Dec. 17 (Bloomberg) -- California officials cut off funding for $3.8 billion of construction on schools, roads and other public works as a political stalemate over how to close a record budget shortfall threatened to drain the state of cash.

The California Pooled Money Investment Board, made up of the controller, the treasurer and the governor’s finance director, took the step to save money a day after the Legislature failed to approve tax increases for a second time. The impasse may hamper the state’s ability to raise funds by selling bonds, and the officials said it may cost tens of thousands of jobs in a state already reeling from the housing market’s collapse.

“California’s fiscal house is burning down,” Treasurer Bill Lockyer said in a statement. “The people still wait for their elected leaders to pull them out of the fire, stop the blaze and rebuild the house on a solid, lasting foundation. Until that happens, the infrastructure work so vital to getting our economy back on track will lie crippled.”

California, the most-populous U.S. state, will run out of money as soon as February unless lawmakers end an impasse over how to replace revenue lost amid the recession. Governor Arnold Schwarzenegger’s administration has said it may begin paying bills with IOUs should the state run out of cash, a measure used only once since the Great Depression.

Without a budget in place, Lockyer has said the state can’t raise money from investors by selling bonds to replace the funds that are being drawn down for construction. By cutting off the construction projects, the state is preserving money that can be used to pay its bills. Schwarzenegger faulted the Legislature.

Bills Fail

“It’s outrageous that Republicans and Democrats would continue to play politics while tens of thousands of hardworking Californians face the possibility of being laid off this holiday season,” said Aaron McLear, a spokesman for the Republican governor. “Californians have seen enough politics and posturing from the Legislature. It’s time for them to negotiate and reach a compromise.”

Last night, Democrats were unable to pass bills to cut $7 billion of spending while raising $11.3 billion with higher taxes on retail sales, oil production and alcoholic beverages. The tax increases, some of which were similar to those backed by Schwarzenegger, were blocked by Republicans, a minority that still commands enough power to prevent the two-thirds vote needed to pass a budget.

Today, Democratic leaders said they had a plan that would raise more money from incomes, gasoline and retail sales that may pass even without Republican endorsement.

Schools, Fire Stations

The funding decision will shut down or delay work on dozens of projects across the state, including veterans’ homes, state prisons, schools and rural outposts that fight the wildfires that periodically ravage the state, according to a list compiled by state officials.

The range of projects indicated how the record $41.8 billion shortfall facing the state over the next 18 months will ripple through the economy, where the unemployment rate of 8.2 percent is already the third-highest in the nation. Republican lawmakers have opposed raising taxes to balance the state’s books, saying it would be the wrong step to take in a recession.

The escalating financial crisis has depressed the state’s bond prices, driving up the yields. A California bond maturing in 2033, which pays 5 percent interest, dropped to 76 cents on the dollar today to yield 7.08 percent. That’s down from as much as 80 cents yesterday, when it yielded 6.66 percent.

California Controller John Chiang said the decision to shut off funding, while painful, was necessary because the projects would have used more than $600 million a month that the state can’t afford.

“The state is out of money, and the special funds we rely on to tide us over are fast running dry,” Chiang said. “Regardless of your political philosophy, it is not fiscally responsible to endanger these state projects.”

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

Last Updated: December 17, 2008 18:04 EST