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Why the State Budget Never Adds Up

June 29, 2008 |
In a democracy, accountability to voters is the real source of fiscal discipline. But it doesn't exist in California.
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Gov. Arnold Schwarzenegger says he wants more than a balanced budget this year. He wants budget reform too.

For a state that has already laced itself into straitjackets of spending mandates and formulas, Schwarzenegger proposes new constitutional chains: a combined rainy-day fund and spending limit, to be added on top of the rainy-day fund and spending limit that voters have already approved separately. His implicit message: The Legislature and I have chosen badly, so please restrict our ability to choose again.

As any parent knows, you can't instill individual responsibility in children by depriving them of the opportunity to choose. The same goes for fiscal responsibility in government. Real budget reform in California shouldn't require more spending straitjackets and, except in one case, shouldn't require a constitutional change. It's simpler than that. Here's what we need to do:

Adopt transparent and honest accounting

The first step in fixing the budget mess is to understand the size of the problem. That's not easy for Californians. The way the administration and the Legislature talk about the state's finances defies common sense and the rules of accounting.

Most people understand that their household budget is balanced when they spend no more than they earn each year. If they must dip into savings to pay rent, or run up a credit card balance to buy groceries, they know the budget is out of whack and they're headed for trouble.

Not so in California. Budget documents routinely fail to provide the number most useful in making budget choices -- the discrepancy between annual general fund spending and tax revenue. Instead, budget officials and politicians speak of what they call a "shortfall" -- the state's cash reserve at the beginning of the current year, plus the deficit or surplus in the current year, plus the projected deficit or surplus in the next year for which the budget is being written, plus the desired reserve at the end of that budget year. For instance, when Schwarzenegger announced in January that California faced a $14.5-billion shortfall, what he actually meant was that the state was running a deficit of about $7 billion for the current 2007-08 fiscal year and would have a deficit of about $8 billion next fiscal year unless corrective action was taken.

In this decade, California has run a budget deficit -- spent more than it has collected in taxes, fees and interest on cash reserves -- nearly every year. But that has been largely hidden from the public. From 2000 to 2003, the deficits were concealed by cash reserves carried over from the Internet boom. In 2005 and 2006, they were also masked by more than $20 billion of borrowing treated as "revenue."

Getting the accounting right isn't just a cosmetic nicety. It's essential to letting policymakers and the public see the real problem. If the public understood today that California's core problem is an ongoing structural deficit of about $5 billion a year, currently exacerbated by the housing bust, it would be easier to come up with a solution.

Real budget reform starts with transparency. Budget documents should lay out spending, revenue and whether the balance between the two produces a surplus or a deficit, as federal budgets do. Only taxes, fees, interest and transfers from other government funds that don't have to be paid back should count as revenue. Money borrowed in financial markets or from other government funds should be listed as borrowing. Any cash surplus in a budget year should be assigned to the existing rainy-day fund created by Proposition 58 in 2004, and the budget should clearly say when those funds are being tapped to cover a deficit.

None of this requires a constitutional amendment such as Schwarzenegger is seeking. It only takes an agreement between the governor and the Legislature to set up a clear and honest accounting of the state's finances.

Adopt pay-as-you-go budgeting

California's current budget crisis has its roots in the Internet boom of the late 1990s, when the state, its coffers overflowing with tax revenue from capital gains and stock options, raised spending for such programs as children's health and Cal Grants for college students and cut the vehicle license fee and other taxes. Then the boom went bust, leaving California with the structural deficit that continues to plague us. Ever since, the budget reform debate has centered on creating some constitutional contraption to prevent the state from again enacting programs or tax cuts that cannot be sustained over the long run.

But here again, no constitutional change is necessary to solve the problem. The governor and Legislature need only follow the example of Congress, which in 1990 joined with President George H.W. Bush to institute pay-as-you-go budgeting. Under "paygo," as it's known in Washington, new spending programs and increases in existing ones must be paid for with increased revenue or offset by an equal spending cut in other, lower-priority items. Tax cuts must also be paid for by either balancing revenue increases or spending reductions. This self-imposed discipline played a key role in turning the enormous federal deficits of the 1980s and early 1990s into a surplus by 2000.

Paygo isn't ironclad protection against fiscal irresponsibility. Self-imposed discipline can be shrugged off. But not easily. If California were to adopt paygo as a standard rule of the budget game, every new program, tax cut and bond measure would come with a five-year price tag and the requirement that it not create a budget deficit. Lawmakers could ignore the rule. But not without having made clear to the media and public the budget consequences of their decision -- and not without being seen as in violation of normal standards of fiscal prudence. Combined with transparent budget accounting, paygo would have made it far harder for California to dig itself a budget hole over the last decade.

Restore political accountability for budgets

The budget reforms above would be designed to create a better-informed and more disciplined budget system. In a democracy, however, accountability to voters is the real source of fiscal discipline. And it doesn't exist in California.

The reason is the state's constitutional rule requiring a two-thirds majority to pass spending and tax legislation. By giving, in effect, a budget veto to the minority party in the Legislature, the two-thirds rule has prevented California from enacting the spending cuts and tax increases needed to correct its structural deficit. Democrats oppose deep spending cuts; Republicans reject higher taxes. Forced by the two-thirds rule to act together, they pass budgets -- almost always late and after weeks of meaningless posturing -- that enshrine both parties' contradictory priorities and make up the difference with borrowing. That's fiscally irresponsible. But when irresponsibility has both parties as co-authors, which party can voters hold accountable?

For more than 200 years, the U.S. and most of the states have operated according to the democratic principle that the party that wins an electoral majority gets to write the budget and be held accountable for its choices. For decades, California has experimented with a different principle: Requiring a two-thirds vote on fiscal issues will yield a more responsible result.

The results of that trial are in. California's credit rating is the lowest in the country. The state has been in almost constant budget turmoil in this decade, suffering deficits even in good years. The experiment has plainly failed. Democratic accountability works better. If it's real budget reform the governor and the Legislature want, it's time for California to give democracy another chance.


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