Standard & Poor’s tells FOX Business that California faces a downgrade to its outlook if the state doesn’t pass a credible budget in time, as Democrat governor Jerry Brown continues to struggle to close a $15.7 billion budget deficit.

California must submit a budget June 15. S&P says that although California’s economy is about an eighth of U.S. gross domestic product -- and is about the size of Italy -- its budget deficit is a huge 30% of all 50 states’ budget deficit.

Gabriel Petek, an S&P analyst and co-author with analyst David Hitchcock of a new report on California’s fiscal crisis, tells FOX Business in an interview that the state “faces a downgrade to its outlook” to negative “if it bungles its budget.”

Petek says that S&P is “keeping a close eye on budget gimmicks” that the state has tried to use to paper over problems. Petek says that the most populous state in the country, with an economy the  ninth largest in the world, already is “overly reliant on personal income taxes” and that the state’s “tax structure is behind the deficit, because it over relies on the personal income tax” as its source of revenue.

He adds that “for California to rely on capital gains tax revenue from things like the Facebook initial public offering is like looking for change in the seat cushions.”

FOX Business has already reported that California governor Jerry Brown was too optimistic in forecasting more than $2 billion in expected state capital gains revenue over five years from the social networking site’s IPO.

Even the state’s own legislative analysts told the governor’s office its forecast was too rosy -- as investors could sit on the Facebook (FB) stock and not cash out, or simply move out of the state, among other things.

Already, California has seen a migration of upper bracket taxpayers out of the state. It has the worst credit rating out of all 50 states at single A minus.

Brown has backed steep cuts to social, health and welfare programs, and is asking state voters to approve a ballot measure this November that would hike the state's sales tax as well as personal income taxes on the wealthy.

But S&P tells FOX Business that California’s problem is not just due to over-spending, or large pension and retirement liabilities for state workers, or an excessive tax burden.

Spending as a share of its economy is lower than at any time in the past 39 years, and state retirement costs are not a current, but a long-term problem, the S&P analysts note.

Instead, California’s main problem is its budget operation itself

Petek and Hitchcock call it a “dysfunctional” and “deficient” revenue operation, which is in dire need of restructuring along the lines of how New Jersey reformed itself.

Watch this rigmarole -- California’s state constitution requires it to enact a balanced budget.
But “it does not also require that the state end the fiscal year in budgetary balance,” S&P notes. So an overflow of deficit hits the next fiscal year’s books, continuously -- a chronic problem.

The state is also often strait-jacketed by constitutional requirements on budget moves like tax and spending, including a two-thirds majority of legislators to approve changes.

“So its ability to make straightforward budget adjustments is complicated, a lot of times its budget gimmicks don’t work out,” S&P’s Petek tells FBN.

Meaning, “the state passes budgets that balance on paper, but several months later, the budget is again out of balance and out of whack,” says Petek.

“With that track record, that’s why the state has such a big cash flow deficit,” Petek adds.
Worsened because the state, home to Silicon Valley and a huge housing market, has been careening from bubble to bubble.

Standard & Poor's has already warned in a report earlier this year: "We could change the outlook to negative or lower the rating if we believe the state's credit quality weakens through the budget process."  

The credit ratings agency last February had upgraded California's financial outlook from "stable" to "positive,” offering a glimmer of hope to California that its credit rating of A-, the worst of all states, might be upgraded, too.  

Petek and Hitchcock note in their report that: “63% of California’s tax revenues come from the personal income tax,” but that the state’s tax revenues are “increasingly volatile” and “unpredictable.”

But the state’s economy is now more “heavily based on services rather than retail sales.”

So, does that mean a value-added tax on state services is headed California’s way?

Elizabeth MacDonald joined FOX Business Network (FBN) as stocks editor in September 2007 and is the author of Skirting Heresy: The Life and Times of Margery Kempe (Franciscan Media, June 2014).
Follow Elizabeth MacDonald on Twitter @LizMacDonaldFOX.