Facing a one-two budget punch

The heavy shoe is about to drop. Sacramento on Monday intends to begin stiffing people owed tax refunds, vendors who sell goods to the state and recipients of many social services.

Up to 276 more construction projects also could be halted next week; 5,300 already have been.

That’s because the state is horribly in debt, has already borrowed to the hilt and can’t secure more loans -- or sell construction bonds -- until the governor and legislative leaders agree on a budget solution that can muster the necessary two-thirds legislative vote.

And when that happens -- and the state can begin corralling enough cash to resume paying creditors -- the other shoe will drop with a loud thud: Government services will fall precipitously and taxes will rise.

It’s inevitable. And Californians haven’t been prepared by their political leaders for the one-two punch. Sure, the public has a vague idea of what’s coming, but too many people aren’t certain it’s necessary -- especially the tax hikes during a deep recession.

That’s not just my view. It’s also the observation of Gov. Arnold Schwarzenegger’s predecessor, the governor he ousted in the 2003 recall election: Gray Davis.

Since being dumped, Democrat Davis has been careful not to publicly criticize Schwarzenegger. In fact, he has often praised the Republican.

But on Tuesday, Davis told me: “People are going to get hit with major tax increases and program reductions and no one is preparing them. Part of leadership is not just doing the job, but explaining to the public why a certain action needs to be taken. Why it needs to happen and how long it will remain.

“You have to bring people along with you. President Obama is a master of selling the public on why his programs make sense -- in contrast to the deafening silence coming out of Sacramento.”

The former governor speaks from experience. “I could have done more,” he acknowledges.

Davis occasionally did try, but never could adequately explain the energy crisis -- generated by a flawed state deregulation law he inherited, power pirates such as Enron and an unfriendly Bush administration. Then, as the economy soured, he was dragged -- without enough resistance -- into a budget quagmire by a liberal Legislature. He made a half-hearted attempt at selling a tax hike, and flopped.

Schwarzenegger really hasn’t tried at all, at least not until Wednesday while answering a question at a Sacramento Press Club luncheon.

“I despise tax increases,” said the governor, who ran for reelection in 2006 promising not to raise taxes. “But mathematics is much more powerful than ideology.” He noted that the projected deficit for the next 17 months is $42 billion.

“You can’t do $42 billion in cuts. It doesn’t exist. Anyone that thinks that you can do all of this with just cuts doesn’t know math, and they should go back to Math 101.”

He equated the firm opposition to tax increases by many Republican lawmakers with the solid support of abortion rights by Democrats. Getting either group to change positions is equally tough, he asserted.

Yet, he indicated some Republicans were now willing to raise taxes in exchange for significant spending cuts and an “economic stimulus” package that includes changes in work rules and streamlining of environmental permitting on public works projects.

Schwarzenegger contended that half of the deficit has been caused by the global recession and the other half is “self-inflicted.” It’s “bigger than any problem we have ever had in this state.”

I called Davis because he was the state controller the last time Sacramento issued IOUs rather than pay people with real checks. That was in 1992. I wanted to compare the two situations.

No comparison, really. The dilemma back then wasn’t nearly as dire. The Legislature was in a summer budget brawl -- some things haven’t changed -- and the state was short about $4 billion cash. Davis asked Gov. Pete Wilson for permission to sell revenue anticipation warrants (RAWs), short-term debt. Wilson refused, theorizing that the borrowing would relieve pressure on Democrats to cut spending.

“We had no option but to issue IOUs,” Davis says.

These days, the state couldn’t sell RAWs even if it wanted to. There’d be no takers. In 1992, banks were stronger. No meltdowns. And Bank of America not only was headquartered in San Francisco, it was a California institution. It agreed to accept the IOUs.

Then other banks followed B of A’s lead.

That lasted one month, until August. After that, most banks rejected the IOUs.

“Issuing IOUs is the easy part,” Davis says. “Working with financial institutions so the IOUs are treated as legal tender is the challenge.”

The 1992 budget wasn’t enacted until Sept. 3. State employees sued and a federal court ruled it was illegal to pay them with IOUs. So that option no longer exists.

“It would be our druthers not to pay legislators and state officials,” says Hallye Jordan, spokeswoman for the state controller. But that would violate the state Constitution.

Controller John Chiang is trying to hold onto enough cash to pay schools and bond holders -- who legally have first claim on the treasury -- and then state employees.

Even if the governor and Legislature were to pass a budget by next week, it probably wouldn’t be soon enough to head off payment deferrals, the polite word for stiffing. “Mechanically, I don’t think they could generate a revenue stream in time,” Chiang says.

But he’ll do everything possible -- short of cutting off legally required payments -- to avoid issuing IOUs. “That would be a horrible signal to Wall Street, effectively shutting us out of the bond market.”

Surely, however, Capitol politicians will have balanced the books long before IOUs would be needed, maybe in March.

“Nothing says I love you like a Valentine’s Day budget agreement,” quipped H.D. Palmer, the governor’s budget spokesman.

Schwarzenegger will need to do some sweet-talking and explaining to California citizens, who are about to be banged by two heavy shoes.

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george.skelton@latimes.com