By J. Fred Silva, senior advisor, and Kim Rueben, research fellow, Public Policy Institute of California
This opinion article appeared in the San Diego Union-Tribune on January 26, 2003

The state's huge budget deficit, we now know, is in part attributable to its decision to fund long-term program commitments with relatively volatile revenue sources. Income tax revenue, for example, declined $10 billion with the disappearance of the high-technology boom of the late 1990s. That drop has led to a mismatch between spending and revenues that the nonpartisan Legislative Analyst says will continue for years unless the state takes corrective action.

The current crisis would seem to be the perfect occasion for reviewing the state's tax structure, spending obligations, and fiscal arrangements with local governments. Although Gov. Gray Davis has proposed many changes, especially in this last area, his proposal does relatively little to reform California's quirky public finance system. Consequently, it misses a rare opportunity to address the state's underlying fiscal problems.

In general, Davis' proposals resemble those made by previous governors facing budget shortfalls. To close the two-year budget gap, he has proposed major cuts in state spending, including $10 billion in the current fiscal year; raising $8.3 billion in new taxes; and rolling a $5.8 billion deficit from this fiscal year into the next.

Some of the new spending cuts are real, including the elimination of some state-supported health benefits. Many are postponements of current obligations, such as the $900 million deferral of state reimbursements for new education mandates and the cancellation of cost-of-living increases for education programs.

On the revenue side, the governor's budget proposes to increase the general sales tax, tobacco taxes, and income tax rates for some households. The proposal seems to spread the pain of the tax increases across income groups. The new sales taxes will fall most heavily on low-income Californians – at least insofar as such taxes absorb a larger portion of their income. And the income tax hikes will target high-income households.

Some would argue, however, that the state already relies too heavily on these revenues, which rise and fall dramatically with the business cycle.

Because the governor is constitutionally required to propose a balanced budget, there is little explicit borrowing included in Davis' proposal. However, the Legislature is not required to pass a balanced budget, and this will mean substantial borrowing to cover shortfalls. Last year, that shortfall came to $3.5 billion, which the state will need to cover this year. Next year, the state will almost certainly need to borrow again to close the remaining gaps.

Luckily for the state, interest rates are low; but it already has floated large energy and general obligation bonds, and that outstanding debt may raise its borrowing costs.

The governor's budget certainly satisfies his constitutional obligations; in many ways, it is the fiscal equivalent of "keeping the lights on." And he has balanced his proposed budget in the traditional way – by blending program cuts and tax hikes. The necessary borrowing will be done later, when legislative leaders and the governor iron out the actual budget.

But the centerpiece of Davis' budget – the so-called realignment proposal – deserves special attention. It would shift most of the new revenue – about $8.3 billion – to county governments to provide health and human services. (Counties already administer these services, but the programs are currently paid for out of the state's general fund.)

At first blush, the realignment seems to address a basic issue in California governance: the difficult and sometimes contentious fiscal relationship between state and county government. Much of that contentiousness flows from the dual nature of county government. On the one hand, county governments are autonomous political jurisdictions providing various services within their borders. On the other, they are "creatures of the state," administering state programs, mostly in health and human services. County officials often complain that the state requires them to deliver services but does not always provide sufficient money to do so.

By diverting new revenue as well as program responsibility to the counties, the governor seems to be addressing that complaint. But there may be at least two other motives for the proposed realignment.

First, the demand for the affected health and human service programs – including those for substance abuse, child welfare, mental health and long-term care for low-income seniors – is growing rapidly, and the state has not been especially successful in meeting that demand. The handoff to county governments may leave local officials scrambling for answers that the state itself has yet to produce.

Second, the realignment may be a politically adroit way to cope with the constitutional aspects of the budget process. In 1988, California voters approved Proposition 98, which guaranteed a certain percentage of general fund revenue to schools and community colleges. If Davis simply raised taxes to close the current deficit, a significant share of the new revenue would be allocated to K-14 education. However, it now seems that he wants to protect some health and human services programs by diverting new revenue directly to counties, which already administer them.

When viewed this way, the realignment is not an attempt to reform state and local responsibilities so much as a way to avoid losing part of the new tax revenue to K-14 education.

It will be interesting to see how county governments respond to the governor's proposal. Most will soon realize that the underlying issue is which level of government controls program standards (including eligibility) as well as administration and finances. In theory, the government entity that sets the standards should raise the revenue to meet those standards. But this proposal is silent on that issue.

So far, counties seem more concerned about the Davis plan to stop reimbursing them for declines in revenue from the vehicle license fee. The VLF, which voters earmarked for local governments in 1986, was the third-largest source of general-purpose revenue for localities. State officials increased VLF revenue during the budget crisis in the early 1990s; but in 1998, when state coffers were filling up again, the state lowered the VLF significantly and began compensating counties and cities for the lost VLF revenue.

Now Davis proposes to eliminate that compensation. Although the VLF has never provided counties with a major portion of their revenue, that money represents a large portion of their discretionary revenue – that is, dollars that may be spent on something besides state-mandated programs. By eliminating that source of revenue, Davis would make it more difficult for counties to fund programs that are not covered by his realignment proposal.

Aside from raising these specific issues, the governor's budget reflects a more general problem: namely, the need to reconcile a high level of public services with a tax system that can pay for them.

In many ways, voters have helped create this problem. Last year, for example, voters passed three statewide ballot initiatives that expanded the state's obligations in transportation and education. Proposition 47, the largest school facilities bond measure in state history, will cost taxpayers over $800 million per year in principal and interest. Proposition 49, which increases state support for after-school programs, will cost anywhere up to $550 million in 2004-05. And Proposition 42 dedicates the sales tax on gasoline to transportation and transit projects, thereby limiting funds for other programs.

Yet even as voters continue to approve measures such as these, they have put restrictions on the government's ability to fund them. The passage of Proposition 13 in 1978, for example, famously capped property taxes and led to the state assuming more responsibility for funding local services, including education. By limiting property taxes, a much more stable revenue base than both sales and income taxes, California has committed itself to a budgetary roller coaster ride.

We now need a serious discussion about the best way to fund public services. There is no shortage of suggestions along these lines; the question is, who will provide the political leadership required to champion and implement them?

Because the governor's proposal will frame the budget discussion, we are unlikely to hear more about underlying problems at this critical juncture. This may well be a missed opportunity. The governor is not obliged to propose or implement sweeping solutions to systemic problems. But we should not conclude that these problems will disappear with the next upswing in the business cycle.