Last week, Governor Newsom and state legislators agreed to a balanced budget for California’s upcoming fiscal year, closing the multibillion-dollar deficit that has hung over the state for months. Despite eliminating thousands of vacant government jobs, and making deep cuts to prison funding and affordable housing programs, the approved $288 billion spending plan appears unlikely to resolve the structural revenue and spending concerns that led the state off a fiscal cliff in the first place. Newsom’s office’s own projections, which are often rosier than those of the nonpartisan Legislative Analyst’s Office, already suggest California will face a deficit exceeding $36 billion in FY 2025-26.

The Governor made good on his promise to not raise taxes this time around. But the approved budget retains billions of dollars in funding for the recent expansion of free healthcare and in-home supportive services to low-income illegal immigrants, the state’s disastrous high-speed rail money pit, and a multibillion-dollar homeless services industry recently found to not consistently track program spending or results. Worse, around 36% of the deficit was closed by using gimmicky one-time spending deferrals or transferring about half of the state’s “rainy day” reserve fund to its general fund. The latter is highly unusual and required Newsom declare a formal “budget emergency,” suspending a constitutional rule that precludes such transfers, while the former simply kicks the can down the road.

And this is to say nothing of the state’s over $600 billion in public employee pension debt, of which $150 billion is unfunded.

Likely aware California will not be able to indefinitely stave off tax hikes as its deficit grows, Newsom and the state legislature sued the citizen’s group that fielded a proposition which would’ve required voters approve any new state tax increases — successfully keeping it off the November ballot.

But California’s top marginal tax rate is already the highest in the country, and if the state raises taxes to balance the budget, it risks triggering a mass exodus of its most successful firms and wealthiest residents. Though this would be concerning anywhere, it would be particularly catastrophic in California, whose extremely progressive tax system means a significant portion of tax revenue comes from just a handful of high-earning households and businesses. If California continues to push these highly wealthy (and mobile) contributors out, as recent proposals for exit and wealth taxes suggest it may, it risks sending itself into a fiscal death spiral — wealthy out-migration leads to declining public services and perpetual budgetary crises, which in turn lead to more tax hikes, pushing out even more top earners and shrinking the tax base further — a doom loop that could irrevocably transform the state.

HOW CALIFORNIA GOT HERE

In May 2022, riding the wave of a post-pandemic market rally, Governor Newsom announced California had an unprecedented $98 billion budget surplus — “a sign of how well a number of people are doing in this economy,” as he put it, beaming, at a press conference in Sacramento. He said the state would invest much of the windfall in an $18.1 billion “inflation relief” package which sent thousand-dollar checks to millions of residents to offset high energy, gas and rent prices, and would also increase investments in state-subsidized healthcare and climate change initiatives. When asked whether it was wise to spend, for instance, $11.5 billion on sending every eligible vehicle owner in the state a $400 check (per car), given this might actually increase inflation, Newsom bristled. Investing in these kinds of welfare payments was “wise and noble, and it’s something [that] should be celebrated and not criticized,” he said.

But just under two years later, in February 2024, the Legislative Analyst’s Office announced the state faced an unprecedented $73 billion (and growing) shortfall. What happened? Most immediately, Newsom’s budget staff appears to have made wildly unrealistic predictions about how long the post-pandemic stock market rally would continue. Since California relies heavily on personal income and capital gains taxes, which together account for around 66% of total tax revenue, it is exceptionally vulnerable to the market volatility that seemed obvious to follow the 2021-22 rally. Still, as UCLA economist Lee Ohanian explained, Newsom’s staff predicted revenues for FY 2022-23 and 2023-24 would reflect continued windfall, which led to the state overspending by around $83 billion. It’s difficult to characterize this as anything other than gross incompetence, if not outright negligence.

Then, the state spent billions on a tidal wave of no- to low-return investments like the $18.1 inflation relief package mentioned above, one-time welfare payments (including a “Vaxx for the Win” program that spent over $116 million giving out $50,000 checks to randomly selected recipients of the COVID vaccine), then still-ongoing “pandemic relief” programs, $20 billion of which was stolen by foreign and domestic criminals (one filled out his name as “Mr. Poopy Pants” and still got jobless benefits), initiatives to house homeless addicts in non-sober hotel rooms, indefinitely deferred “downpayment loan assistance,” and the like. In other words, the state took its massive windfall — underwritten almost entirely by a tiny group of ultra-wealthy households that pay disproportionately high taxes — and invested it in literal money giveaways and programs for non-contributors.

WHERE CALIFORNIA IS HEADING

How long can the state continue to rely on these contributors to fund a dysfunctional set of expenditures ranging from the non-existent $100 billion high-speed rail line to the nearly $6 billion per year homeless services industry, which attracts and traps homeless transplants, helping them get high until they die? It bears emphasizing the tiny number of high-earning households that foots a significant portion of this bill. In 2019, the top one percent of income earners (around 135,000 households) paid almost 45% of all state income tax. Of this, just slightly over 8,200 households — the 0.05% earning more than $5 million annually — paid almost 20% of all state income tax.

This income tax revenue accounts for over 60% of all general fund revenue, which the state uses for almost all day-to-day operations — over double that brought in by retail and corporate taxes, combined. This is an ironic, and unfortunate, byproduct of the state’s highly progressive tax system. Ironic because it means California, for all its ostensible leftism, is disproportionately dependent on the patronage of ultrawealthy individuals; unfortunate because recent studies have found these ultrawealthy individuals are also extremely mobile, and particularly responsive to tax increases.

And what of these well-off, if not ultrawealthy, taxpayers? A significant number work in the tech and entertainment industries, which together comprise around one-third of nonfarm employment statewide. But both industries are more tenuously connected to California than they’ve ever been. Tech workers, empowered by the shift remote during the pandemic, are increasingly mobile, while entertainment workers are increasingly either unemployed or poorly paid. As Daniel Bessner details in a recent Harper’s article on the death of Hollywood, employment fell by 26% industry-wide between August 2022 and December 2023, and the median TV writer-producer now makes almost 25% less per week, adjusted for inflation, than their counterparts did a decade ago. Revenue growth for the entertainment industry overall declined almost 50% between 2021 and 2022, and box office revenue specifically is down 22% since 2019.

But even as California relies heavily on a skittish group of high earners to fund ballooning, unproductive expenses, its politicians continue to flirt with pushing them out of the state by further raising taxes. Earlier this year, a 2022 law eliminating the wage cap for the state’s payroll tax went into effect, raising the potential tax burden for top-bracket earners to 14.4% (from 13.3%). In Los Angeles, the “mansion tax” on new constructions worth over $5 million contributed to a nearly 70% drop in luxury single-family home sales in a year, robbing the state of that much more property tax revenue and, ironically, hindering the development of some multifamily affordable housing projects. In San Francisco, an “overpaid CEO tax” imposing an additional tax on companies whose top executive earns 100 times more than the median employee, has made the city an even less attractive headquarters location for many.

State legislators have also repeatedly tried to push through a wealth tax that would levy an additional annual tax on individuals worth over $50 million. They’ve sought to amend the state’s constitution to scrap the legally mandated ceiling on personal property taxes. All this is on top of the Trump-era Tax Cuts and Jobs Act, still in effect, which capped the amount of state and local taxes residents can deduct from federal tax returns at $10,000, meaning most of the ultrawealthy residents now face higher federal tax burdens (since their state and local taxes often far exceed $10,000).

“Ultra-wealthy millionaires and billionaires generate their wealth from California’s robust economy [while] working Californians shoulder the burden to pay for our roads, schools, infrastructure, and so much more,” said Assemblymember Alex Lee, who proposed the wealth tax. But Lee has this exactly backward; California’s tax system actually means millionaires and billionaires fund a share of expenditures disproportionate even to their extreme wealth. For instance, though someone who makes a million dollars per year earns 20 times more than someone who makes $50,000 per year, the millionaire pays over 33 times more income tax. The difference is exponential — progressive, not proportional.

California also makes it onerous for those who try to leave. It doesn’t technically have an exit tax yet (though some lawmakers have advocated for one), but it’s extremely aggressive about taxing nonresidents on income they determine to be “California-source.” This includes wages earned by nonresident employees while physically in California, freelance income earned for services rendered to a California company, even if the freelancer was never physically in California during the tax year, and stock options earned in California, even if the beneficiary has left California by the time they vest.

One CPA told Pirate Wires he's noticed California has become much more proactive about sending invoices to out-of-state clients it believes have earned “California-source” income in recent years. “California has an $800 minimum filing fee which they have been aggressively going after, and once clients pay it, California seems to think they owe more for income allocated to the state.” He said he actively counsels wealthy clients not to move to the state.

CALIFORNIA EXODUS

What happens if the wealthiest Californians leave? Most immediately, tax revenue will crater, which will mean the state either has to hike up taxes on those who remain, or cut spending. The former would likely mean higher income, capital gains, and property taxes — along with, potentially, new wealth and exit taxes, or a myriad of arbitrarily increased local taxes (e.g. mansion tax, overpaid CEO tax) — all of which would further the exodus of the wealthy.

On the other hand, the latter would likely entail a dramatic decrease in the quality of public services statewide. Signs of this degradation are already visible. The proposed repeal of Prop 47, the 2014 law that effectively decriminalized serial retail theft of less than $950 worth of merchandise, has come up against stiff opposition from progressive Democrats who rely on the money the state saves by not incarcerating thieves — and keeping them on the streets, leaving the public to deal with them — to fund their social welfare programs. These progressives are, in turn, proposing more cuts to the state’s prison system to bridge the deficit that would inevitably curtail the state’s (already limited) ability to incarcerate criminals. Meanwhile, “L.A. County juvenile halls are so violent that many officers are skipping work,” a recent LA Times headline reads, after legislators just cut an additional $400 million from the state’s prison department.

Amid the “Defund” hangover, cities like Oakland and San Francisco are facing steep shortages of police officers, with Oakland mulling further cuts to its police and fire departments if a deal to sell its portion of the Coliseum to private developers falls through. SF is set to lay off around 600 teachers and merge some public schools to stem its school district’s growing budget deficit. And BART, the Bay Area public transit network that serves around 170,000 people a week, has said the only way to address its “financial crisis” is either via new tax revenue or steep service cuts. Safety on the trains also remains a concern; violent crime on BART is up 13% since 2022, and crimes like mugging have skyrocketed almost 60%.

What are the odds of the state getting ahead of this doom loop? On the lower side, certainly. Though Newsom is moderate by California standards and has signaled awareness of the need to reform the state’s volatile tax system, he’s termed out in 2026 and increasingly eyeing a gig in Washington. If a progressive wins the governorship and gives free rein to the Democratic supermajority in the legislature — whose recent proposals to implement a wealth tax, give unemployment benefits to striking workers, and provide free transit passes to all students (irrespective of family income level) were all either opposed or vetoed by Newsom — the state’s budget could quickly spiral out of control.

Affluent states and industry cities have fallen before. Detroit’s population has declined over 60% since its peak in the 1950s, when it was the thriving center of car manufacturing, “like Silicon Valley in the 1980s,” as one historian put it. The city declared bankruptcy in 2013. Hollywood and SV are now vulnerable to downsizing and outsourcing. Is a Detroit-like future in store for California? Probably not; the state’s economy is far more diverse and resilient than the Motor City’s ever was, and its 840 miles of coastline and temperate climate will always attract a population. Maybe the fate that awaits it will be more akin to Southern Europe-style stagnation — a gradual shift to a tourist-focused economy, in which locals are priced out of their homes by short-term rentals, infrastructure investments are crippled by deficits, and cutting-edge industry vanishes. Or maybe it will be something different altogether. An unimaginable decline.

For now, California continues to add high net-worth taxpayers and still has more resident billionaires than any country in the world, except China and, of course, the US as a whole. But politicians would be naïve to assume these high-earners will indefinitely tolerate uncapped tax increases and dysfunctional public services. Industry cities are vulnerable. Insurance companies are pulling out of the state in record numbers, citing risks of wildfires and flooding from climate change. And a wave of baby boomer retirees are preparing to collect their pensions. California’s budget crisis has only just begun.

— Sanjana Friedman