California budget deficit exposes dependence on the stock market

By Michael Liedtke, The Associated Press
Friday May 17, 2002

SAN FRANCISCO — California’s $23.6 billion budget deficit exposed a glaring financial weakness that lawmakers knew about but didn’t want to think about — the state’s dependence on money collected from relatively few taxpayers profiting from steadily rising stock prices. 

An estimated $17.3 billion of the budget gap, or almost three-fourths of the deficit, is tied to the stock market’s 2-year-old slump, according to the state Department of Finance. 

Most of the money was supposed to come from roughly 5 percent of the state’s taxpayers expected to cash in on higher stock prices. 

But the sharp decline in stock prices has wiped out most of the shareholder windfalls enjoyed during the last half of the 1990s and early 2000. The Nasdaq stock index, a benchmark that tracks many of the high-tech companies fueling the California economy, has plunged 66 percent from its March 2000 peak. 

The reversal of fortune left the state with less money to tax. 

The state’s estimated stock market losses include lost opportunities to collect revenue from activities unlikely to occur because investors won’t be reaping the same kinds of profits they did in the boom years. 

For instance, the state doesn’t expect to collect as much sales tax on luxury items, such as cars and jewelry. 

It’s a financial hangover that might linger for years unless lawmakers find revenue sources more reliable than the volatile stock market. 

“We should rethink how California should structure its tax system in the future,” Gov. Gray Davis said Thursday. Covering the shortfall for the new fiscal year beginning July 1 is a bigger priority right now, Davis added. 

The dangers of relying on a steady stream of stock market windfalls wasn’t a secret in the state’s Capitol, said Ted Gibson, California’s chief economist for seven years before leaving the job late last year. 

But it was easy to forget about the possible downside during the exuberance of a dot-com boom that made investments in the high-tech industry seem like easy money. 

“The Legislature was no different than the investor on the street at the time,” said Gibson, now an economic adviser for Metropolitan West Financial and Strategic Services. “Everyone thought they had found a magic money machine. We all knew that was crazy, but everybody was caught up in the mania.” 

Other analysts are more forgiving. 

“This the worst volatility we have ever seen. I don’t believe anyone could have planned for a drop like this,” said Jean Ross, executive director of the California Budget Project, a nonprofit research group. 

The state’s addiction to revenue generated from stock market profits and other capital gains began to accelerate in the mid-1990s, just as excitement about the Internet economy began to escalate. 

During California’s budget year ending in June 1996, the stock market and other capital gains accounted for $2.6 billion of a $46.3 billion budget — 5.6 percent of the total revenue. Five years later, the stock market and other capital gains generated $17.6 billion of a $71.4 billion budget — 24.6 percent of the total revenue. 

The revenue from the stock market and capital gains is expected to dwindle to $7.2 billion, or 9.2 percent of the budget, in upcoming years. 

California isn’t the only state battling budget problems tied to the sliding stock market. 

New York, New Jersey and Virginia are among the other states that have lost a significant amount of taxable income during the stock market’s downturn, said Scott Pattison, executive director for the National Association of State Budget Officers. 

Like California, those states benefited from a small number of taxpayers who capitalized on rising stock prices or received bonuses tied to the stock market, Pattison said. 

In California, state Sen. Steve Peace, D-La Mesa, has introduced a bill recommending that the Legislature lessen the state’s dependence on the stock market by lowering the capital gains tax and drawing more money from sales taxes and taxes on the property owned by businesses. 

Peace’s ideas likely would face fierce opposition from businesses. 

“There are no easy solutions,” Gibson said. “We got ourselves into a situation where we have lasered in on a small group of people who are taking big risks with their income.”