Spending Problem, Still

June 15, 2005 • Commentary
This article first appeared on National Review Online on June 15, 2005

Last Monday Governor Schwarzenegger announced that California will hold a special election this fall on several high‐​profile initiatives.

While Schwarzenegger’s willingness to use the initiative to circumvent the legislature is admirable — going straight to the voters — the content of these initiatives is in many respects disappointing.

Schwarzenegger withdrew support from previous efforts to use initiatives for pension reform and reducing bureaucracy. But what is perhaps most disappointing is his fiscal‐​reform initiative. While his Live Within Our Means Act is a well‐​intentioned effort to minimize the severity of the next budgetary shortfall, it fails to place effective curbs on spending. Such curbs are necessary to ensure long‐​term fiscal solvency in the Golden State.

Shoring up California’s finances has been one of Schwarzenegger’s top priorities since taking office. During the recall campaign and after his inauguration, Schwarzenegger considered promoting an expenditure limit to reduce the $38 billion deficit his predecessor, Gray Davis, left behind. Yet Schwarzenegger instead compromised with Democratic legislators to support a measure that would tighten California’s balanced‐​budget amendment. Since that time, Schwarzenegger has kept a tight lid on government spending and earned the top grade among all governors in the Cato Institute’s 2005 “report card” on governors.

Still, California remains over $8 billion in debt. As a result, Schwarzenegger is promoting the Live Within Our Means Act, a ballot initiative designed to minimize the size of the next budgetary shortfall. Under this proposal, spending increases would be limited to average revenue growth for the previous three years. As such, when revenues are booming, part of the money would have to be diverted to a reserve fund. Then when the economy slows, money from the reserve fund could be used to maintain expenditures.

This proposal would limit the amount government could expand during times of prosperity. However, the sizeable reserve funds would provide legislators with very little incentive to economize or downsize during recessions. Furthermore, legislators might be even less likely to cut taxes since any revenue declines will result in immediate budgetary cuts. Overall, while this proposal may reduce the size of the next budget shortfall, it fails to remedy the high spending, high taxes, and sluggish economic growth that currently plague the Golden State.

Schwarzenegger should instead focus on the causes rather than the symptoms of California’s fiscal problems. California’s fiscal woes stem from the use of highly volatile revenue instruments combined with the legislature’s inability to place institutional or political limits on spending. As such, when the economy is doing well, soaring revenues are quickly spent by eager legislators, resulting in sharp budgetary increases. Then during economic downturns, revenues crash, creating sizeable fiscal shortfalls in California.

There are a number of reasons why tax revenues in California are so volatile. The most important is that the state government obtains most of its revenue from a progressive income tax. With a bottom rate of one percent and a top rate of 10.3 percent, California’s is easily one of the most progressive state income taxes in the country.

If California moved to a flat income tax like those of Colorado, Indiana, Illinois, Massachusetts, Michigan, and Pennsylvania, it would not only stabilize government revenue but save California taxpayers countless hours when filling out their tax returns.

More important, California’s persistent budget deficits have been brought on by sharp budgetary increases, particularly during the technology boom of the late 1990s. This problem could best be handled by a constitutional revenue or spending limit. During the 1990s, limits such as Colorado’s Taxpayer’s Bill of Rights and Washington State’s I-601 have demonstrated success at limiting the growth of government. Furthermore, Governor Schwarzenegger needs to look no farther than his own state for another example of an effective spending limit.

California’s Gann Limit, which was approved by 74 percent of California voters during the tax revolt in 1979, placed a low limit on appropriations of tax revenue. Indeed, between 1980 and 1991, California’s rank in state per‐​capita expenditures fell from seventh to 16th. Its rank in per‐​capita revenues showed a similar decline during the same time period. Subsequent ballot initiatives in the late 1980s and early 1990s severely weakened the Gann Limit, rendering it virtually powerless. However, the Gann Limit still provides a working model of how a spending limit could work in California.

Governor Schwarzenegger erred when he failed to aggressively pursue a similar constitutional spending limit after his inauguration. Even though he has done an admirable job in limiting spending since then, he will not be governor forever. The window of opportunity for enacting serious fiscal reform may therefore be closing. Ensuring California’s long‐​term fiscal solvency by revamping the tax code and placing effective limits on government growth would be a great legacy for Governor Schwarzenegger to leave behind.

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