As the pandemic raged last May, California was reeling. Spending on unemployment assistance and health care had jumped while tax revenues were on the verge of cratering. State officials, just months earlier counting on a $5.6 billion budget surplus, now anticipated a $54 billion shortfall. Severe cuts would be needed, making an already frightening recession even worse.

Gavin Newsom, the Democratic governor of California, warned of dark days ahead. “We are confronted with a steep and unprecedented economic crisis,” he wrote in his budget.

Then Wall Street came to the Golden State’s rescue.

The stock market, after a steep but brief downturn in March 2020, has soared to new heights, prompting a record number of companies—many of them based in California—to go public. The rising market minted new millionaires and padded the incomes of the state’s wealthiest residents, who typically own a lot of stock. And for California, that meant a windfall. Its taxes on such stock-based gains are the highest of any state, and its largest revenue source is personal income taxes.

According to its most recent forecast, California is expecting a roughly $15 billion budget surplus next fiscal year, which runs from July through June. It is putting money into its rainy day fund and is expected to reverse some cuts, including to the wages of state workers, which were imposed just a few months ago. The state is so flush that it is now running its own stimulus program, writing one-time checks of $600 or $1,200 to poorer households and spending some $2 billion on aid for small businesses.

“It’s a far better place to be than where we thought we would be,” said Chris Hoene, executive director of the California Budget & Policy Center, a Sacramento think tank that promotes policies meant to help low- and middle-income households. The state has resources available to address the economic fallout of Covid-19, he said. “In a normal economic downturn, the state would probably be doing far less.”

Markets and Tax Revenue Rise

California’s budget turnaround comes as President Joe Biden prepares to unveil a proposal this week to nearly double the tax on capital gains—the term refers to the proceeds from selling an asset such as a stock or a business—on people earning $1 million or more a year, to help pay for his plans to revive the American economy.

The richest people in the United States pay 20% federal tax on capital gains, compared with 37% on ordinary income. The Biden plan would push the top rate paid on both types of income to 39.6%, taking a page out of California’s playbook—the state levies a 13.3% tax rate on both capital gains and ordinary income earned by its wealthiest residents.

Almost half of the personal income tax revenue that California collects comes from the top 1% of the state’s earners. Since much of that group’s income comes from stock holdings and stock-based compensation, their fortunes are tied to the performance of the stock market.

In the early days of the pandemic, no one would have looked to the stock market for salvation. From February to late March of last year, the S&P 500 suffered one of its sharpest crashes ever, falling nearly 34%. But once the U.S. government began pumping money into the markets and the economy through bond-buying programs and stimulus, the market began rebounding.

And professional money managers kept buying stocks. Amateur investors, stuck at home, piled into the market and drove up stock prices further. After hitting a bottom in March 2020, the S&P 500 is up nearly 90%, creating close to $17 trillion in paper gains.

Much of that value was created by California companies. The market value of Apple, based in Cupertino, California, has risen by more than $1 trillion in the past year. The gains for Alphabet and Facebook, combined, have created another $1 trillion in value. Tesla, based in Palo Alto, California, added more than $500 billion.

The surge in market value created a significant amount of wealth for executives and workers, including in the technology sector. Executives at major companies typically have pre-established stock sale programs in place that are constantly converting some of their shares into cash. As they’ve sold into a rising market over the past year, those gains have been especially large; last August, Apple’s chief executive, Tim Cook, sold more than $130 million worth of his stock.

“When the stock market does well, they do very well,” said David Hitchcock, the primary analyst on California for bond-rating firm S&P Global, of the state’s wealthy residents. “And in fact, it’s not just the stock market, but initial public offerings. Because with Silicon Valley, when entrepreneurs get stock grants that they exercise, or stock options, California makes out very well.”

A Boom in IPOs

Eager to cash in on the market optimism, entrepreneurs and venture capitalists have sprinted to list shares in public offerings. Last year, 457 companies listed shares, raising $167.8 billion, both records, according to Dealogic. Almost a quarter of those dollars were destined for the 100 California companies that made the jump—the most of any state.

Initial public offerings can open the door to epic paydays for executives and early investors who fund, run or work for startups. Once the shares begin to trade publicly, these insiders can begin to cash out on the stock and options they hold after a “lockup period” of a few weeks. And the executives selling those shares pay tax on the gains.

Christopher Payne, the chief operating officer of DoorDash—which went public in December—sold more than 250,000 shares in the company in early March, according to filings with the Securities and Exchange Commission. The transactions were worth more than $30 million. The shares are down roughly 15% since they began trading.

Frank Slootman, the chairman and chief executive of Snowflake, a San Mateo, California-based data-warehousing firm that went public in September, sold more than 30,000 shares in the company on April 20 through an automated plan, according to a recent filing. Those sales were worth more than $7 million; the stock is down 7% since trading began.

With potentially thousands of such paydays for California to tax, revenue tied to capital gains surged over the past year. The governor’s office projects that revenue from capital gains taxes next fiscal year will top $18 billion, a key driver of the state’s surplus. And the final number could be much larger.

It’s Not All Markets

California’s finances would perhaps have looked less winsome had it not been for efforts in recent years to fix its problems. Newsom’s predecessor, fellow Democrat Jerry Brown, who left office in 2019, pushed through several measures intended to stabilize the state’s finances. During his administration, California paid down debt, made contributions to pension funds and passed a constitutional amendment ensuring the state’s rainy-day fund was adequately provided for.

“They took a lot of steps to fix their finances,” said Karen Krop, who covers California for bond rating firm Fitch Ratings. “They had a long period of growth. They took that opportunity, during that period of growth, to fix things that had been a huge overhang.”

And while it’s no surprise that California’s tax structure leans heavily on the rich given its left-leaning politics, the state also benefited from having a large and highly paid workforce, made up of people whose jobs held up better during the pandemic.

California’s budget rebound was aided by larger-than-expected federal government spending—on things like unemployment aid and stimulus checks—that kept people afloat and the economy from complete collapse. Such federal funds continue to flow. Analysts expect that when Newsom revises his most recent budget next month as required by law, it will show an additional $26 billion in federal funding to California as a result of Biden’s $1.9 trillion American Rescue Plan passed last month.

While California’s surplus will continue to grow in the coming months, the state has significant problems. The unemployment rate, at 8.3% in March, remains higher than the 6% national reading. The state continues to contend with a large-scale housing and homelessness crisis. An ongoing drought is putting the state in a precarious position heading into wildfire season.

Analysts say that with the state’s overflowing coffers, there’s no pressing budgetary reason to hold back a spending push that could help the state exit the recession with momentum. However, they caution against the state's locking itself into any major ongoing spending programs based on the bulging surplus. After all, there is no telling when the stock market will sour.

“The problem is that it’s a highly variable revenue stream,” said Hitchcock, the S&P Global analyst. “So they go from feast to famine and back.”

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