Downturn Looms as Leadership Test for California, World’s 5th Largest Economy

LOS ANGELES — It has the highest concentration of billionaires in the country. It exports more computers than any other state. It is the nation’s largest producer of agriculture products by far: More than $6 billion in dairy products alone last year.

California is an economic powerhouse — now the fifth largest economy in the world after surpassing the United Kingdom in total output this year.

But this state may be facing a financial reckoning at the very moment that Jerry Brown is stepping down as governor: a possible recession coinciding with deepening concerns about its fiscal stability. His two potential successors — Gavin Newsom, the Democratic lieutenant governor, and John Cox, a Republican business executive — have significantly less experience than Mr. Brown, a fixture in California for nearly a half a century and through five national recessions.

California is now on the verge of putting one of the world’s largest economies in the hands of a relatively untested governor.

The ability of Mr. Brown’s successor to navigate California through challenging fiscal times could be critical to assuring both the state’s continuing economic durability and its outsize contribution to national prosperity.

“So goes California, so goes the U.S.,” said Christopher Thornberg, the founding partner of Beacon Economics, a consulting firm in Los Angeles. “It is far and away a dominant source of job growth in the U.S.”

Amid all its successes, California has become a stark example of economic disparity, illustrated by the juxtaposition of homes selling for tens of millions of dollars in the hills of Los Angeles and colonies of tents a few miles away along Sunset Boulevard. A disproportionate amount of this state’s wealth is being generated in the Bay Area, where an explosion of new tech companies has produced jobs with six- and seven-digit salaries. In Santa Clara County, the heart of Silicon Valley, average pay tops $130,000 per year.

A severe lack of affordable housing has fueled concern by business and political leaders of a labor shortage, because there will be no place middle-class people can afford to live. “We are going to have a two-million-person gap in about 20 years,” said Anthony Rendon, the Democratic speaker of the State Assembly. “I can see that getting bigger if we can’t figure out the housing crisis.”

Policies embraced by President Trump — including tariffs on Chinese goods and a crackdown on undocumented immigrants — could be harmful to this state’s economy, home to a vast network of farms already struggling to find field workers, and to the nation’s two largest ports.

The tax bill enacted by Congress is raising the cost of living for many homeowners by limiting the deductibility of state and local taxes, which are high in California, though some have done better under the new code. A drive to repeal a gas tax, on the ballot this fall, could undercut Mr. Brown’s ambitious effort to rebuild roads and bridges and blast a hole in the next governor’s budget.

And by nearly every account, a national recession is overdue. Another economic downturn could be especially devastating to this state, with a tax system heavily reliant on high-income wage earners. The last one resulted in the loss of one million jobs across the state.

“Jerry Brown has warned of the chances some headwinds on the economy coming down the pike are pretty high — we are not prepared for that,” said Austin Beutner, a former Wall Street investment banker and deputy mayor of Los Angeles, who is the superintendent of the Los Angeles school district. “We haven’t modernized the tax base and reformed the property tax system. We haven’t done the hard work to make sure if there is a change or a correction, the resources are there to do the things the state has to do.”

Mr. Newsom and Mr. Cox have both spoken of the huge economic challenges facing the state, pointing to widespread poverty and homelessness that both men — invoking the same phrase — say, “happened on our watch.”

Their responses reflect their political philosophies. Mr. Cox has called for cuts in taxes and regulations, while Mr. Newsom has advocated increased spending on early childhood development, higher education and health care. But both Mr. Newsom and Mr. Cox have steered clear on offering detailed plans on how they might manage one of the world’s most powerful economies.

“The California Dream is predicated on upward mobility and the upward mobility cannot exist if people can’t afford to live here,” Mr. Newsom said in an interview. “The issues that are highlighted in terms of how we are not performing are legit. The richest and the poorest state. It has to be addressed.”

Mr. Cox, in contrast to Mr. Brown and Mr. Newsom, said he did not think a recession was necessarily in the state’s near future. Still, he described California as a place that had become increasingly difficult to live in.

“The economy has grown,” he said in an interview. “And it has obviously helped people at the top. And everyone is working, the unemployment rate is pretty low. But people can’t make it here. And a lot of people are thinking of moving.”

Many of those people who are moving out are younger residents, heading for places like Texas, Arizona and Nevada, apparently after concluding that California has become too expensive, according to a report by the state Legislative Analyst’s Office.

Economists also expressed concern that the exit of Mr. Brown could open the way for more spending by the Legislature. Mr. Brown has a reputation of pushing back on expenditure demands by the Legislature, unions and other interests that he saw as potentially wasteful. Mr. Newsom, who polls suggest is likely to win this race, is a former mayor of San Francisco who has appealed to liberal voters and has the support of the California teachers’ union.

“What Governor Brown has done is try to maintain a certain amount of fiscal discipline in his party, which I don’t see the next Democratic governor doing,” said Juliet Musso, a professor of state government at the University of Southern California. “I haven’t heard a lot of talk about fiscal reform, and that’s not something that’s going to play with the base he has been speaking to.”

Mr. Newsom said he would prove to be as much of a fiscal steward as Mr. Brown. “I think people, to the extent they are concerned, I think they’ll be soon assuaged of that concern,” he said.

But in the same interview, he said he would push to restore cuts in early childhood education and higher education that took place under Mr. Brown. He has also called for a statewide single-payer health care system. “It’s time to guarantee prenatal care, in-home nurse visits, and access to quality pre-K for every child in California,” he said in his latest television advertisement.

California’s economy is a colossus, with a diverse set of industries that is unmatched in the United States. There is Silicon Valley in the Bay Area, which has become a dominant economic driver in the state. The farms that blanket the state’s vast center grow two-thirds of the nation’s fruits and nuts. The entertainment industry is still thriving in Hollywood (or more accurately, across Los Angeles.) And Southern California is home to two ports that receive nearly 40 percent of all foreign goods shipped into the country, plus a sprawling warehouse and transportation network needed to distribute them across the country.

This state has accounted for 20 percent of the nation’s economic growth since the end of the Great Recession. Unemployment is at a historic low. And after struggling under a $26 billion deficit, the state has a budget surplus of nearly $16 billion.

But at the same time, the gap between the richest and poorest is wider here than almost anywhere in the country. California’s poverty rate, at 19 percent, is the highest of any state.

The state’s ability to finance its operations has been complicated by two powerful forces. The first is Proposition 13, an initiative passed by voters in 1978 that imposed caps on property taxes. The second is its income tax system, which is volatile because it is heavily reliant on the top 1 percent of income tax payers. About 70 percent of the state’s revenues come from personal income tax.

There has been a clamor to change Proposition 13 — which would likely require another voter initiative — and to rewrite the income tax system to make it more reliable. But Mr. Brown was governor when Proposition 13 was passed in 1978 and it was a searing experience for him: He campaigned against it, but quickly moved to embrace it after voters rebuffed him.

Over these past eight years, he has refrained from tackling either Proposition 13 or the state tax system, making it clear he saw both as losing battles.

If Mr. Brown, who enjoyed abundant political capital and good will, was not willing to take on the fight, it seems unlikely that Mr. Newsom or Mr. Cox are going to step into that ring. “It’s not politically popular to say let’s try to have a less progressive income tax system,” Professor Musso said.

Both Mr. Newsom and Mr. Cox said they agreed the tax system needed to be reformed, but have resisted offering detailed ideas on how they would enter such politically complicated terrain.

Mr. Cox for example, said he would look for “other sources of revenue.” When asked for examples, he responded: “I don’t know. But I’d be more insistent on cutting the spending. I think this state wastes incredible amounts of money.”

The revamp of the tax code enacted by Congress could prove damaging to California if wealthy people start fleeing to lower-tax states. “The difference between California and other states is now much larger, and we have no idea of how people are going to react to that,” said Irena Asmundson, the chief economist at the California Department of Finance.

But the next governor will have one advantage that Mr. Brown did not. Mr. Brown pressed the Legislature, as the economy recovered, to create a rainy-day fund to carry the state through an economic downturn — a buffer against the kind of cuts imposed eight years ago. There is now $14 billion in the fund.

Toni G. Atkins, the Democratic president pro tem of the State Senate, applauded the creation of the fund, but noted that it was dwarfed by the size of the deficit the state faced during the last recession.

“That amount of money doesn’t go as far as you think,” she said. “We know what it felt like to go through a decade of serious recession. We had a really hard time. I am part of a last class of legislators who came here when we faced a $26 billion deficit. Those who came after us may feel somewhat different. They didn’t have to make $26 billion in cuts.”