Rising Budget Gap Puts Davis in Bind

California’s fiscal hole has grown by as much as $3 billion since January because of flagging tax collections and surging demands on state services, presenting new difficulties for Gov. Gray Davis as he begins work on budget revisions that will frame a looming Capitol showdown over spending priorities.

In January, Davis warned of a dire situation in the state’s finances and proposed a budget that included $20 billion in cuts and fund shifts as well as $8.3 billion in tax increases. Now, he is required to submit a revised budget known as the May revision, and that document will form the basis for talks with the Legislature on a final spending plan for the fiscal year that begins July 1. According to administration officials and others familiar with state finances, the situation since January has only worsened.

If the latest projections are borne out by crucial revenue collections after the April 15 tax-filing deadline, Davis and state lawmakers could face a budget shortfall that exceeds the current estimate of up to $35 billion over the next 15 months.

“One can assume there will be a significant, additional downward adjustment as a consequence of higher caseloads [for Medi-Cal and other state programs] and lower revenues,” Finance Director Steve Peace said.

So big are the problems -- and so polarized the players -- that some state officials believe that it will take intervention by Wall Street to force action in Sacramento. According to that view, Democrats are so committed to certain programs and Republicans so steadfast in rejecting tax hikes that only further downgrades in the state’s credit or the refusal to extend loans until the state has a credible budget will dislodge partisans on either side.

In an interview with The Times, Davis discussed the frustrations of trying to balance this year’s budget and acknowledged the unhappiness with his proposals. Although Davis would not address specifics of the choices now before him, he stressed that this budget process has been arduous.

“From the beginning it became clear to me that there were no good choices,” Davis said. “Every decision was painful. Many caused me to lose sleep. This was by far the most difficult budget I had to present, and one I spent the most time on.”

Interviewed separately, Peace said the size of the hole had grown by more than $1 billion since January. Other administration officials and budget experts estimated the shortfall would grow by as much as $3 billion by the time Davis presents his revised budget to the Legislature in mid-May.

On top of that, the sale of $2.3 billion in tobacco-settlement bonds that Davis has been counting on is in jeopardy and a plan to shift $8 billion in state services to local governments faces legal challenges. State employees are resisting pay cuts and Indian tribes say a request to share an additional $1.5 billion in casino revenue with the state is unrealistic.

Davis also faces difficulties with the Legislature, where Republicans are refusing to support his proposed tax increases and Democrats have agreed to only $3.3 billion of the $20 billion in cuts and fund shifts he says are needed.

The governor is considering whether to cede some ground to Democratic lawmakers by reducing the size of his plan to shift state services to local governments and by replacing some health and social services cuts with reductions in the Department of Corrections budget and other areas that don’t directly hurt the poor -- positions that some advisors and key Democrats favor.

Assembly Speaker Herb Wesson (D-Culver City) said he expects that Davis will demonstrate “a certain sensitivity to the concerns that we on the Democratic side of the aisle have laid out” by restoring some social program cuts.

“I think if people see that he is moving it would make it easier for them to move,” Wesson said.

The Constitution requires the Legislature to pass a budget by midnight June 15, but last year the Assembly couldn’t reach agreement until the early morning of Sept. 1. This year, with the state running low on cash and its ability to borrow money increasingly constrained, Davis and the Legislature must find a way to close the gap, overcome their differences and pass a budget this summer, if state government is to continue functioning fully, officials say.

“The choices are limited and they are bad,” Peace said.

And even after debating the budget for months, there is barely a hint of consensus between Democrats and Republicans. The Constitution requires two-thirds approval to pass the budget, and that means the Democrats need the votes of two Republicans in the Senate and six in the Assembly.

“We have very difficult, tough choices to make,” said Senate Republican leader Jim Brulte of Rancho Cucamonga. “I think some people are hoping the May revision will show a huge increase in revenue and minimize the number of tough decisions we have to make.”

That seems unlikely, and the Davis team is just beginning discussions aimed at “threshold questions,” aides said, such as whether to propose tax increases even greater than the $8.3-billion package. Davis already has recommended increases in taxes on retail sales, cigarettes and wealthy Californians.

Additionally, Davis must decide whether to take some cuts off the table, as Democratic lawmakers and interest groups want. And he must decide whether to accept a Republican proposal to carry some of the shortfall over to next year’s budget by borrowing money.

There are differences among Davis advisors on these questions.

“We’ve got to find more solutions,” said one aide, who like several budget insiders, would only speak if not identified.

“So that’s one level of the discussion. But the second level is: Are there some conceptual things that we want to do to take another strategic step in the process? We’re kind of going back and forth on both of those.”

One of those “conceptual things” is the provocative notion of borrowing money to roll over part of the deficit into next year’s budget, the rare idea that has gained some bipartisan support in recent weeks.

Davis aides are studying the financial and legal implications, but the governor is cool toward the idea, advisors said.

“He’s inclined against it, but if it makes the whole thing work and if he gets answers to his questions, it might be something he would consider,” an aide said. “But I don’t think he’s there yet.”

Linked to the question of taxes -- and how much to raise them -- is the fate of the $8-billion local funding realignment plan Davis has proposed. The plan faces opposition in the Legislature, with Republicans opposing it because Davis wants a tax increase to pay for it and with Democrats believing it is too big and unworkable because of the rising demands it would put on local governments.

The Legislature’s legal counsel says a portion of the new taxes Davis wants for realignment must be diverted to public schools under Proposition 98 requirements. The proposition requires that public schools receive about 40% of general fund tax collections and about 60% of new tax revenues.

Administration lawyers, however, say the tax increase could circumvent Proposition 98 if it is specifically dedicated to realignment. Former Republican Gov. Pete Wilson successfully made the same argument in the early 1990s when he shifted some services to local governments.

The debate points to a fundamental question Davis faces: How much does he rewrite his plan in an effort to ease legislative opposition?

In preliminary discussions with Finance Department staff and others, Peace has suggested that the administration keep the governor’s January budget largely intact and make additional cuts to address any increases in the shortfall, according to people familiar with the discussions.

The dilemma Davis confronts is that for every cut he takes off the table or every dollar he takes out of realignment and returns to the general fund budget, he must find a dollar of additional revenue or cuts.

But aides said the governor is open to compromise with Democratic lawmakers.

Even if Davis deviates little from his January plan, as many lawmakers expect, the governor will still have to propose additional cuts or taxes to fill holes caused by the expected slide in tax collections and increased caseloads in federally required programs such as Medi-Cal, administration officials and budget experts said.

At the same time, Davis must find substitutes for millions of dollars in proposed cuts that are being restored to the budget because they posed unintended threats to public safety or security. One example is the governor’s January proposal to eliminate a state botulism laboratory, the only one in the country. That decision is being rescinded because of the facility’s perceived importance in case of a bioterrorism attack, an aide said.

Davis aides and budget experts are already sifting through programs for any relatively painless cuts that may have been overlooked last fall and for possible loans from funds earmarked for specific types of spending.

Other considerations are a pair of legislative proposals: Davis could get $1 billion in savings by increasing the size of bonds to pay for the state’s annual contribution to public employee pension plans and $1.1 billion by returning the Medi-Cal program to a cost-based accounting methodology.

Even if Davis does agree to “roll over” a portion of the shortfall to next year -- for example, the current-year deficit of $8 billion to $10 billion -- the Legislature would still have to approve about $25 billion in cuts and taxes to pass a balanced budget for next year, experts said.

Administration officials are trying, so far in vain, to dampen partisan rhetoric in their search for a middle ground.

“This is not a time for a political debate,” Peace said. “This is a time to have a business-management approach.”