July 21 (Bloomberg) -- California lawmakers reached an agreement with Governor Arnold Schwarzenegger over how to close a $26 billion budget deficit that pushed the most-populous U.S. state to the brink of insolvency.

The deal, reached by legislative leaders after two months of frequently acrimonious negotiations, would slash spending for schools, public works and welfare programs amid the longest recession since the 1930s. If approved by the full Senate and Assembly, the agreement will also siphon money from municipalities, force companies and individuals to pay income taxes sooner and make it more difficult to receive state aid.

“We came to a basic agreement, a budget agreement,” Schwarzenegger told reporters outside his office last evening. “This is a budget that has no tax increases and this is a budget that is cutting spending and it deals with the entire $26 billion deficit.”

The agreement promises to end a battle over the $100 billion budget that forced California to pay some bills with IOUs, pushed debt ratings on $72 billion of bonds closer to non- investment grade and threatened to further batter the state’s economy. It is the second time this year that the government redrew the budget amid job losses that pushed unemployment to 11.5 percent in May and declining incomes that lowered tax collections 15 percent from a year earlier.

Spending Cuts

Senate and Assembly leaders said they will seek to put the proposals to a legislative vote by July 23. It would require passage of more than a dozen bills by a two-thirds margin. While Democrats control both chambers of the Legislature, they are six votes shy of such a supermajority.

The agreement calls for cutting spending by $15 billion, including $6 billion from schools, $3 billion from colleges and $1.2 billion from prisons. Schools will be repaid $11 billion once the state’s economy turns around. It also raises $4 billion by in part accelerating personal and corporate income tax withholdings and increasing income tax withholding schedules by 10 percent.

It also calls for the state to siphon $2 billion of local property taxes meant for cities and cities, $1 billion of gasoline tax revenue meant for local governments and another $1 billion earmarked for redevelopment agencies. Some of that borrowed money would be repaid with interest. Local governments could sell bonds backed by the promise of repayments.

Shifting Funds

The agreement also shifts $1.5 billion between accounts to save money and moves the last payday for state workers in the current fiscal year into the next.

The agreement also would clear the way for new offshore oil drilling along the coast of Santa Barbara, though regulatory details of that plan remain unresolved. The state would earn about $100 million in royalties in the current fiscal year and a combined $1.8 billion over the next decade and half.

Cities and counties have said they would sue to block any attempt by Schwarzenegger and lawmakers to siphon local gas and redevelopment agencies’ monies, arguing that it would violate voter approved constitutional amendments that dedicated those funds for local use only.

“If, in fact, that is what’s adopted by the Legislature, depending on the actual language of the legislation, we would challenge both those of those premises in court,” said Paul McIntosh, executive director of the California State Association of Counties, in an interview today.

A budget deal struck in February nearly faltered in the Legislature, only to pass after a weekend of all-night sessions when enough Republicans agreed to what Schwarzenegger called the largest tax increase in California history. Still, the deficits reappeared as the economy failed to emerge from the now 20-month recession.

No Taxes

The magnitude of the slump made it difficult for Democrats and Republicans to agree on a response. Schwarzenegger, who bucked his party by supporting February’s increase, and his fellow Republicans ruled out another round of raising taxes. Voters in May defeated a proposal to extend the tax increase and borrow money to shore up the budget, an outcome Schwarzenegger said was a message that politicians needed to scale back government.

“We were able to resolve California’s $26.3 billion budget deficit without raising taxes,” Senate Minority Leader Dennis Hollingsworth, a Republican from San Diego, told reporters. “It solves our cash-flow issues and saves money by reforming key government programs so they operate more efficiently.”

Democrats contested the scope of his proposed cuts, which would have eliminated welfare programs that provide aid to jobless families and health insurance to nearly a million children.

Notes Sale

Passage of a budget would also clear the way for Treasurer Bill Lockyer to borrow the billions California needs to pay its bills until the bulk of taxes are collected later in the year.

Without a balanced budget, officials said such a borrowing would be costly, if not impossible, because of the state’s tumbling credit rating and concerns among investors about how they would be repaid. Instead, California began issuing IOUs to businesses and individuals to ensure that it has enough cash to meet key obligations -- including interest on its bonds -- that are given high priority under the constitution.

The use of IOUs has been done only one other time since the Great Depression and it brought unfavorable attention to the state.

First Step

Lockyer said in a statement today that it is too soon to say when the state can attempt a cash-flow note sale and how much the state will need to borrow.

“Getting this budget agreement enacted will be a big step forward, but our state still has a lot of hard work and sacrifice ahead before we are out of the woods,” Lockyer said. “At this point, it’s too early to assess the effect of the budget deal on our cash borrowing needs.”

On July 14, Moody’s Investors Service cut California’s bond rating by two steps to Baa1, three ranks above speculative ratings and said the state may face further downgrades. That followed Fitch Ratings, which on July 6 lowered its rating on California debt to BBB, just two ranks above high-yield, high- risk junk.

Bond Yields

California bond yields, which move in the opposite direction as price, have jumped compared with top-rated municipal bonds. The difference between a 10-year California bond and a top-rated municipal security reached as much as 1.71 percentage points on July 1, when the California debt yielded 5.21 percent, according to Bloomberg data. The difference has since slipped to 1.57 percent as investors speculated that prices would improve once a budget deal is struck.

California, the world’s eighth-largest economy, was already the lowest-rated U.S. state. Standard & Poor’s gives the state it’s A grade, the sixth-highest of 10 investment levels. The firm reaffirmed that assessment on July 1.

Several banks also exerted pressure on lawmakers to act quickly by refusing to exchange IOUs for cash, threatening to deal a blow to businesses that work for the state. Among the banks were JPMorgan Chase & Co. and Bank of America Corp.

The proposal would leave the state with a $900 million reserve for the fiscal year, an amount that lawmakers acknowledged could be quickly spent if the state’s economy stumbles further.

To contact the reporters on this story: Michael B. Marois in Sacramento at mmarois@bloomberg.net; William Selway in San Francisco at wselway@bloomberg.net.

Last Updated: July 21, 2009 14:49 EDT