California’s budget clean-up
California narrowly averted its own fiscal cliff last week when voters approved a state ballot issue – Proposition 30 – that raised income and sales taxes. Income taxes will increase 3% for seven years on those earning over $250,000, and a supplemental 0.25% sales tax increase will take effect four years. Prop 30 is hoped to generate $8.5 billion in annual revenue and cover about half of the state’s deficit. The other half will be made up through budget cuts.
The state continues to have significant fiscal challenges, but it now has the revenue to meet its commitments through the end of the fiscal year 2013 if the economy stays on track. Fund and ETF manager Blackrock sum it up:
Following several years of fiscal stress that showcased dramatic mid-year deficits, California budgetary shortfalls have narrowed and longer-term structural balance may actually prove achievable.
Voters considerably aided the state’s move toward fiscal health by backing the first statewide tax increase in eight years on November 6. Ironically, that same day, voters also gave Democrats their first supermajority in both the Assembly and the Senate since 1883 — a development that likely would have meant legislative approval of Prop 30, negating the need for a public vote.
Notwithstanding the state’s fiscal complexities, we continue to find value in California munis and remain vigilant in analyzing the risks and opportunities across issuers and credits.
As Blackrock notes, California’s state budget is on stronger footing, but what about the cities and counties? The state has had a very hands-off approach for local governments, but it seems to be shifting gears:
The State of California does not provide any formal fiscal oversight for cities or counties in distress, with a noninterventionist approach that reflects its tradition of local “home rule.” Of late, state officials appear to be revising their thinking. State Treasurer Bill Lockyer recently reported that California is exploring early-warning signals and fiscal tools that it could implement to help locals avoid bankruptcy. We believe headway in structuring an administrative oversight role by the state, with progressive involvement via an advisory and financial support network of state agencies, would be well received by the market.
As the map above from Blackrock shows, there are some California towns that are in very weak condition. But none of them have a lot of municipal debt compared to the state. From Blackrock again:
To date, the market has not exacted an extra risk premium for local California issuers, but market access could come at a higher cost without a better “parental” response. The cases of Stockton and San Bernardino could set landmark Chapter 9 precedent in terms of the treatment of a more robust creditor class that includes public pension systems. (Historically, pensions have been treated as a preferred creditor class. It is unclear whether this will remain so.) Bankruptcy plan negotiations that include CalPERS and result in a local no longer required to make full pension payments may force the state’s hand to become more proactive managers of city and county fiscal affairs.
There is a lot more fiscal adjustment to come in California, but progress continues. Governor Jerry Brown, in leading the tax increase effort, saved the state from falling off its own fiscal cliff. But he shouldn’t put away his budget axe. The state budget still needs reshaping. And Brown seems willing to do it.