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Municipal Podcast recorded on June 28, 2016

State of California

Podcast Transcript

Hello, I'm Natalie Wright, Product Manager at Breckinridge, and welcome to the Breckinridge podcast. Today I'm joined by Andrew Teras, one of our credit analysts and he will be giving us an update on the State of California and the new budget for fiscal year 2017. So Andrew, we recently had some budget news for the State of California, can you give us more details about that?

Yeah, absolutely. So on June 15th, California governor, Jerry Brown, and the legislature reached a budget agreement for fiscal year 2017. That's the fiscal year that will begin on July 1st. Just a quick overview of the budget, it's a $122 billion general fund spending plan. It was a balanced approach providing for moderate increases in social services spending, Medicaid and education. It also includes $2 billion in supplemental Rainy Day deposits, so this is something that we've been talking about for the last few years, the state adding to its reserves so at the end of fiscal '17, the budget projects $8.5 billion of Rainy Day reserves which is about 7% of general fund revenues.

Can you give us some takeaways from this year's budget?

Perhaps the most notable thing about the budget this year is that it's really not all that notable. In many ways, it's more of the same in terms of what we've been seeing out of the Golden State at budget time the last several years.

And what about the timing? I know we've heard a lot about different states and having budgets postponed, there's a lot of budget uproar in the muni market. Can you talk a little bit more about California?

California has a long history of late budgets. This is something that plagued budget management for many years but this year's budget, I think, is the sixth consecutive budget agreement that was reached before the start of the fiscal year, so this has really become status quo so they've really come a long way on that front. Another thing that's notable is that Jerry Brown got his way again. So as we've seen over the last several budget cycles, the governor's conservative approach to budget management largely trumps the heavily Democratic legislature's desire to capitalize on the state's fiscal rebound to restore services and expand social programs. Going into next budget year, it's going to be interesting to see if Brown's political capital begins to wane a little bit so he's going to be heading into the latter half of his current term and he can't run for reelection, so it will be interesting to see how much longer his message of fiscal austerity, that he's been pushing since he came into office, how much longer will that resonate.

Right, and I know he's still quite popular with California residents.

That's right, correct.

So is this budget a positive for local governments across the state? What do we think?

Definitely a positive for local governments, particularly school districts and community colleges in the state. So the budget has basic funding for K-14 schools, that's up 4% this year and a cumulative 52% from 2012. So this obviously bodes well for the fiscal performance of our school district and community college district holdings, many of which are very reliant on state aid for a large portion of operating revenues. These schools have seen an infusion of state money over the last few years and many of them have been reporting operating surpluses and healthier cash positions. The one caveat to all this is that a good chunk of the money that they have been receiving is actually nonrecurring in nature, so what you have to watch for with these districts is how they're choosing to spend that money and where it's going.

I see. Well, how is California's economy looking?

Yes, so just transitioning a bit here. California's economy continues to perform quite well. We just had some GDP numbers for 2015 come out. GDP growth increased 4.1% in California, labor force growth, personal income growth are outpacing the nation. These are trends that have continued for the last several years. Another interesting thing is the housing market recovery that we've seen that was initially restricted to the coastal urban centers of the state, that's now starting to really expand into many of the inland communities which is a trend we will continue to watch.

Well, anything that the research team is keeping an eye on?

You know, a lot of things are looking good, but there are definitely some potentially troubling indicators on the horizon that we're watching for sure. The first thing is the state's tax collections have actually underperformed the last several months. They've come in below forecast and in the governor's proposed budget that he released in May, he actually revised downward his tax revenue forecast for the year by nearly $2 billion. You know, looking at Silicon Valley, obviously an important catalyst for the state's economy, there's been some signs of a potential slowdown there. In terms of the real estate market in the bay area, there are also some indications that maybe things are softening a bit there. And then obviously globally, China continues to exhibit some potential warning signs on their economy and then you know this past Friday with Brexit, that has rattled the stock market into today. So these are definitely issues that we're watching.

All right, and the stock market volatility that you talked about has implications for the state's tax collections, I mean, can you go into that a little bit and remind us why tax collections are so volatile in California?

Yeah, absolutely. So personal income taxes comprise the majority of the state's general operating tax revenues, it's almost 70%, and collections from this revenue source can fluctuate significantly and they're extremely difficult to forecast so this is particularly true for capital gains which in California are taxed as ordinary income. So what this means is that California's tax revenue collections are highly correlated with economic performance and the stock market. What's interesting is, Moody's actually put out a piece recently in the last few weeks, they ranked California the least prepared of any US state in terms of their ability to weather a recession. So it's pretty amazing given how far that they've come that they're still as vulnerable as they are.

So the items you're keeping an eye on, are those more speed bumps or do they mark a real fundamental shift in California's credit profile?

It's really too soon to tell, but you know, remember, as Jerry Brown constantly likes to remind people, another recession is inevitable and California's credit profile has historically been extremely cyclical so in good economic times, jobs are being added, tax revenues are flowing, the credit picture looks good but when the state hits an economic rough patch, the bottom falls out. It's hard to imagine but just a few years ago, many people were comparing California's fiscal profile to Greece. So now that things are humming along, the question is, are things actually different this time? You know, there is no doubt that California's fiscal health is stronger than it's been in a long time and the state's made meaningful structural changes that reduce the likelihood of future fiscal crises similar in magnitude to those experienced in the past, but the jury is still out and we still feel a somewhat cautious investment approach is the wise course.

I see, because things in California can be really good until they're not.

That's right.

Okay, so California has definitely come a long way since the Great Recession. Do we see much additional upside to the credit at this point?

Not really for the reason that we were sort of touching on just now. I think that one thing that would really help go a long way is some changes to the state's tax structure that would reduce revenue volatility and concentration. Just to give you some illustration on what I mean there is, if you look in the governor's budget document from this year, he has a stat in there that's pretty amazing in that the top 1% of Californians account for 48% of the state's income taxes and as we already talked about, income taxes, personal income taxes in California, account for over two-thirds of total tax revenues. So that's a really remarkable statistic and you know, it helps illustrate why California's fiscal health is on perpetually shaky ground so the key for California would be to reduce revenue volatility and concentration so that the budget is more predictable from year to year.

Okay, so will we see a tax overhaul in California that might reduce this volatility?

It's hard to really see anything materializing in the near future. We have seen various tax overhaul proposals floated in recent years. Actually a week or two ago, the state controller published a report on this very topic, but nothing really has been able to gain much traction and that's largely because this is a very difficult issue to address from a political standpoint in terms of getting buy-in.

I see. Well, going back to the budget, with the budget in place, is there anything else to watch for on the horizon?

Yeah, one thing would be in November, voters are likely to be considering a long-term extension of the Proposition 30 temporary income tax rates on high earners that were passed in 2012. Those are currently scheduled to be phased out beginning January 1, 2017. So those tax increases, they've definitely helped. Most of the extra dollars that came in have been pumped into education and been allocated to the state's reserve funds, but Governor Brown's 2017 budget shows moderate gaps in the out years under the assumption that those tax rates expire so the fiscal picture would get definitely brighter with the extension of those taxes if that is approved in November. But at the same time as we've talked about it, I really think to take the next step for California in terms of their credit picture, they really need the revenue base to be less volatile. Extension of those tax rates is really not going to produce that at all.

All right, well thank you so much, Andrew. We hope that you in the field have found this informative. We look forward to joining us on our next podcast. Thank you.



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