My beloved state of California, whose $2 trillion economy is the eight largest in the world just ahead of Italy and Russia, has a new problem: it’s awash in cash. It’s projecting multi-billion dollar surpluses for years to come, and the feeding frenzy in Sacramento is a sight to behold.
Not all that long ago, in February 2012, California was in a $3.3 billion hole. The out-of-money-date would have been March 8. In order to stay afloat, the state shuffled money between different accounts and made a few cosmetic spending cuts to appease Wall Street lenders which then filled the remaining hole with new debt, as they’d almost always done.Almost always, because twice in California’s illustrious financial history they didn’t, most recently in 2008, when California escaped default only by printing fancy official-looking IOUs and handing them to suppliers, instead of paying them with real money.
Now legislators are fighting over a surplus.
California’s budget is dependent on a magnificent revenue stream: capital gains taxes.Magnificent when the housing and stock markets are booming, when people flip homes for quick outsized profits and sell dubious stocks that have doubled or quintupled, and when founders and employees pocket spectacular gains from ludicrously valued California startups, either after IPOs that are flying off the shelf one after the other and then continue to soar, or when big local mastodons like Google, Facebook, and Yahoo acquire them at dizzying prices with their own currency – their shares – of which they can print an endless amount. The bigger the bubble, the more magnificent the capital gains tax revenue.
But capital gains realizations are not exactly a paragon of stability (chart). In 1995, at the cusp of the dotcom bubble, Californian taxpayers realized $20 billion in capital gains. Then the dotcom bubble took off, and capital gains realizations soared. By 2000, they’d sextupled to nearly $120 billion. As the bubble was imploding, they plunged and bottomed out in 2002 at $33 billion.
Then the next bubbles came along, this time in housing and stocks – particularly in housing, while the California-based IPO-hype industry didn’t reach its full bubble potential. By 2007, capital gains realizations hit a new record of over $130 billion. Only to go straight back to heck. Two year later, capital gains realizations dipped below $30 billion. So the Fed started printing money and capital gains realizations jumped, hitting an interim peak in 2012 of $105 billion, before dropping some in 2013.
A drop in what should have been the fabulous year 2013? Indeed. In 2013, higher federal tax rates kicked in for certain taxpayers. That tiny number of lucky Californians in that high-income category sold what they could in 2012 to realize capital gains before they’d get whacked by the new higher tax rates, and the State of California grabbed its share.
In 2013, the tax selling was over, and capital gains realizations dropped some, though housing entered a full-blown bubble, stocks soared without economic justification, and Twitter along with hundreds of other IPOs with big net losses and valuations that made your head spin printed thousands of millionaires and a few billionaires. But there are lockup periods and other reasons – and they just haven’t dumped their paper in a wholesale manner yet.
Most capital gains realizations, and the taxes to be collected, don’t kick in until investors sell their stakes. During the dotcom bubble, the peak selling, and hence capital gains realizations, occurred as the bubble was blowing up in 2000 when everyone was trying to save what they could at still high valuations.
But 2013 wasn’t that year of fear. It was a bubble year. Wholesale dumping hasn’t started yet. Some of the biggest California IPOs are yet to come, and exuberance is still driving the stock market, and the housing bubble hasn’t imploded just yet, though the first cracks have appeared. So a lot of manna is still to rain down on the State of California. Because it’s during the early stages of the next bust that capital gains tax revenues will hit new peaks.
The Legislative Analyst’s Office has included that manna in its projections for the budget, which triggered the feeding frenzy in Sacramento. That boom-bust cycle is as old as California itself, and the bust always comes – and it’s never included in the projections. Projections for capital gains taxes only know one direction: up.
Alas, during the last bust, capital gains tax revenues plunged by $7 billion and caused California to issue IOUs because it couldn’t pay suppliers with real money.
The record capital gains realizations of 2012 generated over $10 billion in revenues in the 2012/2013 budget year ending June 30, according to the Legislative Analyst’s Office. It amounted to a record 15.4% of total personal income tax revenues ($65 billion). During the dotcom bubble, capital gains revenues maxed out at 10.6% of personal income taxes. By comparison, sales and use taxes brought in $20.5 billion, the corporation tax $7.7 billion, and various other taxes $6.6 billion, for a total of $100 billion. So, in the 2012/2013 budget year, capital gains taxes, the most variable of all taxes, made up 10% of all revenues!
That manna was a rare miracle. But it brought the budget into balance. And now, an endless series of these miracles are going to generate an endless series of surpluses, according to the projections. California’s propensity to use miracles to manage its budget is well known. People believe in the annual reappearance of these miracles and base important decisions on their punctual arrival. Doubters are not tolerated.
So the bubbles must go on, simultaneous bubbles in housing, stocks, and IPOs – by now, a stock market bubble alone won’t be enough – just to keep California afloat. And the next bust? Well, if you ask around, it’s not going to happen. And when it does happen, expect budget chaos and voluminous printing of IOUs.
Meanwhile, the IPO scene is sizzling: 25 pre-IPO startups, dogged by puny revenues and hefty losses, have “valuations” from $1 billion to $10 billion. But there are already the first multi-billion dollar fiascos, even in the immensely hyped Cloud and Big Data sector. A harbinger for things to come. Read…. IPO Highflyer Hits the Sidewalk After Smart Money Bails Out