COVID-19 has created tremendous revenue shortfalls for states, and California is no exception. In May, the state administration estimated a revenue shortage of $54 billion for the 2020‑21 budget.* In June, Governor Gavin Newsom declared a state budget emergency that allowed the state legislature to further tap into California’s $17.9 billion rainy day fund. Although the fund helps alleviate the shortfall, it is far from sufficient to cover the entire deficit.
In terms of expenditures, the Golden State has one of the highest unemployment rates. Its September unemployment rate of 11% was only trailing Hawaii (15.1%) and Nevada (12.6%). In order to pay for the unprecedented number of jobless benefit claims, California has exhausted its unemployment insurance trust fund, and the federal aid from the CARES Act is quickly phasing out. The state has been borrowing heavily from the federal government to pay for unemployment benefits. As of November 16, California has borrowed over $15 billion from the federal government to pay these benefits, accounting for almost 40% of outstanding federal unemployment benefit loans.
To resolve these mounting financial imbalances, California has been calling for additional federal assistance, based on the belief that the federal government is obligated to help financially distressed states. At the same time, the state legislature is searching for revenue sources from within to address the budget crisis. This blog post discusses the state tax voucher, an innovative tool recently proposed by California’s state legislature.
California’s Tax Voucher Program
The idea first appeared in the legislature’s Joint Economic Stimulus Plan, which allows Californians to pay the state ahead of time in exchange for a voucher that can be used to pay income tax obligations in future years. Taxpayers will benefit by prepaying their California income tax at a discount, and the state will collect approximately $25 billion up front to build an economic recovery fund. This recovery fund will not be part of the general fund; instead, it will be spent on small businesses, worker retraining, public infrastructure, affordable housing, green economy investments and other projects to stimulate the economy.
Preliminary information indicates that the vouchers will amount to $3 billion per year and will be redeemable between 2024 and 2033 for taxpayers who choose to participate. The discount for the prepayment will be around 2% to 3% or consistent with the return of state’s municipal bonds (discussed further below). Lawmakers believe the vouchers will look like most financial instruments and expect strong interests from investors and institutions.
State lawmakers did not formally design the voucher program before they adjourned in the end of August. Instead, part of A.B. 107 directed the Franchise Tax Board, Treasurer, and Department of Finance to research the California Economic Improvement Tax Voucher Program and provide a comprehensive proposal before March 1, 2021 to be considered by the legislature. The proposal will include details such as the costs of administrating the program, the levels of discount and ways to incentivize participation. Although the bill does not include program details, it lays out certain features of the voucher program.
The bill specifies that the vouchers are allowed as a credit against a taxpayer’s personal income tax or corporate income tax. It also states that the voucher amounts shall be in small increments so taxpayers across different wealth and income levels can all participate. In terms of a timeframe, they can only be applied against future tax liabilities, usable after the year in which they are sold. However, there will be a limit for the number of years the unused vouchers can be carried forward.
In addition, the vouchers are transferable, which means the holders can sell them to others who could use the vouchers to satisfy their own tax liabilities. Although the bill also requires the Franchise Tax Board to maintain a confidential registry of the vouchers to track their ownership, this tradable feature enables a secondary market where the vouchers can not only be used to offset tax liabilities, they can be used as an investment tool. Any capital gains associated with the vouchers are exempt from state income taxes.
Traditional Voucher v. California’s Voucher
Simply from a terminology perspective, the tax voucher is not a new idea. However, the way California plans to use its tax voucher program is different from what most taxpayers are currently familiar with — primarily because of the longer prepayment period and the financial returns involved.
Under the current income tax system, taxes must be paid as taxpayers earn or receive income throughout the year, either through withholding or estimated tax payments. If not enough taxes are paid through these channels, taxpayers may be charged a penalty.
At the federal level, millions of taxpayers use Form 1040-V to pay their taxes every year. Form 1040-V is primarily used to clear the current year tax liability for the balance due, usually accompanied by a check or other forms of payment. Another well-known voucher is Form 1040-ES, which is commonly used by millions of independent contractors to make tax payments on income not subject to withholding. In both cases, the tax liabilities will be trued-up when the tax filing is complete. The prepayment period generally does not extend beyond the current taxable year, therefore no interest is involved. A similar mechanism applies at the state level.
Traditional Debt v. California’s Voucher
Going beyond terminology, the voucher program is essentially a vehicle to borrow against the future, or to accelerate future tax revenue for today’s use. As such, it includes certain features that resemble a debt instrument, which makes a comparison between the new voucher program and the established municipal bonds mechanism meaningful.
State and local governments issue bonds that are commonly known as municipal bonds (“muni bonds” or “munis”). Muni bonds can generally be classified into two categories: general obligation bonds and revenue bonds. Revenue bonds, the more commonly used of the two, are typically sustained by specific revenue sources such as toll roads, bridges and airports, whereas the general obligation bonds are backed by general revenue of the issuing jurisdiction and the issuer’s power to tax.
From a financial perspective, muni bonds typically entitle investors to periodic interest payments and a repayment of principal at maturity, which allows issuing authorities to spread the costs across a long horizon. Federal income tax typically exempts muni bond interest payments from taxable income, essentially letting state and local governments borrow at lower costs than other issuers, ceteris paribus. Because many muni bonds are revenue bonds that are used to finance infrastructure, observers view the tax exemption as a subsidy to state and local governments’ capital projects. Critics argue this subsidy is inefficient, because the federal revenue forgone through tax-exempt bonds is greater than the associated reduction in borrowing costs for state and local governments. From a distributional perspective, they also claim that high income taxpayers benefit disproportionally from the exemption, and many of them would have purchased the muni bonds even with less generous financial terms.
There are several major differences between the voucher program and the typical muni bonds. First, general obligation bonds typically require voter approval and are subject to limits on total debt outstanding. On the other hand, tax vouchers do not require voter approval. In addition, the voucher program does not involve periodic interest payments and is similar to a zero coupon bond or a zero coupon muni issued at a discount.
Furthermore, the voucher has certain characteristics that make it a hybrid instrument instead of a pure form of debt. For instance, unlike a debt instrument that has a “maturity date” when the principal is repaid, the voucher has an expiration date, after which the voucher has no value.
Finally, although the capital gains associated with voucher transactions are exempt from state income taxes, the bill specifically indicates that the vouchers are treated as credits against taxpayers’ income tax liabilities. Whether the gains are exempt from a federal income tax perspective is unclear.
Federal Reserve Borrowing v. California’s Voucher
An alternative to the muni bonds is Federal Reserve’s Municipal Liquidity Facility (MLF), which lends directly to state and local governments for their liquidity needs. This facility has a three-year term, and the interest rate is calculated as the sum of the comparable maturity overnight index swap (OIS) rate plus the applicable spread based on the long-term rating of the security.
The MLF is thinly used, with only two borrowers at the end of September. Perhaps not surprisingly, the borrowers have relatively low credit ratings and are potentially unable to borrow at comparable rates in private markets. Among 50 states, Illinois has the lowest credit rating at BBB- and was the first to utilize this facility. In June, Illinois borrowed $1.2 billion at an interest rate of 3.36%. The second borrower, New York’s Metropolitan Transportation Authority (MTA), obtained a $450 million loan in August at 1.93% and has a credit rating of A+.
Some potential borrowers and observers claim that the terms under the MLF are overly restrictive and the rates are not attractive, which limits its utilization. The Federal Reserve disagrees and indicates that the facility’s intended purpose is to serve as a backstop of the credit market. The low utilization shows that the robust recovery of the muni bonds market can provide sufficient access to credit, therefore borrowers do not need to use the MLF.
California’s current credit rating for its general obligation bonds (AA (Fitch), AA- (S&P), Aa2 (Moody’s)) is better than either Illinois’ or MTA’s credit rating. Using these ratings as a high-level proxy, California’s loan is likely to have an interest rate of comparable maturity OIS rate plus a spread of 125 to 140 basis points. However, as the Federal Reserve states, the MLF is intended to bridge states’ short- to mid-term liquidity needs, and California may need longer terms to repay the loan. In addition, the state needs a much bigger loan than the current borrowers, which may substantially increase the interest rate.
California’s voucher idea appears simple and innovative, and much of the outcome depends on how the program is ultimately designed. There are several additional issues to consider.
One of the voucher’s major benefits is that it raises revenue for the state without tax increases or budget cuts in the midst of a recession. From this perspective, it is a creditable option. However, a major concern is that the voucher essentially borrows against future state tax revenue for today’s needs.
Although such borrowing may not lead to immediate state credit rating downgrades, rating agencies may still see this as the state taking on more risks. To address this concern, state officials believe an annual cap over a pre-specified period of time (e.g., $3 billion per year over 10 years) will limit the state’s risk of pulling too much revenue from future years.
In the proposal, lawmakers present the voucher as a way to help balance the budget. The balanced budget requirement largely applies to the operating budget (or states’ general fund) that is subject to annual or biannual appropriations; bond finance is generally not part of the requirement. As a result, it is unclear whether the voucher itself is subject to the balanced budget constraints.
Another pressure point is whether the voucher program will raise the expected amount of revenue and which taxpayers will benefit from the voucher. Although the intent is for taxpayers from all income and wealth levels to participate, it is still likely that wealthy taxpayers and tech companies will purchase a disproportionate number of vouchers because they are certain to have positive future tax liabilities. How taxpayers perceive the future trends in terms of changes in interest rates and the tax environment will also affect their willingness to participate.
Whether or not the voucher plan eventually materializes and how the program is designed will in part depend on California’s financing alternatives. The “borrowing from the future” idea may be unpalatable for some, and, to some extent, it challenges a state’s established fiscal discipline. The alternative — austerity measures such as tax increases and spending cuts — institutes a more solid economic foundation in the long run, but comes at the expense of a painful short-term transition. The tax voucher is an intriguing thought experiment. If implemented, it will be an interesting case study for other states to observe and learn from California’s experience.
*Shortly after the administration released its estimate, California’s Legislative Analyst’s Office (LAO) projected a deficit between $18 billion and $31 billion through June 2021 depending on whether the recession presents a U-shaped (a more optimistic scenario) or an L-shaped recovery (a more pessimistic scenario). This translates to a 16% to 20% decline in revenue. In its spring fiscal outlook, the LAO explains the difference between the agency’s estimates and the administration’s $54 billion projection is primarily attributable to different revenue and cost assumptions and a difference in presentation. The administrations’ estimates largely reflect gross changes in the budget’s bottom line, whereas the LAO’s estimate includes the net effects of current law.