An Agenda For California’s Fiscal Reform

The California state budget for years has been “balanced” with heavy borrowing, various kinds of raids on localities and special funds, and transfers from the future to the present.

More generally, spending profligacy, high tax rates and onerous regulations have worked their magic: The gap between the ability of the state economy to generate tax revenue and the demands of the spending interests for preservation of their programs is massive — estimated at $20 billion to $25 billion merely for the next two fiscal years.

California fiscal governance thus has hit rock bottom, the only starting point from which real public-sector reform is possible. The state now has an opportunity to impose the hard spending discipline and other reforms necessary to restore fiscal soundness for the state government and competitiveness for the state economy.

• Spending limitation. Because spending interests have large inherent political advantages over diffused taxpayers, a hard spending limit is necessary. But alternative spending limits are not created equal: They provide differing incentives for public officials in terms of tax and regulatory policy and the composition of the state budget.

One common proposal is for a spending limit defined as the budget for the previous fiscal year, adjusted for inflation and population growth. While certainly better than no spending limit at all, this kind of limit is problematic in that it provides few disincentives for the legislature to impose tax increases or costly regulatory mandates.

And by increasing income-transfer programs, the legislature would be able to attract more people into the state and thus increase allowable spending.

Instead, a spending limit defined as a specific percentage of state gross product would provide the legislature with powerful incentives to take actions making the economy bigger rather than smaller. Reductions in marginal tax rates and regulatory restraint are obvious examples.

(For California, such a spending limit might have induced the legislature not to pass such monstrosities as the state’s global-warming law, a regulatory system just now beginning to impose massive costs with no benefits that even the proponents can identify.)

Within the budget, such a limit would create incentives to shift spending to needed infrastructure investments and a system of education yielding stronger achievement outcomes for students instead of more pork for the education establishment. This sort of limit, similar to that proposed by Gov. Ronald Reagan in 1973, might begin at, say, 5% of SGP and then decline slowly to 4%.

• Tax reform. California’s high tax rates (and regulatory policies) have yielded an economic environment roughly the worst among the states in terms of investment and employment incentives.

Because revenues are heavily dependent upon the taxation of higher incomes, capital gains and stock options, they are highly volatile in the face of changing economic conditions. And this narrow tax base means millions can vote for more government while bearing little of the added costs.

So tax rates must be reduced and the base broadened. Just as the needed reductions in tax rates will be impossible to achieve without spending discipline, tax reduction and reform are necessary for spending limitation, because spending will be difficult to control as long as a substantial part of the electorate pays little in taxes.

In short, such tax reform — a shift to a flat income or consumption tax of, say, about 5% — would improve the state’s competitiveness, reduce political pressures for spending growth and smooth revenue flows.

One remedy often proposed for the revenue volatility problem is a large “rainy-day” fund, to be increased when revenues are strong and spent when they are weak. But the existence of a large rainy-day fund is inconsistent with tax reform, in that it “solves” the revenue volatility problem without tax reduction or a broadening of the base.

Therefore, it does little to improve competitiveness. It also is inconsistent with spending limits, as it does little to change the incentives of those paying little in taxes to vote for more government spending. Therefore, proposals to limit state spending while establishing substantial rainy-day funds are inherently inconsistent, and the California electorate was wise to reject a toothless version of just such a plan earlier this week.

The opportunity for real reform now is huge, even more so than in 2003-2004, when the newly elected Gov. Schwarzenegger decided to use his immense political capital for such infantile pursuits as permits for hybrid autos to use the car-pool lanes.

But the need for such substantial reforms — far more than mere adjustments at the margins — also is great, in that nothing less than wholesale institutional reform will lead California out of the abyss.

Public education must be forced to compete, and the state education funding guarantee must be combined with management reforms, a transfer of authority away from Sacramento, and a system of accountability driven by the welfare of the students rather than the teachers’ unions.

Substantial parts of state operations must be privatized — prisons are a good example — so the monopoly power of the public employee unions can be reduced. Moreover, the existing contracts with large numbers of state employees were negotiated by the unions and public officials dependent upon their political support, hardly an arms length process; the contracts must be terminated and renegotiated.

Spending limitation and tax reform, however difficult, are good places to start.

Zycher is a senior fellow at the Pacific Research Institute.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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