Controller Chiang: California Needs Honest, Sustainable Budgets Beyond 2011-12

Frank Mottek, host, KNX 1070 Business Hour: We're delighted to have with us the honorable John Chiang, the controller of the state of California, who will give his presentation on the California budget situation. California is facing a crisis that is real and unprecedented. We heard Governor Brown speak at the Chamber dinner the other night about the $25 billion budget gap to fill. The situation is very complex and difficult, and choices need to be made to get the budget back on track. Controller Chiang, we look forward to hearing your approach to our budget deficit, so to speak. Please welcome the honorable John Chiang.

As many of you know, as the state's controller, I am the state's chief fiscal officer, responsible for accounting, auditing, and some of the investment functions: a lot of the finance operations of the state. Does anybody remember what was taking place in our state, exactly this month, two years ago? I was holding up your tax refunds. I was holding up $3 billion. Yes, it is my signature on your tax refund check. I was holding up $3 billion worth of tax refunds. I was holding up payments to the college units. I was also not making the state's contribution of SSI to the federal government. It's not because we were trying to inflict pain upon Californians; there was $2.7 billion remaining in the state's treasury two years ago. Expected revenues for the month of February were $3.3 billion, but as the state's cash disbursement manager, I had $10 billion worth of bills.

There are certain constitutional requirements. The first payment is education. The second payment is debt service. California, of the 38 states that take on debt, is the only state that places debt service as its number two priority. However, the failure to pay debt service, and thereby defaulting, triggers insolvency. I was trying, at that particular juncture, to keep California from going insolvent. I was trying to stop what Meredith Whitney today is predicting as a massive failure of municipal bonds. Was it taking place because of the economy, or what was transpiring in Sacramento? And in part, the answer is both.

Second question: Does anybody know the last date California was operating in the black from a cash perspective? As you know the federal government created bankruptcy in 1937, and does not permit for the state bankruptcy. The last time California was operating in the black was July 12, 2007. As David or Nancy can tell you, the National Bureau of Economic Researchers, which sets the recessions, started the recession at December of 2007. Our fiscal difficulties from the state perspective preceded what transpired at a national and, some would argue, global level. In California, we saw the disintegration of the real estate market and the loss of construction jobs. The three things that move an economy are human capital, financial capital, and infrastructure. We missed the ball in all principle areas. After what transpired in 2008, where we witnessed a national crisis starting with the bankruptcy of Lehman Brothers. I sit on one of my financing authorities, the Pooled Money Investment Board, and we had to shut down financing for 5,300 infrastructure projects. Each billion dollars, with their bonds, in construction projects in the state of California, is worth 18,000 jobs. We had to preserve the cash. Some of you have seen that I've had disputes with the previous governor and the Legislature about budgeting. They had signed a budget for over $100 billion. I said, "Aren't you generous and optimistic in light of what is taking place in the United States economy?" And in fact, we collected less than $90 billion.

Jumping forward to July of 2009, does anybody know what happened then? I started issuing registered warrants, or as you may more commonly know them, IOUs. It is the last tool I had in my toolkit to keep California from going off the fiscal cliff. California would be a very different state today if I hadn't taken that action. Our very sense of underlying democracy, the sense of opportunity and education, tying into the most important element of economy-our skill set, our human capital-would have been severely impacted. Public safety would have been impacted, and services, such as access to healthcare, would have been devastated in the state of California.

Governor Brown has taken us on a new path. It is, simply, not going to be easy. He has proposed a budget that infuriates many. But from a pure economics perspective, it's very strong. Taking into account the biases that have existed for a long period of time in government, economics and finance, he looks at two of them-first, from an economic standpoint, the "interest" bias. Who is supporting what types of programs and policies? When we have a crisis, we ought to look at interest bias. Secondly, something that this nation needs: we have to examine "stability" bias. If you look at budgets for corporations, private individuals, or government, you have a bias where you've been basically doing the same thing for 15 years, and as much as you want to change, the budget pretty much stays the same.

In a few senses, Governor Brown has blown up the boxes, which provide for a reexamination opportunity. And clearly, as this audience knows, expanding international trade has to be an underlying premise of what California and the United States need to do for our economic prosperity. Governor Brown has proposed a budget of about $84.6 billion, which recognizes a debt of $25.4 billion for the remainder of this fiscal year, ending on June 30, and for the next fiscal year. A lot of this is debt past on because of poor earlier policies.

However, it is very, very important to understand that we are going to need sustainable, honest, sane budgets for the foreseeable future. As I explained to Governor Brown, even if he has an honest, strong budget for this year, it does not get the state out of debt. The poor policies of the past two years have dug a hole that is significant and deep. For instance, as I just drew the example for the others, if you make $100,000 a year, and you owe $1 million, you really have to be smart and wise about the use of your assets for a long period of time. That's sort of a sense of what we have with California. The budget doesn't recognize all the liabilities, frankly because it does not have to. We have liabilities, such as owing money for unemployment insurance; borrowing, both internal and external; or education, which we have to pay back.

How many of you know what the three largest expenditures of the state of California are? They are: number one, education, about 52 percent of the state budget; number two, healthcare and social services; number three, public safety, principally corrections. The three largest revenue sources in California are: number one, income taxes; number two, transactional taxes, the largest being the sales tax; and number three, corporate taxes. Most people guess property tax. Property tax is a local tax.

If you look at what we have for the foreseeable future: education wasn't impacted that much this year for the budget. The reason is that it is owed a lot of money under the formula that the voters of California passed. In fact, it is owed over $7 billion. Second is healthcare and social services. Frankly, we are near the bottom of the barrel for additional cuts to social services. Governor Schwarzenegger tried to eliminate some healthcare programs, and the courts declared the governor and the Legislature's actions illegal, because you have to provide some basic care for people who have lost their safety net. Third is corrections, which makes up about 9 to 10 percent of the state budget. It is difficult to work budget solutions there because of a major macro problem: the cost of healthcare. As prisoners live there for the rest of their lives, as they get older, we have tremendous expenditures. The courts have determined that the California correctional system has not provided constitutional care, and so that in fact, we have to be adding more money into that pot.

If you're looking at what the future looks like on the revenue side, Governor Brown has proposed a five-year extension of taxes. If that does not get on the ballot because the Legislature chooses not to do so, or if it does get placed on the ballot but the voters choose to reject the extension of taxes, the hardest area to be impacted in the future of California is education. This year appears to be, from discussions with representatives from the UC system, the first year where there is going to be greater contributions by students paying their tuition than contributions from the state government. That's a discussion we have to have, as to how we want to educate the baby boomer generation. We are not educating individuals in sufficient numbers to replace the current educational capital that we have in California's internal system. It is a matter of great, great concern.

We are frankly, in a better position than we were two years ago. As I pointed out, I was not paying out tax refunds; today I am paying out your tax refunds. If you are concerned about the state's finances, just go on my website. When I became controller, I started posting all the state's financial information because I didn't want you to be blind-sided like some who were impacted by the national financial crisis or the situation in Bell. All that information is posted on my website and updated monthly.

The governor and Legislature need to take action because we will have cash issues again come July. You have to have a budget in place for the treasurer, who is the state's banker to borrow externally. Frankly, we have to get whole, because when anywhere from 10 to 15 percent, for our normal borrowing and for cash flow purposes, we don't have enough cash revenue coming in during the early months of the fiscal year. But we still have huge educational bills that we have to push up during the summer. It is going to be incredibly difficult on Californians. That being said, many of you are impacted. For instance, Union Bank, when I had to issue the IOUs a couple years ago, you were receiving pressure from your customers-that is a possibility, but not a strong possibility, for this upcoming summer. For those of you landlords that didn't get paid last summer: once again, it's incumbent on the legislators, the childcare providers, and others who contract with the state. We need to work with the governor and Legislature to make sure they have sound budgets for the foreseeable future, so that we don't have to revisit what has taken place in 2008 and 2009. Thank you very much.

Any talk about changing state tax policy here to try to get things moving here, to try to make California more business-friendly? Can you tell us about some of the initiatives that are being discussed?

You isolated something that the entire state needs to work on. We're before a business group. Let me ask this question-how many of you, an educated group, can describe the California corporate tax methodology? That highlights the very problem we have with state finances. It's a serious problem. We talk about government at the state level; it's tax-and-spend. With the federal government, you have monetary ability. People don't understand how the major revenue sources for the state of California ought to make us not only nationally competitive but also globally competitive. It is a fundamental problem. Once you understand it, it is even more difficult. They talked today about what happened with Japanese Business Association and talking about worldwide unitary methodology. One of the things we have to do is talk about what type of tax system would make California competitive.

In the governor's proposal, he proposed to eliminate the election factor for single-sales factor. Up until a couple years ago, one of the corporate tax methodologies was to double-weight the sales factor (sales in the state of California), the payroll factor (how much is spent on payroll in the state of California), and the property tax factor. That supports out-of-state business. If we're the California state government, why are we supporting out-of-state businesses versus in-state development? Then we go to elective single-sales factor, to promote in-state and out-of-state businesses. Then we give this election methodology, which basically provides incentives for people to play with the tax system. That's not smart for the long-term economic health of California. We need to work something out.

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The governor has also proposed eliminating redevelopment agencies and the cutting of enterprise zones. Tell this group about those discussions and what you think should happen there.

The governor, in trying to repair a $25.4 billion deficit for the remainder of the fiscal year and next year, obviously was trying to find revenue solutions-that's the reason for the taxes-and some cuts. Up until recently, the budget was facing over 50 percent in cuts and slightly below 50 percent in tax extensions to bring in additional revenues. One of the areas that the governor identified was redevelopment agencies. For those of you who are not familiar with the finances of redevelopment agencies, you take a base year for the property value or a certain area, you redevelop that area, and use the additional property tax for economic generation in those areas. This is all about a value judgment, and it goes back to what we should be spending the money on. Should we be using money for economic development in targeted areas, or should we be spending money on security, education, and healthcare? None of those dollars are free. Should we continue to recognize that government has, through this methodology, a responsibility for economic generation? And if we do, we are taking money from education or other programs.

What's your reaction to the idea of declaring a state of economic emergency here in California until the unemployment rate comes down to 7 percent?

I don't know if Governor Brown needed to do that. He has been so focused on isolating the core critical in Sacramento. In fact, to his credit, Governor Schwarzenegger had some significant accomplishments, but that diverted attention from the fact that we were in great financial difficulties. Everything that Governor Brown is working on says, "Let's address the budget. Let's look at more long-term fiscal health."