July 25 (Bloomberg) -- California Governor Arnold Schwarzenegger will spend the weekend trimming $1 billion from the state budget, after lawmakers rejected two parts of a plan to erase a $26 billion deficit that threatened the largest U.S. state with insolvency.

The governor said he would sign a package of more than two- dozen bills, approved by the Legislature yesterday. The measures divert tax money from municipalities, force companies and individuals to pay income taxes sooner and reduce spending on schools, welfare and public health programs.

“With this budget, California has safely navigated the greatest economic crisis since the Great Depression,” Schwarzenegger said during a news conference in Sacramento yesterday. “I think the financial community is going to look at this in a positive way.”

The package cuts spending by $15 billion, including $6 billion from schools and community colleges, $3 billion from universities and $1.2 billion from prisons. It also raises $4 billion, in part by accelerating personal and corporate income- tax withholding and increasing the amount withheld by 10 percent.

The passage ended a two-month partisan battle over how to eliminate holes that emerged in the $100 billion budget just months after spending cuts and tax increases were enacted in February to bolster the state’s finances. Without a balanced spending plan, California has been forced to pay bills with IOUs to avoid running out of cash. Ratings on $72 billion of bonds were cut close to high-yield, high-risk junk status.

“There are a whole host of cuts that pain me,” said Senate President Darrell Steinberg, a Sacramento Democrat who was among the leaders who brokered the deal. “Nobody likes this budget because there’s not much to like about it.”

Local Government Hit

The Assembly rejected a measure approved in the Senate allowing new offshore oil drilling along the coast of Santa Barbara, which the state projected would create royalties of about $100 million this year and $1.8 billion over the next 15 years.

Assembly Republicans blocked a proposal for the state to take $1 billion of gasoline tax money meant for local governments. The Senate passed the bill. The $1 billion will be made up by line item vetoes from the governor and with reserve funds. Lawmakers will consider how to replenish the fund when they return from vacation next month.

The passage will allow the state to use $2 billion of local property taxes meant for cities and other local jurisdictions and some $1.7 billion earmarked for redevelopment agencies.

Cities May Sue

California cities may sue to block the state from appropriating local revenue, said Chris Mackenzie, executive director of the League of California cities.

The deficit plan also shifts $1.5 billion between accounts and moves the last payday for workers this fiscal year to the next 12-month period.

It is the second time this year that the government redrew the budget amid job losses that pushed unemployment to a record 11.6 percent in June and declining incomes that lowered tax collections 15 percent from a year earlier.

As the financial strains worsened this year, California bond yields, which move in the opposite direction as price, had 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 slipped to 1.5 percent today, the lowest since June 19, as investors speculated that prices would rise once a budget deal was struck.

Even those who said they recognized the need for the steps said there was little to welcome in its passage.

“There is a lot to dislike in this budget,” said Republican Senate Leader Dennis Hollingsworth. “We are solving a very big problem and there are no easy solutions to a problem like this.”

To contact the reporters on this story: Ryan Flinn in San Francisco at rflinn@bloomberg.net; Michael B. Marois in Sacramento at mmarois@bloomberg.net

Last Updated: July 25, 2009 00:01 EDT