Big Arnie's Narrowing Options

Even with a new $15 billion bond issue, Schwarzenegger may have to break his campaign promise and raise taxes

By Christopher Palmeri

It played out like a script from one of his movies. With the eyes of California upon him, movie star turned California Governor Arnold Schwarzenegger won a come-from-behind victory on ballot initiatives this month that authorize $15 billion in bonds to pay off looming state debts and mandate balanced budgets going forward. He pulled it off with a smile and the trademark I-can-do-it attitude that got him elected to Sacramento last year.

By plugging the immediate hole in the state finances, the bond measure averts a fiscal crisis for the Golden State. Yet it does nothing to fix a long-term mismatch between revenues and expenses that the state's Legislative Analyst's Office estimates at some $7 billion a year.


  And there are tougher battles yet to come. Over the next four months, Aw-nauld must persuade the legislature to approve massive cuts in the coming year's budget. Along the way, he'll face renewed pressure to raise taxes, particularly for the wealthy. "Even after we go through the very painful cutting process there will remain a gap," says Darrell Steinberg, the Democratic chairman of the State Assembly's budget committee.

For now, Schwarzenegger's focus is clearly on cuts. California faces a $14 billion deficit for the fiscal year that begins July 1. That's a huge hole for a state with a $99 billion budget. The governor has proposed closing the gap through borrowing and spending cuts, including a 10% reduction in payments to Medicaid providers, lower welfare payments for families, and a $1.1 billion hit to transportation. Legislators are already balking. On Mar. 8, a Senate subcommittee rejected his plan to cap enrollment and create waiting lists for health-care programs for children and AIDS patients.

Cash is tight. Of the $15 billion in new bonds, $12.3 billion will go to pay prior deficits. Rating agencies have made it clear that California, already the lowest-rated state in the country in terms of debt risk, needs to close the deficit if it wants to see its ratings improve. "We'd like to see movement toward structural reform," says David G. Hitchcock, a state credit analyst at Standard & Poor's.


  In February, Schwarzenegger created a special commission to make that kind of reform. The commission is expected to consider recommendations such as those from the libertarian Reason Foundation that suggest annual savings of more than $10 billion by privatizing government jobs, renegotiating state-employee contracts, and cutting the cabinet-level agencies from 12 to 7. Not everyone is so sanguine about the approach, however. "It's the Yellow Pages approach to government," says Republican state senator and former gubernatorial candidate Tom McClintock. "If you see somebody else doing it in the Yellow Pages, contract it out."

California Democrats, who solidly control both houses, say they are willing to work with Schwarzenegger in his effort to reinvent government. They also plan to hold hearings over the next few months highlighting the impact of Schwarzenegger's cuts on children, the elderly, and the disabled, setting the stage for possible tax hikes. "The Governor has said he doesn't want taxes," says Steve Westley, the state's Democratic controller. "But every solution that we can see says it will be hard to solve the budget issue without a combination of spending restraint and new revenue."

State Treasurer Philip Angelides, a Democrat widely believed to be considering a run for governor in 2006, has been pounding the table for increases in the state's top tax rate from 9.3% to as high as 11% for individuals making more than $280,000 per year. Such a hike, similar to one introduced by Republican governor Pete Wilson in 1991, could raise $6.8 billion over the next three years. A January poll by the nonpartisan Public Policy Institute of California found that 71% of those surveyed favor raising the top tax rate.


  Even California's controversial Proposition 13 may be under attack. The 1978 referendum, which capped property taxes at 1% of a property's purchase price, has led to huge discrepancies in tax payments between properties with similar market values, as well as a massive shift in education spending from local tax coffers to the state's general fund. Borrowing a page from Schwarzenegger's populist play book, the California Teachers Assn. is gathering signatures for a November ballot initiative that would raise the tax on commercial property to 1.55%, a proposal they believe could generate $6 billion a year for schools.

The irrepressible Schwarzenegger is expected to fight the tax hikes with all he's got, but it will be a struggle. "Most states that were in a hole have raised taxes," notes Jean Ross, executive director of the nonprofit California Budget Project. Even the self-avowed Tax Terminator may have do so before the year is out.

Palmeri covers the Golden State from the Los Angeles bureau of BusinessWeek

Edited by Douglas Harbrecht

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