The Great Recession and California's Recovery

December 2018 The Great Recession and California’s Recovery MAC TAYLOR, LEGISLATIVE ANALYST LEGISLATIVE ANALYST’S OFFICE Ten Years Ago… On December 31, 2008, Governor Schwarzenegger’s proposed budget projected a $42 billion deficit. This shortfall was stunning, but, in fact, it turned out to be optimistic. A few months later, the Governor’s deficit projection was $15 billion larger. In the subsequent weeks, the Governor released two more revised budgets, each one addressing larger shortfalls. In the months that followed, California was called “ungovernable,” “a wreck,” and a “failed state.” Today… California’s fiscal position today is dramatically different. Last year’s budget enacted a higher level of reserves than the state has seen in decades. In recent years, the Legislature and Governor have taken action to address many of the state’s outstanding debts and have passed budgets that have consistently increased savings. While California’s budget still faces challenges, the state has made undeniable progress. Few could have predicted this turnaround. So how did the state achieve this feat? Here, we tell the story of the California budget over the last ten years. 1 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE California Enters the Great Recession With No Reserves When California entered the Great Recession at the end of 2007, it faced a deteriorating revenue picture with effectively no reserves. The Legislature passed the 2007-08 budget in August of 2007, but by November, our office was already warning that the revenue situation was weakening due to slowing property tax collections and cash receipts that were falling short of projections. While the state believed it had a year-end surplus of $4 billion in August, by November, before the recession had even officially began, our office How to Read This Report projected the state faced a $2 billion deficit. The coming recession would be the second largest in state history, resulting in formidable Timeline events in this report are categorized year-over-year revenue losses and budget shortfalls of tens of billions of into the following five areas: dollars in each year. The state also entered the Great Recession with its budget fundamentally misaligned. At the end of 2007 and in the years before, our office’s Bond Rating projections indicated long-term spending exceeded projected revenues. Budget Related This meant that, even though the state passed budgets that were balanced for the upcoming fiscal year, the budget faced projected Economy “operating deficits” in future years. 2007-2018 LAO Projected Operating Shortfalls in Federal November 2006 Government (In Billions) Voters -$2 -4 -6 -8 06-07 07-08 08-09 09-10 10-11 11-12 2 3 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE Lasting Effects of the Dot-Com Bust In part, the state entered the Great Recession without reserves because it never fully recovered from the last recession—the dot-com bust of the early 2000s. This recession was short-lived, but had an outsized impact on California’s budget. This was primarily because the recession originated in the technology sector, which played (and continues to play) a large role in the state’s economy and budget. The revenue declines were striking: year-over-year, revenues from California’s tax on personal income—its History of the S&P 500 largest revenue source—declined nearly 30 percent in 2001-02. 1,500 AUGUST 24 OCTOBER 9 Governor Schwarzenegger The S&P 500 closes at a record 1,000 signs the 2007-08 budget, high of 1,565 (the highest close which anticipates ending the prior to the 2008 financial crisis). To address the sharp revenue shortfalls of the dot-com bust, the state year with $4 billion in reserves. relied heavily on borrowing and short-term solutions. For example, in 2004 the voters allowed the state to issue $15 billion in Economic DECEMBER 500 2007 Recovery Bonds, which carried debt service costs ranging from $1.5 billion According to official government statistics, the Great Recession begins. to nearly $3 billion per year. The state also issued bonds for future tobacco settlement receipts and deferred education expenses. 2006 2007 2008 Each of these actions addressed budget deficits in the short term, providing the state with a temporary infusion of money and allowing it to DECEMBER 21 spend at higher levels than could be supported by current-year revenues. Sales of new and existing homes in California decline 39 percent However, the state failed to pair these borrowing plans with ongoing relative to the prior year. changes to address the shortfalls. As a result, the imbalances persisted. A year before the Great Recession began, the state faced ongoing operating shortfalls of billions of dollar‘s. 07 4 5 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE Budget Shortfalls Keep Growing Larger JULY 30 President Bush signs the Housing and Throughout the Great Recession and years that followed, budget Economic Recovery Act of 2008. projections were repeatedly revised downward. Sometimes SEPTEMBER 15 these revisions occurred only months, or even weeks, apart. On Lehman Brothers files for bankruptcy September 23, 2008, when Governor Schwarzenegger signed the SEPTEMBER 15 2008-09 Budget Act, General Fund revenues were expected to total The Legislature passes (and the Governor later $102 billion. Two months later, our office warned these revenue estimates signs) the 2008-09 Budget Act with $16 billion were off by $5 billion. A year later, the state had revised this estimate in budget solutions. FEBRUARY downward to $84 billion—$18 billion less than originally estimated. In a special session, OCTOBER 3 the Legislature President Bush signs the Troubled Asset These continual changes reflected the rapidly deteriorating economic adopts mid-year Relief Program into law. conditions, and later, a relatively slow recovery. Moreover, budget problems revisions to the occurred each year during this period because the state took numerous 2007-08 budget NOVEMBER 6 one-time or temporary actions to address what was an ongoing budget providing $7 billion The Governor calls a special session to in budget solutions. address a major budget deterioration that problem. As a result, the Legislature would pass a budget closing the occurred in the six weeks since the budget deficit in one year, but the problem would reemerge in the next year when was passed. The administration projects the the actions expired and ongoing spending continued to exceed revenues. budget faces a year-end 2008-09 budget problem of $22.5 billion, nearly entirely due to a deteriorating revenue situation. 2008 DECEMBER What Is a Budget Solution? Fourth quarter gross domestic product decreases at an annual rate of 6.2 percent. When the state’s budget faces a shortfall or deficit (meaning that state DECEMBER 16 expenditures exceed resources available) the state must adopt “solutions” The Federal Reserve reduces short-term to address the problem ‘and bring the budget into alignment. These interest rates to 0 percent for the first 08 solutions can include revenue increases and expenditure reductions, as time in U.S. history. well as actions that allow the state to borrow or shift costs. DECEMBER 18 The Legislature passes a budget package addressing a portion of the shortfall. The Governor vetoes the package. 6 7 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE California’s Cash Crisis Throughout the course of a normal and healthy fiscal year, the state State’s Available Cash in 2008-09 collects more money than it spends in some months and spends Neared Minimum Levels more money than it collects in others. (For example, the state collects (In Billions) much more money than it spends in April when income tax returns are due.) These normal, seasonal cash flows mean that the state often must borrow—either internally or externally—to ensure it can pay its bills on $40 time. When the state has insufficient internal resources to cover these expenses, it sells short-term bonds to investors, providing an infusion of cash that the state repays by the end of the fiscal year. 35 In the fall of 2008, however, the state faced a cash crisis. The Legislature 30 passed the 2008-09 budget on September 15, the same day Lehman Cash Cushion Brothers filed for bankruptcy. In the following weeks, the state approached in 2017-18 the bond market for cash flow borrowing and found the U.S. credit 25 market had frozen, partly in response to the uncertainty following Lehman Brothers’ collapse. On October 3, Governor Schwarzenegger wrote to the 20 Secretary of the Treasury alerting him to the possibility that California might ask the federal government for short-term financing. 15 In the days that followed, the state underwent a campaign to encourage Californians to aid the state by purchasing short-term bonds through 10 brokerages. This included radio advertisements, which featured Governor Cash Cushion Schwarzenegger urging Californians to invest in their state. The campaign in 2008-09 was unexpectedly successful and the state raised $5 billion—more than it 5 Target Cash Minimum initially planned. On October 9, the Governor again wrote to the Treasury Secretary, this time to express optimism that no federal loans would be required. Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun In the months and years that followed, the Governor, Legislature, and ‘ State Controller took extraordinary actions to address the state’s cash 08 crisis over the short and long term. These included issuing IOUs to cover state expenses, deferring payments to schools and local governments, and making state funds more accessible for internal borrowing. But the most important remedy to the cash crisis, over the long term, was to balance the state’s budget. 8 9 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE JULY 24 The Legislature adopts (and the Governor FEBRUARY later signs) revisions to 2008-09 and The California unemployment rate reaches 10 percent. 2009-10 budgets which include an 12% additional $24 billion in solutions. California 10 Unemployment JUNE 8 According to government statistics, the FEBRUARY 1 Great Recession officially ends. Aug The Governor’s plan to furlough state employees 2004 6 by two days per month goes into effect. MAY 29 4 Aug The Governor releases a third May Revision FEBRUARY 2 2018 proposal in response to our office’s lower revenue estimates. Cumulatively, the Governor 2 Standard and Poor’s (S&P) lowers estimates the state’s shortfall is $24 billion. California’s bond rating from A+ to A. OCTOBER FEBRUARY 17 The U.S. unemployment rate 2009 President Obama signs the reaches 10 percent (the California American Recovery and Reinvestment Act. unemployment rate is 11.8 percent). MAY 26 The Governor releases a second May Revision proposal to avoid using budgetary borrowing to FEBRUARY 19 address a portion of the shortfall. The Legislature passes (and the Governor later signs) the 2009-10 budget package a few months MAY 19 early. It includes $42 billion in budget solutions. Voters reject Propositions 1A through 1E, which would have made a variety of changes to help balance the budget, including raising revenues and allowing the state to borrow from the state lottery. To address the failure of these measures, FEBRUARY the administration proposes an additional $7 billion in alternative budget solutions. The State Controller delays over $3 billion in scheduled payments. ‘ MAY 14 09 Governor Schwarzenegger releases a May Revision identifying a MARCH 9 new $15.5 billion budget problem for the end of 2009-10. Most The S&P 500 closes at 676, of this budget problem is related to projected drops in revenues. its lowest point during the financial crisis. 10 11 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE Help From the Federal JANUARY 8 Governor Schwarzenegger releases a 2010-11 Government budget proposal identifying a $19 billion shortfall. JANUARY 13 Two key pieces of federal legislation helped California’s budget and cash S&P lowers California’s bond rating from A to A-. position during the Great Recession. First, the federal Troubled Asset Relief Program helped support some of the nation’s largest lenders during MARCH the financial crisis. This created more liquidity in credit markets, easing The Legislature passes (and the Governor later signs) several special session bills that reduce California’s cash crisis by indirectly contributing to the state’s ability to General Fund expenditures by $1.2 billion. borrow. Second, the American Recovery and Reinvestment Act injected significant MARCH 23 federal funding into California at the time of the state’s worst budget President Obama signs the Patient situation. Between 2007-08 and 2009-10, while state spending dropped Protection and Affordable Care Act into law. significantly, federal spending increased substantially, which helped the state maintain overall spending, even as state revenues experienced 2010 massive declines. Federal Funding Increased JULY 22 President Obama signs a six-month While General Fund Spending Declined extension of emergency jobless benefits (Year-Over-Year Change, in Billions) for the long-term unemployed. $20 OCTOBER 8 The Legislature approves (and the 15 Governor later signs) the 2010-11 budget. 10 It is the latest budget in state history and includes $19.3 billion in solutions. 5 NOVEMBER 2 Voters approve Proposition 25, which changes the vote threshold for the -5 budget from two-thirds to simple General Fund majority. Voters also approve -10 Federal Funds Proposition 22, which restricts the -15 state’s authority to use or redirect state 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 fuel tax and local property tax revenues. The federal government also initially considered taking the extraordinary Majority Vote Budgets action to help California directly with its fiscal situation (for example, with a loan). Eventually, the federal government decided against it. On June 16, Before 2010, the constitutional vote threshold for passing budgets and 2009, the Washington Post reported that Obama administration officials raising taxes was a two-third majority. Proposition 25 eliminated the had “decided that California could hold on a little longer and should get its two-thirds vote threshold for passing budgets. Since 2011, the Legislature budget in order rather than rely on a federal bailout.” can enact budgets by majority vote. 12 13 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE Structural Changes to the Budget Many of the actions the state took in response to budget shortfalls post-2008 were one time or short term in nature. However, the state also made some long-term changes that have lowered the growth rate of JANUARY state spending (or increased the growth of state revenues), resulting in the The California unemployment rate begins to fall state’s better budgetary position today. (from 12.2 percent to 12.1 percent). Shifting Some Programs to Local Governments. In 2011, the state JANUARY 10 government shifted responsibility (and funding) for some criminal justice, Governor Brown releases his first budget (of his new term) behavioral health, and human services programs to local governments. This shortly after assuming office. The budget estimates a problem of $25.4 billion for the end of 2011-12. saved the state money by: (1) moving certain felons from high-cost prisons to less expensive jails at the county level, (2) requiring local governments MARCH to spend a portion of local revenues on these programs, and (3) creating The Legislature passes the first iteration of a incentives for counties to control programmatic costs. It also reduced the budget bill for 2011-12 by majority vote under the new requirements of Proposition 25. (This minimum funding requirement for schools and community colleges. budget bill is not signed.) Dissolving Redevelopment Agencies. Prior to 2012, cities and JUNE 15 counties could create redevelopment agencies to address urban blight. The Legislature passes a Redevelopment agencies received property tax growth from all the local second budget bill. governments—city, county, special districts, and schools—within the designated areas of the agencies. Due to constitutional requirements for school funding, redevelopment agencies created state costs by increasing the amount of General Fund required to go to schools. In 2011, the Legislature passed a package of bills to limit redevelopment agencies. Due to subsequent litigation and a Supreme Court decision, however, JUNE 16 redevelopment agencies ultimately were dissolved completely. As a The Governor vetoes the second budget bill. result, property tax revenue that had gone to the redevelopment agencies JUNE 28 increasingly is going to local governments. This reduced state costs for The Legislature passes (and the Governor schools in 2017-18 by $1.5 billion. later signs) the 2011-12 budget package, which includes $27 billion in budget solutions. Increasing Personal Income Tax Rates at the Top. In 2012, voters approved Proposition 30, which temporarily increased the state sales tax AUGUST 5 rate for all taxpayers and the personal income tax rates for upper-income S&P downgrades U.S. credit taxpayers. In the few years after voters passed it, Proposition 30 increased rating for the first time in history. revenues by roughly $7 billion per year. Increasing Reserve and Debt Payment Requirements. In 2014, voters approved Proposition 2, which requires the state to set aside minimum amounts each year for reserves and debt payments. By taking money off the top and using it either for savings or paying off debt, the measure lowers ongoing spending. 14 15 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE JANUARY 5 Governor Brown proposes a budget package for 2012-13, which estimates a $9 billion budget problem. FEBRUARY 1 JANUARY 10 All redevelopment agencies in California are dissolved. Governor Brown proposes the 2013-14 budget. It is the first budget introduced in six years that does not MAY require budget solutions to close a shortfall. The administration revises its estimate of the budget problem upward to $16 billion. JANUARY 31 MAY 18 S&P raises California’s credit rating from A- to A. The social networking company Facebook holds its Initial Public Offering. At the time, our office estimated this would give the state an additional $2.1 billion in revenues. MARCH 1 JUNE 15 Automatic budget cuts known as The Legislature passes (and the Governor “sequestration” take effect. later signs) the 2012-13 Budget Act with $16 billion in budget solutions. 2012 2013 APRIL 10 SEPTEMBER 12 The S&P 500 hits a new all-time intraday The Governor signs the Public Employees’ Pension record high of 1,589, surpassing the Reform Act into law, which made significant changes previous record on October 11, 2007. to California governmental employee pension benefits. SEPTEMBER 15 JUNE 14 Amazon.com begins collecting California sales tax. The Legislature passes (and the Governor later signs) the 2013-14 budget package, NOVEMBER which enacts a reserve level Voters pass Proposition 30, which of slightly more than $1 billion. increased personal income tax rates for high-income taxpayers and sales tax rates. DECEMBER The California unemployment rate falls below 10 percent. 16 17 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE New Rules for the State’s Rainy Day Fund JANUARY 9 Governor Brown releases a 2014-15 budget proposal, which includes a proposal to make the first On November 4, 2014, voters approved Proposition 2, which created deposit into the state’s rainy day fund since 2007-08. new rules for the state’s rainy day fund. Proposition 2 requires the state to deposit minimum amounts each year into reserves. In particular, JUNE 15 Proposition 2 requires the state to set aside a share of capital gains The Legislature enacts a funding plan for the revenues—a particularly volatile revenue source—that exceed a specific California State Teachers Retirement System. The plan aims to eliminate the system’s $74 threshold. This means that the state sets aside the “spikes” in these billion unfunded liability in 32 years by increasing revenues when they are peaking so that they can be used later when contributions from the state, teachers, and revenues fall short. school and community college districts. JUNE 15 In addition to the required deposits under Proposition 2, in recent years, The Legislature passes (and the Governor later signs) the state has put more money into reserves than is required. For example, the 2014-15 Budget Act, which anticipates a year-end in 2016-17 and 2018-19, the state made extra deposits of $2 billion reserve level of slightly more than $2 billion. The and $2.6 billion, respectively. By the end of 2018-19, total reserves are budget also pays off the remaining outstanding debt 2018 projected to stand at an estimated $16 billion, far more than the budget associated with the Economic Recovery Bonds. had available in the years before the Great Recession. Recent Budgets Have Enacted Higher Levels of Reserves 2017 Total Enacted Reserves as a Percent of Revenues 2,500 AUGUST 26 14% The S&P 500 closes above 2,000 for the first time. 12 10 2,000 8 NOVEMBER 4 Voters approve 6 Proposition 2, which 4 creates new rules 2013 1,500 around the state’s 2 rainy day fund reserve. History of the S&P 500 NOVEMBER 5 07-08 08-09 09-10 10-11 11-12 12-13 13-14 14-15 15-16 16-17 17-18 18-19 2012 S&P raises When the state makes deposits into its reserve accounts, there are two California’s credit 1,000 rating from A to A+. key benefits for the budget. First, using money to make a deposit, rather than increasing ongoing spending, lowers the budget’s spending base, shrinking the size of a future budget deficit. Second, saving money means the budget has more funds available later to address a shortfall. 18 19 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE Recent Budgets Have Focused on Reserves and One-Time Spending JANUARY 9 Like reserves, one-time or temporary spending helps insulate the budget The Governor releases a 2015-16 budget proposal. from future shortfalls. One-time or temporary spending—which is often devoted to infrastructure projects, repaying debts and other short-term JUNE 19 purposes—does not increase the state’s expenditure base. That is, the The Legislature passes (and the Governor later spending occurs in the budget year, but does not necessarily reoccur in signs) the 2015-16 Budget Act, which anticipates a year-end reserve level of nearly $5 billion. future years. In contrast, ongoing spending often expands programs or services. Without action by the Legislature to reduce it, ongoing spending JULY 2 continues in future years, increasing the state’s expenditure base. S&P raises California’s credit rating to AA-, its highest level in 14 years. How Recent Budgets Allocated DECEMBER 16 The Federal Reserve raises interest Discretionary Resources rates for the first time since 2006. Ongoing Ongoing 2016 Spending Spending JANUARY 9 Reserves The Governor releases a 2016-17 budget proposal. One-Time Reserves Spending One-Time FEBRUARY 5 Spending The U.S. unemployment rate falls below 5 percent for the first time in eight years. 2016-17 2018-19 JUNE 19 The Legislature passes (and the Governor later signs) the 2016-17 Budget Act, which anticipates a year-end reserve level of $8.5 billion. In several recent budgets, the Legislature had additional discretionary resources available to allocate, typically because revenue growth has exceeded the underlying growth in state expenditure commitments. The NOVEMBER 16 Voters approve Proposition 55 Legislature mostly used these funds for one-time—rather than ongoing— which extends the increases in budget commitments. For example, the 2016-17 and 2018-19 budget personal income tax rates for packages each allocated most available resources to building reserves. high-income taxpayers until 2030 These budgets then focused remaining resources on one-time spending (under Proposition 30 these and allocated only 12 percent and 13 percent, respectively, of available increases were to expire in 2018). resources to ongoing spending. 20 21 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY LEGISLATIVE ANALYST’S OFFICE Key Takeaways JANUARY 9 The State Budget Situation Has The Governor releases a 2017-18 budget proposal. Dramatically Improved Since 2008 FEBRUARY 5 The California unemployment rate falls below 5 percent for the first time in ten years. The Economy Has Played a Major Role in Improving the State’s Financial Situation... The single most significant factor in the state’s JUNE 19 improved fiscal health is the long period of economic growth. Sustained The Legislature passes (and the Governor later growth in the economy and asset markets have resulted in many signs) the 2017-18 Budget Act, which anticipates consecutive years of positive revenue growth. a year-end reserve level of $9.9 billion. In the Early Years, the Federal Government Played an Important SEPTEMBER 15 Role in Helping the State... In the early years of the Great Recession, S&P 500 closes above 2,500 for the first time. the federal government played a role in assisting the state in its financial situation. Federal funding increases in 2009 and later cushioned sharp DECEMBER 22 President Trump signs the declines in state funding. This alleviated the state’s worsening budget Tax Cuts and Jobs Act into law. condition and blunted the worst of the economic and programmatic 2017 negative effects that would result from declines in state spending. …But Policy Decisions Also Were Important. Economic growth and federal assistance were both important factors for the state’s financial 2018 turnaround to occur, but they would not have been sufficient alone. Steps taken by policymakers were critical, as well. In particular, in recent years, state policymakers have chosen to dedicate most available discretionary resources to building reserves and focused many new spending proposals on one-time, rather than ongoing, budget commitments. (That said, JANUARY 9 average annual spending growth over the period has not been low—in fact, The Governor releases a from 2011-12 to 2018-19 General Fund spending grew 7 percent per year.) 2018-19 budget proposal. California Is Much Better Prepared for a Recession Today Than It Was in 2007. As a result of these factors, the state is much better JUNE 19 prepared for a recession today than it was when it entered the Great The Legislature passes (and the Recession ten years ago. When the state entered the Great Recession Governor later signs) the 2018-19 in 2007, the Legislature had recently enacted a budget with just over Budget Act, which anticipates a year-end reserve level of $15.9 billion. $4 billion in reserves. But by November of the 2007-08 fiscal year, our office was already warning that this reserve balance was actually a $2 billion deficit. By contrast, in June 2018, the Legislature enacted a 22 23 THE GREAT RECESSION AND CALIFORNIA’S RECOVERY reserve level of about $16 billion and our office’s November estimates suggest the state’s bottom line may be even better than the budget anticipated. The state’s significant reserve balances also dramatically reduce the likelihood that the state will face another cash crisis. The State Budget Still Faces Challenges A Volatile Revenue Structure Yields Significant Growth. California’s budget relies on volatile revenue sources—meaning the growth of revenues can fluctuate significantly from year to year based on economic conditions. On one hand, California’s volatile tax system results in significant declines in revenues in years that the economy is weak. On the other hand, this tax system has underpinned the state’s robust revenue growth in recent years. Revenues are volatile in part because high-income Californians (who see significant fluctuations in their incomes depending on the economy and financial markets) pay the highest marginal tax rates. High-income earners also have experienced the largest earnings growth since the Great Recession. Consequently, California revenues have surged as the economy has expanded. Other Challenges Also Loom. While its situation is undeniably better than it has been in decades, the state budget still faces challenges. Although reserve levels now are relatively high, they may not be enough to fully address a budget deficit in a future recession without significant spending cuts or revenue increases. In future years, the budget will need to confront cost pressures for infrastructure, health care, and pensions. 24 This report was prepared by Ann Hollingshead and Sarah Barkman and was reviewed by Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov.