State Weighs a Tax Hike

The Davis administration has drafted plans to create a new state authority that would issue bonds to help bail California out of its budget troubles and then increase the sales tax by half a cent to repay those bonds.

The plan, parts of which were shared privately with major Wall Street firms last month, is modeled after the one that kept New York City solvent in the 1970s. It would pay off much of California’s current deficit this year, then repay that loan over several years.

By creating a separate entity to raise those taxes and issue those bonds -- which the administration estimates will amount to at least $8.2 billion -- officials hope to demonstrate that the money should not be subject to Proposition 98, which requires that a percentage of all general-fund revenue be spent on education. This money would be kept entirely separate from the general fund and would only be used to pay off California’s budget deficit for this fiscal year.

The plan, which was drafted by the state Finance Department but which aides said Davis himself has not approved, faces political and financial uncertainties. Some legislators are hesitant about borrowing to pay off the deficit, which they say would in effect delay the state’s reckoning with its budget problems. Others are wary of any tax increase, including one that would be used to pay off new debt.

Still, legislators and others have acknowledged in recent weeks that dramatic moves are necessary to close the state’s budget gap, which already has forced cutbacks in medical services and education, and tuition hikes at state colleges and universities. In addition, officials are contemplating even deeper service cuts as they turn to next year’s budget, which the Legislature is supposed to adopt by mid-June.

Approval of the latest proposal would require a two-thirds majority in both houses of the state Legislature, where Democrats hold most -- but not two-thirds -- of the seats.

Letters sent by the investment banking firms show they reacted favorably to the proposal but also warned that trying to borrow the money to pay off all or part of the deficit without raising such a new tax or making severe cuts could prove disastrous. The firms said that if the state does not soon reach a solution that closes the budget gap next year and balances revenues and spending, it risks running out of cash and losing its ability to borrow altogether.

“Without a timely solution, the state’s credibility will suffer, and it will be very difficult to find anyone willing to make loans of size to the state,” warned a letter from Lehman Bros. It was one of several sent by major banks at the request of state finance officials seeking comment on potential budget solutions.

The Lehman Bros. letter went on to say a “worst-case scenario would find the state out of cash and out of cost-effective options within 12 months or sooner.”

David Takashima, the Davis administration’s chief deputy finance director, said the plan was worked out over two months in response to Republican proposals to borrow billions of dollars but not to authorize a tax hike for repaying those loans. Takashima said no decision has been made about whether the plan will be included in the revised budget that Davis is scheduled to release next week.

Although most Democrats say the letters are further evidence that any reasonable solution to the crisis must include a tax increase, many Republicans are vowing not to be bullied by financial firms looking to boost profits for their shareholders.

GOP Warning

“Wall Street will bluff you into accepting certain terms to make a deal happen,” said Assemblyman Todd Spitzer (R-Orange), who negotiated with banks on the bonds Orange County used to emerge from bankruptcy while he was a local official there. “They’re like any other big company.”

Republicans have accused Davis of trying to use Wall Street as a club to pressure them into raising taxes. The governor said Monday that he is eager for Republicans to hear for themselves from the Wall Street executives. Bankers from several firms are scheduled to make presentations to the GOP caucuses in coming days.

“The bankers will present their own views to the Legislature directly, and the Legislature can make up their minds,” Davis said. The governor, who met with investment bankers last week, had earlier cautioned against borrowing to pay off the debt, warning that it would just prolong the state’s financial problems into the future.

But support for borrowing to ease the pain of balancing the budget has steadily gained momentum in the Legislature, where officials are daunted by the challenge of coming up with enough cuts and fee and tax hikes to close the current-year deficit and projected shortfall estimated to be as large as $35 billion combined. Now, Davis says he is open to the idea.

“My preference was to get it all behind us, to take the bitter medicine,” he said. “The Legislature on both sides of the aisles seems more inclined to using multiple years to solve this problem. I’m not unilaterally opposed to that, but I will only do it in a way that is financially responsible.”

A New Authority

The plan calls for setting up a Fiscal Recovery Financing Authority that would oversee the issuing of bonds to pay off the deficit. The agency’s board of directors would include the state finance director, treasurer, controller and other officials.

As drafted, the legislation says the temporary 0.5% sales tax increase would be dedicated solely to pay off the deficit bonds. Proceeds from the hike, which would raise about $2.3 billion a year, would go directly to a special Fiscal Recovery Fund separate from the state’s troubled general fund.

The sales tax varies across the state: It currently is 8.25% in Los Angeles County; 7.75% in Orange, Riverside and San Bernardino counties; and 7.25% in Ventura County.

The draft legislation would require lawmakers to annually appropriate receipts from the tax increase to pay off the deficit, but would not allow the Legislature to use that money for any other purpose. The attorney general and the state’s bond counsel have preliminarily reviewed the proposal and at this point believe that the annual appropriation would not violate the state Constitution’s requirement for a vote of the people before certain types of long-term debt can be issued.

“The courts in the large majority of states which have considered the question have recognized that [the bonds] do not violate constitutional debt limits,” the draft plan says.

It notes that several other states and cities have used such bonds to pay off their deficits, perhaps most notably New York City in the 1970s and New York state in the 1990s.

The letters from the firms do not tell Davis that they would require a tax hike to lend the state more money. But they suggest that the state would have a difficult and dangerous time financing its way out of the crisis without such an increase.

Three Goldman Sachs executives -- including Kathleen Brown, who was the state treasurer during California’s last financial crisis and whose father and brother both served as governor -- urged in their letter that any bonds be backed by “a new tax that does not cannibalize other parts of the budget.”

The letter noted that when the deficit bonds are taken together with all the other short- and long-term borrowing that the state plans, California could rack up $40 billion to $50 billion in new debt by year’s end, putting the state in a vulnerable financial situation.

“We have the financial equivalent of a high-wire act, and the state’s goal should be to have a sufficient margin of safety to avoid any significant risk of failure,” said the Goldman Sachs letter, which added that California risks losing its ability to borrow “at any cost.”

The bankers made clear that deficit financing would be a one-time-only option, and that it is essential the state not have a budget that falls out of balance again next year.

“The markets and credit community are looking to the state to adopt a package of sound measures with this budget that will provide a final ‘fix’ to the state’s structural deficit, and not continue to push the problems off into future years,” said the letter from UBS/Paine Webber.

Lehman Bros. wrote that “at all costs” the state must avoid leaving the impression that “fiscal matters remain out of control and that the deficit financing represents ‘punting’ into next year.”

The message was sobering to lawmakers, who are moving into the most difficult negotiation stage, with the June 15 constitutional budget deadline nearing.

“They are telling us they have never seen California in worse shape,” said Assemblyman Keith Richman (R-Northridge), a leader of a bipartisan group of lawmakers working on budget solutions. “Wall Street is receptive to deficit financing, but they want a fiscally sound budget in place going forward that answers the structural deficit.”