During the COVID-19 lockdowns and early part of the recession, the governor’s state budget update predicted a $54 billion shortfall over three fiscal years. As a result, California Gov. Gavin Newsom decided that properly funding future state employee pension costs seemed like a luxury California could not afford. In last May’s budget revise, Gov. Newsom eliminated the state’s planned $2.4 billion supplemental payment to the California Public Employees’ Retirement System (CalPERS), which would have reduced the public pension system’s unfunded liabilities.
Since that time, however, state revenues have greatly outperformed the dire estimates. In fact, last month’s budget estimated higher tax revenues in the current 2020-2021 fiscal year than the state estimated it would generate in its pre-pandemic budget a year earlier. Despite, the positive budget news, the governor chose not to reinstate the extra CalPERS contribution. This is a decision well worth revisiting.
The need for CalPERS to make catch-up contributions did not diminish. Indeed, the system reported asset returns of just 4.7% for its fiscal year ending June 30, 2020-—well below its 7% assumed rate of return. When actual investment returns fall below a public pension system’s expectations, unfunded liabilities increase. At CalPERS, the red ink grew from $158 billion in 2019 to an estimated $163 billion in 2020. The current fiscal year may be better for CalPERS given relatively strong stock market performance thus far, but we won’t know for sure until the summer.
Either way, CalPERS will still have an enormous unfunded liability, which should be paid down. One reason for urgency is the coronavirus pandemic’s potential impact on California’s long-term fiscal health. In late 2020, the state’s coffers benefited from the continued dominance of Google, Facebook, and other California-based technology companies. With people working and spending more time in the virtual world, demand for online services is booming. This increased employment, compensation, and capital gains on company stocks that tech employees chose to liquidate, is producing a windfall in unanticipated income and capital gains tax revenue for California.
But the coronavirus pandemic has also given rise to longer-term budgetary concerns. The adjustments companies have had to make to get work done in the COVID-19 environment showed that it is not necessary for some employees to be in offices every day to be productive. Many companies are expected to let employees work remotely, even after COVID fears diminish. Also, tech professionals have also gone almost a full year without in-person networking, suggesting virtual conferences can do much of the work of in-person events.
These findings mean that tech workers, other knowledge workers, and entrepreneurs are going to be less tethered to fixed locations going forward. And that is likely bad news for California. An increasing number of high-tech, high-income professionals are realizing that they can achieve their career objectives far away from the Pacific coast, where housing and other living costs are often much lower.
By moving from California to Nevada, Texas, or Florida, for example, workers can fully eliminate their state income tax liabilities, which top out at 13.3% here and are mostly no longer deductible from federal tax due to Trump-era tax legislation.
High-profile executives such as Elon Musk, Larry Ellison, and Joe Lonsdale have already left California. Each billionaire who exits California can reduce state tax revenues by tens, or, perhaps in a few cases even hundreds, of millions of dollars annually.
When lost state tax revenues from these mega-taxpayers are added to the hundreds of thousands of upper-middle-class families leaving California and coming off the state’s tax rolls, the potential impact on tax collections could be quite large in the years ahead. Although state legislators have kicked around ideas about taxing California ex-pats after they leave the state, such legislation is unlikely to survive court challenges.
As workers eligible to telecommute flee to other states, California’s future state income tax revenue potential could end up being much less than it was before the pandemic. But, unfortunately for the state, the future pension costs for CalPERS will be little changed. For this reason, California should be paying down public pension liabilities now, when times are flush, rather than waiting for a future during which state finances are likely to be much more constrained.
Gov. Newsom should consider replacing some of his new spending initiatives and reinstating payments to reduce CalPERS’ debt.
A version of this column previously appeared in the Orange County Register.
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