How to Avoid Budget Crises
California is broke but won’t go bankrupt
August 1, 2008
Fred Foldvary, Ph.D.
Economist

The State of California is suffering from a budget crisis. The legislature and governor have not agreed on a budget for the new fiscal year that began on July 1. Without legal authorization, the state well for government programs is drying up. Services such as medical may shut down, and many businesses are not being paid what they are owed for their sales to the state. This failure of the state to pay its bills is especially hard on small business.

As of September 7, 2008, California has now been without a government budget for over two months. The state is being squeezed by a $15 billion budget deficit. State payment for programs such as hospitals already ended in July.

Governor Schwarzenegger sought a “temporary” increase in the sales tax, despite his previous pledge not to raise taxes, but the Republicans in the legislature wisely oppose this tax hike, knowing that with a permanent budget deficit, there is no such thing as a temporary tax increase.

There is a perverse incentive at work. The lawmakers receive a bonus payment for staying in session longer. I don’t think that they are delaying the budget to get the extra money, but it would be more effective if they lost wages for not passing a budget on time.

The solution to such budget impasses is to have a constitutional rule that temporarily continues the past budget when a new one is not enacted. All fund allocations would be reduced by the same proportion to eliminate the budget deficit. The governor, however, has rejected a continuing resolution for a temporary budget.

The governor has also said he would veto legislation sent to him before the budget is passed. The deadline for signing the bills is September 30. If he does not veto a bill by then, it becomes law. The lawmakers could rush the bills to him near the deadline to test his resolve.

Since the concept of automatically continuing the previous budget is obvious and nothing novel, one may well ask, why is this not already in the state constitution? The special interests who finance political campaigns have the most to gain from the absence of automatic continuation. The budget deadline puts pressure on legislators and the governor to pass bills they would otherwise oppose. But this year, it backfired as the game of chicken created an impasse.

California’s budget problems go back to 1978, when voters approved Proposition 13 to amend the constitution to limit real estate taxes. Local government was deprived of its natural source of revenue, land value. The state reacted by raising other taxes, and power shifted to the state government. But higher state income and sales taxes progressively harm enterprise, and many businesses are already leaving the state. There is no way to know how many small businesses would have been started in the state if not for punitive taxation. California’s unemployment rate has been higher than that of the country.

When a corporation is insolvent, it declares bankruptcy and possibly shuts down. California’s government should do likewise. Declare bankruptcy and shut down the state government. Since the State of California would no longer exist, the state constitution would no longer be in effect. The bankruptcy resolution would shift all state revenues, debts, programs, and spending to the counties in proportion to their land values.

The counties would then come up with their own public finances to deal with the responsibilities thrust upon them. Income and sales taxes are not suitable for local government, since people and enterprises can flee to lower-taxed areas. Public finance would shift to property taxes, and if the county boards were wise, the main source of public revenue would be land rent or land value.

The counties would then form a California Association of Counties (CAC) to coordinate services that span county boundaries, such as the major highways. The CAC would also hold elections for the US Senate. The CAC council would be elected from the members of the county boards. California would become a decentralized bottom-up association of counties.

Freed of state income and sales taxes, enterprise would thrive and the economy of the state would quickly recover, especially in those counties that set their property tax only on land. A new constitution would be drawn making the CAC a permanent institution.

Of course, nothing like this will happen, but one can ask, why not? The blockage is the status quo which uses its power to prevent fundamental changes. This could change if all Californians refused to vote for candidates of the establishment parties. But alas, most folks only seek pennies of change rather than the billion-buck changes we need to resolve not just the budget crisis but the whole dysfunctional public finances of the state and country.

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Fred Foldvary, Ph.D.
Economist

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.