California $68B Potential Budget Shortfall Needs Airtight Fix

California’s budget shortfall for the upcoming 2024-2025 fiscal year is $68 billion, according to the latest report by the Legislative Analyst’s Office. Many of fellow Californians have seen this movie before—shortfall, increase revenue through taxes, surplus, shortfall, and repeat.

California has tried to remedy deficits through a combination of raising taxes and taking away tax attributes, but this time may be different. Gov. Gavin Newsom (D) stated in May that he won’t support tax increases.

But if California can’t close the projected budget deficit with tax increases, removal or suspension of certain tax attributes may be the only option available.

Income Tax Revenue

It’s no secret California is an expensive place to live. From high property values to one of the largest marginal personal income tax rates in the US, the “sunshine tax” to live in California is steep.

California is also home to some of the wealthiest individuals and companies in the world. From Hollywood celebrities to Silicon Valley billionaires, along with a smattering of the most valuable companies in the world, California has developed a large tax base that’s concentrated largely with a few taxpayers.

Many of these wealthy taxpayers make up a disproportionate amount of California’s tax revenue. That revenue spikes when these individuals are doing well—by selling stock of their companies or taking their companies public. These events generate significant capital gains, which lead to increased tax revenue.

The flipside is when these activities slow down, so does the state’s tax revenue.

This phenomenon is amplified by a housing market that has screeched to a halt. Increased interest rates have slowed sale of homes, which has slowed the number of large gains realized by home sellers of appreciated property. Those gains often translate to increased taxes.

This boom-or-bust cycle isn’t new. The state saw this in the early 2000s with the dot-com boom, and again with a sizzling housing market in the mid-2000s. But then the state saw the hangover from these booms during the dot-com bust and the housing market crash of the late 2000s.

Tax Attribute Suspensions

California often resorts to tax attribute suspension to curb a projected budget deficit. In the past 35 years, the state suspended use of net operating losses five times, most recently in response to the Covid-19 pandemic in the 2020-2021 tax year.

Each of suspension year had different requirements. For example, the 2008-2009 suspension was limited to businesses with $500,000 or more of post-apportioned income, while the 2010-2011 suspension was limited to businesses with $300,000 or more of pre-apportioned income.

The pandemic suspension limited NOL use to business income, on a post-apportioned basis, of at least $1 million. It also limited the use of credits to reduce a tax liability to no more than $5 million.

For most taxpayers, NOL suspensions and credit utilization restrictions were primarily a timing issue. Any suspended NOL or unused credits could be carried over into non-suspension years, often with an extended carryover period that matched the years of suspension or restricted use. This time may be different.

Unprecedented Tax Changes

The word “unprecedented” gets thrown around a lot, but unfortunately, it’s an apt description for the projected California budget. The $68 billion projected deficit for the 2024-2025 fiscal year, compounded by a projected $30 billion yearly, means that merely kicking the can down the road by suspending tax attributes may not be enough.

Given the long-term projected deficit, California lawmakers may be forced to permanently suspend certain tax attributes. They may have several options.

First, California lawmakers could eliminate tax attributes that impact only a handful of taxpayers to stem some of the bleeding. Second, lawmakers could conform to certain federal provisions that limit deductions or credits.

California currently conforms to the Internal Revenue Code as of Jan. 1, 2015, so any changes enacted by the federal government under the Tax Cuts and Jobs Act generally aren’t applicable in the state.

For example, California doesn’t conform to the deduction of fringe benefits limitations enacted by TCJA. Conforming to this measure would extend the federal deduction limitation to California.

The third way California lawmakers can try to close the budget deficit is to implement suspensions like years past but condition them on objective markers. For example, California could suspend use of net operating losses for most taxpayers and allow reinstatement only after the state reaches a specified budget surplus.

What Comes Next

Newsom will present a budget proposal to the legislature in January. Then, lawmakers will try to reach a budget deal with the governor by June. The variables will be whether Newsom budges on his prior reluctance to raise taxes and how creative the legislature can be if he doesn’t.

Newsom’s reluctance to raise taxes may be solidified by his rumored national political aspirations. Nonetheless, it seems likely California will apply another band-aid to its budget deficit.

In the state capital and beyond, it seems clear that California needs to move away from its dependence on using income tax revenue to stay afloat. But of course, there’s no agreement on how to implement this change.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Shail P. Shah is shareholder at Greenberg Traurig with focus on complex California tax planning and representation.