Time to Get Serious In California

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Last week, the governors of New York and California took to the rostrums in their respective state capitols to give their State of the State Addresses. Both states face budget crises -- New York's extremely bad, California's even worse -- and both governors will be in a position of pushing for unpopular solutions. Are they ready for this challenge of leadership?

While much of the content of the governors' speeches was necessarily similar, their tone and emphasis were strikingly different. New York Governor David Paterson took a direct approach, declaring that he would dispense with "congratulatory pronouncements and self-reflected praise" given the state's ongoing difficulties. He went on to renew his on-again, off-again hard line against profligate spending by the legislature.

Schwarzenegger instead began with a cute story about his pet pig and pet pony, who conspire together to steal his dog's food. He then compared this to what he and the legislature can accomplish, if only they work together. The parable makes sense -- what are a governor and his legislature other than a bunch of animals working together to divide up somebody else's property? -- but I don't think that's exactly what Schwarzenegger meant.

The speech was full of laugh and applause lines, hokey "we-can-do-it" exhortations ("If I had hesitated in my career every time I made a move because it was too hard, I would still be yodeling in Austria"), and calls to spend money on feel-good programs like a sales tax exemption for Green Jobs.

Despite the speech's tone, not everything in it (and the accompanying executive budget proposal) was bad or unserious. In fact, the budget includes many good ideas to close the state's $19.9 billion budget gap, including cost-saving reforms in Medicaid, welfare, and prisons. And it omits another broad-based tax increase, which is important because California just raised taxes last year, giving the state the second-highest average sales tax rate and the fourth-highest top income tax rate.

Schwarzenegger also broached two thorny, but important, long-term reforms for California. One is improving the state's tax code to reduce revenue volatility -- in the current downturn, tax revenues fell eight times faster than gross state product, because of the state's outsized reliance on taxing wealthy individuals. He also called for reining in the state's mushrooming costs for employee retirement benefits.

But much of Schwarzenegger's proposal is unimpressive.

For starters, he takes a wishful-thinking approach to federal aid, expecting Washington to come up with nearly $7 billion to help California balance its budget. It's likely California will get something out of a second stimulus, and other requests from Washington (like waivers of federal "Maintenance of Effort" requirements) could be provided for free. But it's highly unlikely the feds will come close to meeting this full ask, meaning that more cuts will be needed to close the budget gap.

The budget also relies extensively on accounting gimmicks and fund shifts that create more paper savings than real savings. And it takes many actions to shift revenues from localities to the state, or to shift program obligations from the state to localities. (For example, he'd increase the number of convicts who could be sentenced to county jails instead of state prisons.) These moves will help balance the state budget, but will likely push local taxes upward unless accompanied by unlikely mandate relief.

The biggest problem, though, is that Schwarzenegger's proposal does nothing about the fundamentally broken budget process in California. State lawmakers have a rancorous annual fight about balancing the state's budget, and consistently end up passing one that is full of accounting gimmicks.

The principal blame for this situation lies with the electorate. The California public wants to spend like New Jersey, so they approve ballot measures to spend lots of money on all sorts of things -- education, roads, mental health care, stem cell research, high-speed trains. But they also want to be taxed like Arizona, so if you offer them tax-restricting initiatives, they often approve those, too. And in California, the legislature can't repeal or amend voter-passed initiatives. The result is that legislators have few options to close budget gaps when they appear.

Schwarzenegger's budget proposal contains a great example of the contortions that stem from California's excess of direct democracy. He proposes to eliminate the state's sales tax on gasoline, which is mostly used to fund general fund transportation projects. Then, he wants to impose a new 10.8 cent excise tax on gasoline, which will go to the transportation fund.

Why this accounting shift? Because a voter-passed initiative limits how the state can use gasoline sales tax revenue. Excise taxes also face voter-imposed limits on their use, but they're less strict and more in line with what the governor wants to do with the money. Plus, moving transportation revenues from the general fund allows the governor to cut education spending by $836 million, based on the formula from a third ballot initiative. Confused? So is everybody else.

Schwarzenegger's tax reform proposals nibble around the edges of these issues, but they don't get at the key problems with the state's overly restricted budget process. In fact, last week he even proposed a new constitutional spending mandate: a requirement that higher education spending be at least as much as prison spending. While Schwarzenegger framed this as a measure to rein in excessive prison costs, a more likely outcome is that California will overspend in both areas.

More constitutional spending mandates are a move in the wrong direction. Instead, Schwarzenegger should be pushing to loosen budget strictures so the state can pass honestly balanced budgets. If he does not lead California down the path to permanent reform, budget deficits will be back, every year.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.

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