The roots and ripple effects of Calif. deficit

Governor Davis urges tax hikes as part of a plan to fix a shortfall bigger than those of all other states combined.

It is larger than the budget of every other state - except New York. It is greater than the annual economic output of Bulgaria or Afghanistan. Indeed, it is so massive that one of the world's leading credit agencies sees no possible budget solution this year.

It is California's deficit, and on Friday Gov. Gray Davis revealed the consequences of being $35 billion in the red. In his proposed budget, schools, the poor, and the ill will face service cuts of $21 billion. The rest of the state will swallow $8.3 billion in income and sales taxes, and various fees.

California's deficit, by some estimates larger than the deficits of all the other states combined, is partly due to the Golden State's own peculiarities - from its reliance on high tech to a raft of binding ballot initiatives. Yet it is also simply a more extreme example of what has happened in nearly every state.

As such, California offers insight into how states have found themselves with such dire deficits, even amid a relatively mild downturn - and what it will take to get back to a balance.

"[For every state] revenues have been unbelievably volatile," says Alan Auerbach, an economist at the University of California at Berkeley.

Blame a stock-market boom unlike any in United States history. Not that legislators haven't dealt with cycles of boom and bust before. But during the 1990s, the stock market brought money such as states have never seen before.

From 1999 to 2001, California taxes on capital gains and stock options rose from $8 billion to $17 billion. Flush with surpluses that seemed to have no end, the state budget signed in 2001 - at $103 billion - was one-third larger than the one signed two year earlier. The Legislature gave back billions more in tax cuts.

When the stock market slipped last year, the taxes tied to it dropped to $6 billion. Yet the budget has largely remained unchanged - now tied up in long-term education and health-insurance initiatives. Even Governor Davis's supposedly grim budget proposal still tips $96 billion.

Clearly, part of the problem was innately Californian. As the capital of the New Economy and the great engine of dotcom wealth, California was more vulnerable to the vagaries of the stock market.

"We should have known what would happen," says Professor Auerbach. "But there was no mechanism for planning for that in the budget."

To guard against stock-market swings, many states set up rainy-day funds. Yet even among those more cautious states, California's experience is a template of what went wrong nationwide: States committed to tax cuts or spending that have persisted well after the gold rush of investor cash evaporated.

"That's one of the major lessons that's going to come out of this," says Scott Pattison of the National Association of State Budget Officers in Washington. "How do you identify the revenues that are one-time only and spend [them] in a way that's not recurring?"

California, though, has created its own share of problems. More than $10 billion of the shortfall exists mainly because legislators didn't want to deal with it last year. Part of that has to do with 2002 being an election year. But a tangle of unusual laws doesn't help.

For one, California is one of only three states - along with Arkansas and Rhode Island - that require a two-thirds majority to pass the budget each year. And even here, where Democrats are only a few seats short of that threshold in both houses, unanimity on tough cuts is next to impossible.

"Pushing it off to another year is the one thing they can all agree on," says Auerbach.

Moreover, Californians have taken to frequently passing ballot measures that limit lawmakers' discretion when shaping a budget. One, Proposition 98, provides a formula to ensure that a minimum amount of the general fund is spent on education. Another, Prop. 42, moves gasoline taxes from the general fund to transportation projects.

"It's a way to make sure something gets funded, but it's not a good way to do a budget," adds Auerbach.

Thankfully for lawmakers, California's energy crisis will have little effect on balancing the budget. Ratepayers will end up paying that bill. And in the end, some analysts say, it is the public that will decide how California handles this crisis.

The economy will muddle through, even with Davis's proposed tax hikes, says Steven Levy of the Center for the Continuing Study of the California Economy in Palo Alto. This is a question of how much Californians value services for the poor and for schools.

"What California is struggling with is whether to transfer 1 percent of their income from private spending to public spending," says Levy. "Will we tax ourselves for a year or two to sustain public programs?"

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