Dec. 17 (Bloomberg) -- California lawmakers for a second time rejected tax increases intended to narrow a record budget shortfall, even as the state’s swelling financial problems may force it to cut off $3.8 billion in spending for work on schools, roads and other projects.

The Democrat-backed bills sought 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, similar to those backed by Republican Governor Arnold Schwarzenegger, were blocked by Republicans, a minority that still commands enough power to prevent the two-thirds vote needed to pass a budget.

“We are in a crisis” said Assemblywoman Noreen Evans, a Democrat from Santa Rosa, during a debate on the defeated proposal. “This is not something we can run away from. This is not something we can just stick our heads in the sand and hope it goes away.”

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. Schwarzenegger’s administration has said the state may begin paying bills with IOU notes as early as February, a measure that has been utilized only one other time since the Great Depresssion.

Bonds Fall

Republicans and Democrats, ordered into an emergency session by Schwarzenegger, have been deadlocked over how to eliminate a swelling budget deficit that emerged in the spending plan they passed just three months ago. Last night, Assembly Speaker Karen Bass of Los Angeles ordered lawmakers locked into the Capitol in Sacramento in an unsuccessful bid to force a deal. Democrats abstained from voting last night after it became clear the measures would fail.

The state has a $14.8 billion shortfall in the current budget year that’s projected to swell to $41.8 billion by July 1. On Dec. 1, Schwarzenegger, 61, ordered lawmakers in a special session to deal with the problem and threw his support behind tax increases.

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 to yield 7.08 percent. That’s down from as much as 80 cents yesterday, when it yielded 6.66 percent.

Republican Plan

The governor invoked powers granted him in 2004 to declare a fiscal emergency, which gives the Legislature 45 days to plug the shortfall. If no solution is found in that time, members are barred from doing any other legislative work until they have dealt with the problem.

Democrats sought to fill some of the gap by raising the state’s sales tax by 1.5 percentage points for three years to 7.25 percent, as well as adding a 9.9 percent-per-barrel severance tax on oil produced in California and a 5-cent tax on every 12 ounces of beer, 5 ounces of wine and 1.5 ounces of spirits sold in the state.

Republicans, a minority in the Legislature, have the power to block any proposal and have ruled out tax increases. They want to cut spending by as much as $15 billion from schools and welfare programs, such as health care for the poor.

The Republicans also want to ask voters to divert $6 billion of tax money that is earmarked for specific uses such as mental- health programs. Their plan is scheduled for a vote later today.

“Those proposed taxes would kill our economy,” said Republican Assemblyman Chuck DeVore. “California already has the highest income tax rate in the nation. We have the highest sales tax rate in the nation. We have the highest gas tax in the nation. We have the highest corporate tax in the Western U.S.”

State Can’t Borrow

Lawmakers’ failure to reach an agreement comes as a state board prepares today to vote on whether to shut off $3.8 billion of funding for construction projects as the financial crisis threatens to drain its cash.

Usually the state replenishes funds spent from the Pooled Money Investment Account by selling bonds. With growing doubts about the state’s solvency and with money scarce on Wall Street, Treasurer Bill Lockyer said that can’t be done.

The board’s decision will delay or halt work on prisons, schools, hospitals, roads and other public projects, dealing a blow to an economy that’s already reeling from a housing market crash that has cost about 136,000 construction jobs over the last two years. Such a step would come as President-elect Barack Obama is preparing a plan to funnel billions to states for infrastructure, a move intended to stoke the economy.

Last night’s failure was a second defeat for Democrats who command a majority in the Legislature. Lawmakers from the party offered a proposal last month that would have sliced $8.1 billion from the budgets of schools, colleges and other programs and raised another $8.1 billion by increasing vehicle license fees and freezing income-tax brackets at 2007 levels. That plan fell short of the necessary two-thirds vote on Nov. 26, when no Republicans backed it.

California, the biggest borrower in the municipal-bond market, has $51.9 billion in general-obligation debt. It’s rated A+ by Standard & Poor’s and Fitch Ratings, the fifth-highest grade, and an equivalent A1 at Moody’s Investors Service.

To contact the reporter on this story: Michael B. Marois in Sacramento, California, at 1612 or mmarois@bloomberg.net;

Last Updated: December 17, 2008 14:11 EST