May 5, 2004 - From the Dec., 2002/Jan., 2003 issue

State Budget Crisis Expertly Analyzed & Prospects For Meaningful Fiscal Reform Assessed

While the exact amount of the state's budget shortfall is being debated, there is no debate about its magnitude: it's huge. Governor Davis and the Legislature have a tough row to hoe to balance the budget, but they also have an opportunity to look at reforms that could prevent the state from being in such a bind in the future. MIR is pleased to present this interview with Fred Silva, Senior Advisor, Governmental Relations at the Public Policy Institute of California, in which he discusses what's at stake for California in this critical budget cycle.

Fred Silva

If there is anyone in Sacramento who is versed in the complexity of the state's current fiscal crisis, it's you. Given your experience on the subject and the context of the governor's response to it, brief our readers on what the state faces and how it's likely to approach balancing the state budget this year.

The problem that the state faces is not new. It happens about every ten years. We had a major fiscal crisis in the early nineties. We had a minor fiscal crisis in the early 80s. Even Governor Reagan had a fiscal crisis to deal with in the 1960s

In this case, we are experiencing the hangover from the dot-com boom of the late-nineties. The state's revenue grew substantially over a short period of time. After the boom ended, the state's revenue structure is beginning to look like it does in a slow growing economy. On the spending side the state made long term spending commitments in important state programs and tax relief. That level of state's spending has grown so rapidly that revenues are not sufficient to maintain this level of spending.

So, what did we do during the boom of the late 1990s? The state put a lot of money into K-12, education, which many thought was badly needed. We put money into health and human services programs, which many people also thought was needed. And now, the revenue structure simply can't maintain these expenditures. Who is affected? Most of the major services that the state has responsibility to provide will see reductions, including education and health and social services. The counties are certainly affected, since they provide health and human services.

The dilemma is that we increased spending in a number of programs by cutting taxes, particularly the vehicle license fee-which is taxes levied on cars in lieu of property tax. Since the vehicle license fee revenue helps support local government services such as public safety services, the state promised to backfill that money-a little under four billion dollars-in the future. Governor Davis has proposed to end the back fill and keep the vehicle license fee reduction.

So, we're stuck in this place where revenues are not sufficient to meet all of the spending obligations.

In what ways do the rules of the Legislature inhibit or empower the governor to resolve this budget deficit intelligently?

I don't know that the rules do prohibit them from addressing this intelligently. The main rule that gets all the attention is the vote requirement-it takes a two-thirds vote to pass the budget, to raise taxes, and to spend less money on K-14 education than the constitutional guarantee would otherwise require. If two-thirds of the members of the legislature can come to an agreement, this problem can be solved.

It requires Democrats and Republicans to sit down and solve this problem, which, as Californians, we would expect them to do-it's their job.

Put your answer in the context of all the fiscal crises that have arisen in California over the last twenty years. What is likely to be resolved when increasingly partisan forces sit down in the capitol to address whether to balance the budget by, in part, increasing taxes?

My favorite example is the crisis that occurred in the 1930s during the Depression. We had this huge problem with property values declining, so the property tax revenues were also declining. The state wanted to keep spending on vital services-particularly education- so it decided to levy a sales tax to support the schools, freeing up property tax revenue for cities and counties. A constitutional amendment was passed in 1933 that reformed the budget process. It imposed s spending cap of 5 percent only to be exceeded if the budget was passed by a two-thirds vote. Although well intended it did not stop the state from running large deficits throughout the decade. From 1933 through 1943, the state carried substantial deficits. The result was that the state tried to keep the spending flat, raised taxes, and still ended up with deficit budgets.

In the post World War II period, California grew and revenues grew. We spent a lot of money and we built major elements of the state infrastructure. That carried us into the 60s and into the 70s, when a variety of things occurred and property values rose to extraordinarily high levels. The inflation of property values motivated the big tax revolt. As a result, the state budget grew from about $11 billion dollars in 1977 to about $18 billion dollars in 1979 because the state took on the job of helping schools and local government services after Prop 13.

In 1982, after adding major new responsibilities to state spending, the state suffered a mild recession. What approach was used to solve this problem? The state raised some taxes, cut spending, and rolled the deficit into the next fiscal year. That's what the state did. We move forward to 1990. What did the state do with its structural problem? In the 90s, the Legislature agreed by a two-thirds vote to levy additional taxes, cut some programs, and it rolled deficits.

So, this strategy of reducing expenditures, raising taxes, and carrying deficits was laid out for this state in the 30s. We used it in the 80s, we used it in the 90s, and I suspect the state will use it again in this circumstance.

When and how did the two-thirds vote requirement to pass the state budget become law? Do we need a constitutional revision commission today to review that requirement?

As noted earlier, in 1933, the state passed the Riley-Stuart Act, which installed the sales tax increase I mentioned before as well as put a spending limit in the constitution. If the budget were to grow by more than 5%, then the vote requirement was two-thirds. If it were to grow by less than 5%, it would be a majority vote. That requirement was in the constitution until the 60s when the constitution commission removed the spending limit, but left in the two-thirds vote requirement.


Fast-forward to today, The California Constitution Revision Commission was appointed in the mid-1990s to review, among other things the budget process. It recommended that a two-year budget process be established and that the budget be approved by a majority vote. Increasing taxes would still require a two-thirds vote. Although the governor's budget proposal does not include any ideas like this, it is probably time to put some thought back into the budget process and review the entire state and local finance system.

The budget the governor proposed is a missed opportunity because his plan simply addresses the spending side and the internal workings of how the education guarantees operate when you're raising taxes. It leaves many questions about the relationship between the state and counties unanswered. Certainly we've had commissions over the last ten years with recommendations that have not been implemented, partly because there wasn't a crisis to drive their solution. Today, I believe that window of opportunity is open.

What does this mean fiscally and programmatically for local government in the next couple of years?

Cities and counties are in a bit of a spot. Cities have a high reliance on the sales tax, they get a small share of the property tax and they receive a subvention from the state that is funded by the vehicle license fee. Counties also receive the subvention.

The vehicle license fee is distributed based on population. The sales tax is a cited tax, so the city that levies it gets the resources. And then the property tax, as we know, is one that is controlled by the state and the state at its whim can allocate it to whomever they want.

In the late 1990s the governor and the legislature reduced the vehicle license fee and backfilled the reduction to cities and counties leaving them whole. The budget plan proposed by the Governor eliminates the back fill which will result in a major reduction in city and county discretionary revenue, most of which is used to support expenditures for police and fire services.

The next year or two is going to be very difficult for cities and counties as they structure their local spending plans.

Fred, state Senator Steve Peace has been tapped to be the governor's financial director. The senator has, for a number of years, spoken about the structural problems and weaknesses of our current state/local fiscal arrangement. What can we expect from his becoming the governor's top financial advisor?

Senator Peace has many ideas for trying to deal with some of the issues that you and I have been talking about. The constitutional duty of the governor is to submit a balanced budget to the Legislature is done. The next phase will focus on fiscal reform and there are few people who have as much knowledge as he has.

The governor indicated early on that he wanted to bring people together to do address the budget. He hasn't put out an agenda, but I suspect that Steve Peace is going to put an agenda together soon. The period between the middle of January and June should be an exciting time for those who care about fiscal reform, both on the tax side and on the state/local relationship side.

Lastly, what, given the next six months of policy deliberation is crucial, should be on the Governor and state legislature's fiscal reform agenda?

Three things. One of them is to try to get the spending base down as flat as possible. You have to just look at state programs and make a concerted effort to reduce the growth in spending, and that may mean that people will have to take off their partisan hats or program advocacy hats and look at the way state government approaches general fund programs. That's the first thing.

Second, it's time to look at the state's tax structure. I don't know that there is a problem with personal income tax and capitol gains and stock options. The problem is what you do with the money, not the tax itself. For the sales tax, it's time to look at the sales tax base and review how transactions are taxed and the breadth of the sales tax. There are many transactions to which the sales tax doesn't apply and there ought to be a concerted effort to review the sales tax base. Probably the most important item for review should be the property tax. We haven't looked at the property tax in twenty-five years, since Prop13, and it is time to look at the way property is assessed, both commercial and residential.

The third and final agenda item should be a deliberate look at setting up a multi-year budget that will allow the state to carry over deficits. It's interesting to note that the governor's budget, as he proposed it for the current year and the budget year, has $5.5 billion of deficit spending rolled from the current year into the budget year 2003-4. The 2001-2002 budget carried a deficit of $3.5 billion. The state needs to look ahead at least 2 years and attempt to arrive at a general fund balance by 2005. As everyone will see, we can't get to where we want to go by balancing the budget in a year-the balance is so large that the reductions you have to do in state spending, or the taxes you have to raise, are simply too high. You can't simply close university campuses and you can't go from a class size of twenty-five kids to thirty-five kids in a short period of time in order to accommodate this revenue shortfall.

So there are three parts to it-keeping spending flat, reviewing the tax structure, and looking at a multi-year plan that will carry some deficits, at least into 2005.


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