Why Would You Insure the California Budget With the Stock Market?

Joe Mathews
Connecting California Columnist and Editor, Zócalo Public Square, Fellow at the Center for Social Cohesion at Arizona State University and co-author of California Crackup: How Reform Broke the Golden State and How We Can Fix It (UC Press, 2010)

Governor Brown’s rainy day fund proposal called for filling a reserve fund with capital gains tax revenues that exceed a certain amount. Details of a deal reached Thursday, while sketchy as of this writing, would also set aside money based on capital gains. That would seem to be common sense, since capital gains revenues are very volatile.

What’s wrong with that? Potentially everything.

Start with the logic. Common sense budget reforms never work because the California budget process isn’t based on common sense; the budget system is a crazy, unplanned mishmash of conflicting provisions. Applying common sense to such a monster is crazy. The only sensible thing to do with such a machine is to unplug it.

Because capital gains are so volatile is actually reason not to rely upon them. You want reserve funds to have predictable revenue streams – so your emergency money is really there in an emergency. But capital gains tax revenues are so unpredictable that the state often doesn’t have accurate numbers for one year’s revenues until many years later. If the rainy day fund ultimately depends on capital gains, there could be serial revisions of previous year’s budgets and revenues that would cause huge swings (and more volatility) to present year budgets. This also would make the already fiendishly complicated budget process even more complicated.

A second problem: as the California Budget Project has pointed out, capital gains revenues may work against the central idea of a rainy day fund – to transfer reserve funds into the budget during difficult economic times when money is short. According to CBP’s analysis of Brown’s original proposal, there could be required deposits to the rainy day fund immediately following a recession –when the stock market spikes (and capital gains increase) but when there is still desperate need to restore cuts to the budget. You don’t have to imagine a time like that, by the way – we’re living in just such a time right now.

CBP suggested a fix – adding another provision to the rainy day fund that would allow for the suspension of deposits until the state reaches certain thresholds after a recession – but that fix also would add more complexity to the proposal and to the budget.

It will also be important to ask about the details of the rainy day fund, with regards to pensions and retiree health care.

The governor’s rainy day proposal would allow the fund to be used not only for a rainy day, but also for other things—including pension and retiree health payments. You read that right. California has huge unfunded liabilities in retiree benefits because the stock market returns won’t be able to match the promised benefits. And yet the governor put forward a rainy day fund that proposes to use the stock market – and capital gains – to insure against that stock market failure.

That’s backwards. A rainy day fund is supposed to be insurance. But that approach means doubling down on risk – we’d be insuring against market loss with market gains. Instead, the state needs to make bigger, annual payments on teacher pensions (and get rid of retiree health care, which is redundant in this age of Medicare and Obamacare) that aren’t dependent on capital gains – and get more from employees too.

The bottom line: California’s broken budget machine needs a total dismantling – and replacement by something far less complicated. It appears that yet again, California may instead add another small patch to the machine.

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