California’s ‘Spending Limit’ Is A Sham

California’s ‘Spending Limit’ Is A Sham

The outlook for the California economy is dreadful, driven by a deeply perverse tax and regulatory environment, combined with Governor Arnold Schwarzenegger’s highly successful five-year effort to avoid hard choices.

And so the state budget, the utter profligacy of which for years has been papered over with accounting tricks and massive borrowing, now has imploded: A projected deficit of $42 billion over two years has forced the legislature to cut some spending while increasing taxes by a hoped-for $28 billion. Nonetheless a deficit of $8 billion to $14 billion looms for the next fiscal year.

That is why the legislature and the governor now claim to have found religion: They have placed on the ballot this May an initiative that purports to impose a spending limit and a rainy day fund with teeth.

It will do nothing of the kind: It will put a floor under spending and encourage tax increases, even as the rainy day fund will be weak.

For a given fiscal year, the initiative mandates a revenue projection based upon a 10-year trend line.

The projected revenues determine allowable spending, divided between required deposits into the rainy day fund and normal budget outlays; but the governor is empowered specifically to suspend or reduce allocations to the rainy day fund not only in the face of emergencies, but whenever projected revenues would fail to support spending from the previous fiscal year adjusted for inflation and population growth.

But in years with strong projected revenues, transfers into the rainy day fund would not increase above those required.

And so the inflation/population growth baseline will serve as a floor rather than a limit on spending, yielding higher long-term spending growth and a rainy day fund smaller rather than larger.

Moreover, the population adjustment must be estimated, and so will be subject to manipulation and political pressures for “corrections” of innumerable purported “errors.”

The initiative allows the (assumed) revenues from a tax increase to be included in the revenue projection for the current fiscal year, thus increasing allowable spending.

Inclusion of the new revenues in the projections for future fiscal years is prohibited for the rest of the 10-year period; but that provision is largely inconsistent with the technical requirements of the revenue projection methodology specified in the initiative.

Because those future new revenues to be excluded from the projections would have to be estimated, the inevitable political conflict over the estimates would offer yet another opportunity to circumvent the spending limit.

More important, tax increases have adverse economic and revenue effects over time, consideration of which also is prohibited by the initiative over the 10-year projection period.

Because a tax increase yields more allowable spending immediately, increasing the spending baseline with no recognition of the future adverse economic and revenue effects, future transfers out of the rainy day fund would become more likely, exacerbating the separate bias caused by the governor’s power only to reduce transfers into that fund.

Tax reductions, on the other hand, would lower current projected revenues without recognition of the favorable future effects. Thus does the initiative make future tax increases more likely, and future tax reductions less likely.

The initiative will extend the tax increases recently enacted for one to two additional years, yielding an additional $16 billion in taxes.

The legislature inserted this provision into the budget rather than the initiative itself, in an obvious attempt to mislead the voters. Accordingly, the initiative should be defeated in part because such dishonesty ought not to be rewarded.

More broadly, the initiative provides incentives for the legislature to substitute regulations in place of spending.

Moreover, the annual population adjustment for allowable spending creates a separate incentive for the legislature to expand income transfer programs, so as to attract more people into the state. This would result in larger constituencies favoring further increases in such programs.

A different approach — a limit defined as some specific percentage of state gross output — would provide Sacramento with incentives to make the economy bigger, by avoiding unnecessary regulations and by finding ways to attract investors and productive workers.

This would be very similar to the spending limit proposed by Governor Ronald Reagan in 1973, which was defeated narrowly.

Because spending interests always have crucial political advantages over diffused taxpayers, an effective spending limit is needed to allow Californians to decide how much may be spent on government programs, just as they must make hard decisions among housing, food, and other competing needs.

The proposed initiative is the product of profligate spending, reduced revenues, and Sacramento dishonesty, and so would discredit the concept of spending limitation. Californians can do far better.

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.