The working class may be taking a beating from spending cuts used to close a cavernous deficit, Mr. Williams said, but the root of California's woes is its reliance on taxing the wealthy.
Nearly half of California's income taxes before the recession came from the top 1% of earners: households that took in more than $490,000 a year. High earners, it turns out, have especially volatile incomes—their earnings fell by more than twice as much as the rest of the population's during the recession. When they crashed, they took California's finances down with them.
Mr. Williams, a former economic forecaster for the state, spent more than a decade warning state leaders about California's over-dependence on the rich. "We created a revenue cliff," he said. "We built a large part of our government on the state's most unstable income group."
New York, New Jersey, Connecticut and Illinois—states that are the most heavily reliant on the taxes of the wealthy—are now among those with the biggest budget holes. A large population of rich residents was a blessing during the boom, showering states with billions in tax revenue. But it became a curse as their incomes collapsed with financial markets.
Arriving at a time of greatly increased public spending, this reversal highlights the dependence of the states on the outsize incomes of the wealthy. The result for state finances and budgets has been extreme volatility.
In New York before the recession, the top 1% of earners, who made more than $580,000 a year, paid 41% of the state's income taxes in 2007, up from 25% in 1994, according to state tax data. The top 1% of taxpayers paid 40% or more of state income taxes in New Jersey and Connecticut. In Illinois, which has a flat income-tax rate of 5%, the top 15% paid more than half the state's income taxes.
This growing dependence on wealthy taxpayers is being driven by soaring salaries at the top of the income ladder and by the nation's progressive income taxes, which levy the highest rates on the highest taxable incomes. The top federal income-tax rate has fallen dramatically over the past century, from more than 90% during World War II to 35% today. But the top tax rate—which applies to joint filers reporting $379,000 in taxable income—is still twice as high as the rate for joint filers reporting income of $69,000 or less.
The future of federal income taxes on the wealthy remains in flux. The top tax rate is 35%, following the Congressional tax battle last year. But in 2013, the rate is scheduled to go back to 39.6% unless Congress takes further action.
State income taxes are generally less progressive than federal income taxes, and more than a half-dozen states have no income tax. Yet a number of states have recently hiked taxes on the top earners to raise revenue during the recession. New York, for instance, imposed a "millionaire's tax" in 2009 on those earning $500,000 or more, although the tax is expected to expire at the end of 2011. Connecticut's top income-tax rate has crept up to 6.5% from 4.5% in 2002, while Oregon raised the top tax rate to 11% from 9% for filers with income of more than $500,000.
As they've grown, the incomes of the wealthy have become more unstable. Between 2007 and 2008, the incomes of the top-earning 1% fell 16%, compared to a decline of 4% for U.S. earners as a whole, according to the IRS. Because today's highest salaries are usually linked to financial markets—through stock-based pay or investments—they are more prone to sudden shocks.
The income swings have created more extreme booms and busts for state governments. In New York, the top 1% of taxpayers contribute more to the state's year-to-year tax swings than all the other taxpayers combined, according to a study by the Rockefeller Institute of Government. In its January report downgrading New Jersey's credit rating, Standard & Poor's stated that New Jersey's wealth "translates into a high ability to pay taxes but might also contribute to potential revenue volatility."
State budget shortfalls have other causes, of course, from high unemployment and weak retail sales to falling real-estate values and the rising costs of health-care and pensions. State spending has expanded rapidly over the past decade. California's total spending grew from $99.2 billion in 2000-01 to a projected $136 billion in 2010-11, not including federal funds, according to the state Department of Finance. Though California's spending slipped by 15% during the recession, it has since returned to near prerecession levels.
Some states may get a lifeline this year from the financial markets. Starting late last year, California, New Jersey and others began seeing higher-than-expected income-tax revenues and capital-gains revenues, suggesting the start of the next boom cycle. Still, because many states based their spending plans on the assumption that the windfalls from the wealthy would return every year, they are now grappling with multibillion-dollar shortfalls.
A recent study by the Pew Center on the States and the Rockefeller Institute found that in 2009, states overestimated their revenues by more than $50 billion, due largely to the unexpected fall-off in personal-income taxes. Sales and corporate taxes have also fallen, but they account for a much smaller share of tax revenue in many states.
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