California Will Likely Face Fiscal Crisis Sooner Rather Than Later, Despite $31 Billion Surplus

 Roughly 40 percent of California’s personal income tax payments are from just the top ½ of 1 percent. And this handful of taxpayers and much of their tax dollars could easily leave, for reasons explained below.

But first, imagine the consequences of losing that revenue. Take away those taxes and California would suffer the mother of all fiscal crises, one that could dwarf the crisis of ten years ago, when California was in such dire straits that the state was forced to issue IOUs because it ran short of cash—and in which nearly every major bank in the country took just a few days to decide that they would not accept California’s “funny money” for payment.

But today, the potential for such a crisis is even worse as the share of tax payments paid by such a small group has become even more concentrated over time. Recent data show that the top 0.1 percent earn about 2/3 of the income earned by the top ½ of 1 percent. Extrapolating from this statistic suggests that the top 0.1 percent pay about 25 percent of California’s personal income taxes. Just eighteen thousand households overwhelmingly fund a state government that serves forty million people. You don’t need to do the math because it is obvious what the problem is.

But this is even more critical than it appears, because personal income taxes make up nearly 44 percent of the state budget—about $80 billion. The hypothetical of losing tax dollars from those eighteen thousand households that make up the top 1/10 of 1 percent becomes a huge issue for the state.

Make no mistake: the massive amount of state taxes this group pays—approximately $1.2 million in taxes per filing family among the top 1%, and roughly $360,000 each return among the top 12%—will almost surely drop after the present stock market bull market has run its course. This is because, as the stock market has skyrocketed for the previous ten years, capital gains, which are taxed as regular income and most likely at California's highest rate of 13.3 percent, make up a large portion of the taxable income in this category.

Bull markets, on the other hand, do come to a conclusion, and the present one is the longest ever recorded. And the current stock price to current earnings ratio, which is at its second highest level since this statistic was started, is at its second highest level since it was started. A high figure might indicate that stock prices are about to fall. Bull markets are usually followed by a long period of asset value declines (bad markets), during which capital gains are made at a considerably slower rate. This is one of the main reasons why California's tax revenues are always fluctuating in relation to the stock market and the worth of private companies.

A smaller and more unpredictable tax base, along with the conclusion of the longest bull market in history, is bad enough, but California now faces a new challenge. Will the top one-tenth of those one-percenters continue to claim California as their tax domicile? Due to existing tax rates and predictions for even greater taxes in the future, it is less likely now than in the past.

During California's recent economic crisis in 2012, voters adopted a 13.3% marginal tax rate for the wealthiest earnings, which will expire in 2016. But, in the legislature's never-ending drive for revenue, voters made the temporary tax increase permanent, despite continuous commercials that "make millionaires pay their fair share" and "billionaires can afford it." For progressive Californians, the problem with the country's highest tax rate is that it makes the thought of migrating to, say, Florida (home to practically every high-earning PGA golf professional, including former Californian Tiger Woods), where there is no state income tax, all the more appealing.

But there was an unexpected turn of events following the 2012 tax hike. Joshua Rauh of the Hoover Institution and the Stanford Graduate School of Business reports that as much as 60 percent of the expected revenue windfall from higher taxes evaporated, reflecting high-tax payers relocating their main residences to other states and much lower realized incomes from the state’s highest earners in response to the higher tax rate.

Rauh's research demonstrates that, contrary to what politicians and state revenue forecasts assume, high incomes are very sensitive to taxes and make significant adjustments in reaction to increasing tax rates. After all, the difference in taxes between residing in Florida and California is worth more than $1 million a year for somebody like Tiger Woods.

Since the pandemic, economic activity and placement decisions have grown more fluid, but state legislators have failed to recognize this, proposing a 16.8 percent top income tax rate. If such a tax rate were to pass, the state's highest earners would face a total marginal tax rate of roughly 62 percent from federal and state income taxes as well as local sales taxes. Prepare for more "funny money" from California if this happens. A whole deal more. Tiger isn't likely to return to his hometown.