California-size budget mess faces governor

The two months of grinding, 18-hour campaign days are over. The high-pressure fundraising and strategy meetings about policies and opponents' attacks are past.

Now comes the hard part.

The governor of California will oversee the biggest budget crisis in the history of America's most-populous state. In fact, the Golden State's fiscal shortfall far outweighs that of any other state. It's these complex economic challenges that fueled the historic recall, and voters will expect him to tackle them head on.

"There are more economic challenges to the next governor of California than you can fit on paper," says Ross DeVol, director of regional studies at the Milken Institute in Santa Monica, Calif.

With revenues pinched, bond ratings plummeting, companies making an exodus, and deferred budget deficits, the intractable problems could fill a David Letterman "Top Ten" list of "Why anyone who wants this job is probably nuts."

The three most pressing challenges for the governor, according to Mr. DeVol and other analysts, are the state's tax structure, a term-limits law, and budget-approval provisions.

Since California's tax system relies heavily on sources of personal income that fluctuate wildly - such as capital gains and stock options - state leaders often fund social programs based on erroneous estimates of incoming revenue. Such was the case leading to California's recent years of budget deficits, including an $11 billion shortfall in tax revenue that happened between 2001 and 2002, the year after Silicon Valley's high-tech, dotcom industry went bust. Unemployment, a nagging issue for the state, has also hurt incoming revenue.

"California has yet to find a way to swallow the money they lost in personal income tax that year," says Claire Cohen, an analyst at Fitch Ratings, a bond rating service. When the income dried up, legislators were stuck with the conundrum of which programs to cut amid pressure to raise taxes.

"Even if recession ends and jobs come back in a big way to the state, it's not going to bring back the kind of money that was coming in during that year," says Ms. Cohen. "The legislature is going to have to look at ways to get longer-term solutions by relying on less volatile income."

The occupant of the governor's mansion must confront the reason California's budget woes seem to make headlines every year: a tricky negotiation process in the legislature. The threshold of votes needed to pass a budget - two thirds, which is higher than most states - means small groups can hijack the process by demanding favors in return for their support.

Related to this is the state's redistricting in 2000. In order to maximize the number of pro-Democratic seats, Democratic redistricters redrew the previous lines in such a way that a large majority of both Republican and Democratic districts were considered "safe seats" - meaning they would have little or no opposition from the opposing party. Such districts spawn far-right or far-left candidates who tend to be less prone to compromise.

"Either the new governor will have to be willing to expend lots of political capital to get these people to budge, or the state will have to reconsider its two-thirds threshold," says Ted Lascher, chair of the Public Policy and Administration Department at California State University, Sacramento.

There aren't enough skilled leaders to make that happen. Since the state passed term limits in 1992, the legislature has been home to a large number of novice lawmakers.

"There is very little institutional memory left in the California legislature because so many of its career politicians had to move on," says Jack Kyser, chief economist for the Los Angeles Economic Development Corporation. "Many were not around when the state went through a similar crisis in the early '90s and thus have no experience to draw on."

To cut through these obstacles, California's governor will need to exhibit qualities of leadership, persuasiveness, political savvy, and the ability to intimidate as well as forge a diplomatic compromise, say experts.

Those abilities will be severely tested. California has borrowed heavily to finance this year's budget, allowing $8 billion in debt to roll over until next year. Borrowing to cover debt is also increasingly expensive, as the state's bond rating deteriorates.

That means either cutting spending by that amount - about 8 percent of the state's $100 billion budget - or reducing outlays on education, health, welfare, prisons, and other services. So far, Democrats have not wanted to make cuts, and Republicans have not wanted to raise taxes. "Republicans clutch to their no-tax mantra like religious zealots while the Democrats have never met a spending program, or a tax, they didn't like," says Joel Kotkin, senior scholar at the Pepperdine School of Business.

The good news is that the governor is likely to have a window of time in which compromise is more likely. The pressure is to create the perception that change is imminent - a perception that has vital implications for businesses considering moving to California, and for bond firms assessing the state's problems.

"Because the state's problems have been so entrenched, everyone is going to be more open to change for a period," says DeVol. "How the new governor deals with these problems in whatever honeymoon period he has is likely to shape the economic and business environment in the state for years to come."