Tuesday, November 30, 2010

The Economic Reality of the California Budget Crisis

The population of Ontario is one fifth  of California’s.  It has the same gross deficit.  However bad California is, multiply it by 5.  Why isn’t Hudak SCREAMING? 



California is a very large room, and perhaps that is why the state’s political machine has so long been able to ignore the multi-billion dollar elephant that is the state budget shortfall. But there comes a point where the size of the room is irrelevant. Where evasion is not only impermissible, but impossible. Where the only alternatives are fundamentally reworking long-standing policies—and being crushed under the weight of the beast. The current budget crisis is proof that California has reached that point.

California’s financial situation is dire. According to the Legislative Analyst Office (LAO), the state faces a $20.7 billion deficit for the 2010-2011 fiscal year. Even the Governor’s Office, which uses more optimistic projections, places that figure $18.9 billion. Recall that the Governor’s Office predicted a $500 million reserve for 2009-2010, while the actual year-end figure was a deficit of $6.6 billion. And the $20 billion deficit for 2010-2011 still masks the actual size of California’s spending issues. Much of the governor’s deficit reduction efforts—approximately 40%— focus not on reducing state spending, but on “aggressively seek[ing] additional federal funding,” with a projected total of $8 billion of California’s spending financed by uncertain, one-time federal relief.

It would be one thing if California had reached this point because low revenues were insufficient to finance necessary spending obligations. But it is quite another when the state has seen revenues increase 30% since 2000, and still managed to bring multi-billion dollar deficits upon itself by expanding its expenditures 17% more.

Figure 1: Expenditure Growth outpaces Revenue Growth:

Expenditure vs. Revenue Growth

There can be no contention that the discrepancy is the consequence of California’s reluctance to tax its citizens. Indeed, the state has long had to maintain some of the of the highest tax rates in the nation to bear the cost of this spending growth. Compared to other states, California has the highest sales tax rate, the second highest top income tax rate, and one of the highest corporate tax rates which translate into the sixth highest per capita collections from corporate income taxes. California’s per capita state tax revenue as a percentage of personal income stood at 6.3% for 2009, well above the national median of 5.8%, and the state had the 12th highest per capita tax burden. Nonetheless, California last year also had the third highest budget deficit as a percentage of its overall budget.

Nor can the spending gap be explained by population growth or inflation. Since 1990, per capita spending has increased over 87%; inflation, as measured by the California Consumer Price Index, rose only 66%.

Figure 2: Per Capita Spending Growth Outpaces Inflation:

Per Capita Spending Growth vs. Inflation

Looking at the operation of the state reveals, all too clearly, that the actual driver of the state budget deficit is inefficiency—systematic, structural, politically sanctioned inefficiency. Per person, California’s spending is the twelfth highest in the nation. Lest anyone claim this is inevitable because of its size, note that California’s per capita spending is 68% higher than that of Texas, the next largest state by population, and 21% higher than the average for the ten largest states by population.

Figure 3: Comparing California’s Per Capita Spending:

Per Capita Spending Comparisons

Much of the reason the state government is so costly to operate is the number of employees it hires and the amount it pays them. From 1990 to 2009, the number of state employees rose approximately 37% percent; the number of state employees per capita, approximately 7%. And some of these employees are among of the highest-paid state workers in the nation. California public school teachers and prison guards, for instance, earn more than their counterparts in any other state, and over $10,000 and $20,000 per year, respectively, more than the national average. At the same time, the state pension system has resulted in $100 billion in unfunded retirement liabilities for state employees, which, the LAO notes, “because of recent investment value declines for retirement systems, may actually exceed $130 billion.”

Figure 4: Rise in the Number of State Employees:

Growth in Number of State Employees

Governor Schwarzenegger has attempted to attribute, at least in part, the state budget gap to the fall in revenues as a consequence of the 2008-2009 recession. But the recession merely laid bare fiscal instability that had been mounting for the past 20 years. The state budget has long been alternating between precarious, short-lived balance and deep, systematic deficits, particularly in the past decade. Looking to projections by the LAO, we see that even during periods of strong economic growth from 2005 to 2007, the state continued to post multibillion dollar operating deficits leading up to the 2008-2009 recession. And, in large part, the only reason the state was able to finance those deficits was through borrowing backing by expectations that housing prices would maintain their steep upward trajectory, since the growth of the housing market was a major source of revenue for the state. Given that the state faced operating deficits while the housing bubble was nearing its peak, it is no surprise that California finds itself with a projected $20 billion deficit for the 2010-2011 fiscal year with the bubble burst and the ramification ongoing.

And those ramifications place significant weight on the state’s fiscal standing, and, in turn, its basic operations. In July of 2009, the LAO released an open letter to a member of the Assembly detailing California’s liabilities, which are not included in the budget deficit calculations. These liabilities totaled over $200 billion, with $63.9 billion consisting of short- to mid-term debt. Around $35 billion of that is the direct result of deferrals and loans the state has used to close past budget gaps. As a reflection as the magnitude of these liabilities, California’s bond rating has fallen sharply in the past decade, leaving it with the lowest rating of any state. This not only makes it more difficult for the state to bring in short-term revenue by issuing bonds, but also increases the long-term interest costs California will have to pay on the bonds it does manage to issue.

But the gravity of the state’s present fiscal distress will be an afterthought if current spending policies remain in place. LAO projections place the annual operating deficit for each of the next five fiscal years near $20 billion.

Figure 5: Projected Operating Deficits under Standing Law:

Projected Operating Deficits

Such deficits are not merely unsustainable—they are unendurable. Given that its liabilities are already massive, California would have no choice but to file for bankruptcy if these projections are fulfilled. We have already begun to see the consequences of forced, unplanned spending cuts. Consider the UC system, for which tuition has risen 32% while its course offerings and student services have been sharply reduced and staff cuts sharply increased. These types of emergency retrenchments, made more severe, and imposed across all state institutions—that is the reality these figures project. And that is the reality California is on course to encounter.

Avoiding that reality demands a diametric change in state spending policy. Such a change, in turn, demands that the voters and political leaders of California come to grasp and apply the basic economic principles which have so long been absent from California’s budgeting decisions. The foremost of these is that state spending is consumption. Every dollar the state spends represents real wealth used, exhausted, depleted. The more the state spends, the more it consumes; but the amount of wealth available for consumption is finite and limited. No number of payments deferred, loans taken out, or shifts from one fund to another, will allow the state to consume more than it brings in, which means, to consume at its present rate.

The implication of this principle is that California’s spending structure must be made efficient. The state cannot afford to continue to pay for any program that chances to find political favor. It must prioritize. We have reached the point where something must be cut—indeed, not just something, but much. And what is maintained, needs to be reformed to function more cost-effectively. California currently has positions, sub-groups, and entire departments charged with the same purpose; eliminating redundancy and streamlining the state government has the potential to reduce spending by billions of dollars. That reduction will require cutting the number, pay, and benefits of state workers. It might be pleasant to entertain the idea of fixing the budget gap without doing so, but the idea clashes with the economic reality that state employees’ pay is a core reason for California’s operating deficits.

These suggestions are common sense. Here, though, applying common sense requires grappling with a complex, large-scale problem. And that is what California’s political leaders have shown themselves unwilling, or perhaps unable, to do. They will ignore the elephant at the peril of the state. If California’s political system is to confront spending excesses and inefficiencies, it is the voters of California who will have to not only point out that elephant, but force their elected officials to take action before what fiscal standing California has left is trampled as well. It is our money that is being consumed. It is our state government that is financially unstable. And it is our responsibility to bring common sense to bear on a budgeting process in which it is precisely sense that has been lacking.

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