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Preparing for California’s Next Recession

Summary

This report begins with the assumption that California will face a recession in the none-too-distant future. When that recession comes, the state will most likely experience a fall in revenue over multiple years. Our goal is to estimate the impact of a recession on the state’s budget, determine the extent to which current reserves could help the state navigate drops in revenue, and help identify steps policymakers can take to reduce the next recession’s impact on the state’s economy and residents.

Because California’s tax structure is highly sensitive to economic ups and downs, recessions hit the state’s budget particularly hard. Past recessions have caused deep drops in General Fund dollars leading to a combination of spending cuts, tax increases, and borrowing in an effort to balance the state’s budget.

Since the Great Recession, the governor and legislature have taken a number of steps to help the state prepare for the next economic downturn. But there is room for more preparation. Using the state’s experience with past recessions as a guide, we outlined scenarios for the next downturn: mild, moderate, and severe. We also factored in the impact of revenue shortfalls on funding levels for the K–12 and community college systems, which are guaranteed by Proposition 98.

  • We estimate that a relatively mild recession would produce a drop in total General Fund revenue between $28 billion and $36 billion spread over three years. Should the state experience a moderate recession, revenue declines would range between $69 billion and $100 billion over four years. And finally, in a severe recession declines would be even deeper, between $173 billion and $185 billion over five years.
  • We find that California is prepared to withstand a mild recession given its current level of reserves. In the moderate and severe scenarios, policymakers would exhaust current reserves and still be looking to close a gap in the budget anywhere from $5 to $18 billion each year, for several years.
  • Our estimates suggest that under these scenarios, the Proposition 98 guarantee would fall $4–5 billion per year below projected levels in a mild recession and between $8 and 15 billion per year under the moderate and severe scenarios.

Given that filling gaps of that magnitude would likely cause considerable hardship for the state’s residents, we recommend that as the state continues to prepare for the next recession, it should take steps to mitigate the effect of a possible economic crisis, in a manner similar to a community preparing for an earthquake or other natural crisis. These include:

  • Continuing to set aside reserves, limiting recurring spending commitments, and undoing changes made during earlier recessions that are no longer needed.
  • Determining budget priorities now by exploring detailed “what if” state budget recession scenarios, including an explicit discussion about Proposition 98 spending during a recession.
  • Anticipating opportunities for strategic investments that may arise during an economic crisis.

In the past, the federal government has provided financial support to states during economic downturns. But now that the federal deficit is moving into uncharted territory, it is not clear how much assistance will be forthcoming when the next recession hits. Given this fiscal uncertainty at the federal level as well as a changing global economy, careful preparation for the next recession takes on even greater importance.

Supported with funding from the Arjay and Frances F. Miller Foundation

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