Not All That Glitters is Golden

Shauna and I are spending the next two weeks in sunny California not an hour’s drive from ground zero of what will likely be the biggest financial mess in any state’s history. Plenty of talking heads are pontificating about exactly what’s causing the problem. Most of them blame one thing or another, but they’re missing the point. California has managed to produce a perfect storm for their current crisis.

A lot of people blame Prop 13, California’s famous restriction on property taxes. The measure caps property tax rates at 1% of total value and restricts the increase in assessed value to 2% per year. Property taxes happen to be a very stable source of revenue when used properly, thus they often form the solid base for basic services such as schools, transportation, and public safety. Unfortunately, restricting the rate made property tax revenue vary wildly from boom years to bust years. Compare this with Utah’s “truth in taxation” system whereby the restriction is upon the revenues collected, not the rate imposed. Not only is Utah’s system more resistant to economic fluctuations, it accomplishes the true end goal to not tax people out of their homes. You can see where Cailfornia went wrong, causing property, sales, and income taxes to all fluctuate with the economy.

The measure also restricted the Legislature from raising any state tax rate without a 2/3 majority vote. On its own, this seems like a good idea that would restrict state government from overextending itself. In practice, however, California has managed to act just like the federal government and borrow in lean times to make ends meet while failing to pay down debts in good times. In fact, good times usually resulted in a glut of new ongoing spending that made successive shortfalls even more painful.

It also didn’t help that legislators are required to pass a balanced budget every year with a 2/3 majority, something that has caused frequent budget gridlock. Since Republicans never budged on raising taxes and Democrats never budged on cutting spending, California has put itself into a position where the budget needs to be loaded with special interest line items designed to buy votes, not too unlike the recently passed federal stimulus package. Public employee unions also play a strong role in crafting the budget, none of them willing to accept cuts in their special interest areas. That the Legislature passes a budget at all is a minor miracle.

This is only made worse by the initiative process in California. Every year, voters approve mandatory special interest spending that the legislature is required to fund. At the same time, they repeatedly reject any measure that would raise taxes to pay for these same items. This truly bizarre behavior, a “yes to cookies, no to calories” approach, takes an already thinly stretched budget and tries to get it to go even further. Given our collectively tendency to buy things we can’t afford using credit, this isn’t too terribly surprising.

Now the debt gravy train is rapidly coming to a close. One of the main bond-rating firms recently devalued California’s bonds to BBB, two steps above junk status and a notch below Louisiana. As investors lose confidence in California’s ability to repay its debts, interest rates will rise and the state will completely lack available credit.

A responsible Legislature would have a hard enough time doing the right thing with their hands so tied by voters. The current irresponsible cabal, though, has kept on chosing to spend irresponsibly in the good years so that these restrictions are made much worse in lean years. I believe California has placed itself in an intractable position with no easy answers. Is it any wonder that they have now become The Pyrite State?