What Went Wrong With California?
Patrick Boyle
The video starts with laying out the groundwork and that part is pretty good, but then he gets into the nuts and bolts of the problems and my brain started going numb, so I copied the transcript and pasted it here. It came out as one big block of text, so I spent some time cutting it up into paragraphs.
Transcript:
California has the largest economy in the United States with a Gross State Product of over four trillion dollars. If it was its own country, it would have the world's fifth largest economy, behind Japan and ahead of India. California is home to some of the world's most valuable technology companies, it’s the center of the global entertainment industry and its farms are amongst the most productive in the world, growing over half of Americas vegetables, fruits, and nuts.
California’s workers are hugely productive too, the state has a GDP per capita of $104 thousand dollars which would rank it as number six in the world – if it was a country. Tax havens (which California definitely is not) often have distorted GDP as multinational companies frequently transfer intellectual property assets to tax havens – like Ireland - which get counted as that countries GDP. Income on foreign owned capital held in a tax haven also gets counted as GDP because the income originates in that country – even if the financial firm has nothing but a PO Box to show for it.
If we exclude tax havens from the list – to remove these distortions - California really stands out as the most productive place in the world. Unfortunately, some of the shine has started to come off of the Golden State in recent years as companies and workers have been leaving. Elon Musk famously announced this summer that he would move the headquarters of his companies from California to Texas. He has long complained about overregulation and excessive taxation in California but said that the final straw was a new law relating to parental rights.
Critics argued that Musk was attacking the state after years of benefiting from its abundant government support – which was of course paid for by the high taxes. The president of the California Labor Federation told the LA Times that “California, through tax credits, electric vehicle subsidies and training grants made Elon successful.” It’s not just Elon Musk however, companies like Chevron, Hewlett-Packard, Palantir, and Charles Schwab have all left the state in recent years.
According to the Financial Times, over 200 companies have left California since 2019 with very few companies moving there to replace them. This contrasts with states like Texas and Florida where the exact opposite is happening. This isn’t all that new either, research from the Hoover Institution shows that this trend began well before the pandemic and has been slowly picking up pace. They point out that corporate relocation planning takes years, giving the example of the NHRA who left California in 2021 after a twelve-year study.
According to Joseph Politano at the Bureau of Labor Statistics, the biggest beneficiaries of the post pandemic move have been States like Texas and Florida, whose economic growth has outstripped most emerging markets in recent years with huge jobs growth too. Now, it’s worth noting that despite all of this negativity, California has been growing faster than the United States overall, and the United States has experienced great economic growth in recent years, but as Texas and Florida have grown, so have jobs, but in California there has been economic growth paired with very weak jobs growth – which is a problem.
The US unemployment rate sits at 4.1%, which is not far off its low, but in California, the unemployment rate has risen to 5.3%, the highest of any US state. The recent tech and AI boom has been good for California, but not for Californians. According to the LA Times, California’s homelessness problem – which has always been an issue has grown by 40% over the last five years and half of all homeless people in the United States live in California.
So, how is California different from the rest of the United States, how did they go from a hundred-billion-dollar budget surplus two years ago to a budget crisis with a $73 billion dollar deficit today? And what explains the Californian exodus, and lack of new arrivals?
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Early settlers mistakenly believed that California was an island – entirely separated from the United States by the Gulf of California. In many ways it developed like an island too with its major population centers all on the coast - as it was cut off from the rest of the United States by huge mountain ranges and hard to cross deserts. Before rail and good roads were laid the easiest route from the East Coast to California was by sea.
The state’s modern economic history began with the Gold Rush in 1848, which attracted over 300,000 settlers, boosting the population and infrastructure which led to statehood two years later in 1850. The oil industry played a significant role in the state’s early economic development too, after oil was discovered in Los Angeles in 1895. California quickly became the biggest oil producing state up until 1936 after which reserves became depleted. Today oil and natural gas are mostly imported into California from abroad – which partially explains the States high energy costs.
Agriculture has been a huge industry in the state too, with Californian farmers focusing on the production of the highest margin produce. The film industry is possibly what California has been most famous for around the world, and along with the tech sector, it contributes significantly to California's global cultural influence – which has been huge. The development of Silicon Valley in the late 1970s transformed California into the global leader in technology and innovation – which it remains to this day.
Given the size of the State economy, it is no surprise that there is also a vibrant financial sector too. California’s public universities are ranked amongst the best in the world for academic excellence, research and innovation. They attract top-tier faculty and focus on research and development which has driven advancements in technology, medicine, and the arts.
The top Californian universities have policies in place that encourage students to take ownership of their research. Students are often given the opportunity to be named on patents they developed and are supported by the universities in commercializing their work. The UC system has resources like technology transfer offices and entrepreneurship programs to help students navigate intellectual property rights and develop their research into marketable products or services.
At other universities, the ownership of research and IP might be more strictly controlled by the institution itself, many universities retain ownership of all IP created by students, faculty, and staff. The UC system's policies have fostered a sense of ownership, empowerment and entrepreneurship among students and can be given credit for a lot of the innovation and business success that has come out of the state.
California is famously America’s most left leaning state, earning it the nickname “The Peoples Republic of California” – and making it the whipping boy of conservatives, for whom California has long been shorthand for everything wrong in the country.
The State is home to many of America’s most progressive policies, it has the heaviest tax load in the country. Criminal justice policies like de-carceration, de-prosecution, and de-policing (these are all new words to me) have led to a crime problem that has damaged the state’s image along with residents feeling of safety.
Energy prices which are high to begin with in California are likely to only rise higher as the state mandated transition to a zero-carbon grid takes conventional power offline and replaces it with more expensive green sources.
According to research from George Mason University, California is the most regulated state in the US with more than 419 thousand restrictions in place, the majority of which cover “industry, commerce and development”. This overall combination of high taxes, high regulation, high crime and an extreme homelessness problem makes California an easy target for right-wing politicians, and as the situation gets worse – outsiders rush to declare it a “failed state”, or announce that “the California dream is turning into a nightmare”. – I should probably use one of those as a video title… - or something about – checking out of the Hotel California – you guys will click on that… hopefully… The cost of housing and energy are so high in California – when compared with the rest of the United States that even high incomes look a lot less impressive once adjusted taxes and the overall higher cost of living.
The price-to-income ratio for buying homes is twenty-five times median income in Newport Beach, nineteen times median income in Palo Alto, twelve times in San Jose and 11 times in San Francisco, this compares to a national average of 5.6 times for the overall United States, according to researchers from Harvard. According to The Hoover Institution, headquarters migrations out of Santa Clara, Alameda and San Mateo counties reflect high-tech companies in the digital and social media world opting for less expensive locations not only to control business costs but so they can recruit workers who will benefit from lower housing costs in other States.
California’s three greatest challenges today are rising unemployment, growing fiscal strains and population outflows, all of which relate to each other and don’t have easy solutions. In the United States overall the unemployment situation is quite good, with an unemployment rate near its long-term lows and with 1.6 job openings per unemployed person.
In California, the situation is a lot worse, unemployment rose more than in any other state since interest rates were hiked in 2022 and there are just 0.8 job openings per unemployed person—the worst ratio in the country. Big Tech, which had hired aggressively during the zero-interest rate environment, began laying off staff a few years ago as soon as they experienced a slowdown. These layoffs affected the overall Californian economy – not just tech, as when laid off tech workers stopped spending it affected retailers, restaurants, transport and service workers too.
With the slowdown, California’s income-tax collection fell by 25% last year, a drop equivalent to the decline that happened during the bursting of the dot com bubble in 2000 and the global financial crisis in 2008. California’s State Constitution requires a balanced budget in that, if proposed spending exceeds estimated revenues, the Governor has to recommend the sources to make up the budget shortfall.
Governor Newsom projected a deficit of $38 billion dollars for this fiscal year but the Legislative Analyst’s Office, a nonpartisan fiscal adviser for California’s legislature has estimated that the state is on track to spend 73 billion dollars more than it brings in in taxes. This is quite an about turn as just two years ago the state had a 100 billion dollar budget surplus.
The reason California’s budget fluctuates so wildly is that California has a very progressive tax structure, where higher earners pay a much larger share of taxes. When the state’s highest earners do well, the state budget does well – like in 2022, but during business slowdowns tax revenues dry right up. This volatility in tax collections explains why every few years California has a major fiscal crisis.
Governor Newsom defends this setup, saying that it creates a lower tax burden on low- and middle-income workers, but the problem is that the policies are pro cyclical, meaning that when the state needs to spend money – during a slowdown – it has no money to spend and instead needs to cut back.
It’s not obvious that cutbacks on government programs – that are most relied on by low income workers during downturns benefits them. Solutions that have been put forth for dealing with the current budget deficit include deferring promised funding—for universities, the homeless and the disabled. In prior budget crises Californian politicians have played games like pushing payments out an extra day so that they come out of the next years budget or paying IOUs to businesses, students and taxpayers to whom it owed money. None of this fixes the core problem.
The LA Times writes that despite what people believe, overspending is only a small part of California’s problem, they say that the state’s fiscal headache is largely the result of an unstable state tax system that relies too heavily on the rich. For decades, California’s revenues have been heavily dependent on capital gains taxes on the richest residents. Thus, revenues spike in years when the stock market booms as a lot of IPO’s occur and investors sell stocks and other assets.
For example Facebook’s IPO in 2012 brought in an extra 1.3 billion dollars in state taxes. The problem is that in years with an IPO drought, insufficient taxes are collected to keep government programs running As an example, in 2021, the top one tenth of one percent of Californians paid almost thirty percent of all state income tax.
The problem with relying on such a small number of people for such a large percentage of state taxes is that if they choose to leave the state, the tax revenue dries right up. A famous example of overreliance on top earners was in 2016 when New Jersey’s wealthiest resident moved to Florida, throwing the New Jersey State budget into chaos as hundreds of millions of expected revenues evaporated. This is already a problem in California, the State has been losing a growing number of high-earning residents, with the trend picking up pace during the pandemic. In 2021 – according to The Economist - the state lost almost $30 billion dollars in net taxpayer income to other states – as wealthy taxpayers relocated.
California was not always set up like this. In the 1950’s income tax made up only 10% of California’s general fund and sales tax – which is much more stable - was the main revenue source. Since then, California has become much more of a services-based economy and is one of the few states that doesn’t tax services.
Tim Hartford wrote an article this week on some of the strange taxes that have been introduced throughout history like Peter the Great’s beard tax, whose aim was to encourage Russian nobles to shave or Argentina’s bachelor tax which brought about a new profession “the lady rejecter” where women would charge men a fee to write a letter stating that the man had proposed marriage to her and that she had declined the offer. The fact that the man had tried but failed made him exempt from the tax.
Hartford – who was writing about the UK and not California argued that it often works better – when a government needs to raise revenue - to broaden the tax base - while lowering the tax rate at the same time rather than to single out small groups to tax. This is possibly more the case for a state than a country – as it is easier to move to a neighboring state in the United States than it is to move country.
The Economist points out that there is nothing new about more Americans leaving California than move there – they say that this has been going on for over thirty years, but they point out that something else has changed. California’s population still grew over that period because of foreign immigrants arriving there to work. A slowdown in immigration to California from abroad that started during the pandemic has sustained and California has now seen an outright decline in its population for three straight years, the first sustained drop since becoming a state in 1850.
California’s reliance on capital-gains taxes limits the state’s flexibility to fix its budget crisis as hiking taxes further could just drive more rich Californians to leave, exacerbating the problem. According to the Hoover Institute California has hit a wall where the State can’t bring in any more tax revenue without significantly damaging the economy. California’s state income tax rate is amongst the steepest for wealthier people in the United States, topping out at 13.3% for millionaires, and its gasoline tax of almost sixty cents per gallon is the nation’s highest.
While California’s taxes are very progressive, hitting the wealthiest the hardest, the public policy institute of California reports that seventy percent of Californians still feel that they are paying more than they should in state and local taxes. Most taxpayers weigh up what they get in terms of public services for their tax money, and with high crime and extreme levels of homelessness many Californians don’t feel they get any additional public services that are not available in low tax states. They simply feel that they are not getting value for their money.
The one area where the state’s tax collections are lower than in other states is property tax. Proposition 13, which was adopted by California voters in 1978, requires that properties be assessed at market value at the time of their sale, and after that assessments can’t rise by more than 2 percent per year until the house is sold again.
This means that in a situation where property values increase by more than 2 percent per year (which they have in California), homeowners are incentivized to stay in their original home rather than move as their taxes are lower than they would be in a different house of the exact same value. This distorts the Californian real estate market and the data shows that Californians tend move house a lot less than Americans in other States.
This rule benefits wealthier older residents at the expense of new home buyers. The people who have left California cite high taxes, expensive real estate, crime, homelessness and overregulation as the reasons they decided to move to other states. So, how bad is the regulatory environment in California? We saw earlier that California has the most regulation of any state in the US by a significant margin, but the same report showed that Texas – a state that people are leaving California for is number five on that list – which doesn’t seem a whole lot better.
According to The Pacific Research Institute, California doesn’t just have more regulations than other states, but the regulations are more restrictive than in other states too. The report argues that California’s regulatory environment is particularly difficult for small businesses that lack the scale to efficiently manage the administrative burdens and finance the higher costs created by onerous regulations.
According to the Bureau of Labor Statistics – a big reason for the migrations we have seen out of states like New York and California to states like Florida and Texas is that the pandemic weakened the economic clusters that dominated pre pandemic America. Pre pandemic, 19% of all tech jobs were based in California, today only 16.5% are.
It’s not just tech jobs that are moving out of state either, according to The LA Times, film and TV workers are leaving too. During the pandemic when work could be done remotely people moved to more affordable locations. This happened right as the tech industry was booming, which just meant that California had a smaller slice of a growing pie – everything seemed fine. Once the tech recession occurred as interest rates rose, California was just losing outright – with a smaller slice of a smaller pie.
Technology stocks today make up just under one third of the value of the S&P 500 Index. If you add in communications services stocks, many of which connect with the technology arena, the group represents more than 40% of the overall stock market. On top of this there are lots of huge privately owned tech firms too.
The growth of the tech sector has been a huge contributor to Californian growth over the last sixty years, but people are starting to question if these companies can continue to grow – from their already massive size - going forward. The tech sector is well suited to California – as it relies on small numbers of highly paid workers to design products or software that are really scalable.
Unfortunately for the state – you wouldn’t really manufacture physical products there due to the expensive real estate, high regulation and high taxes. There is a reason that every Apple product says Designed in California, Made in China and Taxed in Ireland on the back of it… If the tech industry stops growing – the state might struggle.
Tech layoffs have been hitting California quite hard over the last two years – I made a whole video about this a few months ago, and while Californian tech workers receive the highest average tech pay of any US state they have not only been hit the hardest with layoffs but also withstood the largest year-over-year pay drop when they find new jobs, as demand for their skills has dried up.
Since the gold rush, California’s economy has been built on ready access to fresh water. The state’s agriculture sector faces significant water challenges today due to prolonged droughts and over-reliance on groundwater. California's water reservoirs are often well below average capacity today, leading to stringent water use restrictions. This puts a lot of strain on the agricultural sector, which is vital to California's economy, and once again, there is no obvious solution to this problem.
California clearly faces a number of challenges, and its economy today is suffering in ways that the overall US economy is not, but California has had rough patches in the past, like in the early 2000’s and in the wake of the Credit Crunch, but its innovation-led growth model has managed to stand the test of time. The state made up 14% of America’s total output last year, up from 12.5% in the late 1990s – there is no need to count the state out yet…
The biggest problems appear to be unaffordable housing, excess regulation and a procyclical tax system that finds itself in crisis every few years. The unaffordable housing problem is driven by a combination of excessive regulation and Nimbyism which combined make California the most difficult part of the United States to build new housing in.
Fixing this problem – would likely fix a lot of California’s other problems. It is worth noting that the states that people have been moving to – the ones experiencing the fastest growth are also the states with affordable housing where it is easy to build. Workers like living in places where they can afford a comfortable home, and employers like hiring in these places as workers with affordable homes are willing to accept lower pay. You don’t really benefit from high pay – if it all goes out the door in housing costs.
So, can all of California’s problems be blamed on progressivism? After all Californian refugees have been moving to states where there are no state income taxes, to states with lower regulation where it is easier to build or to places where crime rates are lower than in the Golden State.
Janen Ganesh made an interesting point in a recent FT article on the balance between the right and left arguing that the governing climate in which urban life flourishes is a blend of progressive ideas (such as liberal immigration rules and infrastructure spending) with conservative ideas (like market incentives and toughness on crime). He argues that while cities might benefit most from low taxes, less burdensome regulation and a business-friendly atmosphere, they often vote for policies that would harm them.
California has been a hugely successful economy because of its ability to attract in the best and brightest, and if these people are starting to move away for greener pastures, it might be worthwhile mimicking some of the qualities of the states that are attracting them away. If you found this video interesting, you should watch my video on what’s driving tech layoffs next.
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