Bangkok--20 May--Standard & Poor's
Governor Jerry Brown's revised budget proposal for California (A-/Negative) for fiscal 2012 recognizes both an increase in revenues and more complicated politics than he had expected when he released his original proposal in January. The governor's May revision to the proposed budget nonetheless represents a shift in tactic more than a fundamental change to his ideas for addressing the state's fiscal shortfall, in the view of Standard & Poor's Ratings Services.
Tactically, the governor's updated proposal calls for extending fewer temporary tax increases (than set forth in the original budget proposal) with voter ratification to follow legislative approval. The broader fiscal strategy of realigning the delivery of certain services to the local level of government remains largely intact. Funding for the realignment plan would be provided from the proposed extension of certain sales and use taxes and vehicle license fees.
Whether recent revenue improvement will soften the sense of urgency among members of the legislature and result in a missed opportunity for the state to improve the fiscal structure of its budget remains to be seen. In the context of a modestly paced economic recovery and the possibility of serious strain on state cash flow that could occur early in fiscal 2012, we believe the terms of the final revised budget the May budget revision could represent an important crossroad for the state's rating.
Part of the governor's rationale for extending the temporary tax increases, as highlighted in his revised budget proposal, includes the extent to which the state has relied on a patchwork of one-time fixes to address its budget deficits during the last decade. During this time, the state has amassed $34.7 billion in future payment obligations stemming from various types of borrowing and payment deferrals. All but $9 billion of these budgetary obligations are in addition to the state's debt and retirement liabilities and include, for example, amounts we consider significant that are owed to the state's public schools. We view the presence and growth of these obligations as a negative long-term rating factor since they will absorb a portion of the state's future revenue growth, thereby curtailing its fiscal options (see "State Review: California," published April 25, 2011, on RatingsDirect on the Global Credit Portal).
Revenue of $6.6 billion more (through fiscal 2012) than what had been assumed in the governor's original January budget proposal helps lower the anticipated deficit to $9.6 billion from the approximately $15 billion it would have been according to the prior revenue forecast. But we believe the stronger revenue trends may also have undercut, to a degree, the political urgency to extend the temporary tax increases from our perspective. In recent weeks, political opposition to the governor's tax proposal appears to have coalesced around the idea that extending the temporary tax increases was less necessary because tax collections were exceeding those assumed in the January budget proposal.
In response to the updated revenue trends, the governor's revised proposal refrains from seeking an extension of the personal income tax (PIT) surcharge of 0.25% until the start of calendar 2012. If this occurs, the state would forego an estimated $2.9 billion in potential PIT revenue. Although this revision is premised on the stronger revenue trends, we recognize that the condition of the state's general fund does not necessarily improve by an amount equal to the revenue growth above budget expectations. We identify several reasons for this.
First, pursuant to Proposition 98, a significant portion ($1.6 billion in fiscal 2012) of any stronger-than-expected general fund revenue growth automatically goes toward increased education funding rather than improving the fiscal position of the general fund (unless the constitutional requirement is formally suspended, which the governor is not proposing). Second, aside from the tax revenues noted above, actual performance of certain other revenue and some spending trends have proved less favorable as of the May Revision (adding more than $2 billion to the projected deficit, not including the increased Proposition 98 education funding) than originally assumed, thereby eroding the fiscal benefit of the tax revenue trends. In addition, June is important for total annual tax revenues and if collections were to deteriorate relative to the forecast for that month, the projected deficit could grow. Finally, the economic recovery remains sluggish and skewed toward higher income earners--whose taxable incomes tend to be among the more volatile and less predictable of the state's tax bases.
In light of the large budgetary liabilities noted above, if the recent higher revenue trends entice lawmakers to defer adopting a budget with structural solutions in hopes that the economy will resolve the state's fiscal shortfall, we believe that the potential to chip away at the state's negative balance sheet position--and the effect it has on the state's rating--could be missed.
More imminently, the state's planned cash flow borrowing could be complicated by the absence in the proposal of a timeline for voter ratification of the proposed tax extensions--should the legislature agree to this approach. The borrowing could also be complicated by the lack of framework for how the budget would be balanced without the tax extensions. Because we expect the state's revised pro forma cash flow forecast to call for an infusion of short-term note proceeds with or without the tax extensions, the lack of an alternative budget plan could loom larger in the state's credit profile as the start of fiscal 2012 approaches.
Media Contact:
Edward Sweeney, New York (1) 212-438-6634,
[email protected]
Analyst Contacts:
Gabriel Petek, CFA, San Francisco (1) 415-371-5042
David G Hitchcock, New York (1) 212-438-2022