The results are in for statewide ballot initiatives in California and the impact is generally positive for the stability of the state’s fiscal position and credit quality.

As we observed at our September 6 presentation to clients in San Francisco and in several issues of Independent Thinking, Evercore is generally not a supporter of the initiative process. Simple yes or no votes on complicated issues can have long-term and unintended fiscal consequences. In the case of California, the general electorate is adding constitutional provisions to what is already one of the longest constitutions in the world. The growth of this initiative trend is as much a reflection of legislators abrogating their legislative responsibilities as it is an opportunity for disenfranchised groups to make their mark in a heavily partisan state. This time around, there were 17 statewide initiatives on the ballot with 12 passing.
 
The proposition results this time around were a credit positive. However, relying on the electorate, especially in unpredictable and tumultuous political periods, provides a level of uncertainty that is rarely beneficial for municipal bond investors. As noted below, the poorly worded and potentially disruptive Proposition 53 No Blank Checks Initiative failed by only 51% of the vote. Proposition 55, Proposition 30 Tax Extension to Extend the Income Tax for Another 12 Years, which, as the name implies, extended the income tax surcharge for another 12 years, may have alleviated many difficult budgetary decisions for the state but represented a betrayal of the original Proposition 30 that was intended as a temporary surcharge until the state could address its structural budget imbalance. The imbalance was addressed, but the tax lives on.
 
Here is a brief review of the five propositions highlighted in our earlier papers as likely to have an outsized impact on the state’s operating and capital budgets:
 

• Proposition 51 (passed with 54% of the vote): $9 Billion in State of California General Obligation Bonds for K-12 and Community College Facilities. Proposition 51 provides for $3 billion in new K-12 school construction, $3 billion for K-12 school modernization, $2 billion for community college districts, $500 million for charter school projects, and $500 million for career technical education facilities, but only if it receives a local match to leverage this new pool of money. Without Proposition 51, districts would have had to rely entirely on local funding sources (which for some districts are limited) or wait for legislative action to replenish the state School Facility Program matching funds or modify the program. Proposition 51 was opposed by Governor Brown, who wanted funds to be distributed based on districts’ needs rather than on a first-come, first-served basis. Under this process, the system favors larger, wealthier districts that have the sophistication to efficiently apply for these funds. Newer or expanding school districts also benefit from this passage, as building developers are relieved of placing special property tax assessments on these new properties. Proposition 51 will prohibit the Legislature from changing the fees K-12 districts may collect from developers until 2021 or until all of Proposition 51’s dollars for K-12 facilities are spent, whichever comes first.
• Proposition 52 (passed with 70% of the vote): State Fees on Hospital Federal Medi-Cal Matching Funds. The measure makes permanent the California Hospital Quality Assurance Fee, which increases reimbursement to hospitals with high Medi-Cal (Medicaid) exposure. The program levies a tax on hospitals and managed care companies that generate revenue, which is then matched by the federal government. The state keeps a portion of the federal matching funds and the remainder is redistributed to hospitals to offset low Medi-Cal reimbursement rates. Passage is a credit positive for most 501(c)(3) hospitals because it solidifies a program that significantly increases reimbursement and had been subject to periodic renewal and delays, which created liquidity stress.
• Proposition 53 (failed with 51% of the vote): Require Public Vote on Revenue Bonds in Excess of $2 Billion, also known as the “No Blank Checks Initiative.” The Governor was adamantly opposed to this initiative, as were the building trade unions, which would have required statewide voter approval for revenue bonds above $2 billion for projects that are funded, owned, or managed by the state. Financial support for this initiative came primarily from a Delta-area farmer and food processor that was opposed to the Governor’s $15.5 billion water tunnel project to move water past the Delta to San Joaquin Valley farms, southern California and Bay Area residents. It also could have further complicated the high-speed rail project, approved by voters in 2008 and now under construction in Fresno. Due to poor drafting of the initiative, Proposition 53 could have subjected many large financially self-supporting regional projects to a statewide vote with little reason for non-benefitting regions of the state to approve it. In the guise of combating government debt, which certainly is an issue, Proposition 53 would have increased construction costs and added unnecessary layers of complexity and uncertainty to an already unwieldy state government.
• Proposition 55 (passed with 62% of the vote): Proposition 30 Tax Extension to Extend the Income Tax for Another 12 Years. The tax extension should generate $4 billion – $9 billion a year, varying with the economy and stock market, a significant portion of the state’s $122.5 billion in General Fund spending. This tax extension maintains a personal income tax hike on high earners for an additional 12 years starting in 2019 despite the fact that the original Proposition 30 approved in 2012 was billed as a temporary measure to structurally balance the budget and address lingering balance sheet issues. Two-thirds of California’s General Fund revenues in fiscal 2017, or $83.4 billion, comes from personal income taxes, primarily on the wealthiest residents. This revenue source is inherently unstable, fluctuating dramatically along with the stock market or other determinants of capital gains, such as a technology bubble. The state’s heavy dependence on personal income taxes has grown over the past decade (from 54% to 67%), increasing revenues but also the risk associated with economic downturns. Passage of this proposition, while saving the state some difficult immediate budgetary decisions, perpetuates the risks associated with a heavily progressive tax.
• Proposition 56 (passed with 63% of the vote): Increase Cigarette Tax to Fund Healthcare, Tobacco Use Prevention, Research and Law Enforcement. After two failed attempts to raise the tax failed over the last decade, the state’s cigarette tax will now increase by $2 a pack with proponents of the measure able to raise significantly more funds to counter the tobacco companies $70 million to fight the tax hike. It is estimated that at least $1.3 billion will be raised next year from this tax, although revenues are expected to gradually decline as consumption decreases.

We would be remiss if we also didn’t at least mention that 343 or approximately 80% of the 420 local bond and tax measures have passed. This includes $32 billion in facility bonds of which $23 billion is for school construction and $7.2 billion for transit, homeless housing and services, and affordable housing. Voters see these local measures as effective mechanisms for addressing key issues, needs and concerns that they feel are going unmet or underfunded. Unlike voting for a candidate or a statewide ballot proposition that would implement a new policy, local ballot measures provide voters with a tangible way to get something done in their communities. It also reinforces the notion that voters are willing to impose additional taxes upon themselves for specific localized benefits.
 
We are pleased that these results were mostly a net positive for the state. We remain reasonably confident that California will retain its recent fiscal discipline and that the state and most local entities will manage their long-term liabilities while identifying new revenue sources to address capital needs.
 
However, we remain cautious about the process. Any state with a proposition process where the electorate is asked to weigh in directly on fiscal issues and complex, politically charged programs, is a credit concern and could have an impact not only on state credits but underlying issuers within the state that rely on state funding. California’s initiative process is additionally troubling, more so that those, in say, Oregon and Colorado, as there is no stipulated time limit for a passed initiative to expire, no legislative vote before the initiative goes on the ballot, and no formal review of the text of the initiative prior to signature collection.
 
The complications arising from the initiative process continue to focus our attention on bonds that may not be as susceptible to the whims of the voters. Specifically, bonds secured by essential purpose enterprise systems or local government tax bases both located in affluent regions of the state. We continue to research and purchase a diversified variety of state and local credits that help provide appropriate risk-adjusted returns for our clients.
 
Howard Cure is the Director of Municipal Bond Research at Evercore Wealth Management. He can be contacted at cure@evercore.com.