what we've done so far — thinking that we're going to be in good times for a number of years — it's turned out painfully not to be the case.

The governor was very mindful of that back in May. And he said, let's be smart about how we deal with this surplus. And the Legislature agreed with him and they were smart in a couple of areas. 

They chose to pay down debt for prior years, they chose to build up our budget reserves, they chose to continue reducing our long term liabilities like pension obligations. And they chose to use a good chunk of the discretionary part of that surplus on one-time spending, as opposed to building a higher ongoing level of spending. And probably the best example of that in terms of one-time spending is the $9.5 billion in inflation relief payments that have been going out this fall to a total of about 17 million Californians and are continuing to go out and will go out through the end of the year. That's provided some near-term relief for Californians who have been hit hard by inflation, but that's a one-time expenditure on a targeted program where we think it had a very helpful result. 

Because the economy has declined, as the governor suggested that it would, we are looking at a shortfall that's probably going to be somewhat in the range of what the legislative analysts estimate is, about $25 billion. 

On if these dramatic budget projections are normal 

They are for one reason: We have a very progressive tax system in California, and our fortunes are very much tied to the financial markets as well. 

If you look at all of the personal income tax returns that were filed in California in the year 2020, just 1% of the total number of income tax returns that were filed were responsible for more than 49% of all of the personal income tax that was paid in that year. And unlike most of us who get our income from wages and salaries, that very narrow band of taxpayers derives a lot of their income from things like capital gains, stock markets [and] bonuses that are tied to corporate or stock performance. So when the markets are doing very well, those individuals are doing very well and state revenues are doing very well. Conversely, when the markets go south, their fortunes don't do very well and the state's revenues decline as a result. 

On the main sectors driving California’s economic slowdown

I won't get into corporate names, but I think everybody is familiar with a lot of the marquee names where there have been layoffs or reductions in force or there have been indications that those individuals aren't going to receive the stock bonuses that they were going to hopefully receive this year. That community has pared back, some indications are that they over-hired during the COVID recession. Because of what we've seen in those layoffs, we're seeing that drop in our personal income tax revenue. 

And a lot of people may think, ‘well, wait a minute, we keep hearing all these reports that employment in the state is growing, we're adding more jobs.’ In fact, that's the case. We have almost recovered all of the jobs that we lost since the COVID-19 recession took effect. 

The issue for revenues is that when we had those layoffs and cutbacks in that very high tech sector of the economy — that is affected by the stock market more than other areas — that has a more profound impact or more direct impact on our revenues near-term than than other sectors of the economy would. 

They will come back. We go through cycles in the state. We did it with the dot-com bust 20 years ago. It happened during the Great Recession when the subprime mortgage market collapsed. That affected California disproportionately compared to the rest of the country, along with the stock market collapse that happened with it. So we've been through these before and we will come back. But right now we're in a situation where we've got to deal with the shortfall next year. But again, relative to those downturns in the past, we are in a far better position to deal with that.