California’s revenue rollercoaster hits another blip

The California Legislative Analyst’s Office’s projection of a potential $25 billion deficit in fiscal 2023-24 isn’t likely to change analysts’ ratings outlook on the state.

“Our rating assumes volatility through the cycle,” said Karen Krop, a Fitch Ratings senior director. “We understand California’s reliance on capital gains and that is baked into the rating.”

The state holds a Aa2 rating from Moody’s Investor Service and a AA rating from Fitch, while S&P Global Ratings assigns a AA-minus rating. Moody’s and Fitch have stable outlooks. S&P affirmed in August the positive outlook, it assigned in September 2021.

The revenue forecast in the adopted fiscal 2023 budget is based on the state’s May 2022 forecast, which may prove optimistic based on recent economic trends, S&P analysts wrote in August. “In particular, 62% of budgeted state general fund revenue comes from personal income tax, and about half of PIT is derived from the top 1% of state taxpayers, including their high proportion of income from capital gains.”

This dependence on capital gains means one of the state’s largest revenue source bounces up and down with the stock market. The state’s other two major sources of revenue are corporation and sales tax.

“The state faces a $25 billion budget problem and ongoing deficits,” the LAO wrote in the report released Wednesday. Under its outlook the Legislature would face a $25 billion deficit in 2023-24, according to the LAO.

The anticipated shortfall “is mainly attributable to lower revenue estimates, which are lower than budget act projections from 2021-22 through 2023-24 by $41 billion,” the LAO wrote. The LAO also estimated that annual deficits would decline to $17 billion and $8 billion in subsequent years.

Though the state’s budget boasted a $97 billion surplus for fiscal year 2021-22, revenues have been off for most of the third quarter.

The LAO typically crafts a forecast in November that guides lawmakers as they prepare to craft a budget. The governor introduces a preliminary budget in mid-January, and then lawmakers dig into the budget and the governor releases a budget revision in May. This process gives the state time to make adjustments if revenues come in below expectations, before the final budget is signed by the governor on July 1.

Analysts also noted the LAO’s forecast is an early one looking at the balance of the year, and projecting into early next year.

“Our GO rating outlook on the state of California is currently positive,” said David Hitchcock, an S&P senior director. “The $25 billion projection … is the LAO’s projection, not from the state’s Department of Finance, and is a projected budget gap for fiscal 2024, including potential shortfalls in fiscal 2023, for which the state has not yet enacted a budget.”

“It is not uncommon for a state to have projected out-year budget gaps in the future that are expected to be closed in subsequent budget sessions, and California’s five-year financial projections have often showed future projected budget gaps that will need to be closed in subsequent years.” Hitchcock said. “To the extent that a 2024 budget deficit is projected when the January executive proposal is released, and in the May revise projection, we will monitor the adequacy of current reserves to cover current year shortfalls, and the structural nature of the state’s budget closing proposals for the following year.”

Fitch has commented on the fact that revenues have been reported down the past few months, but this is coming off of two years of extraordinary revenues, Krop said.

“The state has done things like applying one-time revenues to one-time spending,” Krop said. “They have put extra money toward pensions, and they set aside funds in the budget to cash-refund GO bonds, and they did a pay-go financing.”

The state has $22 billion of projected one-time spending for next year, which could potentially provide some cushion in fashioning next year’s budget, Hitchcock said.

“The size of a projected deficit should also be put in context with the large size of the state’s general fund, whose enacted fiscal 2023 budget appropriates $234 billion of expenditures, and projects $37 billion of total budgeted reserves at fiscal end 2023,” Hitchcock said.

There are things they can change if they have a shortfall come January, or even in May, during the budget revision if the LAO’s forecast proves true, Krop said.

“They could issue bonds, instead of doing pay-go on projects, or not continue to pay down bond debt,” she said. “It should be expected after two years of enormous growth that there would be some pull-back in revenues, and we think the state has the flexibility to deal with that, not to mention the rainy day funds.”

As of now, Moody’s “opinion on the state has not shifted and has long incorporated the risks associated with the state’s revenue structure and potential volatility,” said Matthew Butler, a Moody’s vice president/senior analyst.

“Year-to-date fiscal 2023 revenue has lagged the state’s expectations and could force unexpected budgetary decisions if it continues to underperform,” Butler said. “At the same time, state budget reserves, which have been built up over the past several years, could soften the blow of continued revenue underperformance.”