UC Berkeley News


Rosen: The governor’s budget fails to address state’s biggest problems
Haas economist insists that Schwarzenegger ‘has to tackle the painful things’

| 11 February 2004


Ken Rosen
Bonnie Powell photo

During California’s gubernatorial recall campaign, Haas School of Business professor Ken Rosen decided to look beyond the political mudslinging and examine why the state budget was gushing red ink. In September 2003, Rosen, an economist and the chairman of the Fisher Center for Real Estate and Urban Economics at Haas, released “Anatomy of the California Fiscal Crisis: Facts and Figures Do Matter,” a report that examined the origins of the state’s fiscal crisis, identified problems with its revenue system, and suggested areas for reform.

The facts and figures that Rosen cited still matter, perhaps even more so now as the state Legislature considers the budget proposal put forth by Governor Arnold Schwarzenegger.

Why is California’s budget so deeply in the red?
There were a number of small things that contributed to it, including the energy crisis. By far the biggest reason we have a structural deficit is the increase in temporary revenue that was not perceived as temporary by the spenders of the money. There was a huge increase in revenues in 1999 and 2000 from taxes on stock options and capital gains. No one in Sacramento realized the revenue surge was temporary. It happened when the stock-market boom happened; then the boom ended and revenues went back to normal levels. The governor and the legislators increased expenditures to meet those new levels of revenue, totally understandably, but as a consequence we ended up with a budget that’s too swollen for the revenue base that we’ve now got.

Hindsight is always 20-20, of course, but was there anything that should have indicated that these increases were temporary?
They should have looked at the components of those revenues. The stock market had already crashed by the time we had the big one-time surge in capital-gains and stock-option taxes. By November 2000, everyone knew that the stock-market boom was over. They had plenty of time to adjust, but they didn’t act on the news until a year later.

However, they were not alone: I don’t recall anyone writing about it at the time, saying “Don’t believe that money because half of it’s yesterday’s money and it won’t be here tomorrow.” By then it was already built into the budget.

Why not simply cut the programs for which funding was increased during the revenue surge?
They’re programs that are painful to cut for lots of reasons. Education, very painful; we’re probably underfunded on education, and have been since Proposition 13 [the measure freezing property- tax increases at 1 percent per year, enacted in 1978].

That’s when California’s ranking in per-capita spending on education dropped dramatically.

You would think that prisons would be easy to cut, but somehow that can’t happen because of political forces. Health-care benefits: Again, we could probably tighten up the way some of those things are done, but it’s painful to cut off needy people. The University of California: one could easily argue that all UC schools are somewhat underfunded relative to their rivals around the country. The community colleges, meanwhile, perform a very important service.

It’s hard to make these calls. Yet clearly that’s what people elected the governor to do — to make those painful choices. We hope he has come in with a clean slate, and we’re all waiting to see what happens. But we have to give him time. He’s only been there three months.

Governor Schwarzenegger has vowed to reduce the state government as a cost-saving measure. Is California’s government bloated compared to other states?
No. When I heard all this talk in the campaign, I said, “Let’s look at where California sits in relation to other states.” We’re not, by any means, the biggest-spending state per capita. We’re in the upper third. California has 13.2 state employees per one thousand residents. Of the ten largest states in the U.S., six have more employees per capita than we do, including New York, Texas, and Georgia.

California supposedly depends on personal taxes more than other states do. Is that perception also inaccurate?
Yes. California’s state and local taxes as a percentage of gross state product were about 8.5 percent in 2000. That puts us in the middle of the ten largest states. Michigan and New Jersey’s are higher, and we’re about even with New York and Florida.

And when you look at just property taxes, as opposed to all personal income taxes, we’re just about the lowest state. California’s property taxes account for 25.6 percent of total tax revenues, compared with the national average of 33.2 percent. In Texas, the ratio is 43.9 percent; in New York, 39.5 percent; in Oregon, 33.4 percent. When [well-known financier and investor] Warren Buffett, who was advising Schwarzenegger during the campaign, mentioned how unjust California’s property-tax structure was, Schwarzenegger told him to do 500 push-ups. That tells you something.

It’s nice to be in a lower-tax state, but you also get fewer services. There’s no free lunch. Schwarzenegger’s bond issue is trying to let us have a free lunch for another year, but we clearly have to address the structural issues or we are never going to get this problem solved.

What about corporate taxes? Do they discourage companies from locating here?
Maybe compared to Nevada that’s true: Nevada is a tax-free state. But we’re not losing business because of tax policy. California’s job growth has been the same as the rest of the United States, maybe even a little bit better. The real problem is that the country as a whole is losing manufacturing, service, and technology jobs to Asia. California is not any more adversely affected by that trend than anyplace else. It’s a national problem.

I would definitely agree that we need to streamline workers’ compensation, all the things that make it less attractive to do business here. The idea of having some sort of public advocate in Sacramento for companies that want to locate jobs here is a good one, to make sure they get through all the regulations quickly. I don’t think we need to give any tax benefits in addition to what we’ve already got.

There are other factors that make it difficult to attract companies. For example, it’s hard to build housing in California, but the governor has appointed a great person to be Secretary of the Business, Transportation and Housing Agency — Sunne Wright McPeak — who is an advocate of housing production and regional planning.

Schwarzenegger has great people around him. Edward Leamer [UCLA economist] is fantastic, George Schultz [former Secretary of State] — I would trust my life with him. They’re brilliant people. But if the governor is going to be a true leader in the Kennedy or even the Reagan tradition, he has to tackle the painful things even if they make him unpopular. He certainly has more popularity to spare than most.

How did Proposition 13 and Proposition 98, which upped K-12 education funding using the temporary revenues, create a “permanent budgetary imbalance,” as your report called it?
Although counties collect property-tax revenues, where they are insufficient to fund services like education and policing, the state has to take over. For example, in Alameda County, where Berkeley is, Proposition 13 cut property-tax rates from 4.5 percent to 1 percent. When that revenue disappeared, the state made up the difference in K-12 education and elsewhere and has done so since then.

My guess is that half or more of every county budget comes from state money. That disconnect between the revenue source and the service is a problem. If the money goes to this amorphous group of lawmakers in Sacramento and then everyone lobbies to get it back, that’s wrong. The more closely you can match those things up, the better people are going to feel about paying their taxes.

Proposition 13 is somewhat of a sacred cow. Will it ever be revisited?
Yes — I think even as soon as this year. There are already petitions going around to put something on the ballot in November, called the “dual-” or “split roll,” to tax commercial and residential properties differently. That’s a good idea, but before that even happens, I think we should immediately raise Proposition 13’s limits on property-value increases from 2 percent to 5 percent, for both residential and commercial. It won’t affect anyone very much at all at first, but it will keep parity over time.

Now, how do you go back and change things retroactively? I can’t go there. But at least let’s try to make the taxes correspond to actual property values more immediately.

How did revoking the increase in the Vehicle License Fee affect the deficit?
That was a huge mistake. Schwarzenegger promised something that was wrong, that he should never have promised to do. There weren’t many people who opposed the fee increase. Yes, as a tax it’s a little regressive — poor people pay a higher percentage [relative to their incomes] than rich people do. Maybe the tax should have been structured differently, but simply revoking it was done purely for political reasons and has created a huge, gaping hole in the budget.

Won’t Schwarzenegger’s bond measure correct the problem?
No. The real solution, which neither the Legislature nor the governor wants to do, is to decrease expenditures dramatically and raise revenues through taxes. They must solve the structural problem. California can get through this in the short run, with the bond, but in the end, the bond takes money from the next generation of people, from the infrastructure and the things that we need. Our health-care system is broken; our education system is as good as broken. Why concentrate on attracting businesses to the state if there will be no skilled employees for them to hire?

That said, the bond may be the least painful way to address the issue. I haven’t decided how I will vote yet. All the bond does is postpone the pain, but maybe that temporary solution is the right one until we can make deeper changes. That does not make it good public policy, however.

The economy seems on track for a recovery. How much will that help California?
The state of California is going to follow the national economy in terms of job and income creation. If the U.S. economy continues to improve this year, I wouldn’t be surprised to see between $2 billion and $3 billion of additional unexpected revenue show up for California. That’s a good thing. We did have a big stock-market increase last year, but a lot of it was just making people’s money back from the big losses of before.

However, an economic recovery will not fix this completely. The state will still have a $7-billion or $8-billion deficit. California needs to be led to decide what the right spending amount is for the services we need. The idea of a balanced budget, or I should say a cyclically balanced budget, is crucial. When we have these huge revenue surges, we should put them in a rainy-day fund instead of building them into the budget. If in 1999 and 2000 the Legislature had taken that unexpected $25 billion and put half in a rainy- day fund and spent the other half on one-time infrastructure projects like highways, roads, and school construction, we would have been okay.

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