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posted by Stephen Lubben

I just gave an interview with a reporter from Santiago, Chile on the situation in California. My assessment of the situation, which may be of interest to Credit Slips readers, follows:

The key problem in California is that the state budget is comprised of many fixed expenses. Many of these were put in place by voter initiatives. That leaves a relatively small part of the budget (welfare programs and the Universities are two of the larger ones) that can be adjusted down when tax revenues fall, such as they have been, because people's incomes have fallen.

So California faces a tough choice of radically cutting its budget -- which may have collateral economic consequences, for example, cutting welfare will dramatically cut spending by the poor -- or finding some other source of "plugging" the hole in its budget. One possible solution would be to borrow money from the federal government. The federal government might consider doing this if it believes that the austerity measures required to balance California's budget would have knock-on effects for the national economy. Given that California's economy is the biggest single part of the national economy -- California's GDP is comparable to France or Canada -- this would not be an unreasonable assumption.

On the other hand, the politics are quite complex. The Republicans in California hold a blocking position (by virtue of rules that require a 2/3 majority in the legislature to pass a tax increase), and generally hope to use the present situation to achieve the kind of minimalist state government they have always desired. And the Obama Administration has to fear that Republicans in Washington, including some from California, will criticize any further government involvement in the economy, particularly involvement that increases the federal debt load.

Thoughts? Did I miss anything?


You are right about the problem, but off on the solution. California needs CONSTITUTIONAL REFORM, so that things like Governor Schwarznegger's initiative mandating funding of after-school programs (remember that one -- it's what put him on the political map pre-Gubernatorial election) don't crowd out the ability of legislators to make choices that we elect them to make. Funding the State Budget by initiative is like festival seating at rock concert -- seems fair to the masses, until somebody gets killed in the stampede.

You mentioned that fixed expenses are put in place by voters, but so are, in a manner of speaking, fixed tax revenues. Prop 13 put in place a situation where California's property taxes are the equavalent of rent control - they can only rise a limited amount every year, regardless of property values (in addition to the 2/3 rule you mentioned).

The solution to California's budget problems is easy. Spending has increased massively over the past decade, far greater than inflation and population growth. Cut back spending to where it was a few years ago, and problem solved. And as for property taxes, while the ad valorem tax based on property value has stayed low due to limits on reassessment, most cities have added special charges which more than make up for that, particularly on commercial properties (I am a commercial real estate broker). In Berkeley, the combined ad valorem tax and special charges on commercial properties can add up to 1 or even 2 months' rent. Difficult enough for an occupied property, even worse for a vacant one, of which there are an increasing number.

The reason that cutting government expenses is so politically difficult, is that state and local employees have a stranglehold on government. Their total compensation is far above typical private sector workers, and they have much more job protection. We haven't gotten there yet, but further increases in taxes and reductions in what that tax revenue gets in the way of public services, will eventually lead to a ballot box revolt, and the mass contracting out of public services such as education. The alternative is bankruptcy.

And as for tax increases, given the hits to salary and capital gains income amongst the top earners, there will not be much revenue to be had from that oft-tapped source. Any tax increase would have to be broad based -- and today's economy is a poor political environment for such a tax increase.

The initiative process in California has led to a complete abdication of California's elected leaders to tackle any of the major problems. In addition, it has hamstrung needed flexibility in both the taxing and spending arenas. But, don't fault the Republicans for trying to force a minimalist government that works with their 2/3 veto power. California ranks in the top five in total tax burden placed upon its citizens among the 50 states. Why? Because California is among the most highly regulated states as well. It has myriad layers of boards and regulatory agencies filled with former legislators who've received plum political appointments. To justify their existence, all of these boards and agencies must regulate and enforce something, burdening both businesses and ordinary citizens. California should strip state goverment clean, hold a Constitutional convention and eliminate a whole host of state bureaucrats and employees.

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