California’s $15-Billion Question

When Californians go to the polls March 2, they will be asked for the first time in the state’s history to borrow money, not to build something, but to pay off existing debts.

As the vote nears, both the long-term cost of the borrowing and the need for it are subjects of campaign debate.

Proposition 57, the $15-billion Economic Recovery Bond Act placed on the ballot by the Legislature, is a centerpiece of Gov. Arnold Schwarzenegger’s proposal to clean up the state’s financial mess.

His political strategists acknowledge what polls have shown -- many voters balk at a large debt that would not provide anything tangible, like a new school or smooth highway, in return.

To persuade a majority to back the bond issue and its companion measure, Proposition 58 -- a constitutional amendment to restrict the state’s ability to sell deficit bonds in the future -- the governor and his supporters have begun a multimillion-dollar television and radio advertising blitz.

In those advertisements and in his campaign speeches, Schwarzenegger says the bond issue would save taxpayers money because it would “refinance past deficit borrowing at low interest rates.” The bond issue is needed to clean up problems he inherited and would not add new debts, the governor says.

Opponents, who include liberal Democrats and conservative Republicans, contend that the bond issue would cost, not save. Because payments would be stretched out over time, taxpayers would pay billions of dollars in additional interest, by some estimates $1,664 per household.

Borrowing to cover a budget shortfall shifts the bill for today’s spending onto tomorrow’s taxpayers, a practice fiscal experts generally frown on unless the money is spent on something concrete, like a bridge, that will be used by those future taxpayers.

“My view is the bond issue is a way to spread the pain over time,” said Stanford economist John B. Shoven. “It doesn’t get rid of the pain.”

All sides agree that the state continues to face two serious budget problems: one short-term, the other long-term.

The long-term problem is that California’s government programs cost more money than the state’s tax system brings in, and they are likely to continue doing so for years.

The short-term problem is a huge current shortfall, about 12% of this year’s general fund.

Both problems grew out of the stock market collapse of 2001. Steady spending increases for education, health and human services, and tax relief during the boom years under former Govs. Gray Davis, a Democrat, and Pete Wilson, a Republican, were built on soaring personal income taxes. That source proved unreliable when the state’s high-tech bubble burst.

Over the last three years, as state revenue dropped sharply, spending declined more slowly. To fill the gap between the two and balance the budget, California borrowed money from banks, special state funds and local governments. Many of those loans have to be repaid this year.

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The Wisdom of Borrowing

How best to do that is one of the central elements in the campaign over the bond issue.

Those who oppose borrowing the money offer two sharply divergent alternatives.

Some conservative legislators argue that the state could balance its budget without borrowing if it cut spending.

“Long-term bonds are supposed to be used for schools, parks, highways and water projects that will serve coming generations,” state Sens. Tom McClintock (R-Thousand Oaks) and Bill Morrow (R-Oceanside) say in their ballot argument opposing the bond issue.

On the other side of the political spectrum, state Treasurer Phil Angelides and some other liberal Democrats argue that the state should raise taxes. California would be better off if it eliminated the shortfall the “old-fashioned way, where you actually raise revenues to do it,” said Angelides, who is gearing up to run for governor in 2006.

“You increase the income tax for three years on the highest earners,” he said in a recent interview, adding that former Govs. Ronald Reagan and Wilson used that approach during recessions.

Raising taxes on the wealthiest of California’s nearly 14 million taxpayers “would raise $11.9 billion in three years,” the treasurer said. One upper-income tax increase proposed last year would have increased rates for about 400,000 Californians, but would have raised somewhat less money than Angelides projects, according to the state Franchise Tax Board.

Combining a tax increase with a smaller amount of borrowing would cost the state’s taxpayers considerably less money in the long run than would Schwarzenegger’s bond proposal, Angelides argues.

The governor has repeatedly said he would not raise taxes. He has also rejected the kind of spending cuts that would be needed to balance the budget without borrowing. Cuts large enough to do that would be “Armageddon” for the state’s economy, he has said.

Like Davis, Schwarzenegger has turned to borrowing as the best option.

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The Cost of Borrowing

The cost of that borrowing is the other central issue in the campaign.

Part of the debate over the true cost reflects the same dilemma a home buyer faces when choosing between a longer- and a shorter-term mortgage: A longer payment period lowers the annual cost, but increases the total bill.

Proposition 57 would authorize the state to borrow up to $15 billion. Currently, Schwarzenegger says, the state needs $12.3 billion of that. Critics of the bond issue say that in the end, they expect the governor will borrow the full amount.

The governor’s aides say the administration would use about $9.2 billion in borrowed money from the bond measure to pay debts that come due in June. They would keep about $3 billion to balance the 2004-05 budget, using it to pay off debts and avert deeper cuts in the fiscal year that begins July 1. Some money would also be placed in a budget reserve.

Schwarzenegger wants to spread the repayment over as many as 14 years. Repayment could be as short as nine years if an improving economy generated enough money to accelerate payments.

The uncertainty over how much would be borrowed -- as well as what interest rate the state would have to pay on the loan -- complicates the job of calculating a total cost.

The state legislative analyst’s office projects that the interest rate on the bond would be about 5%. At that rate, if all of the $15 billion were borrowed and paid back over 14 years, the bond issue would cost $21.5 billion. If it were paid off over nine years, the total cost would be $18.4 billion, the analysts estimate.

Angelides, who projected that the loans would be paid off over 10 years, estimated the total cost of the bond at up to $1,664 per California household. Schwarzenegger’s aides call that figure misleading, noting that taxpayers must pay to retire the state’s existing debts whether Proposition 57 passes or not.

Indeed, if the bond were to fail, the state’s fallback position would be another form of borrowing -- one put forward by Davis in his final budget. That budget, which the Legislature approved last summer, included provisions to borrow $10.7 billion. The loan would have been paid off over five years. The $10.7 billion in borrowing has been challenged in court because it was not approved by voters, and as a result no bonds have been sold.

Schwarzenegger administration officials now refer to that earlier bond as Plan B, and if either Proposition 57 or Proposition 58 fails on March 2, they would attempt to fight the legal challenge and sell those bonds.

Because the loans under Plan B would be paid back more quickly, the state’s annual interest payment would be twice as large. That means bigger cuts in spending or a tax increase would be needed to free enough money to make the interest payments.

In addition to the higher annual financing costs, Plan B would also give the state less money to help balance next year’s budget.

“Taken together, if we have to go the route of Plan B, we’re going to have to find $5 billion more in savings,” said Department of Finance spokesman H.D. Palmer.

Regardless of which plan the state were to follow, a bond sale would only clear up past debts and help tide the state over into next year. Selling bonds would not resolve the long-term imbalance between spending and taxation. Moreover, the state would still have billions of dollars in loans taken from special funds, such as the state transportation fund, and from local governments that would have to be paid back in future years.

Moody’s Investors Service took note of those problems earlier this month in an analysis of the bond measure that contained both hopeful and ominous assessments.

Voter approval of Proposition 57 would be welcomed by Wall Street as a sign that the state was tackling its problems, the analysis said.

But a victory would not by itself resuscitate the state’s credit, which has been lowered by the three main rating agencies to just above junk bond status.

“With or without the bond sale, the state faces a large structural budget gap,” the analysis said. Closing that gap “requires significant and difficult budget cuts and other adjustments.”