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Here's Why California is in Such Financial Trouble

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California has always been a trendsetter. What happens in California often pops
up elsewhere. Which raises this question: Are the perpetual billion-dollar
deficits that haunt California state government unique to the Golden State or
the harbinger of what other states can expect?

The answer, analysts say,
is that although most states are experiencing some of the same financial stress,
California’s woes are its own. At the same time, other states can take a cue
from California's troubles.

The state’s financial hole is so deep that voters will decide on May 19 six
questions the Legislature put on the ballot as part of budget deal in February
with Gov. Arnold Schwarzenegger (R) that closed a $34 billion deficit. But with
revenues plummeting, the state might still be short $15.4 billion even with the
deal — and $21 billion if voters reject the package. Schwarzenegger has
threatened to lay off 5,000 state workers and 1,700 firefighters, shorten the
school year by five days and release 38,000 prisoners if the ballot measures

Like most other states, California is being hammered by the recession,
but experts say the depth and intensity of the current downturn makes the
situation there particularly tenuous.
“Many other states do face the same kind of problems California faces,
but California’s problems are just so much more bigger and more complicated,”
said Sujit CanagaRetna, senior fiscal analyst for the Council of State Governments.

One reason California’s fiscal ordeal stands out is because of the state’s
size — it’s the eighth-largest economy in the world.
Threatening that economy is a mix of volatile tax revenues, voter-mandated
spending and political factors that hamper effective budgeting.

Rather than having a steady flow of money from several sources as many states
do, California experiences wild swings in revenue because of its dependence on a
small group of people: its wealthiest taxpayers.

The top 1 percent of the richest taxpayers typically pay about half of all
personal income taxes in California. More than 55 percent of the state revenue
last year came from personal income taxes, followed by the sales tax with 27

As long as times are good, this arrangement works because as people
splurge on big-ticket items and make profits, they send large infusions of tax
revenue to the state. But when the economy takes a tumble and people tighten
their belts and corporations’ profits fall, the state’s primary source of
revenue takes a precipitous drop.

“California is unique in that it so dependent on such a small portion of the
population,” said Mark Baldassare, president of the Public Policy Institute of
California, a nonprofit in San Francisco that does independent research on the
state’s economic, social and political issues.

The capital gains tax — revenue generated when people make profits on selling
property or stocks and bonds — is particularly volatile. In 2000, for example,
when Silicon Valley and the rest of the state was enjoying the “” boom,
state revenues derived from capital gains went up nearly 30 percent. A year
later, when the technology bubble burst, capital gains plummeted by more than 55
percent. “California is in a class in itself the way it relies so heavily on
capital gains,” Joseph D. Henchman, director of state projects at the Tax
Foundation, a nonpartisan Washington D.C., research group.

The same boom-bust cycle happened with the rise and fall of the once hot housing
market. All revenues related to the housing sector, including direct revenue
sources like real estate transaction fees, income taxes from construction
workers and indirect revenue sources like sales tax revenues from home
improvement stores like Home Depot or Lowe’s have dwindled.

And the red ink keeps coming. Last month, the state fell short of expected
revenue by more than $1.8 billion in personal and corporate income taxes. The
bleak revenue picture means the state might need to borrow up to $17 billion,
and even more, if voters reject the ballot measures, the Legislature's chief
budget analyst warned May 7.

“California has gotten itself into a deficit crisis of unprecedented
proportions because it relied on an overly progressive income tax system that
produced volatile one-time revenues and overspent those funds on ongoing
programs,” state Republican Sen. Dave Cox, vice-chair of the Senate
Appropriations Committee, said in a statement
last month.

Obviously, politics plays a huge role in the current budget morass: the
Republican governor and Democrats who control the Legislature can’t agree on how
much to tax and how much to spend. But the problems go deeper. Schwarzenegger
came to office in 2003 when voters ousted Gov. Gray Davis, a Democrat, in an
unprecedented statewide recall election. Davis was unpopular, in part, because
of his poor handling of the spiraling budget deficits with his fellow Democrats
in the statehouse.

Other factors contribute to California's chronic budget woes as well. Some of them are:

Supermajority” vote — California is one of 16 states that have
adopted legislative “supermajority” requirements that make it more difficult for
legislators to raise taxes or modernize their tax code because they need more
than a simple majority of lawmakers to approve such a move, with most, including
California, requiring a two-thirds vote.

But California also is one of only three states that require a supermajority to
pass the budget (Arkansas and Rhode Island are the others), again requiring
two-thirds, according to the Public Policy Institute of California.

Term limits — Among the nearly dozen states that cap the length
of legislators’ terms, California is among the strictest. Assembly members are
limited to six years in office and senators to eight, and after they serve, they
are banned from that chamber for life. This often means that by the time
elected officials are experienced in the budget process, they have to leave

Irregular cash flow — The state generally disburses most of
its dollars in the first half of the fiscal year (between July and December),
but it collects most of the money in the second half of the fiscal year (between
January and June). That means the state routinely runs monthly cash flow
deficits through the first half of the fiscal year and has surpluses through
much of the second half, the state’s nonpartisan Legislative Analyst’s Office
said in its May report.

In most years, it's easy for the state to borrow funds to cover these
temporary deficits. But the combination of last fall’s weak revenues and the
tightening of the credit market forced the state to consider borrowing from the
federal government to meet cash-flow needs. Instead, the state halted funding
for thousands of infrastructure projects to conserve resources.

Depleted rainy-day fund — Currently, the state can set aside
up to 5 percent of the general fund, but often doesn’t. Proponents of a ballot
measure that would increase that level to 12.5 percent say a higher threshold
could have ensured that the state had enough money to fill some of the deficits,
rather than make cuts to programs or resort to layoffs.

An adequate rainy day fund also makes it easier for states to borrow money
for financing both long-term and short-term projects. California’s credit
rating fell earlier this year to the lowest in the country.

Antiquated tax system — Like most other states, California
has a tax system that hasn’t kept up with the times. The U.S. economy has
shifted from producing goods, like cars and appliances, which most states have
taxed since the 1930s, to producing services, which most states do not tax.
Consumers also are buying more online and often avoiding paying state sale

A 2007 Federation of Tax Administrators survey showed that California
taxes 21 services out of the 168 that were included in the survey.

Not only are states collecting less revenue under an antiquated system, the
demands put on states are actually increasing, especially on the health-care
front. Simply put, the tax structure
doesn’t generate enough revenue to cover all the services that the state

For many of these reasons, California was one of the bottom two
states in the Government Performance Project (GPP)’s money
last year, with a D+. Like, GPP is a project
of the Pew Center on the States.

Are there lessons for other states?
Scott Pattison, executive director of the National Association of State
Budget Officers, said other states can learn from California’s mistakes by
making sure they have flexibility in their financial management systems and
“avoid walling things off” so that cash reserves can be tapped during a

He also said states “need to get out of this culture of silos where everyone
is trying to protect themselves and stand up and do what is right for the entire
state in the long term, rather than everyone protecting their own slice of the

California’s panoply of problems may make its budget crisis stand out, but
some experts say similar budget nightmares are likely to hit other states during
the years ahead.

“When the budgetary choices become more politically painful, there's a danger
that other states will descend into California-style gridlock,” said Robert B.
Ward, director of fiscal studies at the Nelson A. Rockefeller Institute of
Government, the public policy research arm of the State University of New York.

After states weather this recession, they will still have billion-dollar
headaches. The year after a recession is over is always the hardest for states
because Medicaid rolls and other public safety net programs have swelled,
creating an ongoing difficulty for budgets. The National Governors Association
has estimated the states’ budget gaps could top $230 billion through 2010.

A longer-term problem is the burden of health care and pension benefits for
retiring state workers that are expected to total $2.73 trillion over 30 years,
according to a study
from the Pew Center on the States.

Ward of Rockefeller expects states will be forced to make more unplanned
spending cuts and painful tax and fee increases, reshape programs to emphasize
revenue rather than effectiveness and shift more of the costs to the next
generation. “California, here we come?” he asks.


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