April 30, 2004 - From the April, 2004 issue

Former State Finance Director On State Budgets Past, Present & Future

After serving as an Assemblyman then State Senator from San Diego, and, most recently, as Governor Davis' Director of Finance, Steve Peace knows a thing or two about state fiscal policy and the mechanics of state, regional and local government. Earlier this spring, Peace launched a new, bi-partisan civic organization, California Today – a think tank dedicated to economic issues facing California. Its first goal is to repeal, or at least modify, the federal government's alternative minimum tax (AMT). MIR is pleased to present this interview with Steve Peace, the first of a two-part series, in which he addresses both our increasingly dysfunctional fiscal relationship between state and local government, and how the Schwarzenegger administration is faring in tackling the severe financial issues it has faced over its first several months in office.


Steve Peace

Steve, with the inaguration of Gov. Schwarzenegger in November you, at least temporarily, retired from public service. Please share the lessons learned from your short tenure as state director of finance, as well as your assessment of the new Governor's finance team.

On a personal level, it was an incredible learning experience serving as Director of Finance. There's a lot of talent in that department and an awful lot of capacity to deal with the problems that the state faces. I'm hopeful that the Legislature will recognize the quality resource that exists in the form of data and information, and people who understand the consequence of that information and make good use of it.

A huge chunk of the problem that we confronted at the front end has already been dealt with. We took a budget that was envisioned to be $91 billion and turned it into a $71 billion budget. That was critically important to getting the rate of expansion down-so you're now working off a smaller base. That will make the job of policymakers immensely easier. Having said that, there are still structural problems there.

That is why it was probably necessary and wise to embrace borrowing as part of the short term solution in order to provide the policymakers some breathing room to be able to get at those changes. This is particularly the case because of the historically low interest rates. But that strategy is also fraught with some serious dangers if the illusion is embraced that borrowing functions as the solution rather than its true purpose-to buy time. The danger is that you actually have a temporary little economic recovery and people misread that reversal in the trend line as being "out of the soup," so to speak. There is no economic recovery that solves the structural problems. We will always be in and out of this situation unless we actually get under the hood and fix the problems.

I'm sure that in May, the process initiated by the governor to reorganize government will produce some substantive product. There are ways the government can be better structured and organized. We had identified them, and were prepared to propose organizational changes in January. So, I suspect an awful lot of what Governor Schwarzenegger will propose will be what Governor Davis would have proposed in January. They're good things to do, and they ought to be done. While reorganization will save money and also improve the delivery system of government over the long haul, it doesn't produce immediate-term savings. It takes time to realize the savings associated with reorganization.

The more profound decisions that have to be made over time are associated with how you restructure the revenue stream, not to be confused with "how you raise taxes." We've got to balance the state's portfolio. We've got to get a mix of taxes that reduces the inelasticity currently facing the state. The current attention on Sacramento is important and I hope it sustains itself for a period of time. We'll see what happens as we approach the next election cycle.

Steve, the policy wonks and even electeds talk about structural deficits. For our readers, what constitutes a "structural deficit?"

The non-structural deficit is a deficit that will periodically appear because revenues dip below the expenditure needs. The structural deficit is that which continues to be there even during high-revenue periods. And we have a component of the current deficit that is non-structural – meaning that part of the total deficit will go away as the economy improves. But, a portion of that deficit will still be there even under a robust economic scenario, because the totality of the services that state and local governments in combination provide simply is more than the tax structure can support.

Please elaborate on the less attended to budget challenges facing California. One is the imbalance between what Californian taxpayers give to the federal government and what we get back in the way of federal expenditures. The other is the often described dysfunctional fiscal relationship between state and local governments. Which for you is the greater challenge to California's fiscal stability?

I used to believe that the more pressing question was the local-state relationship. The state and local government relationship is a subset of the bold AB 8 rescue of local government that came after Proposition 13. The Legislature essentially froze in time the world as it looked in 1977. Obviously, that doesn't work very well in the year 2004. It's not local government's fault and it's not the state's fault. It's the consequence of history, and we just have to be honest about it and change it.

But, in part as a result of the influence of the alternative minimum tax, California's increasing subsidy of the federal government is going to be an issue on the national level that will probably dwarf all other domestic issues. It's not just California; certainly there are other donor states. But, no state is in a comparable position to California. The last actual data indicates the Californians pay $60 billion more in taxes than they get back in federal expenditures. But, that data's about four years old, and the extrapolations now suggest that the imbalance may soon exceed $100 billion. And, because of the effects of the alternative minimum tax, that number is likely to increase at a faster pace than it has been increasing over the last decade.

What does California's status as a federal donor state mean for the average voter in California? Why should we care?

It certainly explains why we have this ongoing debate about what the actual tax burden in California is. Many of us, as taxpayers in California, say, "why is anybody debating? We're obviously overtaxed." We're overtaxed by the federal government before we even start a debate on what local and state taxes are. If you look at Californians from the standpoint of their cost of living, their revenue, and their net disposable income, Californians pay more to the federal government in taxes than residents of many states pay in total on taxes, including their federal, state and local taxes. As a result, state and local decision makers and policymakers are confronted with a situation in which their constituents are already feeling, and justifiably so, overtaxed before they pay their first penny to the state or to the local government.

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That's just not a circumstance that we can sustain. There's no way in the world that California can succeed economically and continue to be subsidizing our federal government by $100 billion or more a year.

Steve, Speaker Emeritus Hertzberg often refers to Kevin Starr's historical documentation of California at the turn of the century and the birth and influence of the progressive movement. In 1907, At Levy's Café in Los Angeles, the progressives sketched out the dramatic reforms needed to put California back on track, given the stalemate in government and dominance by the railroads. We're at another turn of the century. If you were sitting in today's equivalent of Levy's Café with an equally influential group, what would be the reform agenda needed to once again give Californian's the chance to be the architects of their future?

I'd start with giving back authority to local governments to make decisions, and that means the state has to give back taxing authority. Then, I would move many decisions and powers that currently reside in the state down to the regional level, and at the same time allow some of the authority currently exercised by discreet local jurisdictions to be exercised at the regional level. California is just too big for most decisions to be governed from Sacramento.

Similarly, if we are to preserve the character and culture of our individual communities (what I like to call preserving the individual character of each "village") and we are to preserve the sense of capacity of the average citizen to reach their government, we have to maintain a vibrant local government that has authority over the land use designs that define that character. That can only be done on a local government basis.

Are there any 20th-century progessive reforms, like the recall initiative and referendum, that you would now like to see amended?

I know the open primary is going to be on the ballot. And, absent some incredibly horrific political campaign run by the two parties, which is certainly possible, it will pass. Eventually I think we'll see some organizational change in the Legislature, whether it's through the reapportionment process, the institution of a part-time Legislature, or the elimination or alteration of term limits. All of those will be on the table and people will get together and ultimately arrive at some sort of combination of those changes resulting in a more functional process.

At its core, you can move the deck chairs around and change the decision-makers all you want, but you have to deal with rebalancing the revenue portfolio. How that gets done, I don't know. But, it will be done. The one bad thing about borrowing money with respect to the current budget is the possibility that it gives the decision-makers and the public a false impression about the seriousness of the misalignment of the resources and the obligations.

Let's conclude with more of your thoughts on how we might best reform our state-local fiscal relationship. Both the earlier Constitution Revision Commission and the later Speaker's Commission on State-Local Fiscal Reform, proposed a tax realignment to allieviate the unintended consequences of today's fiscal arrangements. Among the many proposals is a swap between state and local government of sales tax and property tax. What are your thoughts on the appropriateness and feasibility of such a swap?

You have to get local government off of sales tax dependency. It has produced horrific distortions in land use decision-making. And, it just makes fundamental sense for local government to be principally interested in the growth of the property tax. That's the natural, competitive, free market kind of incentive logically to give to local decision-makers.

Now, to be fair, you also have to give local government the flexibility to establish rates if you are going to make that work, and it's not likely we actually do that. So it's going to be some sort of proxy for that kind of system. Similarly, it makes a lot of sense to capture sales taxes on a more regional basis, but also to be sure that the decision-makers who are the beneficiaries of the sales tax are not involved in land use decisions.

That's the trick. If one assumes your building this revenue mouse trap on the back of a streamlined and smaller state government, then state government doesn't need as much in the way of resources. I would foresee, in an ideal environment, that many of the social services that currently are delivered by counties but paid for by the state would be included in this movement of or devolution of responsibility down to local government. Such a shift would enhance the counties' role, and the revenues would need to follow. The counties' great fear is that the state will devolve responsibility to the counties and leave them without the capacity to pay for those services.

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