November 18, 2005 - From the November, 2005 issue

Milken Institute ‘State of the State': Can California ‘Grow' Its Way Out of Budget Woes?

A panel of experts well-versed in California's budgetary woes assembled at the Milken Foundation's recent ‘State of the State' conference to analyze the state's predicament and discuss solutions. Milken's Ross DeVol moderated the panel of State Director of Finance Tom Campbell, Controller Steve Westly, financier and former gubernatorial candidate Bill Simon, Ron Ritter of McKinsey & Co, and Amy Resnick, editor of The Bond Buyer. MIR is pleased to present excerpts from their conversation.

Tom Campbell

Ross DeVol: Budget policy and the state's economic performance are closely intertwined. After enduring all those perfect storms as it pertains to budget – beginning with the bursting of dot-com and subsequent funding of capital gains and stock options, we have the electricity crisis, the economic dislocation of 9/11, especially on our tourism economy, and lastly, deteriorating climate of business, or at least the perception of a deterioration – there does appear to be a structural gap between the growth of programs and the expenditures necessary to fund them, compared to the growth of tax structures. The current and former governors have used bond offerings to fund what is essentially the operating budget of the state, as opposed to long-term capital investments. I believe we put off the day of reckoning for addressing the structural gap with one-time revenues and bond offerings. At the same time, we must be very much aware of not harming the business climate by imposing higher taxes, which would weaken the competitive position of firms trying to do business in the state.

Let's begin the discussion on the revenue side of the budget. How quickly is revenue increasing? Can we grow our way out of this budget gap?

Tom Campbell: No. The reason I'm so emphatic is that revenues can grow, but the expenditures are locked in. The growth in revenue last year went up 7 percent, expenditures went up 10 percent. In next year's budget we're looking at a growth in revenue of 6.5 percent and expenditures of 8.3 percent. The built-in expenditure growth is an artifact of putting into permanent formulas the one-time money that we had in the dot-com era. And let me be very specific: we have state employee contracts, and there was water in the well, and so Sacramento put it into permanent increases in employee contracts. Prison guards, for example: unbelievable. And then you have the teachers. And there's Prop 98: Whenever you have a one-time burst of revenue, you have to put it into schools. And then we have to keep it in forever more because of that one-time source . . . Unless you go into those formulas and say, "I hereby take out Prop 98. I hereby take out the prison guards union, I hereby take on the state retirement system..." you have to accept the fact that we have built-in expenditures. So we cannot get structural change by just growing.

RD: So we have one ‘no' vote. Steve, what do you see happening with the economy and what's the status of the revenue stream coming into the state budget?

Steve Westly: We're actually seeing some good news here. Revenues are up a little over $1 billion in the first quarter this year, driven largely by the housing and real estate market.

RD: Bill, what's your sense of how the California economy is performing? Lately we've been growing faster than the country overall. Do you think we're underestimating revenue growth for the next year or two?

Bill Simon: Yes, and here's why: I think, generally speaking, all of us tend to underestimate the problem at the beginning of a tough economic climate, and we generally underestimate the strength on the other end. So much as when I ran for governor in 2001, I said the deficit would get larger than it actually did; I said it would be close to $20 billion or something in excess of that. I think now when you look, the structural deficit is at somewhere between $4 and $6 billion, I wouldn't disagree with Mr. Campbell, whom I admire a great deal, but I would say relatively speaking it's probably going to be at the lower end of that range, because I believe that the economy is showing signs of strength. Although, I'm not sure that it's going to continue to exceed the national rate of growth. My bet is that it will lag the national economy over the course of the next 12 or 24 months because we are one of the more unfriendly places for business. And so since we are one of the more unfriendly places, and the national economy improves, we probably won't participate 100 percent. I think we have bigger issues than a structural deficit.

RD: Ron, do you want to jump in on what you're seeing from the business world?

Ron Ritter: I feel that there has been a big shedding of manufacturing jobs away from California in the last 10 years. I think that's going to level off. We've actually increased manufacturing employment this year, and that's due to a number of factors. First of all, options offshore are not as clear and rosy as you might think they are. Fortunately for us, Mexico is even worse off than we are in terms of government and bureaucracy, and a lot of business are actually coming back from Mexico and into the United States . . . . I think there will be some stability, but this is a dynamic situation that could change over time. Ultimately, California is truly competing with all these other locations.

RD: Even when you look at the growth in expenditures in this year's budget, it doesn't seem that fiscal austerity would be a way to explain it.

TC: If you went back to 1999 and expanded every social spending program in the state to match inflation and population growth, we would be balanced. What we did is we expanded eligibility. We're the only state that covers every eligible alternative under Medicaid. What happens when you expand eligibility? It's locked in. We're the only state where once you put new money into education, it can never come out.

We must control the spending growth. What do we do if there's a bubble – oh my god, I said the word "bubble;" I shouldn't have said it! Suppose there's a "banana," and real estate prices just plateau, or housing doesn't turn over as fast. Well, then the obligation of Prop 98 remains the same, the local contribution isn't what it used to be, and the state has to make up the difference.

BS: I'd like to add a point about what Tom said about population and inflation as a benchmark. When we were at our worst, meaning 2002-03 when the deficient approached $35 billion, if we had that simple benchmark, we wouldn't have had a deficit in those days either.

SW: Three points: First, there clearly is a problem of rising health care costs. The question then is, "What do you do about that?" I would submit that the state of California needs to do more of what most people are doing in their business, which is getting smarter about preventative care.... We need to turn down the partisanship, and start coming together to find real-world bipartisan solutions. Turn down the partisan rhetoric, roll up the sleeves, and get back to the negotiating table.

TC: If you go back to 2000, how much money spent as a percentage of how much revenue we have, it's $1.09 for every dollar, it's $1.07 in 2005, and roughly the same all the years in between. Six years running, we've got a systemic problem. It's not a Democratic governor problem or a Republican governor problem.

SW: Tom is absolutely right. We don't want to try to solve this by more auto-pilot budgeting. But I submit that part of the problem is that we need a tougher CEO. We have a governor with a line-item budget, and yet, did he touch the things he promised? $145 million? Barely one-tenth of one percent. So we've got the tools in place. I believe what we need is more backbone, not more auto-pilot budgeting.

RD: Any other ideas in terms of the budget process itself? Statutory changes?

TC: We are one of only 14 states that don't fix a budget crisis in the middle of the term. We let it slide until the end. 36 states fix a budget imbalance during the course of a year, and those have support from both Democrats and Republicans. Our failure to have a mid-course correction in our system is a huge negative. So I would say we need to create a system that would pull the trigger at a serious level, not a critical level, when revenue is falling or expenses are going up substantially, involve the Legislature, involve the governor, and get it signed right away.


RD: Any ideas on structural changes you might want to see?

SW: I certainly want to see a two-year budgeting process that helps smooth out the peaks and the troughs. One of the reasons that Tom will win this argument on Prop 76 but probably won't win on election day is a lot of people are concerned about what happens if you have a few bad years, and will our educational system hemorrhage. I think real backbone is when you make a promise, like the governor did on public education, and you keep that promise.

RD: Let's turn to Amy Resnick. Do the bond markets care about whether we fix the structural gap, whether it's through revenues, expenditures, or tax increases?

Amy Resnick: The market most importantly believes that California needs to set up a system by which over the long term it can meet its needs. I don't think there's any concern that California's not committed to paying back the money it's borrowed. But if you look at the ratings California has, California is probably the lowest rated state. So relative to a AAA state, such as North Carolina or Virginia, on an average basis, California is paying about 20 basis points more for borrowing. That is roughly around $43 per $1000 in additional borrowing costs. Because of some of the conditions over the last five years the bond rating has gone down because lenders need to be compensated more for the risk of doing business with California. And that obviously has a cost to all of the infrastructure spending as well as the borrowing to cover operational costs of the economic recovery bonds. California actually pays fairly competitive rates in the short-term market. I think in the most immediate term, you're seeing confidence.

SW: This is good news for us here. We did an innovative tax amnesty program this year. It was supposed to bring in just $90 million into the budget; when all is said and done, I think we'll see close to $2.4 billion. I often joke that if we had not had the extra money from tax amnesty and the extra two or three billion from the real estate market, the governor really would have been under water.

RR: When you're looking at locating a corporate headquarters or a manufacturing plant, these are long-term capital investments. An astute corporation that is closely watching government affairs would listen to this conversation and decide whether they really want to put that capital in the ground. Often they don't have a very scientific view of it. What that translates to is a cloud of uncertainty that says, "Why would you want to build there?" I can't tell you how many times I've been in that room and heard the CEO say, "Why the heck do we have a factory in California?" The truth is it's actually not a bad place to have a factory, but the fact is that they have this cloud that is causing them to make the decision to move away – whether it's to withdraw a site or not make the incremental investment to expand, and people will say that the reason they don't locate here is that the wages are too high. This is not actually the case. California manufacturing wages are not excessive in terms of the national average. The incremental costs that are attributable to the government and other agencies are a problem, but what people are actually being paid is not the issue. So in my mind, this puts it squarely back on the shoulders of the state.

RD: From that perspective, what can the state do that might change how businesses view the state?

RR: Philosophically, the voters have to decide whether manufacturing is relevant to the future of the state, and that has to translate its way through the government infrastructure to make that happen. Right now it's unclear whether people have the perception that manufacturing is important. I'm not sure that people know that California has more manufacturing jobs than any other state in the country. Today we don't capitalize on that. Taxation is an element, but there are also a lot of regulatory things that are very restrictive. One piece of that is that the company often feels that it has no single point of clarity to go to get an interpretation of what's going on.

RD: Steve, do you have any ideas on whether specific tax incentives should be offered to manufacturers, or should we just have a level playing field?

SW: I believe there are certain industries where we should develop tax incentives. I'm very concerned about California developing what is called the "barbell" economy, a growing number of high-end jobs, a growing number of low-end jobs, and not much of a middle class. In fact, we are still supporting a fairly vibrant manufacturing center, and I want to make sure we don't lose that. The key is that before you provide incentives, tax credits, things like that, you need to make sure that the companies are providing some level of accountability and that they are in fact making investments and providing the job growth they've promised.

BS: When I ran in 2001-02, we had the same issues about regulatory burden. We can talk about targeted tax incentives, but as I went around the state, it was amazing the number of times people told me that the single biggest issue for them, especially small business owners, was daily overtime versus weekly overtime. It's incredible how much impact these things have on people. I don't know what the latest data is, but something like 90 percent of the businesses in the state employ fewer than 100 people. So the regulatory burden becomes a huge issue. If you wanted to really look at one thing, I'd say the regulatory burden is very important.

TC: I'd like to point out the remarkable shortsightedness of the sales tax on manufacturing equipment. This is stupid. Forty-seven states know it's stupid. California's corporate tax rates are high; they top all states except Pennsylvania. California is one of only six states in which the rate of growth of taxes on business exceeds that of taxes in general. Maybe we can have a consensus here. We should follow the pattern of 47 states.

RD: Should we consider any adjustments to Prop 13?

TC: No. It's the only thing we have going for us; when a business decides to locate they know they won't have the property tax increase the minute they pour concrete.

BS: The best thing we can do is to create an environment where businesses are making money. We talk about tweaking or adjusting. I think it's always better to take a step back in a macro way and ask, how are we going to make it more attractive for businesses to locate here and make money? No matter how many problems we talk about, the ultimate question is still, "Where do you want to live?", and California is right at the top. And, I found that to be great news, because I think that over the long term, the single biggest issue is infrastructure. So you're talking about roads and water and power and schools. You're talking about a $180 or $200 billion issue. Tom is correct; we do have a structural deficit. How are you going to pay for the infrastructure with one of the nation's worst credit ratings? Everything we're talking about is tweaking, but we have a much larger, generational issue.

RD: What might we do to be able to reduce the volatility in the budget over time?

SW: It's a challenging question. We need more long-term budgeting, ideally over two or three years. Interestingly, the city of Sunnyvale has a 20-year budget, and you may say that that sounds a little extreme, but it's worked very well for them. Second, we need a rainy day fund. Other states have this, to their tremendous credit. We have it kicking in next year. And the reason we have it kicking in next year is because a lot of people, Democrats and Republicans, got together to fix the state's problems by passing Prop 58.


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