State ranks high in recession readiness

“It’s nice to be recognized for hoping for the

best but preparing for the worst . ... There is

a lot of uncertainty.” H.D. Palmer, California

Department of Finance

Thanks to its large budget surplus, California is well-prepared to get through a moderate recession without having to raise taxes or slash spending, according to a new study by Moody’s Analytics.

In fact, California ranks fourth out of 50 states when it comes to recession readiness. That’s up from 15th place in 2019, the last time Moody’s did the same type of “stress test” on the states.

“It’s nice to be recognized for hoping for the best but preparing for the worst,” said H.D. Palmer, a spokesman for the California Department of Finance. However, when you look at the stock market, the war in Ukraine, soaring inflation and rising interest rates, “there is a lot of uncertainty that warrants our attention and our caution.”

Moody’s found that a record 43 states have enough resources to withstand a moderate economic downturn without severe cutbacks or tax increases.

“The recovery from the pandemic has been a lot quicker than we originally anticipated,” said Moody’s economist Emily Mandel, who co-authored the report. “Federal stimulus has had a significant role in getting the economy moving again. It’s giving money directly to states and creating economic activity that has allowed revenues to come back faster than expected.”

The study first looked at how much cash each state had at the end of fiscal 2021 as a percentage of its 2021 general fund revenues.

It then projected the “fiscal shock” that would result from a recession as a percentage of 2021 general fund revenues. Specifically, it estimated how much tax revenues would fall and how much Medicaid spending would increase in fiscal 2023 and 2024 if there were a recession versus no recession. Other spending would also increase, but Moody’s focused on Medicaid because “it is a massive part of state budgets,” and it’s mandatory, Mandel said.

It then subtracted the “fiscal shock” from the percentage of cash reserves each state had at the end of 2021 to determine how much of a cash cushion or shortfall would remain after a recession. It ranked the states by this number.

North Dakota and Wyoming

were nearly tied for No. 1. “Energy states tend to have volatile revenues,” Mandel said. “They have significant rainy-day reserves set aside, not just now.”

But Alaska, another energy state, ranked second to last, after Illinois.

Alaska “had to spend down a lot of their rainyday fund to try to get through the pandemic. It just doesn’t have the same reserves as it used to. At the start of the pandemic, when energy prices dropped so far, it took a lot to get through that period,” Mandel added.

In general, “states that opened their economies earlier and rebounded relatively quickly from the COVID-19 recession will be better positioned for their economies to weather a new economic shock,” the report said.

Although California had more restrictive public health measures, and for longer than many states, “a lot of California’s economy was made up of white-collar jobs that were able to shift to remote work more quickly,” Mandel explained.

The report also looked at how much each state had in a “rainy-day” fund as a percent of its 2021 general fund revenues, and how much of that fund would be depleted from the fiscal shock of a recession. It found that California had enough in its rainy-day fund alone to cover the estimated fiscal impact.

Going into 2022-23, the state had $23.3 billion in its rainy-day fund for fiscal emergencies, and an additional $13.9 billion in three other reserve accounts. That added up to a record $37.2 billion in budgetary reserves.

Much of that surplus stemmed from the stock market performing far better than expected coming out of the past recession, Palmer said.

In 2012, California voters approved Proposition 30, which raised the state income tax rate on top earners to 13.3%, highest in the nation. The top 1% of personal tax returns were responsible for more than 49% of personal income tax paid in 2020, the most recent year this data point is available.

“That very narrow band of taxpayers has a lot of income generated by capital gains and stock options, which are a function of the stock market,” Palmer said.

The Moody’s report did not take into account the stock market tumble that started in January and accelerated in April. However, “I think it is more of a risk for California than for most states,” Mandel said. As of Monday, the Standard & Poor’s 500 index was down 23% year to date.

Palmer said the state had to “lock down” its 2022-23 revenue forecast in May. Because of the stock market and other concerns, “the governor and the administration said we need to be wideeyed and prudent going forward,” he added.

Gov. Gavin Newsom vetoed almost 170 bills this year; in many cases because of slowing tax revenues. However, he championed “inflation relief payments,” ranging from $200 to $1,050 for almost all Californians except the very richest. Those payments will start going out this week.

Those payments, totaling $9.5 billion, will come from the general fund, not reserve funds, and represent a small portion of the state’s $234 billion in general fund expenditures, Palmer said.

Jerry Nickelsburg, director of the UCLA Anderson Forecast, said the state has been “stockpiling” reserves since the past recession. As a result, state-government deficits will not exacerbate a recession, should one occur, like they have in the past.

Although the stock market has taken a beating, “venture capital investment is still heavily in California, by a significant margin, as is foreign direct investment.” And increased defense spending will boost demand for sophisticated weaponry coming from California.

“Where there is potential weakness” is in residential construction, which will be hurt by higher interest rates, and in transportation and warehousing, Nickelsburg said.

It’s unclear what impact, if any, people and companies moving out of California will have on state tax revenues.

“We have not seen the full shakeout” of the move toward remote work,” Nickelsburg said. But “if you look at the latest data compared to pre-pandemic, California’s economy is growing faster than the U.S.”

Chris Hoene, executive director of the California Budget & Policy Center, said that “from a purely fiscal standpoint, California is in a much better position than other states, and much better than California in prior recessions. But that’s about the state and its finances. The reality is, whenever we have an economic downturn, the burden of that falls most heavily on the people at the bottom of the economic spectrum.”

If the state does face a recession, will the governor and Legislature “make decisions to make sure people at the lower income levels suffer the least harm?” Hoene said. “Or will they do what they did in recessions past and tilt the wheel in the direction of tax credits for businesses to stimulate the economy that don’t prove to be necessary or effective, or make really harmful cuts” to safety-net programs?

“It’s really how they manage it from here,” Hoene said.