(January 11, 2010) Governor Schwarzenegger proposed his final budget last Friday, once again wrestling with spending obligations far in excess of available revenues. 

Given the tax increases, spending cuts and federal aid over the past year, why is the state budget still mired in deficit?

Even before the recession hit California in late 2007, state spending was on an unsustainable trajectory. Between 1998 and 2007, spending increased by an average of seven percent a year, while population and inflation increased by less than four percent. This spending growth was bolstered by $15 billion in deficit bonds approved by voters in 2004. And in 1999, the fuse was lit on accelerated growth in government employee pensions with an enormous boost in unfunded benefit increases. In the meantime, very few revenues were set aside in a rainy day reserve.

When the recession arrived, tax revenues took a dive. With no financial cushion available and the Legislature unwilling to make draconian cuts in public services, the State went even more deeply into debt.

Aren’t state revenues increasing next year? If so, why are we still facing a deficit?

State General Fund revenues will increase next year by about a billion dollars next year (1.4 percent), still less than what was estimated last July. But the deficit remains gaping for three main reasons:

1. Historic deficits. The State begins the year in the hole. Last year, the state’s fiscal year began with a $3.6 billion balance and closed last June with a $5.9 billion deficit. The State must climb out of that hole before addressing the revenue shortfalls and spending demands ahead.
2. One-time solutions. Spending this year was suppressed temporarily by adopting “savings” or revenues that would last only one year. Most notorious was shifting the payroll date for state employees by one day, to create the obligation in the next fiscal year. In addition, billions in federal aid will expire this year, as well as billions in advanced tax revenues that will be unavailable next year and thereafter.
3. Vanishing solutions. This year’s budget also depended on billions of dollars in solutions that will never come to pass, or that will occur far in the future. The Governor has identified more than $7 billion worth of phantom solutions that were either stymied by litigation (e.g., selling part of the State Compensation Insurance Fund) or never fully implemented by the Legislature (e.g. achieving systemic savings in the Corrections budget).

Taken together these defects comprise the major component of the State’s nearly $20 billion structural deficit.

If revenues are increasing year-to-year, why not just freeze spending at this year’s level?

The effect of the deficits and gimmicks discussed above means that spending this year is still far above available revenues; the Governor is targeting $83 billion in spending for next year after covering the accumulated deficits and making up for the one-time revenues and stymied previous solutions. The Legislature must still confront actual spending decisions – meaning eliminating programs, reducing local assistance and income support payments, or cutting government employee salaries or jobs – to bring the budget into balance.

Why can’t the state restrict expenditures to the same programs and services we had the last time revenues were $83 billion?

That would be six years ago, and since then prison populations have increased, state health care entitlement caseloads have grown, and the constitutional guarantee for education spending has continued to rise. Salaries have increased, as has the cost of goods, utilities and other public program inputs.

What a mess! So how does the Governor propose to fix this?

The Governor has three primary strategies: beg, shift and cut.

1. The budget solution is predicated in large part on obtaining nearly $7 billion in federal aid, both in direct funding support or reforms that would permit the State to reduce spending on public services.
2. The budget proposes to finance numerous health and welfare programs from existing tobacco and high-earner income taxes. These taxes are currently dedicated to programs enumerated in the authorizing ballot measures. The budget also proposes to eliminate the current state sales tax on motor fuels, replacing it with a new fuels excise tax (i.e., per gallon tax). This change will enable the state to cease subventions to local public transit agencies and General Fund debt service payments for transportation bonds.
3. The Governor proposes about $8.5 billion in spending cuts, primarily in health and welfare programs, corrections, and state employee salary and benefit costs.

Has the Governor proposed any tax increases?

Not immediately or directly, but he has proposed tax increases “in the event that the federal government fails to provide the $6.9 billion of additional funding proposed in the budget.” This “trigger” would provide additional state program cuts (two-thirds) and tax increases (one-third) to replace federal funds not received. The potential tax increases are:

• Extend suspension of a business’s ability to reduce taxable income by applying net operating losses (NOL) from prior years to reduce current income.
• Extend reduction in the dependent credit on the personal income tax from $319 to $102.
• Delay use of business credits by unitary groups of corporations and instead retain current law which requires subsidiaries to have their own tax liability to use research and development and other credits.
• Delay the change to the single sales factor allocation method for multi‑state corporate income and instead retain the double weighted sales, property, and payroll formula.
• Lower to 30 percent the first year phase-in of the ability of corporations to carry back losses two years to offset prior tax profits.

These tax incentives would be delayed for only one year.

In addition, as described above, the Governor proposes to partially replace the current state sales tax on gasoline and diesel (six cents per dollar) with a new 10.8 cents per gallon fuel tax. The Governor estimates motorists would save nearly a billion dollars a year from this transaction. Transportation advocates will be concerned that, among other reasons, the excise tax will grow more slowly than the sales tax, since the former is based on volume, which grows more slowly than receipts.

Loren Kaye is president of the California Foundation for Commerce and Education, a non-partisan, non-profit corporation that functions as a “think tank” for the business community in California and is affiliated with the California Chamber of Commerce.