Politicians and policymakers are watching a fiscal train wreck unfold in California with a sense of horror – and foreboding. The state is entering the third month of a budget impasse aimed at closing a $19 billion deficit. Unable to agree, legislators are now working on competing budgets, neither of which appears to have the support to pass into law.
California controller John Chiang could start issuing I.O.U.s to the state’s vendors in an effort to retain enough cash to avoid defaulting on the Golden State’s debts. It’s the equivalent of putting the mortgage payment on a credit card, some experts contend. It staves off the inevitable, but makes things worse with every passing day.
“California is the canary in the coal mine,” said John J. Pitney, professor at Claremont McKenna College. “And the canary is dead.”
But what has experts riveted is the sense that California’s woes are a cautionary tale – not just to other states, but to the federal government. Some fear that while California is closer to the fiscal abyss, the federal government is catapulting toward the same destination at breakneck speed.
"California is the canary in the coal mine," said John J. Pitney, professor of government at Claremont McKenna College. "And the canary is dead."
To be sure, the federal government has the ability to print money and set monetary policy — tools that state budget officials don’t have.
“We are coming to the day of reckoning in California sooner because we have to balance the budget, and the federal government doesn’t have that same constraint,” Pitney added. “But sooner or later, when spending reaches 90 percent of Gross Domestic Product, you run out of borrowing power. Then you have to start making very difficult choices.”
Budget-watchers suggest lessons for the federal government from California’s situation:
Move Fast on Pensions: A decade ago, California was contributing just $150 million annually to pension funds for public employees, Governor Arnold Schwarzenegger told a crowd at the Goleta Valley Chamber of Commerce. Today, the state is shelling out $6.5 billion for pensions and health care benefits for retired workers. And pension promises become more costly each year, gobbling up money needed to finance other valuable programs.
“You have to take money away from prisons, from higher education, from childcare and in-home supportive services,” Schwarzenegger said. “All those programs are very important, but they are being robbed blind by the pensions of public employees.”
Social Security and Medicare threaten to do the same to the federal budget, said Scott D. Pattison, executive director of the National Association of State Budget Officers. This year for the first time, Social Security paid out more than it brought in from employment taxes, according to the annual Social Security and Medicare Trustees’ Report. By 2014, these deficits will be common and increasingly large, as retiring baby boomers overwhelm taxes paid by existing workers.
That looming crisis could easily be solved by making two relatively minor moves now, said Pattison. He suggests raising the cap on income subject to employment taxes (now $106,800 a year), and gradually raising the normal retirement age. “If you did that now, you would fix it long before there was a crisis and you could make changes in such an incremental way that the pain would be minimal,” Pattison said. But he noted that politicians are loathe to tinker with popular programs, particularly in an election year.
Broaden the Tax Base: When the recession hit in 2008, California’s finances fell off a cliff. In just one year, the state’s tax revenues slid from $103.4 billion to just $87.8 billion. Since the state was already spending more than it took in, that decline in revenue demanded drastic budget cuts and tax hikes to bring the state’s finances back into balance. Now, legislators on both sides of the aisle feel as if they’ve compromised too much and are unwilling to do it again, leading to the near-record delay in passing a workable budget.
The decline in state revenue could have been avoided if the state had restructured its tax system, said Bill Ahern, director of policy and communications at the Tax Foundation, a Washington, D.C., nonprofit that does research on tax policy. Right now, income and property taxes bring in the bulk of state revenue. Those taxes tend to hit the rich hardest, which might be an attractive public policy goal, but isn’t good strategy to achieve steady revenue because both high paychecks and property values tend to get hit hard in a recession.
To ensure steady income, Ahern suggests taxing more people at least a small amount, such as with a broad-based sales tax. Although California has a sales tax and a high one at that, the state exempts many purchases — most significantly, groceries and services.
There is a sales tax on a stationary bike to outfit your home gym, for example, but fees for a gym membership are tax free. A meal at a restaurant is taxed, but food at the grocery store is exempt. Jean Ross, executive director of the California Budget Project, objects to taxing grocery sales because she says that hits the poor the hardest. Ahern counters that a small fraction of grocery buyers might not be able to afford the tax, but that doesn’t mean you should give everybody else a free ride.
"It’s a dangerous misconception to think that any budget deficit can be bridged by raising taxes on the top 1 or 2 percent of the population."
“If your expenditures are hard to amend, you have to make sure that your revenue is steady-eddy,” Ahern said. “If you turn your tax base into Swiss cheese, you’re not going to have a lot of cheese.”
The federal government has turned its tax base into Swiss cheese with deductions and tax credits for everything from housing to education to simply having children, Ahern adds. The result is that nearly half of Americans don’t pay federal income taxes.
Targeted tax cuts — like the $8,000 first-time home buyer tax credit — are just government spending by another name, he said. Pulling an increasing number of people out of the tax system with these “tax expenditures” places a sometimes crushing burden on the relative few taxpayers who are left.
“It’s a dangerous misconception to think that any budget deficit can be bridged by raising taxes on the top 1 or 2 percent of the population,” Ahern said. “California’s tax system and budget debacle is the poster child for why that doesn’t work.”
The challenge, of course, is that it’s politically popular to spend money; it’s tough to cut. It sounds good to say that you’ll raise taxes only on the rich and you’ll cut just “waste and fraud,” said Pitney. But in reality, there’s not enough “waste and fraud” to make a dent in a trillion-dollar federal deficit and there aren’t enough rich people to soak.
“At some point, you have to cut real programs that affect real people,” Pitney said. “The idea that you can reduce spending without pain is fanciful.”