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August 25, 2014

California's Miracle Will Turn Out To Be A Mirage

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News media from coast to coast are celebrating a "California comeback" after a near-decade-long Golden State economic collapse.

But even this latest recovery may be much more fragile than has been reported, and the state's structural defects still imperil the left-coast economy.

Certainly there are reasons for optimism. Tax collections were way up last year, and the state is balancing its budget after years of scrambling to close multibillion deficits with accounting gimmicks.

Silicon Valley is on fire as the tech boom has rebooted. San Francisco is one of the fastest-growing cities, with rents doubling and even tripling in recent years.

There is even a whispering campaign that if Hillary Clinton tanks, Gov. Jerry Brown, who will be older in 2016 than Reagan was when he left office, may run for president, on a platform of resurrecting the U.S. economy the way he engineered the rebound in California.

For liberals this is a story of "progressive government" — the model of high taxes, heavy regulation and government "investments" leading to prosperity.

That's the message from the left's leading economic sage, Paul Krugman, who recently wrote that the lesson from the "Califor nia comeback" is "that you should take anti-government propaganda with large helpings of salt."

"Tax increases," he maintained, "aren't economic suicide; sometimes they're a useful way to pay for things we need.

Government programs, like ObamaCare, can work if the people running them want them to work, and if they aren't sabotaged from the right.

"In other words," he concludes, "California's success is a demonstration that the extremist ideology still dominating much of American politics is nonsense."

Before we start declaring a California Miracle, let's examine the state's underlying economy, because this looks more like an economic mirage.

First, the tax-receipt bubble may have already burst.

A 3% retroactive tax hike approved in November 2012, hit wealthy Californians on their prior earnings, and took the state's top effective tax rate to 13%. Revenues shot up by more than 20% in fiscal 2013 thanks to the retroactive tax bills wealthy Californians had to pay last year.

But so far this calendar year, according to the latest data from California's State Controller's Office and the Rockefeller Institute, personal income-tax revenues fell by 11% in the first quarter of this year and more than 6% through June.

In fact, the decline through the first quarter, according to the Rockefeller Institute, was more than any other state.

The tech and social media boom has inflated revenues too, with tax windfalls from the Facebook (NASDAQ:FB), Zillow (NASDAQ:Z) and Yelp (NYSE:YELP) IPOs, Tesla (NASDAQ:TSLA) stock sales and the WhatsApp acquisition to name a few.

According to the state's legislative analyst, Facebook's IPO alone was expected to net the $2.5 billion in one-off taxes.

"How many times do Californians have to relearn the lesson that one-off events are nonrecurring?" asks Rob Arnott, chairman of Research Affiliates, a nationally renowned money management firm headquartered in California.

"The revenues soon disappear as is happening now. When Google (NASDAQ:GOOGL) went public in 2004, capital-gains revenues jumped 49% the next year. Within two years, cap-gains taxes accounted for 11% of the California budget. But not long after the Google tax windfall had faded, the state was broke again."

The big challenge for California, says Arnott, is "with the newly higher tax rates, and the resentment caused by tax retroactivity, how many spectacular new startups are likely in California, providing new tax windfalls, and how many will choose other tech hubs, like Austin or Seattle?"

Second, consider the supposed budget surplus. The rosy numbers don't include gargantuan hidden deficits from state pension liabilities.

Moody's reports that the state's pensions assume a discount rate of 7.5% on liabilities. Is anyone getting a 7.5% low-risk return on their money today? Long-term Treasury bonds yield less than 3.5%.

The 4% difference, applied to $650 billion of liabilities, means a hidden deficit of $26 billion that the state hopes to close with investments carrying higher downside risk. If investments don't close the gap, then future contributions — funded by even higher taxes or deeper cuts in state services — are the state's obvious destiny.

In 2013, Moody's prepared an analysis of state pensions, using a still-generous 5.47% discount rate. It found $120 billion in unacknowledged additional unfunded liabilities for California, and nearly $1 trillion nationwide. With a 3.5% discount rate, these hidden liabilities double.

As return assumptions are forced lower in the years ahead, the hidden deficits and unfunded liabilities (which will almost certainly have grown by then) will gradually move onto the official budget as red ink.

Whoever is presiding over the interjection of truth into this process will get the blame.

Meantime, a new report by a taxpayer watchdog group called TransparentCalifornia sheds light on why these pension and health care liabilities for city and state workers are so huge.

It found that in 2013 an assistant chief of police and fire for Los Angeles received a golden egg retirement package worth more than $900,000. An L.A. police captain with 30 years of service raked in $750,000 in '13, and a retired San Diego program manager got $600,000.

There are scores and scores of such taxpayer rip-offs going on each year. And who pays for this largesse? Current and future California taxpayers — many of whom will never earn a six-figure salary let alone a high-six-figure pension.

There are other economic signs of a continuing economic malaise that the California enthusiasts don't acknowledge.

The Census Bureau reported last year that the California poverty rate adjusted for cost of living is 23.8% — almost 50% above the average for all other states.

The Los Angeles Times reported in September 2013 that California's poverty rate is the highest in the nation, despite welfare benefits that are among the highest.

Economist Arthur Laffer, an adviser to President Reagan, notes that "the poverty rate is now higher in California than in Texas, adjusted for cost of living, even though Texas is still a poorer state."

One reason for the high poverty is that almost everything is more expensive in California. Transportation, electricity, water, fees and housing are often 50% higher and sometimes double the rest of the nation, according to a California Policy Institute analysis.

These costs, the CPI finds, are a result of extraordinary regulatory burdens, high taxes, green policies, and generous pay and pensions for state and municipal public employees. Such costs act as regressive taxes on California's working poor.

Naturally, income inequality in California is widening, as the rich in Silicon Valley and Hollywood have seen big wealth gains, while more at the bottom of the income ladder fall into poverty and the middle class is crushed.

For example, despite the hiring boom in the tech industry, the unemployment rate in California is still tied for seventh highest in the nation. In some areas of the state, the jobless rate is 20%.

One of the best indicators of prosperity for a state or city is whether people and businesses are moving to that location or away from it. Detroit went bankrupt in part because fixed government costs (e.g., pensions) were stuck while the population shrank by more than half and the tax base evaporated.

Meanwhile, places that have a friendly environment for business, and especially for entrepreneurs — such as Texas and Arizona — attract people and capital. Here is where California scores most poorly of all.

From 2003 to 2012, a net 1.4 million people left California for other states. According to the CPI analysis based on Bureau of Labor Statistics data, the state lost 5% of its businesses in 2012 due to bankruptcy, outmigration or mergers. And during an economic recovery, no less.

By the end of 2013 (the most recent quarter available), California was still down compared with two years earlier. How many more business owners will add to the growing exodus, moving their businesses to less-hostile tax and regulatory regimes?

The history of California since the 1970s has been one of glorious booms and gut-wrenching busts. In the last two decades, the booms have gotten shorter and the busts more severe.

The state has enormous natural advantages — beautiful weather, mountains, beaches, enormous energy resources, some of the most productive agricultural land in the country, and many of the greatest universities in the world. It's also a magnet for some of the most talented immigrants from every corner of the world.

But the policies that progressives keep pushing are making California unlivable and unaffordable. CEO Magazine has ranked California "the worst state in which to do business" — in terms of taxes, regulations, litigation costs and business friendliness — 10 years in a row.

Joseph Vranich, a business relocation consultant who tracks movement of businesses in and out of the state says, "Over the last decade we've detected a steady acceleration of businesses moving out of California. You routinely see these employers and the jobs relocated in Nevada, Colorado, Texas and Idaho."

Arnott's glum assessment: "We're beyond bankrupt here in California, as are many of the big states. It's only a matter of time before that becomes obvious."

 - Moore is chief economist at the Heritage Foundation.

Originally appeared in Investor's Business Daily

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