Feb. 9 (Bloomberg) -- First, Superintendent Don Iglesias canceled plans to update science laboratories in public schools in San Jose, the center of the U.S. technology industry. Now he’s preparing to fire hundreds of teachers.

The 31,000-student district is a victim of the California budget crisis, an annual event in the most populous state and the biggest ever with a $42 billion shortfall expected over the next 17 months. “We’ve been pushed to the wall,” Iglesias said.

Governor Arnold Schwarzenegger, a Republican, and the Democratic-controlled legislature have been deadlocked for four months on a deficit reduction plan. Revenue is so depleted that Controller John Chiang delayed $1.9 billion in tax refunds and Schwarzenegger ordered state employees to take two days of unpaid leave every month. The governor and lawmakers met yesterday without announcing a plan.

Citing politicians’ failure to act, Standard & Poor’s on Feb. 2 cut $46 billion of California’s full-faith-and-credit debt to A from A+, making the largest tax-exempt borrower the lowest rated state, behind Louisiana. California’s 10-year general obligation bonds are already paying a record 1.23 percentage points in yield above benchmark municipal debt, according to Bloomberg indexes.

California 5 percent bonds due in 2023 traded at a price to yield 4.72 percent last week, almost a half-percentage point more than the 4.27 percent when they were sold in October 2007, according to Municipal Securities Rulemaking Board trade data.

‘Nervous Breakdown’

“It’s a major nervous breakdown,” said Jim Wunderman, president of San Francisco-based Bay Area Council, a business group whose members include Yahoo! Inc. and Shell Oil Co.

That the government of the world’s eighth largest economy can’t pay all its bills isn’t surprising, Wunderman said. A patchwork of voter-approved ballot initiatives since 1978 left California heavily dependent on income taxes and ill equipped for what may become the longest recession since World War II, he said.

California is also one of two U.S. states where both tax increases and spending plans require the approval of more than half the legislature, according to the National Conference of State Legislatures. The dual supermajority demands are why the budget rarely passes on time even when the Assembly and Senate are controlled by one party, Iglesias said. “The governor and the legislature are like a dysfunctional family.”

Rule Rewrite

A bill in the California Assembly to ask voters whether to call a constitutional convention and rewrite the rules hasn’t made it out of committee. Schwarzenegger, 61, hasn’t taken a position on the issue. He didn’t return calls seeking comment.

“There’s a lot of frustration on the part of investors that the state isn’t dealing with the current situation,” said George Strickland, who manages $3 billion in municipal bonds for Thornburg Investment Management in Santa Fe, New Mexico. “There are better places to invest your money. We’re going to be back in a similar situation next year, maybe worse”

Schwarzenegger and lawmakers didn’t agree on a $143 billion spending blueprint for 2008-2009 until three months after the fiscal year began. Fifteen days after the budget was signed on Sept. 23, the state was $3 billion in the red. A special legislative session that began Nov. 6 failed to pass a new plan. Schwarzenegger declared a fiscal emergency Dec. 1 -- when the difference between income and outflow was adding up at a rate of $28,000 a day.

‘Playing God’

The state has taken steps to stem that, including temporarily canceling $3.8 billion in spending on public works, affecting workers around the state.

“They’re playing God with our lives,” said Bill Rumsey, 41, a father of three who lost his $850-a-week job overseeing sheet-metal work on a new government office building in Sacramento on Jan. 16. Politicians “aren’t doing what they’re paid to do.”

The supermajority requirement on raising taxes in California was part of Proposition 13, a constitutional amendment passed by voters in 1978 that also capped property taxes. Arkansas is the other state mandating more than a majority to raise taxes and pass a budget.

Subsequent California ballot measures added programs, often without specifying funding sources, and instructed Sacramento how to spend, according to a report by the California State Auditor.

Prison Population

Among other things, the initiatives set minimums for education appropriations and established a three-strikes-you’re- out law that helped boost the prison population by about 51,500, or 43 percent, from 1993 to 2007, according to figures from the state’s Department of Corrections and Rehabilitation.

“Most of the fiscally oriented initiatives in the last 30 years have ended up placing constraints on legislators’ abilities to respond to dramatic changes, especially dramatic downward changes in economic circumstances,” said Mark Baldassare, the president of the Public Policy Institute of California, a San Francisco-based nonpartisan think tank.

Meanwhile, the state is increasingly reliant on income tax- receipts, said Steve Westly, a former EBay Inc. executive and state controller from 2003 to 2007.

In the current year, about 51 percent of general fund revenue will come from income taxes, up from about 34 percent in 1978, according to the legislative analyst’s office.

Collectively, states count on income taxes for about one- third of general fund revenue, according to the National Conference of State Legislatures.

Capital Gains

In California, income tax collections on capital gains, which last year totaled $11 billion, are expected to plunge 55 percent this year, Schwarzenegger’s office has forecasted.

“When we have good years -- think Google going public, EBay going public, tech booms -- money flows into our coffers,” Westly said. “All too often we frequently commit that money. And when we have poor years, and people report lean income taxes, the state gets punished.”

California’s main general fund revenue and income on its investments dropped 7 percent to $38.7 billion in the last five six months of 2008 from a year earlier, according to the state controller’s office.

Higher Costs

State Treasurer Bill Lockyer has halted debt sales, saying Wall Street won’t lend the money at affordable rates until the deficit and cash crisis are solved. The state last sold general obligation bonds in June.

The Feb. 2 downgrade by S&P is “punishing” the state with higher borrowing costs, said Tom Dresslar, a spokesman for Lockyer.

The day after the credit rating cut, Los Angeles Unified School District sold $950 million in 10-year bonds with 3.84 percent yields, 48 basis points higher than similarly rated bonds tracked by a Bloomberg index.

“The state budget issue had a detrimental effect on our bond sale,” said Tim Rosnick, the school district’s controller.

Schwarzenegger and legislative leaders plan to meet throughout the week if they don’t reach an agreement.

“The political system that we have in place is really the problem,” Schwarzenegger told reporters on Jan. 29. “We have an economic crisis on top of self-inflicted wounds.”

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

Last Updated: February 9, 2009 09:52 EST