Pillars of State Budget Look Shaky

The budget agreement that California lawmakers adopted two months ago while struggling to plug a $38.2-billion shortfall is beginning to unravel.

About $1.2 billion that budget makers were counting on from American Indian gambling taxes and state work force reductions has so far failed to materialize. An additional $2 billion in borrowing has been blocked by a judge. And legal experts say the linchpin of the entire budget -- a $10.7-billion bond sale -- could, for the same reasons, go down in court.

State officials say they are confident they will win the lawsuits, but bond analysts and others are less sure. If the state does lose, the governor -- be it Gray Davis or one of the candidates seeking to replace him in a special recall election Tuesday -- could be embroiled in a fiscal crisis as severe as last year’s and be forced to find other ways to raise revenue or lower expenses.

State Finance Director Steve Peace said the concerns are overblown. He argued that the blocking last week of what he called a relatively minor bond sale by a Sacramento County court -- which set off much of the anxiety about other anticipated revenue streams -- is not a sign that the budget is falling apart.

“Every budget has implementation uncertainty in the beginning,” Peace said. “This budget is actually in good shape.”

In the first quarter of the fiscal year that began July 1, state coffers received $430 million more than expected, a significant boost of cash to help keep the books balanced, he said.

Yet investors and lawmakers have been jolted lately by other parts of the budget. After the bond sale was blocked, the rating agency Standard & Poor’s advised investors that if other borrowing runs into trouble, the state could find itself having “liquidity concerns” by fiscal year’s end. In effect, California would be in danger of running out of money again.

Consider that:

* A Sacramento Superior Court judge last week blocked as unconstitutional a $2-billion bond sale.

The state had been planning to sell the bonds to cover its annual payment to the government employee pension fund -- a technique that would have freed up general fund money to pay down the deficit. At the urging of the Howard Jarvis Taxpayers Assn., the judge refused to permit it, citing a 19th century provision in the California Constitution that prohibits borrowing more than $300,000 over several years to pay routine government expenses without voter approval.

Administration officials had argued that the pension payment was not routine, but something the state is obligated to pay, thus the debt restrictions shouldn’t apply. The case is on appeal.

But the court proceedings have delayed the bond sale and will cause the state to dip into budget reserves to make a $550-million pension payment that was due Wednesday.

* The Pacific Legal Foundation, a Sacramento-based property owners- and taxpayers-rights group, is suing on the same constitutional grounds to stop $10.7 billion in bonds that the state wants to sell to pay off last year’s deficit. The “deficit bond” debt would be repaid over the next five to seven years. The longest amount of time the courts have allowed the state to borrow for routine expenses has been two years.

Administration officials say they are confident that the maneuver will pass legal muster because the Legislature must appropriate the bond repayments each year with a two-thirds vote, and the state has dedicated half a cent of sales tax upfront to paying back the bond.

“We have 100% confidence the deficit bond sale will go through as planned,” Peace said.

Critics say it will be stopped in court as unconstitutional, just as the pension bonds were. And budget experts agree that the critics may have a good case.

“I’m skeptical of how Peace’s argument is going to play in court,” said Kim Reuben, a budget analysts at the Public Policy Institute of California.

* Reopening American Indian gaming agreements was anticipated to produce $680 million. So far, tribes have expressed little interest in sharing more revenue with the state. Larger tribes now contribute about $130 million.

Only three of 61 California casino tribes have agreed to share revenue -- 3% to 5% -- in return for more slot machine permits. But none of this money has arrived in state coffers, and analysts are skeptical that it will amount to much more than $2 million.

* The budget calls for $1.1 billion in cuts to the government payroll. So far, only about half that amount has been saved through eliminating 19,000 jobs that were vacant and reopening employee labor contracts. But officials acknowledge that thousands of the eliminated positions may have to be reinstated if they are for services considered essential, such as emergency room nurses.

* A lawsuit over the recently tripled vehicle license fee also threatens to wreak havoc with state finances. Davis administration officials say a 1998 law that initially lowered the tax also forces it to go back up when the state is in a cash crunch. Republican lawmakers, who signed onto the Jarvis taxpayers association suit as plaintiffs, say the $4-billion annual car tax increase -- which took effect Wednesday -- is illegal because it was not approved by a two-thirds legislative vote. If the courts agree, the state will have to pay back the $4 billion it expects to collect annually from the increased fees.

* The state just sold $2.3 billion worth of “tobacco bonds” to be paid back with money tobacco companies owe California as part of a national settlement over the health effects of smoking. Yet the reliability of those payments depends on how well the finances of tobacco companies withstand future large verdicts against them.

Over the summer, Philip Morris USA warned it was in danger of defaulting when an Illinois judge required the company to post a $12-billion appeal bond in a class-action case. Investors got jittery, forcing California to back its borrowing with money from the budget. If the tobacco companies miss their payments, the money would come out of the state’s general fund -- and the deficit would grow.

These budget-balancing techniques were adopted because lawmakers, after nine months of negotiations, were unable to compromise on raising taxes or making deeper cuts in spending. When the economy began its downward turn three years ago, analysts say, lawmakers failed to adjust for it in the way the state taxes and spends, creating a chronic “structural imbalance.”

On Wednesday, Arnold Schwarzenegger, the leading candidate in the recall election, said that if elected he would rely on some of the same budget financing methods that have so far failed to work for the Davis administration: renegotiating contracts with state workers and taxing casino slot machines.

Schwarzenegger’s plan to repeal the car tax hike would make the state’s problems significantly worse, unless the revenue were swiftly replaced with other taxes or major service cutbacks.

The candidate has pledged to not raise taxes and has not identified any cuts.

Independent financial analysts are not optimistic that state finances are going to be brought under control any time soon.

“This is the kind of climate in which train wrecks occur,” said Donald Straszheim, former chief economist for Merrill Lynch, who has been watching the state budget closely. Straszheim provoked anger from Peace at a conference of investors last week by saying that the political and economic situation in Sacramento had gotten so bad that the state was putting itself at risk of defaulting on a bond payment if things don’t quickly stabilize. California’s credit rating this year has sunk to the lowest of any state since 1993.

Peace, a Davis appointee, said it is wrong to assume that because the pension bonds ran into trouble, the same will happen to the deficit bonds.

“We made it very clear to [Republicans] and others who advocated this budget strategy that we would not accept it unless it had the highest standard of legal acceptability and market acceptance,” Peace said of all borrowing in the spending plan. “We made sure that was met.”

While administration officials argue that a current uptick in the economy blunts some of the shortcomings in the budget, many economists say it would be a mistake to read too much into a blip in revenue mostly from last month. The economists at the UCLA Anderson Forecast, whose help the administration has relied on for projections, reiterated last week that any recovery is going to be slow.

Some suggest it might be better, economically speaking, if all the borrowings fell through. That would force lawmakers to deal with an ongoing imbalance in the books now, instead of continuing to push it off into the future and requiring the next generation of Californians to pay for it.

“They’ve had three years to come up with solutions and haven’t found any,” said Michael J. Bazdarich, director of forecasting at UC Riverside. “This would force them to deal with it. Politically, it’s a whole different issue.”

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(BEGIN TEXT OF INFOBOX)

Items at issue in state budget

In late July, the California Legislature passed a $99.1-billion budget without raising taxes or making deep cuts in programs and services. To balance the budget, lawmakers sought to cover about $20 billion of the deficit with a variety of maneuvers outlined below. Although state officials are confident the budget plan will withstand challenges, these key elements are at risk:

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Revenue source: Pension bonds

Amount: $2 billion

Purpose: Five-year loans to make this year’s state worker pension payment so other general fund money could be used to reduce the deficit.

Timing: Sales to begin Sept. 2003.

Status: Delayed -- Court ruled unconstitutional; appeal process made state miss $550-million pension payment due Wednesday.

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Revenue source: Deficit bonds

Amount: $10.7 billion

Purpose: Five- to seven-year loans to roll over debt from last year so this year’s budget would balance.

Timing: Sales to begin Feb. 2004.

Status: Lawsuit pending -- Suit says it would violate constitutional provisions against deficit spending.

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Revenue source: Tobacco bonds

Amount: $2.3 billion

Purpose: 40-year loans to fuel general fund programs by borrowing against proceeds from the national settlement of lawsuits over health effects of smoking.

Timing: All bonds sold Sept. 2003

Status: Mixed -- State has proceeds; if cigarette companies become unable to pay bondholders in years ahead due to health lawsuit judgments, payments would have to come from state coffers.

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Revenue source: Vehicle licensing fee

Amount: $4 billion

Purpose: Davis administration tripled car tax to avoid general fund program cuts.

Timing: Revenue arrives monthly starting Oct. 2003

Status: Lawsuit pending -- Revenues will flow at least until suit is decided; if state loses, would have to refund fees.

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Revenue source: Indian gaming

Amount: $680 million

Purpose: By renegotiating tribal casino deals, Davis administration sought to raise general fund revenue with new tax on $5-billion gambling revenues.

Timing: Ongoing

Status: Negligible progress -- No money obtained yet; of 61 tribes, only three have agreed to pay roughly $2 million in return for new slot machine permits.

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Revenue source: Payroll reductions

Amount: $1.1 billion

Purpose: To trim general fund costs, Davis administration asked unions to give back a 5% raise to avoid layoffs.

Timing: Ongoing

Status: Limited progress -- Renegotiated contracts and elimination of budgeted vacancies saved about $600 million; unclear if state will press threat to lay off roughly 16,000.

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Sources: California treasurer; Department of Finance; Department of Personnel Administration