Judgment Day on the State Budget : California Must Avoid Federal Example of Tax, Spend, Borrow

Hidden behind this year’s budget imbalance and the failure of all of the state’s fiscal “experts” to accurately forecast this year’s revenues is a more fundamental structural problem.

California’s budget has become a juggernaut without a plan, without direction and without purpose. Our state taxpayers finance a hodgepodge of programs, “pilot” programs and departmental operations.

Once established, each bureaucracy becomes the agent of its own perpetuation, usually assisted by politicians who may have been there at the time of “birth” and protect the lives of their offspring with all the fervor of a mother grizzly.

Each year the governor and the Legislature go through the budget dance, trading charges of callousness and fiscal irresponsibility. But, in fact, each year they argue over less than 4% of the budget. The 96% balance goes virtually unscrutinized.

As the gap between revenues and expenditures has widened, leaders of both political parties have actually worked closely together to postpone Judgment Day. They have redefined terms, borrowed from pension funds and finally this year concocted an unprecedented bond package weighing approximately $6 billion (this only a year after the governor publicly announced the need to maintain a $1-billion annual cap on new indebtedness). All of these actions have been taken in the interest of finding a way to spend more than we have while technically meeting the state’s constitutional requirement of a balanced budget.

This year the bag of magic tricks turned up empty because the gap grew too wide to paper over (as much as $2 billion).

How did all of Sacramento’s fiscal experts get caught so out of touch with reality? In their defense, they were not alone. Financial analysts for state governments all over the nation made similar errors in calculating the effect of the changing economy and so-called tax-conformity legislation adopted by many states in the aftermath of Washington’s tax “reform” hysteria. The net result here was significant state tax reduction for corporations and high-income Californians.

In general the fiscal experts failed to anticipate three critical phenomena, all of which will continue to affect future budgets:

--The changes in economic behavior induced by the federal government’s change in capital-gains treatment.

--The “carry-forward” effect of the unexpected tax revenue that the state realized in 1987 (income that would have been taxable in 1988 had already been realized in 1987).

--The cumulative economic effect of sustained extraordinarily high “real” interest rates.

The bottom line is that people with money have strong incentives to get liquid. Why invest in risk-oriented ventures when you can get high rates of interest without risk and in some cases with preferable tax treatment?

So why not solve the budget problem by simply explaining to the people that Gov. George Deukmejian and the Legislature goofed? “We didn’t mean to cut your taxes. Now we want it back.”

Aside from the obvious political thicket, there is a more serious and structural difficulty. As all of us now know, the celebrated federal tax “reform” was nothing more than a significant tax increase for middle-income families. There is simply little blood left in the turnip.

The average disposable income of California families has been declining steadily for almost 10 years. Our relatively high housing and transportation costs, coupled with the punitive level of federal taxes, simply do not leave room in the average Californian’s budget for another tax increase. And as long as real interest rates remain so dramatically high (the combined result of a low rate of inflation coupled with the need to attract foreign capital to finance our deficits), the household budgets of Californians will continue to shrink.

The lesson here is that even if we raise taxes this year we will fall behind again two to three years hence. We are operating on the slippery slope of a false economy propped up by foreign money. It is a national problem; state government cannot fix it, but neither can we afford to ignore it.

What we can do is to begin to deal with economic reality and make long-overdue structural changes in state and local government finance.

We must adopt a long-range plan for capital expenditures. Every venture must have a sense of direction. You cannot accomplish this when you are looking only one year ahead.

We should budget in two-year rather than one-year increments. Our bureaucrats spend 20% of their time going through the mindless charades of preparing and negotiating the budget every year, and the Legislature is left no time to perform the oversight functions necessary to make rational decisions.

Both the executive and the legislative branches of government are in need of a broader base of staff expertise. In particular, there is a dearth of understanding of financial markets, how the big players react to changes in the financial environment and how that in turn affects aggregate economic performance.

We must embrace, at least initially, the concept of zero-based budgeting, in which proposed budget items are evaluated on their own merits, without consideration of previous budgets. The politicians have got to get a grip on economic reality. Those who are still waiting for a groundswell of support for more taxes and more spending are living in a time warp. They have cried wolf so many times that no one believes their dire warnings. If those who believe in the need for more revenue are correct, they are going to have to let the sky fall before the public will stop viewing them as collective Chicken Littles.

We must stop floating bonds during this period of high real interest rates. This practice dramatically increases the cost of projects and locks future budgets into today’s obligations. (The current budget shortfall projection doesn’t even include the anticipated new debt-retirement obligations.)

Our national economic profile teeters on a pile of debt instruments that we as a nation do not control. We in California cannot escape the negative consequences of our national dilemma. But we can avoid compounding the problem by not following Washington’s lead of tax, spend and borrow.

The taxpayers are saying no not because they don’t care but because they don’t have confidence in our ability to handle their money properly and because they are already being bled dry by a federal government that is out of control. We have indeed entered the era of limits that was once predicted by former Gov. Edmund G. Brown Jr.

Our first challenge as political leaders is to be able to recognize those limits as they loom before us.