The Legacy of Prop. 13 and its Progeny--Bankruptcy

Orange County’s historic bankruptcy did not occur in a vacuum. Indeed, the financial temblor is, in many respects, a result of the accumulated pressures and strains exerted by a tax-weary citizenry demanding ever less costly government, on the one hand, without any reduction in public services, on the other.

Sixteen years ago, California voters, frustrated by soaring real property taxes and the inability of the Legislature and Gov. Edmund G. (Jerry) Brown Jr. to agree on a plan to reform the system, approved the Jarvis-Gann initiative. Proposition 13 slashed real-estate assessments and severely restricted subsequent increases. Two years later, voters passed Proposition 4, the Gann initiative, which imposed constitutional limits on how much state and local government could spend, regardless of available revenues.

For a time, the financial fallout of these anti-tax measures could be contained. The state had enough cash reserves to tide over local governments for a time, particularly in the case of school districts, for which property taxes were the chief source of revenue. Courts strained to find loopholes in the law, exempting such revenue categories as user fees, special assessments and certain non-property-tax income. These kinds of fixes, however, proved to be only temporary. Also, they resulted in some residents and communities having to pay more than others for basic services, thereby compounding the inequity in Proposition 13, which favored longtime residents and commercial owners over more recent home buyers.

Then, in 1988, California voters acted again, passing Proposition 98, which allocated about 40% of state general funds to public education. The effect was to further hamstring budgetary discretion in Sacramento. Meantime, income-tax indexing, begun in 1982, was reducing state revenues, and federal assistance was drying up during the Ronald Reagan presidency.

In regions undergoing rapid economic growth, including much of Orange County during the mid- to late-’80s, the increasing shortage of public funds to pay for new facilities and services was partly offset by exactions placed upon real- estate development. Approval of new housing tracts, shopping centers or office buildings was conditioned on payment of fees or construction of public facilities, including not only the traditional roads and sewers, but also schools, city halls and recreation facilities. Eventually, the scope of these exactions grew to the point where developers were required to contribute nearly $20,000 in public benefits for every single-family housing permit they obtained. They sought protection in court and eventually succeeded in obtaining rulings that sharply restricted the extent of these exactions.

In areas that were not growing, developer exactions never were an option. But in all communities, even in those lucky enough to have developer fees to finance new buildings or other public-works improvements, the long-term difficulty was in paying for day-to-day operations, including such mundane matters as salaries, utilities and supplies. Scrambling for ways to overcome their revenue and spending constraints, local governments fell upon an ideal vehicle--voter-approved bonds, debt that was exempted from the limits of Propositions 13 and 4.

Throughout, voters were increasingly voicing their discontent with the cutbacks in public services, notably in law enforcement and education. Presented with an opportunity to approve bonds earmarked for specific purposes--building a new high school, adding police officers to the force, widening streets--voters resoundingly said yes. By the end of the 1980s, local bond indebtedness was increasing at the rate of $5 billion a year. This steady stream of money freed up a substantial amount of tax revenues to cover routine operations.

The recession that so harshly struck California, beginning in 1990, had a major disruptive effect on this public financing approach. Not only did local tax revenues shrink further, but voters grew more and more leery of bond issues and increasingly rejected them. But their expectations of how government should serve them did not undergo a similar correction. Once again, the pressure on public officials to find new sources of funds mounted.

To some extent, local governments had always relied on interest earned from investing their temporarily idle funds, but the changing political and economic conditions enhanced the attractiveness of this kind of revenue source. Local officials willing to pursue higher-risk strategies--hence, boost their interest income--took their cue from the successful efforts of the brokerage industry, in coalition with certain financial managers, among them Orange County Treasurer-Tax Collector Robert L. Citron, to relax the legal constraints on public-investment options.

The strategy adopted by Orange County--leveraging its funds by means of secured short-term loans used to buy longer-term, higher-interest bonds--was not new. Interest-rate arbitrage has made, and lost, many fortunes. In the public sector, the city of San Jose, a decade ago, was on the brink of bankruptcy as a result of plying this approach. Now, as then, the strategy worked beautifully as long as longer-term interest rates stayed relatively high, enabling the county to profit from the spread between short- and long-term rates. With rising rates making short-term borrowing more expensive, and weakening the value of the funds’ underlying bonds, the whole scheme was endangered.

For awhile, Orange County’s politicians and public officials enjoyed the best of all political worlds. Soaring investment income--not higher taxes--was helping pay for wider roads, more school buildings, more police officers and a larger airport. In such an environment, incentives to look over Citron’s shoulder were virtually nonexistent. Nonetheless, numerous officials, elected and appointed, should be have been watching over the funds’ investment practices. Instead, they apparently simply rubber-stamped them.

Now that disaster has struck, perhaps the time has come to open a serious debate over the effects of Proposition 13 and its progeny. The proportion of the state’s population reaping the full benefits of the initiative has declined steadily, and residents of recently developed areas, such as South Orange County, are bearing a highly disproportionate tax burden.

In the absence of structural changes in local government’s financing methods, Orange County’s folly will probably be repeated, though perhaps not on such a large scale. The political and economic pressures that drove the county’s managers to place--and its politicians to condone--risky investment bets have not eased. The real question thus remains unanswered: Whether the people of California are willing to bring the level of government they demand into line with the level of government they are willing to support financially. If the citizens are unwilling to come to grips with that dilemma, then the bankruptcy courts will do it for them.