California's Jerry Brown Inherits Schwarzenegger's Struggle to Cut Deficit

California Governor-elect Jerry Brown faces the same dilemma over a widening budget gap that helped make his predecessor, Republican Arnold Schwarzenegger, one of the most unpopular state executives in 50 years.

Brown, a Democrat who defeated former EBay Inc. chief executive officer Meg Whitman yesterday, must close a deficit for next year that may exceed the $19 billion gap Schwarzenegger bridged last month. He faces the same fractious Legislature whose standoff over paring spending or raising taxes left the state without a budget for a record 100 days.

California, which accounts for 13 percent of the U.S. gross domestic product, has suffered deficits in seven of the last nine years as revenue trailed formulas that locked in spending for programs such health care for the poor. The state was forced to pay bills with IOUs last year as lawmakers and Schwarzenegger twice deadlocked over back-to-back deficits that combined exceeded $60 billion.

Brown “has to deal with the same budget numbers and the same red ink and the same political pain,” Jack Pitney, who teaches politics at Claremont McKenna College in Claremont, California, said in a telephone interview before the results were known.

Photographer: Paul Sakuma/AP

California Governor elect Jerry Brown celebrates his election win during a rally with his wife, Anne Gust, in Oakland, Calif. Close

California Governor elect Jerry Brown celebrates his election win during a rally with... Read More

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Photographer: Paul Sakuma/AP

California Governor elect Jerry Brown celebrates his election win during a rally with his wife, Anne Gust, in Oakland, Calif.

Schwarzenegger’s approval rating fell to 22 percent in July, tied with Gray Davis’s 2001 trough before the Democrat was driven from office in an unprecedented recall election because of his handling of the budget.

Voter Approval

Brown, who served two terms as governor from 1975 to 1983, has said he won’t raise taxes without voter approval. Without additional revenue, he’ll be forced to deliver another round of cuts to schools and to state services such welfare. Schwarzenegger and lawmakers slashed spending by almost $40 billion in the last two years.

Brown says he’ll employ his political experience and legislative acumen to push through a budget compromise. “I’ll start within a week calling all the legislators,” Brown said at an event in Los Angeles Sept. 2. “I’ll get it done.”

Brown’s first budget, which he is required to unveil seven days after he’s sworn in Jan. 3, will confront the expiration of about $8 billion in temporary tax increases imposed to help erase a $26 billion deficit in 2009.

He’ll also have to repay at least $2 billion that Schwarzenegger and lawmakers siphoned from local governments in 2008. Compounding these problems is the end of federal stimulus money, which helped backfill $6 billion to local schools in 2009.

Brand Name

“The worst thing about those budget impasses is that they hurt our brand -- it makes people say ‘I don’t want to go and do business in California, those people are nuts,’” said Robert Hertzberg, the Democratic speaker of the Assembly from 2000 to 2002. “The biggest noisemaker is the budget.”

California is likely to face a $5 billion gap in the current fiscal year after the budget Schwarzenegger and lawmakers passed last month “relied heavily on one-time measures, optimistic revenue assumptions, and the receipt of funds, some of which may not materialize,” Moody’s Investors Service said Oct. 19. On the same day, Treasurer Bill Lockyer said he anticipated the deficit in the fiscal year that begins July 1 will match or exceed this year’s.

Brown may be aided by the passage yesterday of a ballot measure that lowers the threshold for the Legislature to approve a budget from two-thirds to a simple majority, according to Davis.

Vote Obstacle

“One obstacle facing all former governors was the need to get that two-thirds vote,” Davis, who served from 1999 to 2003, said in a telephone interview. “That inevitably means working with the minority party and meeting their demands.”

Tax increases will still need a two-thirds vote of the Legislature to pass, so a budget that included higher taxes could still face delays, Davis said. Democrats, while in control of both chambers of the Legislature, lack enough votes to meet that supermajority.

Brown may have to contend with a proposed constitutional amendment to go before voters in February 2012 that would require lawmakers to squirrel away 3 percent of revenue each year into a so-called rainy-day fund of up to 10 percent of the budget. If Brown calls for a special election for a tax increase this year, the rainy-day reserve proposal would move forward to that ballot, according to the Secretary of State’s office. If approved by voters, Brown’s first budget would be subject to the new rainy-day provisions.

Opposition

Republicans say their opposition to higher taxes extends to asking voters for an increase through a statewide ballot.

“I won’t ask them because unless they make fundamental changes in the way they are spending the money, they are going to waste that money too,” Bob Dutton, Senate Republican leader, said in a telephone interview before the results were known. “So I’m not prepared to ask them to raise taxes. I can’t in good conscience ask the people to give us more money if I can’t fix the problem.”

Standard & Poor’s rates California general-obligation debt A-, its fourth-highest investment grade and the lowest among states. Moody’s rates it fifth-highest at A1 and Fitch Ratings ranks it seventh-highest at A-.

The extra yield investors demand to own 10-year California bonds was little changed yesterday at 126 basis points more than that provided by AAA rated municipal securities, according to data compiled by Bloomberg. That’s down from 150 basis points in March. A basis point is 0.01 percentage point.

Volatility

Brown should address the nature of California’s tax system which relies on volatile sales and income taxes for 85 percent of revenue, according to Scott Minerd, the Santa Monica, California-based chief investment officer at Guggenheim Partners LLC, which oversees more than $100 billion.

“For the bond market to get comfortable, it would like to see this structural flaw in the revenue stream fixed,” Minerd said in a telephone interview before the results were known.

To contact the reporter on this story: Michael Marois in Sacramento at mmarois@bloomberg.net

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net

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