Despite negative headlines regarding balancing the California budget in 2012, its second quarter appears to be on track and steadily moving forward.

 

The Budget Act of 2012-2013 was signed by Governor Jerry Brown at the start of the fiscal year.  It is in its second year of budget success and has closed the gap by generating a $1 billion rainy day reserve.  This was the result of significant spending cuts, revenue from temporary taxes, special fund transfers, inter-fund loan rollovers and other revenues.

 

Cuts included Medi-Cal, Cal Works, Cal Grants and childcare.  Forecasts are optimistic for moderate economic growth for 2013 that includes income gains of 3.4% and lower unemployment.

 

Prior to the passage of Prop 30 on November 6th the budget relied on temporary tax revenues derived from a 3 % increase on taxes from those earning over $250,000.  The passage of Prop 30 has fortunately avoided the 6 billion in spending cuts targeted at K-12 education and budget gap of 2.5 billion.

 

Budget items that may be at risk include;

  • Savings and one-time cash transfers
  • Personal income tax related to the Facebook IPO ($1.2 billion)
  • Restructuring cost savings at Medi-Cal and CalWorks ( $1.9 billion)
  • New revenues tied to carbon cap and trade auctions ($500 million)

 

The federal fiscal policy is assumed to be resolved by year-end 2012, however, federal spending is 1/3 of total state spending and federal cost cutting may affect California’s fiscal health.

 

Federal spending may include:

  • Federal procurements and salaries (4 % of state GDP
  • 10% reduction in federal grants (costing the state 6.7 billion that would eat into health and human services)

 

A slowdown in China and the financial crisis in Europe will also have an impact on the 2013-2014 State’s budget.

 

1% of California’s wealthiest taxpayers will pay more than 3/4 of Prop 30.

 

San Jose and San Diego passed local pension reform measures this past June and in September the legislature also passed statewide pension reform measures.  Cost savers included:

  • Raising retirement age for new employees
  • Increasing employee contributions to at least 50% for both new and current workers

 

The states analysis of its portion of savings was estimated from $10 billion – $13 billion over the next 30 years.

 

Some investors are concerned about the recent city bankruptcies of Vallejo, Stockton, Mammoth Lakes and San Bernardino.  However, cities, unlike corporate entities under Chapter 11, cannot be liquidated and exist in perpetuity, at least theoretically.  The bankrupted cities suffered from sharply depressed home prices, high fixed costs associated with employee pay and benefits packages, restrictions imposed by Proposition 13 and other events.  Some cities have resorted to declaring fiscal emergencies as a tactic and need to be carefully evaluated.

 

In short, California’s budgetary shortfalls have narrowed and longer term structural balance is expected to be achievable.

 

Moody has determined that it does not expect many other California cities to follow the lead of Stockton and San Bernardino into bankruptcy but notes that as long as the economic recovery is weak there is more of a risk that other cities may make that choice.

 

Risks for investors are related to fixed income investing and credit risk. When interest rates rise, there is a decline in the market value of bonds. Credit risk is when the issuer of the bond does not make principal or interest payments. Some investors may be subject to (AMT) Alternative Minimum Tax. Capital gains are taxable. A fund focused on a single state is a greater risk for adverse economic conditions and regulatory changes than funds with broader geographic diversification.

 

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