June 2001

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State Budget 

By the Cal-Tax Staff

Governor Gray Davis

Spending down the reserve was defended by the governor, who said, "Reserves are for rainy days."

Political columnists noted that the governor, who normally avoids risk-taking, is making a huge gamble by proposing to spend down the reserve.

Reacting to the economic slow down, Governor Gray Davis on May 14 reduced his proposed 2001-02 state budget by $3.2 billion compared to what he offered in January. However, the annual May revision drew heavy criticism because it spends down the state's reserve and puts state finances in a serious bind without a rebounding economy.

Is the governor, known for his conservative fiscal ways, taking too much of a gamble? Should he be slashing more spending?

The governor's new proposal, which was praised by education leaders but panned by Republicans, was not entirely embraced by his fellow Democrats. The Legislature's nonpartisan fiscal watchdog expressed concern over the stopgap nature of the governor's proposed solutions, warning of future budget nightmares.

The $102.9 billion revised budget proposal ($79.7 billion general fund) is $570 million below projected spending in the current year that ends June 30.

Energy crisis: There remains uncertainty over the state's energy crisis. If the governor fails to pull off his plan to sell $13.4 billion in ratepayer revenue bonds to replenish the general fund for tax dollars used to buy electricity, there would be a massive budget problem. The state has already used about $7 billion for electricity purchases. The governor's revised budget assumes the bonds will be sold and the general fund made whole in August. The new fiscal year begins July 1.

Apart from uncertainty over the energy crisis, by spending $5 billion of the state's $6 billion reserve, the state will put out $5 billion more than it takes in during the next fiscal year. This is a "potentially dangerous gamble if the economy doesn't rebound in 2002," reported the San Francisco Chronicle.

Legislative Analyst Sounds Alarm: The Legislature's budget analyst, Elizabeth Hill, also sounded a strong warning that the governor's new budget plan could dig a $4 billion hole that would plague efforts to balance the 2002-03 budget. In her Overview of the 2001-02 May Revision released May 16, Ms. Hill wrote:

"While the May Revision proposal would eliminate the estimated 2001-02 shortfall, it is not a comprehensive solution to the budget problem that has emerged. This is because the May Revision relies most heavily on one-time solutions, even though the revenue shortfall in the budget year is ongoing in nature. Specifically, even if the economy and state revenues rebound in 2002, revenues in 2002-03 would likely fall below expenditures by roughly $4 billion."

Spending down the reserve was defended by the governor, who said, "Reserves are for rainy days" and "we are getting out our umbrellas." However, there appeared to be a significant risk that such a move will require tax increases or deep cuts in government programs in years ahead. Senate Budget Committee Chair Steve Peace told the Los Angeles Times that using the reserve "was the obvious thing to do. But I am afraid the obvious will set us up for huge future problems."

As a hint of what might be shaping up, historians point to 1958, when then-Governor Goodwin Knight decided to empty the "rainy day" reserve fund that had been started by Governor Earl Warren in the 1940s. As a result, taxes went up in the Pat Brown era. Something similar happened in 1966, before Ronald Reagan succeeded Brown and inherited a budget mess. Ditto in 1982, Jerry Brown's last year as governor, leaving George Deukmejian with considerable budget woes.

Assembly Republican Leader Dave Cox said the May Revision was the May "revulsion." He said the Democrat governor wants to "loot" the state's prudent reserve to fund government growth. Republicans had urged the governor to fund a 5 percent reserve.

While Democrats hold strong majorities in both the Senate and Assembly, the budget bill cannot pass without Republican votes, and Mr. Cox vowed to make a larger reserve a top priority. The Chronicle quoted the minority leader: "I'm very troubled because no reserve means no room for error - and the governor has made too many errors already."

Senator Peace said the governor should have been "more aggressive" in cutting spending. It would be better to have an "extraordinary reserve," he noted in The Times' coverage. In response to the legislative analyst's critique, Senator Peace told the San Francisco Chronicle that both the Department of Finance and the legislative analyst have reputations for underestimating sizes of surpluses and shortfalls. "Those numbers could be optimistic because they forecast an upturn in the fourth quarter of this year. I don't see that. The $4 billion may be low. It could be $16 billion," the senator said. He added that the governor's revised budget can be cut "without doing severe damage to programs. The damage would be to political constituencies. If we don't act now and prudently, the following year we will do damage to real people."

The governor was hammered in newspaper editorials, including this passage from The Sacramento Bee: "Davis' failure to get out in front on electricity turned a problem into a crisis that might have been avoided. California must hope that the governor's failure to lead on readjusting state finances to new economic circumstances doesn't cost so dearly."

Political columnists noted that the governor, who normally avoids risk-taking, is making a huge gamble by proposing to spend down the reserve. They say he's banking that the storm now raining on the state's economy will turn out to be a mere shower.

The governor's proposal also abandons nearly all of the modest tax-cut plans that he unveiled last January, including a ballyhooed three-day sales tax holiday period for back-to-school shoppers in late August.

Instead of $108 million in tax-cuts that he proposed in January, the governor trimmed the budget-year list to $70 million that businesses would save through an increase in the manufacturers investment tax credit (MIC) from 6 percent to 7 percent, while extending the program's employment test sunset to January 1, 2008.

The only other survivor from the January budget proposal is the proposal to increase the small business capital gains exclusion from 50 percent to 100 percent, which, beginning in 2006-07, will save taxpayers $30 million per year.

Jettisoned Tax Plans: "The remaining tax proposals from the January budget are withdrawn," Finance Director Tim Gage told reporters. These include the one-time sales tax holiday on clothes and computers as families shop for the new school year. It would have saved shoppers about $27 million.

Also dropped were an expansion of the sales tax exemption for space launches ($6 million); an employers transit pass tax credit ($3 million), a tax credit for employers that loan employees to teach math and science in schools ($1 million), and an extension of the MIC to software developers ($1 million).

With a projected reserve of $1 billion, the state's general fund would fall below the threshold of a 4 percent surplus in back-to-back years that automatically triggers a 0.25 percent sales tax reduction. Thus the Davis Administration expects the state sales tax to be restored to a rate of 6 percent as of January 1, bringing in $600 million in revenue for the second half of the fiscal year.

Governor Davis also announced that he wants to defer for two years the transfer of gasoline sales tax revenue to transportation improvements, keeping $2.5 billion in the general fund. Republicans fought hard to achieve this transfer in last year's budget debate and may not go along with the delay. The governor said projects in the congestion relief construction pipeline will be funded as scheduled under the current timetable, and money will be available when needed in two years. He conceded, though, that his plan would make it hard to add new projects to the program in the next couple of years. However, the legislative analyst said the proposal could negatively impact the State Transportation Improvement Plan over the next few years.

Among other reductions, the governor pulled back his proposal to give $250 million to local governments. He reduced the "clean beaches" program to $10 million, instead of $100 million.

Governor Davis said he would continue to spend more money on schools than the law requires, even though the per-pupil spending would decline slightly, by $6 per student, from his January proposal. He proposed to give schools more than $540 million to help them meet higher electricity costs, as long as districts engage in conservation programs that cut energy use by at least 10 percent. However, Legislative Analyst Hill said the May revision represents a $255 million general fund decrease of Proposition 98 school funding for the budget year.

The governor also wants the state's Franchise Tax Board to bring in more revenue - about $150 million over the next two years - by expanding the number of tax collectors by 123 at a cost of $7.6 million. Auditors will get less for travel and printing, with a budget that reduces funding by more than $1.2 million.

More Bad News: A day after the governor's May revision was released, Wall Street reacted negatively. Moody's Investors Service lowered the state's credit rating from Aa3 to Aa2 on $19.8 billion of state general obligation bonds, and Moody's analyst Raymond Murphy said the failure of the governor to gain bipartisan support for a bond measure to repay the general fund for electricity purchases "threatened to compound the risks and costs of this power crisis," The Associated Press reported.

Governor Davis said the state was fortunate that he insisted on using one-time revenues for one-time programs since taking office in January 1999. However, George Runner, lead Assembly Republican budget-writer, said: "It's interesting to say that and have government grow by a third in the three years you've been in office."

The governor blamed Assembly Republicans for the Moody's downgrade, noting that it followed actions by the Republicans that prevent the state from marketing ratepayer bonds until later this summer. However, Moody's suggested that the governor's revised budget "leaves little cushion for additional bad news."

Ted Gibson, the governor's chief economist, told The Sacramento Bee that California will avoid a full-blown recession this year and there will be gradual improvements in 2002 and 2003. "I would argue that the big drop in stock market income has to be considered a one-time affair, and is not going to provide a huge drag," he said.