TEXT-Fitch: California election opens door to fiscal improvement

Wed Dec 5, 2012 3:41pm EST

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Dec 5 - The State of California's progress in recovering from the severe
fiscal challenges of recent years could receive an additional boost thanks to
the outcome of the Nov. 6 election, according to Fitch Ratings. The state's
fiscal recovery is incomplete and challenges remain, but continued economic
improvement, a demonstrated commitment to more sustainable budgetary operations
and progress on reducing budgetary debt would be viewed positively by Fitch.

On Nov. 6, voters authorized two measures that will increase state general fund
tax receipts. Proposition 30 temporarily raises the top marginal personal income
tax (PIT) rates on high income filers for seven years, through 2018, and the
statewide sales tax for four years, through 2016. Proposition 39 changes the
method by which multistate corporations calculate their income tax liability.
The state Legislative Analyst's Office (LAO) estimates that in fiscal 2013
Proposition 30 will generate $6 billion higher PIT and sales tax receipts, while
Proposition 39 will generate an additional $500 million in corporate income tax
receipts for the general fund.

California's financial performance for more than two decades has been marked by
volatile revenue swings and periodic, severe fiscal and cash flow crises. The
state's ability to respond effectively to these challenges has been hindered by
numerous restrictive voter initiatives and by a highly partisan policymaking
environment. These factors have offset the state's exceptional economic
attributes and a moderate debt burden, resulting in a general obligation credit
rating currently at 'A-', which is below the level of other Fitch-rated states.

Fitch recognizes, however, that California has made notable progress since the
recession and fiscal crisis of 2008 and 2009. The state has benefitted from
modest but steady economic and revenue gains. Employment has grown in California
for 27 months through October 2012, most recently well in excess of the national
rate, and the unemployment rate, despite remaining elevated compared to the
nation's, has fallen sharply from previous levels. Housing market indicators are
likewise improving.

More importantly, the state has also benefited from incremental improvements in
fiscal management. In a departure from longstanding budgeting practice, with its
focus on stop-gap measures, the fiscal 2012 and fiscal 2013 adopted budgets
implemented deep, recurring spending cuts, significantly lowering the state's
longstanding structural imbalance. Several recently-passed voter initiatives
have facilitated more effective budgeting, most notably Proposition 25, which
passed in November 2010 and allows a simple legislative majority (rather than a
supermajority) to adopt the state's spending plan. Various statutory and
administrative changes since early 2009 have augmented the power of the state's
comptroller, treasurer and budget office to effectively manage state cash
resources and avert cash flow crises.

Fitch believes that the passage of Propositions 30 and 39 last month is a
continuation of these positive trends. However, while materially enlarging
general fund resources, in Fitch's view the key credit consideration will be how
California responds to the prospect of expanded revenue flexibility. The
governor has prudently emphasized the need to prioritize repayment of
approximately $34 billion in budgetary borrowing accumulated during the last two
fiscal crises and estimated that the adopted fiscal 2013 budget, assuming
passage of Proposition 30, would enable the state to lower budgetary borrowing
to $8.9 billion in fiscal 2016.

The state faces other near-term fiscal uncertainties. These include the familiar
challenge of an emerging general fund budget gap estimated by LAO at a
cumulative $1.9 billion through June 30, 2014 (although at a level far below the
gaps confronted by the state in recent years). The LAO forecast noted both
revenue underperformance and the state's inability to fully realize budgeted
solutions in the new gap estimate. Likewise, the potential 'fiscal cliff' and
federal deficit reduction negotiations in general pose economic and budgetary
uncertainty to California and other state governments.

In Fitch's view the temporarily elevated marginal PIT rates for high earners
approved by voters through Proposition 30 will likely expose the general fund to
greater volatility in revenue collections prior to their sunset in fiscal
2018-19. The prospect of greater future volatility highlights the importance of
using temporarily higher revenue resources to reduce past budgetary obligations
and rebuild flexibility; the state's budget stabilization fund last carried a
balance in fiscal 2008.

Past fiscal recoveries in California have been marked by big cyclical revenue
gains being absorbed by expanded, recurring state expenditures, setting the
stage for even larger budget gaps when cyclical revenues invariably fall. With
the deep structural cuts of recent years, budget makers may face a similar
temptation to restore cuts going forward. As development of the fiscal 2014
budget begins, Fitch will closely monitor the state's economic and fiscal
progress, including steps toward more sustainable budgetary operations.


Additional information is available at 'www.fitchratings.com'.
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