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California's Budget Mess: Tax Overhaul is the Best Way to End Ride on Roller Coaster

By Fred Silva, senior advisor, Public Policy Institute of California
This opinion article appeared in the San Diego Union Tribune on June 2, 2002

Three years ago, the state government had a surplus of $8 billion. The next budget, due to begin on July 1, currently shows a $24 billion gap between scheduled spending and available resources. How did we go from an $8 billion surplus to a $24 billion budget gap in three years?

The short answer is that revenues have fallen short of expectations, and the state has increased its commitments to education, health care, and other human services. But there's more to it than that.

Certainly, increased spending on popular programs has widened the budget gap. But we Californians demand high-quality public services, and we think more should be done to improve K-12 education, public health, and other state and local services. Even when the recent economic slowdown was clearly upon us, we expected improvements. A statewide survey taken in December 2001 by the Public Policy Institute of California, a nonpartisan research institute, showed that 56 percent of those questioned thought the economy was headed for rougher waters.

That realization might have led some citizens to lower their expectations about state spending. Not in California. Two months later, another PPIC survey showed that 60 percent of respondents were dissatisfied with the level of school spending.

The demand for public services is one part of the picture. Another is the way the state finances those services.

Almost 50 per cent of the state's general fund revenue now comes from an income tax that relies heavily on high-income earners. According to the Department of Finance, over 70 per cent of California's income tax revenues come from people making more than $100,000 per year. Between 1998 and 2001, that arrangement did wonders for the state budget. Business was strong, high-technology industries were booming, and the rush was on.

Higher personal incomes and capital gains propelled the revenue side of the state budget. Gov. Gray Davis came to office with a $3 billion surplus; his next budget ended with an $8 billion surplus.

Spending and Revenues

At about this time, the first law of fiscal politics - spending shall grow to match the funds available - kicked in. No party is exempt from this law. In the 1980s, state spending rose from about $20 billion in 1980 to $40 billion in 1990 with virtually no increase in taxes. When California emerged from the recession of the early 1990s, the same law applied. Between 1994 and 2001, state spending almost doubled again, rising from $41 billion to about $78 billion.

Only a fast-growing economy with lots of high earners could sustain that level of budget growth. Between 1999 and 2001 alone, spending on education and health and human services rose $8 billion. Much of that rise was attributable to caseload increases in health and human services and new programs in education. Once again, PPIC surveys showed that Californians viewed both program areas as high priorities.

Closely related to these spending increases were tax reductions. In the late 1990s, the state temporarily reduced the vehicle license fee. Because the revenues from that fee help finance local government, the state made up the difference to cities and counties. On the budget books, that fiscal backfilling showed up as a spending increase of over $3 billion. Between that increase and the hikes in social and education spending, the state added $11 billion to its spending base.

Covering that base has become increasingly difficult as general fund revenues have not met expectations. When the economy took a downturn again in 2001, the state lost its windfall revenues from the personal income and capital gains taxes. Tax revenues could no longer fund expenditures, and the shortfall was initially bridged with prior-year surpluses. Now those surpluses are gone.

The current fiscal year will end in deficit, and although the coming budget will likely predict a small surplus, it will probably end in deficit as well.

Gov. Davis has proposed a time-honored method of addressing the budget gap - a blend of higher taxes, spending reductions and delays, and borrowed money. Much of that deficit will be financed by Wall Street, which has been surprisingly patient with California's habit of running deficits during economic downturns.

Smoothing Out the Ride

Over the last 25 years, California's economy and state budget have come to resemble Mr. Toad's Wild Ride. When the economy is clipping along, the state increases its spending and reduces taxes, thereby expanding its spending base and shrinking its revenue base. When the economy heads downhill, and the state needs money for critical social programs, the government is forced to retrench, borrow heavily, and otherwise try to ride out the recession.

Fortunately, the California economy has shown that it can rebound impressively, but the ups and downs are unnerving and make long-term state fiscal planning difficult. Only fundamental changes in the state fiscal structure will smooth out the ride.

As long as the state's priorities reflect voter preferences, it's not clear that much can be done on the spending side. We may hate to admit it individually, but most of us have indicated, in one way or another, that we want more public sector involvement in the areas we care about. In the current political climate, cutting back radically on spending and services is probably not the ticket.

The State Tax System

So what about revenues?

Here it's probably time to review the tax base that supports state and local services. Yes, this is boring work. If you prefer excitement, there is always the fiscal roller coaster. But if fiscal catastrophe isn't your idea of a good time, the first order of business is to broaden the tax base and lower tax rates.

Every year, advocates for various interests plead with the state to exempt them from a tax, thereby narrowing the tax base and putting upward pressure on tax rates. This pattern is particularly clear for the sales tax and the bank and corporations tax, but it applies to the personal income tax as well.

Although capital gains are always part of personal income, they tend to be more volatile and difficult to track than wages and salaries.

One way to handle this volatility is to dedicate tax revenue from more volatile sources to a separate fund for one-time expenditures. These one-time expenditures might include school, transportation, and community infrastructure projects that will help sustain California's continued growth and prosperity. In addition to building up the state's infrastructure, this measure also would prevent periodic revenue windfalls from becoming a permanent part of the state's spending base.

The Commission on Taxation and the New Economy was created by the California Legislature several years ago and has taken the issue of the tax system for California on the road. The commission is holding hearings around the state focused mostly on the issue that got it started - applying the sales tax to Internet transactions. It may be time for the commission to broaden its view and review the entire state and local finance structure.

Finally, rather than repeating the budget solutions of the early 1990s, the governor and Legislature should focus on smoothing out the fiscal ups and downs. This will require leadership from politicians and a measure of realism from California's citizens.

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