Independent Thinking^®

The California Ballot 2016

Introduction

This November, voters in California will be confronted with 17 statewide ballot initiatives, the product of record campaign spending. Some, including Proposition 60 on Adult Films, seem trite; many are too complicated for a general electorate. However, five propositions could have an outsized impact on the state’s operating and capital budgets; the estimates from the California Legislative Analyst’s Office on the total operating budget impact is between $6 billion and $11.4 billion, or 5% to 9.5% percent of California’s entire general fund revenue budget for fiscal 2017.
 
For investors in California bonds, the outcome of these initiatives and their relationship to the state’s budget is critical for California’s future. On the operating side of the budget, the importance is based on the state’s volatile revenues, which are linked to difficult-to-forecast financial market performance caused by a highly progressive income tax structure. On the capital side of the budget, there is a huge backlog of deferred maintenance and infrastructure needs across the state. Forcing people to vote on these complicated policies during a tumultuous election cycle makes the outcome difficult to predict.

Why So Many?

The number of signatures required to get a measure on the California ballot is reset every four years, based on the votes cast for governor in the previous general election. Since only 42% of the state’s registered voters – a record low – turned out in November 2014, it’s even easier now to put a proposed law before the voters. Another reason the November 2016 ballot is jam-packed with 17 measures is that state law now requires that all citizen initiatives go before voters in November during a general election.
 
In addition, some California communities are considering their own local measures, ranging from a bond proposal for the local school district (e.g., the Capistrano Unified School District) to a sugary soda tax in San Francisco. Overall, there are expected to be about 240 local tax and bond measures, with about half for schools. Because of the unwieldy ballot, proponents and opponents will have to rethink their strategies to compete in an unusually crowded field. Unlike voting for candidates, in which there are signals around partisanship or ideology based on political party affiliations, individuals voting in a referendum who don’t know the specifics around a measure, or are confused about the wording, may be likely to skip it or just vote no out of frustration.
 
The many propositions involving the tobacco, oil, plastics, and pharmaceutical industries also drive up the costs, as deep-pocketed interest groups are willing to spend considerable amounts of money to protect their interests. As Democrats consolidate their holds on Sacramento and statewide offices, ballot measures are one of the few chances outsiders have to make their mark.
 
Conspicuously absent from the total list of 17 statewide ballot proposals is any explicit mention of funding transportation programs after the governor’s failed attempt during a special session calling for a transportation package of $3.6 billion a year. The money for this transportation package would have come from a $65 annual fee for drivers, increases in the diesel and gas taxes tied to inflation, fees charged to polluters, and monies from efficiencies at the California Department of Transportation or Caltrans. In common with other states across the country, there is little appetite now in California for raising gas taxes while debates rage over the progressivity or regressivity of a gas tax and other taxes and fees. See our September 21, 2015 article, “Fiscal Tremors in California,” page 4, Gas Tax for Transportation Infrastructure, for a full description of the governor’s prior proposal.
 
An initiative that is not included in this report based on a lack of major fiscal impact (perhaps eventually $1 billion) but that could have a big impact on voter turnout is Proposition 64 concerning marijuana legalization. There have been conflicting results from studies of young voters, who are generally in favor of marijuana legalization and who tend to lean Democratic, to determine if they could be persuaded to come out to vote for this issue.
 
The five major ballot questions from an investor point of view are as follows:
 

• Proposition 51: School Bonds. Funding for K-12 School and Community College Facilities. A yes vote on this measure means the state could sell $9 billion in general obligation bonds for education facilities ($7 billion for K-12 public school facilities and $2 billion for community college facilities). An important aspect of this proposition is that the K-12 program is based upon a state and local partnership that generally requires schools that receive state grant funding for approved projects to contribute local funding for these projects, ranging from 40%-50% depending on the use of proceeds. The allocation to individual school districts will be done on a first-come, first-served basis. The community college state distribution is done on a scoring system in which points are given based on the size of the local contribution. While technically, every school district has an equal opportunity to leverage this money, in a practical sense it favors wealthier school districts that are able to convince residents to approve their local portion of the financing. The governor has stated that he would like to see a change in the allocation method that would benefit less affluent school districts and, as a consequence, he is opposed to this measure.
• Proposition 52: This initiative would make permanent a charge already imposed on most private hospitals that is otherwise scheduled to end on January 1, 2018. The federal government’s Medicaid program (called Medi-Cal in California) helps pay for health care services provided to certain low-income patients. For a state to receive federal Medicaid funds, the state has to contribute a matching amount of its own money. In 2009, a new program was created requiring California hospitals to pay a fee to help the state obtain the available federal Medicaid funds. This program has resulted in California hospitals receiving roughly $2 billion a year in additional federal money to Medi-Cal. However, the state has diverted some of the funds from the hospital fee program to the state’s general fund. The initiative would make it harder for the legislature to divert these funds in the future.
• Proposition 53: This is the so-called “No Blank Checks Initiative” that would require statewide voter approval requirement for revenue bonds above $2 billion for projects that are funded, owned, or managed by the state. The measure prevents a single project from being separated into multiple projects to avoid voter approval and does not apply to bonds sold by cities, counties, schools, community colleges and special districts. The impetus and financial support behind this proposition comes from a wealthy Delta-area farmer and food processor in response to the governor’s plan to build two tunnels to divert water around the Sacramento-San Joaquin Delta to the south, with an estimated price tag of $15 billion. However, the definition of “project” is unclear. What if a small local water utility wants to fund a project connected to the multi-billion dollar state water project? Would that require voter approval? Other unintended consequences could include private companies selling bonds to fund a project in order to avoid this voting requirement and the state reimbursing the company at higher costs than the state issuing the bonds itself. In addition to the Delta tunnel plan, California’s $68 billion high-speed rail project could be affected. Though the rail project has secured initial funding, the governor is considering leveraging revenue from the state’s cap-and-trade program (money industries pay to offset carbon emissions) to secure private investment in the project. If those investments take the form of revenue bonds, the initiative would apply.
• Proposition 55: The measure will extend Proposition 30, approved in November 2012, until 2030. That means that joint filers with taxable income over $1.053 million would continue paying the additional marginal income tax rate of 3%, along with the base marginal rate of 9.3%, not to mention the added 1% rate on incomes over $1.053 million dedicated to special mental health funding, for a total maximum rate of 13.3%. (The sales tax increase approved at the same time would still expire.) Proposition 55 assumes increased state revenues ranging from $4 billion to $9 billion from 2019-30, depending on the economy and the stock market. The measure’s resulting increased revenues would continue to be used for K-12 schools and community colleges, health care services for low-income people, budget reserves, and debt payments. If passed, the state will thus maintain its reliance on a volatile tax while burdening a relatively small (and mobile) percentage of California’s population. If the state doesn’t extend this tax, however, what happens to these major state programs, and is the state willing to find alternative revenue sources that are politically palatable? It should be noted that not all spending is equal under the budget rules. Schools may receive less if they only receive their guaranteed share of the general fund under Proposition 98. Debt service still gets paid as a defined “priority payment.” Other spending, especially for social services or discretionary higher education funding, is much more vulnerable. The income tax and the consequences for the state will be discussed further in the California Budget section of this report.
• Proposition 56 is a cigarette tax to fund healthcare, tobacco use prevention, research and law enforcement. State excise tax on cigarettes and tobacco products, including electronic cigarettes, would increase by $2.00 per pack – from 87 cents to $2.87. The increase would make California’s cigarette tax the ninth highest in the nation, up from 36th at present. The tax should generate net state revenue of $1 billion to $1.4 billion in fiscal 2018, with potentially lower annual revenues over time. Revenues for this tax will be deposited into a new special health fund for smoking prevention and research programs. This initiative is designed more to discourage smoking than as a revenue-raising device.

California Budget

This June, the legislature approved a $170.9 billion budget that increases some funding for social services but also puts away more monies in a rainy-day fund. Some of the most consequential decisions for the state’s financial future may not be made until the November election. This is a typical example of California’s dual-track system for managing its finances, with some decisions made in the Capitol and others at the ballot box, as politicians lack the political will to make unpopular decisions.
 
Always a concern for debt holders of California paper is the state’s susceptibility to boom-and-bust budgetary cycles, a by-product of its simultaneously high incomes, progressive income tax regime and above-average poverty rates. During stock and technology sector booms, soaring capital gains incomes and bonuses accrue disproportionately to those at the top of California’s income spectrum. The top one percent of earners, who are subject to the state’s progressive personal income tax schedule, also paid an outsized 48% of total personal income taxes. Besides a heavy reliance on a relatively small number of taxpayers, there is also an obvious downside corollary to linking revenue performance to financial markets, as the personal income tax revenues are much more volatile than the state’s overall economy.

As mentioned earlier, unlike the original Proposition 30 from 2012 that increased both income and sales tax, the proposed Proposition 55 is only maintaining the income tax surcharge. Presumably, it is easier to pass a proposition that just burdens the wealthy, no matter the inherent risks involved with this strategy. For a discussion on broadening the sales tax base in lieu of an increase in the income tax, see our September 21, 2015 article, “Fiscal Tremors in California,” page 5, on the Senate Bill 8 Upward Mobility Act.
 
In addition, when California’s tax revenues begin falling short of the budget forecast, its institutional capacity to make a midyear fiscal course correction is restricted. The governor has limited authority to cut spending or impose allotment reductions after the budget takes effect. The main line of defense is the state’s reserve funds.

California Trading Values

As indicated in the chart below, the municipal market has recognized the progress made by the state, based on trading values for 10-year, non-callable, State of California general obligation debt compared with the gilt-edged AAA scale. At the widest spreads in 2009, the state was in abysmal financial shape. A voter initiative to raise taxes, similar to Proposition 30, failed miserably. During this period, California was also running record deficits and had to resort to delaying payments to local governments, state employees and vendors to manage its cash flow crisis during one of the worst recessionary periods in the state’s history. Since this era of fiscal instability, the governor and the legislature made a series of programmatic cuts and, aided by a growing economy, were able to structurally balance the state’s budget. This restored the faith of enough of the electorate to pass Proposition 30. The time has now come to see if the electorate can be called upon to renew that faith by passing Proposition 55.
 

Conclusions

The passage of one or more of these five critical ballot measures could have a significant impact on California. The state’s revenues, which have a propensity for wide swings in performance, mean that the forecasted tax collections aren’t reliably sustainable, and investors will have to weigh the potential impacts in the context of future recessions along with today’s relatively robust environment. Capital priorities may also need to be realigned during an era of significant underfunding for infrastructure. The hard-fought fiscal alignment achievements of the past five years could be eroded, exposing Californians to more political and financial uncertainty.
 
We remain reasonably confident that California will retain its recent fiscal discipline and that the state and most local entities will manage their long-term liabilities while identifying new revenue sources to address capital needs. However, the importance of ballot initiatives highlighted here and the sheer volume of the entire number of initiatives add a level of uncertainty over which ones will pass. In the interim, we favor purchasing California bonds secured by essential purpose enterprise systems in affluent regions. We continue to research and purchase a diversified variety of state and local credits that help provide appropriate risk-adjusted returns for our clients.

Howard Cure is the Director of Municipal Bond Research at Evercore Wealth Management. He can be contacted at [email protected].