Is California's Budget Endangering Silicon Valley?

Meredith Whitney isn’t well-known in the technology community, but she’s made a name for herself in the financial world. I personally first learned her name from Michael Lewis’s fantastic book The Big Short. Lewis, along with most of Wall Street, was struck by Whitney’s foresight when, on October 31, 2007, she announced that Citigroup’s dividend payments exceeded its profits and would have to be eliminated. Four days later, Citigroup CEO Charles Prince resigned. Anyone interested in how Whitney rose to become one of Fortune’s “50 Most Powerful Women in Business” should read Lewis’s short biography of her on Bloomberg.

After slaying the banks in 2008, Whitney has come out decrying an even greater financially mismanaged beast: The coastal states. Her first, recently released book, The Fate of the States, uses research from the Meredith Whitney Advisory Group to reveal the terrible financial condition of these highly leveraged states. The primary target? California.

The Fundamental Problems: Debt and Pensions

California has about 12% of the total US population, but contributes 13% of GDP and generates $100 billion in annual state and municipal tax receipts. As if you needed more evidence, California is a big state in every sense of the word.

Sadly, Whitney is quick to point out that California made the same gamble on housing that banks and consumers did; the state bet that property tax revenues would never decline, and borrowed and spent money accordingly. It’s no surprise that the state has suffered the same consequences since 2008 as individuals and banks which bought into the housing market.

By 2011, the average Californian had consumer debts of $73,000 and $11,000 in tax-supported state obligations while only earning $43,000 in income. Since 2008, home prices in California have fallen almost 40 percent and nearly 30 percent of mortgages in the state are underwater. In the last decade, debt-per-capita increased 100% in California, 88% of this debt tied to real estate.

These debts and those held by the municipal governments cripple the ability for the state to function. As personal and governmental debt increases, at some point consumer spending and government services have to be cut to cover debt payments. This begins a negative feedback loop where private business growth slows or declines, tax revenues fall, the government must raise taxes to compensate, and economic growth drops further. It’s important to remember that the tax base is the revenue source for a city, state, or country. If citizens make less money and are given reason to leave, government revenues fall.

From 2008 through 2010, California’s tax receipts fell from $118 billion to $105 billion, with total state and local receipts dropping from $781 billion to $702 billion. In an attempt to compensate, California already raised income and sales taxes in 2011 and 2012.

One of the biggest debts many states, especially California, face are unfunded pension liabilities for retired and current public employees, particularly in the prison and education systems. In 2009, new Government Accounting Standards Board rules forced states to disclose unfunded pension and health-insurance obligations. What California unveiled when forced was not a pretty picture. From 2000 to 2010, state spending grew 72% to $107 billion annually. State government spending as a percentage of state GDP was 25.3%. Most horrifying, this spending outpaced the government’s revenues by 224% in 2009 and 92% in 2010, and increased by 50% in the past year. Over 20% of this spending (over $21 billion) goes toward state liabilities including general obligation debts, unfunded pensions, and other post-retirement benefits.

Pensions are particularly challenging for states to manage because they are given special legal protection or “seniority” over other liabilities and expenses. These, as part of pension contracts, can be enforced in court. The pecking order has pension obligations and municipal debt required to be paid before everyday expenses like education, police, roads, and public services. “The fight is not just political but constitutional too: Courts are now deciding whether municipalities can use ballot measures and bankruptcy laws to void or change public-employee pensions,” writes Whitney. “At the heart of the problem is a difficult truth: There’s not enough money to pay for everything, and by law, pension payments trump most other types of spending.”

Employees contribute little to their government pensions (generally less than 10% of the total contribution). The rest is covered by taxpaying citizens. At the same time, pensions are given embedded cost-of-living (COLAs) which are meant to buffer the pension funds against inflation, except they are not benchmarked to inflation. The average COLA is 3%, but average wage growth has been 2% in the past decade. The COLAs have effectively been pay hikes of 1% over the average for people who are not working.

Before breaking down the liabilities into greater detail, the problem for California is summed up by Whitney early in her book: “California allows a police chief to retire with a pension of over $200,000 after less than a year on the job but doesn’t have enough money to buy new books for classrooms or to keep violent felons in jail. No wonder the state is facing an exodus of employers and employees alike…. With not nearly enough money to go around, the impending war over public-employee pensions threatens to be one of the more vicious political debates this country has seen, pitting Americans against Americans, neighbor against neighbor.”

The Logical Question: How Will This Affect Silicon Valley?

The evidence for California’s impending financial apocalypse isn’t difficult to understand. Given the above numbers showing that, as a state, California owes and is spending more than it earns, the jig is going to have to be up at some point in the future. One could propose that California could try to maintain its spending-more-than-it-earns ways by continuing to borrow money from the federal government, international lenders, or bond markets, but as we’ll show, these cash sources have their own problems and can be wary of investing in something when it’s uncertain whether the state will be able to afford providing a return on the investment.

I am suggesting that, while California simultaneously looks at the above options for money and finds them increasingly unattractive or unavailable in the future, the state government will look to its best internal sources of money to cover its obligations. And California’s most notable and profitable sector is the technology industry in Silicon Valley. Connecting the dots from California’s financial woes to the money generated by the companies and cities in the Valley reveals the question: Are the companies and cities in Silicon Valley going to be asked or forced to assist the rest of the state financially so California doesn’t collapse around it? What form will this “help” take? New, higher taxes for the companies in the Valley? A decrease in federal funding for the municipal governments of San Francisco, Palo Alto, Cupertino, and Mountain View so the money can be used elsewhere?

Further Dissecting California’s Finances

Another problematic industry plaguing the state budget is prisons. In 2010, California spent $6 billion on 30,000 prison guards and other prison system employees. That year, the state’s highest paid employee was the head parole psychiatrist with a staggering $838,706 income. From a 2011 Wall Street Journal story, Californian prison guards could receive $85,000 per year in pensions when retiring at age 55. A 55 year old private sector worker would need $1.63 million in savings to purchase an annuity with similar yield. The insanity of this relationship is that private sector workers must save huge sums of money for their own retirements while covering the taxes that are used to pay for public worker pensions.

By comparison, in 2010 the state only spent $4.7 billion on higher education and has continually cut college funding. In the past 30 years, the state has sunk from being 30% of the University of California’s budget to 11%. In 1980, a Cal student spent $776 in tuition per year. This number was $13,218 in 2011. From 2004 to 2011 alone, university tuition in California rose 80%.

Kindergarten through 12th grade schooling accounts for 20% of state spending and colleges are another 10%. The second largest expense is Medicaid. Given California unemployment at 12%, the Medicaid budget has continued to grow and taking room from education spending. California has cut $6 billion in education spending since 2008. In 1990, California had a 1.3% lead over the USA average for the percentage of its population graduating high school. By 2008, it was 6% below the national average. Only 18% of those high school graduates enrolled in state colleges in 2012. In-state community college enrollment dropped from 2.9 to 2.4 million.

The two primary segments where the federal government gives financial aid to states is for Medicaid and food stamps. These two programs are meant to support for people living in poverty (defined as an annual income of $23,000 or less for a family of four). As of early 2013, the poverty rate in this country was 15%. It was 11% in 2000. One in seven (43 million) Americans live off food stamps. California spent $10 billion in fiscal 2010 on public assistance programs. In 2000, 7% of the California budget was spent on public assistance. While this was down to 4.9% in 2010, the number of unemployed who rely on these programs in the state increased by 2 million.

The results of these debts and the economy have already hit Californian cities. In the early 2000s, Lou Paulson, head of the Contra Costa County, California firefighter’s union, negotiated new contracts for its member which allowed them to retire at age 50 with an annual pension equal to 90% of their final salary for the rest of their life. This same city levied a new $75-per-year-per-home tax in November 2012 to support the current fire department which would otherwise need to close six fire stations due to lack of funds. The ballot failed. Kris Hunt, director of the Contra Costa Taxpayers Association, was outraged at firefighters for raising more taxes and posted online the name of every retired public employee with a pension above $100K. It had 665 names, 24 who exceeded $200,000 per year. 268 of the 665 were firefighters, while there were only 261 firefighters currently employed on the streets.

A local construction worker named Matt Heavy on NPR: “I felt hostage…either pay the extra money or we’re going to start shutting down stations. And the bottom line is the reason that they’re asking for the money is because the pensions are just skyrocketing.”

The Main Competition: Texas

I currently live in Illinois (another debt-burdened state) and interned for a summer in San Francisco, so I have little bias in telling this story. With all California’s financial problems laid bare, the next question is who is in position to take advantage of California’s decline? Whitney’s answer: Texas. Why? Because by a variety of economic metrics, Texas is a better state in which to live and work.

Over the past decade, the life prospects for the typical Californian have gotten significantly more precarious than the average Texan. The average debt-to-income per capita in California is 170 percent compared with Texas’s 80 percent. Since the housing crash, the percent of homes with negative equity has risen to 29 percent in California versus only 9 percent in Texas. In the early 2000s, California’s unemployment rate was 20% higher than the national average and 30% higher by 2010. “By 2010, the last year for which data is available, consumer debt per capita in California hit $74,950, a debt-to-income ratio of 174%. By comparison, the average debt per capita in Texas was $36,000, which translates to a debt-to-income ratio of 89%,” Whitney elaborates.

For an individual deciding where to live, Texas offers the obviously better bang-for-your-buck deal. Texas does not tax individual income. California voted to raise income-tax rates on those earning over $1 million to 13.3% (the highest state income-tax rate in the country) and 10.3% for those making over $250,000. Compared to Texas’s zero rate, that’s an extra $26,000 taken out of your pocket annually.

Along with no income tax, personal income was growing 73% faster annually by 2012 in Texas than in California, and the average home price is 60% lower.

From 2009 to 2010, 12% of people moving out of California moved to Texas, which is astonishing considering that the move is basically across half of the country. By 2012, the problem had piqued the interest of California’s legislature enough that it sent an economic research team to Texas to investigate the population drain. A total of 1.9 million Californians left between 2000 and 2009.

University of Michigan economic professor Mark Perry noted, “In April 2012 the cost of renting a U-Haul truck for a one-way trip from California to Texas was twice that from Texas to California. The price ratios suggest that demand for trucks leaving California is roughly double the demand for trucks coming into the Golden State.”

Whitney added, “The fact is that California’s total obligations – obligations that can be escaped by the simple act of moving – increased by 50 percent in one year alone…. Moving has become an easier decision for businesses too. Consider, for instance, a corporation headquartered in Silicon Valley. The average corporate tax rate in California is over 8.8 percent and the average sales tax is 7.25%. Sure, property taxes are kept in check by Proposition 13, but the cost of living is higher than in most other states and social services are vanishing….

“When a satellite operator like Globalstar moves from California to Louisiana or a food company like Chiquita relocates its headquarters from Ohio to North Carolina, the decision to move often boils down to taxes….

“By mid-2006 the real cost of homeownership in California was more than twice the national average. The ratio of average home price to per-capita income was 9.7 in California versus 4.2 for the United States nationally. The price-to-income ratio in Texas was a mere 2.6. Was it really worth over three and a half times more to live in California than in Texas?”

It’s not just individuals who are moving; companies are too. Major tech companies like Google, eBay, Amazon, Intel, and Apple have all added new offices and invested hundreds of millions in Texas, especially in the city of Austin. According to a study by Joseph Vranich, an expert in studying business relocations, the number of businesses leaving California increased fivefold between 2009 and 2011.

Whitney elaborates, “In 2012, when Apple was deciding where to invest $300 million and add 3,600 new sales and accounting jobs, it chose to build in Austin Texas, instead of near its Cupertino, California headquarters. When San Jose-based eBay and its PayPal subsidiary were looking to add 1,000 new jobs, eBay also chose Austin, Texas. Where jobs go, taxpayers follow: According to the Manhattan Institute for Policy Research, of the 1.1 million Californians who left the state in the 2000s, 225,000 of them moved to Texas, making it far and away the most popular destination for ex-Californians.”

She continues, “The smart money understands that taxes can only go up given the massive sums of bonded debt and unfunded pension and health care liabilities coming due in future years. Thanks to reckless fiscal mismanagement by cities and states, individuals and corporations still residing in those states will all be on the hook. The smart money also understands that with those higher taxes will come a lower level of public services- that the states in the deepest fiscal trouble have far fewer resources to invest in roads, bridges, airports, education, public safety, and all the other things relocating businesses look for in a new home…. No wonder smart money is flocking to states with lower tax burdens and less strained budgets. The dumb money is those left behind to pay high taxes for lesser services.”

Historical Precedents

California is no stranger to having individual cities collapse. The below examples are meant to drive home the point that if these continue, the state government will have to step in (and in some cases already has). If the state government has to continually bail out its bankrupt cities, it may have to take money from the successful cities to prop up the losers.

Orange County went bankrupt on December 6, 1994 when it was the sixth largest county in the country. County Treasurer Robert Citron had used derivative markets and high-yield bond investments to boost county revenues during the early 90s recession. When those trades lost $1.4 billion, the city had to declare the largest municipal bankruptcy in US history. When the muni bond markets responded by raising interest rates on all cities in California, it was cheaper for the state of California government to support an Orange County reemergence in 1996 than pay higher rates on government-issued bonds. One Orange County citizen stated, “I don’t know who will make up the deficit but I really don’t think it should be the citizens.”

In June 2012, Stockton, California became the new largest US city Chapter 9 bankruptcy. A city of only 292,000 residents saw home prices triple to an average of $400,000 from 2001 to 2006. The city officials assumed the area’s economic growth would continue indefinitely and increased its spending habits accordingly, going from $160 million in 2003 to $200 million in 2007. Stockton also had one of the worst pension agreements of any city. California state law requires public employees to contribute between 7-9% of their salary to their pension plans. The city of Stockton agreed to pay this contribution for its public employees! On top of these mounting expenses, Stockton borrowed $125 million through a city bond issue in 2007, only to invest that money in the stock market and lose $25 million of it. From 2006 to 2011, home prices in Stockton fell 58%. The city had to cut public services, slashing the police force by 25% and the fire department by 30%. Now it has the tenth highest rate of violent crime for all cities in the country. As of September, 2012, the city was embroiled in legal battles with two bond insurance companies attempting to force the city to suspend payments to its public employee pensions and redirect the funds to its bondholders. The city has spent at least $4.9 million on lawyers. Stockton City Manager Bob Deis was quoted saying, “We are trying to be responsible in dealing with our creditors, but in the process we cannot destroy a community and its hope for the future.”

Mammoth Lakes, California filed for Chapter 9 bankruptcy on July 12, 2012 after losing a $43 million lawsuit against Mammoth Lakes Land Acquisition for breaching a land development contract. This judgement was three times the small city’s annual budget, which was already $2.3 million in the red.

Two days earlier, San Bernardino filed for its own Chapter 9 bankruptcy. From 2008 to 2012, the city trimmed its public workforce by 20%, and yet the budget gap was still $46 million with another $157 million in unfunded pension and health-care obligations.

How did so many Californian cities get into so much trouble? San Jose mayor Chuck Reed speaks from experience, “Hell, I was here. I know how it started. It started in the 1990s with the Internet boom. We live near rich people, so we thought we were rich.” San Jose is under heavy financial stress. By 2015, San Jose pension costs are expected to be $400 million to $650 million. Once run by 7,450 public workers, the city is maintained by 5,400 employees. Remaining workers have taken a 10% pay cut from a couple years ago. Reed expects that his city of a million people, the 10th largest in the country, will be serviced by only 1,600 public employees in 2014.

What Can Be Done

Thus far we’ve established that the State of California and many of its municipalities are in great financial danger. The thesis of the essay is that these budget weaknesses may force the state to look at Silicon Valley as a source of extra income. But before this happens, are there any other options the state can pursue?

From Fiscal 2008 to 2012, states used the following measures to close their budget gaps (the differences between their large expenses and decreasing tax revenues) based on Bureau of Labor Statistics and MWAG research:

  • Spending Cuts: 45% of money used to close budget gaps
  • Federal Funding from the American Recovery and Reinvestment Act of 2009: 24%
  • Revenue Increases: 16%
  • “Rainy Day” Funds and Other Cash Reserves: 9%
  • Other (Date shifting, on-time/short-term borrowing): 7%

Sadly, Whitney adds, “There is no more money. There are no more stimulus dollars. There are no more rainy-day funds to raid. The emergency options have all been tapped.”

Pensions are huge expense. The state and cities need to renegotiate the pension contracts with public worker unions to decrease benefits owed and lighten the burden on current taxpayers. It’s important to remind ourselves going into these talks that no one is right or wrong and almost nobody at the table is to blame. Government employees were promised benefits and negotiated their contracts. Taxpayers pay taxes with the expectation of certain levels of services: Education for their children, safe streets, and running water. Municipal bondholders lent money to these cities expecting a return. The politicians currently in office are generally not the ones who got the cities into this mess.

Rhode Island provides a bright example of a state grappling its pension problems. In 2012, the state raised its the percentage of its pension liabilities funded from 48% to 60%, reducing its unfunded liability by $3 billion. This was accomplished with bipartisan support from government officials to negotiate concessions from the public employee unions on benefits and cost-of-living adjustments for current and future retirees.

Privatization is the government taking businesses it owns and selling them to private companies. Indiana Governor Mitch Daniels set a controversial precedent when, in 2011, he leased the state toll road for 75 years to private investors for an upfront payment of $3.8 billion. This and other privatizations like it raise cash for the government while losing its long-term revenue-generating assets. Opponents of privatization will ask: Why sell the income of tomorrow for cash today? The answer: Given the heavy debts states carry, they have to raise cash just to survive.

There is also a successful historical precedent for privatizations, particularly in Europe in the 1980s and 90s. To join the European Union, a nation’s deficit had to be under 3% of GDP. Many countries accomplished through selling assets. From 1990 to 2009, $1 trillion was raised by EU countries through these sales, $100 billion from privatizing transportation industries alone. By comparison, the United States government has planned and funded less than $20 billion in similar transportation projects. Given the lack of investment by the US government and states in transportation, a case could be made that infrastructure and transportation would be improved under companies that have a profit motive, rather than government politicians untrained in asset management.

Some parts of California have started to privatize their assets out of necessity. The state has outsourced operations for six of its public parks. The Brannan Island State Recreation Area, outsourced in 2012, used to cost the state $740,000 per year, twice its revenues from fees and concessions. These parks are being privatized either through profit-sharing between the state and the operators or outright sales for cash.

There are numerous other changes state governments need to make: Invest whatever cash they can into improved education and jobs programs, monetize their natural resources, and promote right-to-work laws (job growth in right-to-work states was double the non-right-to-work states from 1977 to 2008). These cost the states little and allow them to grow in the coming decades while using their current cash to cover their short term problems.

Unanswered Questions

While it’s clear that California is one of, if not the, worst managed state financially, what’s still unclear is what exactly this means for Silicon Valley. None of what I’ve presented definitively demonstrates that Silicon Valley will be crushed by California’s mounting debts. To truly answer the original question, we would need more research and answers to the following questions:

What is the political relationship between the local Silicon Valley governments and the state? How much can the San Francisco, Palo Alto, and Mountain View politicians keep their cities siloed from the rest of the state’s problems?

How will Berkeley and Stanford be affected by decreases in state funding? These universities have endowments. Will the be able to easily dip into these funds to continue their operations? Will they need to cut costs? What about the other California universities? The state has a reputation for being leading technology and business schools. Can the local schools continue to feed intelligent, high-income earning and job creating student? It’d be a shame if these programs suffered due to financial mismanagement higher in the food chain.

In the face of increased taxes and even higher standard of living costs, will technology entrepreneurs still gravitate to the Valley? Although Paul Graham’s essays on Startup Hubs and Professor Richard Florida’s “Clustering Force” explain why Silicon Valley has grown into the leading location for the technology industry, there must surely be some structural limit to the pull startup hubs have. Those structural limits are determined by the institutions of the location’s government. Things like regulations and taxes will impact how people perceive a city, and if taxes continue to rise, would-be entrepreneurs around the world will reconsider Silicon Valley when there are other fertile environments.

Despite California’s problems being financial, the solutions will be political. Who will bear the weight of these debts as they continue to be called? Who will volunteer to decrease their standard of living (fewer public services, increased crime, under-performing schools) so the greater system can continue?

I can imagine a defensive reaction from Silicon Valley residents. After all, they aren’t the cause of these problems, they and their cities are still doing well, and the bleak future I’m proposing is in the future. Why worry about something which might not happen?

Because, as the evidence shows, while Silicon Valley might not directly suffer, the rest of the state in which it resides will. It is not a large mental leap to think the rest of the state will ask the technology community for help. It’s better to be aware of these possibilities than to be ignorant of the systemic risks which underlie society.

I do not have all the answers and haven’t completely solved them in this essay. Some of these are hypothetical. But these problems need to be discussed publicly and resolved by those it will affect in the very near future.

If anyone has any questions, comments, or information which would could help with research on these issues, email me at