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Debt, Borrowing and
Balanced Budgets in California

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July 2004
Final update of text and links.

 LIBRARY
Institute of Governmental Studies
University of California
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Berkeley, CA 94720-2370 
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Introduction

With the passage of Proposition 58 in the March 2004 primary election, the California Constitution for the first time required the enacement of a balanced budget (Art. IV, Sec. 12(f). Until then the Constitution required only that the governor submit a balanced budget for consideration by the legislature. While the stricter balanced budget requirement is quite new, the Constitution has a long standing prohibition on state indebtedness that exceeds $300,000 without voter approval (Art. 16, Sec. 1). Indebtedness exceeding $300,000 requires a two-thirds vote of each house of the state legislature and a majority vote of the electorate. Over the years the debt prohibition has been interpreted broadly by the courts, and the governor and legislature have much leeway in crafting the budget. The debt prohibition and other constitutional provisions regarding the state budget are, according to Richard Krolak in California's Budget Dance, "often bent or ignored when it meets the needs of one or more of the major actors in the process." Various approaches, including the issuing state bonds, incurring short-term indebtedness, "off-budget" borrowing and spending, and relying on optimistic revenue forecasts, have been used to deal with deficits.

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Borrowing and Balanced Budgets on the March 2004 Ballot

California's budget crisis, fueled by continuing revenue shortfalls after the state fell into recession in 2001, was a major issue in the October 7, 2003 gubernatorial recall election. The day after his November 17 inauguration, Governor Arnold Schwarzenegger proposed a California Revovery Plan. A key element of the plan was a general obligation bond authorizing up to $15 billion to refinance the budget deficit, to be submitted to the voters in the March 2004 primary election. Other key elements of the governor's plan were a new constitutional spending limit and workers' compensation reform.

The legislature, beset with partisan and philosophical differences, initially rejected the bond proposal, but negotiations continued. On December 11, 2003 the Assembly passed a compromise budget package including the bond and a constitutional amendment requiring a balanced budget, but not the new constitutional spending limit proposed in the governor's plan. The Senate passed the package the next day, and the governor signed it into law on December 13. Retitled the "Economic Recovery Bond Act," the bond measure appeared as Proposition 57 on the March 2004 primary ballot. The "California Balanced Budget Act" appeared as Proposition 58. The propositions are described, with pro and con arguments, in the Supplemental Voter Information Guide.

Negotiations on the budget package proceeded in great haste because the deadline for putting measures on the March 2004 primary ballot was at hand. Proponents of the bond measure claimed that it is the only alternative to making drastic and unacceptable cuts in state programs, and that, coupled with the balanced budget provisions of Proposition 58, it put California on a prudent fiscal path. Detractors of the bond measure made several interrelated claims. The central claim was that general obligation bonds are intended to finance infrastructure needs, not to refinance debt, and that the solution to the budget deficit is to reduce spending and/or raise taxes. Related claims were that the state was already carrying a heavy debt load, that infrastructure needs requiring bond financing would suffer if the state's bond financing capacity were committed to debt relief, and that a strict spending cap is the means to fiscal discipline.

The bond measure was in part a repackaging of a $10.7 billion bond issue already approved for debt relief in the adopted 2003-04 budget signed by Governor Gray Davis. While authorized by the legislature in the California Fiscal Recovery Financing Act, the bond issue was not approved by the voters. In September 2003 the Pacific Legal Foundtion challenged the constitutionality of the bond issue in a suit before the Sacramento Superior Court. A press release accompanying the suit cited two reasons for calling the California Fiscal Recovery Financing Act unconstitutional: "First, because it allows the state to borrow billions of dollars through the use of long-term bonds without voter approval; and second--even if it were approved by the voters--because the purpose of the bonds is to pay the state’s past and ongoing operating expenses rather than to fund infrastructure projects." The suit was still pending as of early December 2003.

Also appearing on the March 2004 primary election was Proposition 56, the "Budget Accountability Act." This measure was an initiative constitutional amendment and statute, and is described, with pro and con arguments, in the Voter Information Guide. Its most controversial feature would have permitted the legislature to enact the budget with a 55 percent vote rather than the two-thirds vote currently required. The measure would also have required the governor and legislators to forefit their pay for each day the budget was late.

Propositions 57 and 58 passed, the fomer 63.4% to 36.6% and the latter 71.2% to 28.8%. Proposition 56 failed 65.7% to 34.3%.

Peterson, Shane.
"The Big Bond," California Journal, vol. 35, no. 1 (Jan. 2004), p. 12-17.
Salladay, Robert; Berthelsen, Christian.
"Budget Deal Not the 'Usual' Effort: Dems Applaud Schwarzenegger's Compromise," San Francisco Chronicle, Dec. 13, 2003.
Berthelsen, Christian; Gledhill, Lynda.
"Governor, Lawmakers Reach Deal on Budget: Bipartisan Pact Seen As a Win for Schwarzenegger," San Francisco Chronicle, Dec. 12, 2003.
Lucas, Greg; Gledhill, Lynda; Sallady, Robert.
"Governor, Dems May Be Near Budget Deal: Proposal for $15 Billion Bond Requires Balanced Budgets," San Francisco Chronicle Dec. 11, 2003.
Berthelsen, Christian; Gledhill, Lynda; Salladay, Robert.
"Sacramento Scrambling Anew on Bond Proposal," San Francisco Chronicle, Dec. 9, 2003.
Gledhill, Lynda.
"Schwarzenegger Forced to Turn to Plan B: Legislature Denies Spending Cap, Bond Proposals," San Francisco Chronicle, Dec. 7, 2003.
Chorneau, Tom.
"Governor Moves Ahead with Bond Deal That Won't Go to Voters," San Francisco Chronicle (Associated Press), Dec. 5, 2003.
Proposition 58, the California Balanced Budget Act. Sacramento: Legislative Analyst's Office, Dec. 2003.
The Administration’s Spending Limit and Budgetary Reserve Proposal. Sacramento: Legislative Analyst's Office, Dec. 1, 2003.
An analysis of Governor Schwarzenegger's constitutional spending limit proposal.
Matthews, Joe; Halper, Evan; Jones, Gregg.
"Schwarzenegger Seeks Public Support for Borrowing Plan," Los Angeles Times, Nov. 21, 2003.
Hill, John.
"Schwarzenegger Tells How He'd Fix the Budget: Big March Bond Sale Is Key Plank," Sacramento Bee, Nov. 19, 2003, p. A1.
Lucas, Greg.
"Analyst Warns against Borrowing: State Urged to Shun Future Perils of Debt," San Francisco Chronicle, Nov. 15, 2003.
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Background and History

An Overview of State Bond Debt. Sacramento: Legislative Analyst's Office, Nov. 2003.
"The level of General Fund debt payments stated as a percentage of state revenues is referred to as the state’s debt service ratio. This ratio increased in the early 1990s and peaked at slightly over 5 percent in the middle of the decade. The ratio currently stands at about 3.3 percent, and is expected to increase to 4.6 percent in 2004-05, and further to a peak of 4.9 percent in 2005-06 as currently authorized bonds are sold."
"Using Borrowing to Help Address the Budget Problem." In: The 2002-03 Budget: Perspectives and Issues. Sacramento: Legislative Analyst's Office, 2002, p. 103-111.
Recommends that the legislature focus on three questions when "evaluating the different types of borrowing that potentially can be used to help address the budget shortfall:
"What interest rate has to be paid--either directly or indirectly--on a given type of borrowing?
"What are the timing and magnitude of future borrowing repayments, and what do they imply for managing future budgets?
"How does a given option "stack up" when compared to other options for achieving needed budget savings? [p. 110]."
Borrowing against the Future: Is Securitizing California's Tobacco Settlement Revenues the Best Way to Close the Budget Gap?. Sacramento: California Budget Project, 2002. 6 p. [pdf version]
Argues that borrowing against future tobacco settlement revenues to balance the budget should be a last resort only.
California. Legislature. Senate. Advisory Commission on Cost Control in State Government.
California's Budget Process: Improving Quality, Cost-Efficiency, Effectiveness and Accountability in State Government. Sacramento: The Commission, 1999. 67 p.
"The state Constitution requires the Governor to introduce a budget that recommends sources of revenue to fully cover expenditures. This balanced budget requirement has encouraged some revenue forecasts that have been overly optimistic, if not wholly misleading. On the other hand, failure of revenues to reach projections and fall below authorized expenditures may create serious political problems for a governor. Some Governors have regularly approved revenue estimates considered conservatively low. Fiscally conservative Governors have been accused of holding down spending by underestimating revenues [p. 10]."
California Citizens Budget Commission.
A 21st Century Budget Process for California: Recommendations of the California Citizens Budget Commission. Los Angeles: Center for Governmental Studies, 1998. 94 p.
On a balanced budget: "The commission recommends that California join the great majority of states with true balanced-budget requirement and require that all future state budgets have a balanced General Fund as presented to the Legislature, passed by the Legislature and enacted into law. ...
"The Commission sees no easy solution to the problem of enforcing a constitutional state balanced-budget requirement. ...
"Most experts reject the idea of having the courts enforce balanced-budget requirements. ...
"The Commission concludes that the best approach to enforcing the balanced-budget requirement would be to spell out the balanced-budget principles and requirements in the California Constitution and allow the people to enforce them through the regular political processes. ... [p. 41]."
On external borrowing: "The Commission ... recommends that the Constitution be amended to prohibit all external short-term borrowing, unless it is used to meet the State's normal cashflow fluctuations and is repaid within the same or next budget year from designated revenues [p. 42]."
On short-term debt: "The Commission believes that long-term borrowing (more than five years) is appropriate to finance public investments that provide long-term public benefits, such as highways, parks or state buildings, as long as projected revenues can service the debt. ...
Therefore, the Commission recommends that the Constitution be amended to limit long-term debt to the financing of long-term capital investments. [p. 43-44]."
Krolak, Richard.
California's Budget Dance: Issues & Process. 2nd ed. Sacramento: California Journal Press, 1994. 150 p.
"Given the timing of the inflow and outflow of funds, it has not been unusual for the state to engage in limited short-term debt financing, including internal borrowing from special funds, to cover the expected ebb and flow of general fund cash management. ...
"This trend took a significant turn for the worse in 1992 when the state, because of the ongoing fiscal difficulties, exhausted all of the available internal borrowing options and found itself having to increasingly rely on external borrowing to cover fiscal year operating needs. The "needs" were approximately $3.2 billion in 1993-94 with the anticipated need to borrow more than $6 billion in 1994-95. Bluntly stated, California found itself out of cash. The state began to issue Revenue Anticipated Notes (RANs) in 1992 and then issued Revenue Anticipation Warrants (RAWs) to cover the RANs when sufficient revenues did not materialize to cover the outstanding debt during the fiscal year. Some sarcastic observers have referred to RANs and RAWs as the State's version of Visa and Mastercard [p. 118]."
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Experience in Other States

Briffault, Richard.
Balancing Acts: the Reality behind State Balanced Budget Requirements. The Balanced Budget Debate Series. New York: Twentieth Century Fund Press, 1996. 90 p. [Excerpts]
The states "balance their budgets not necessarily because their constitutions require it, after all households and businesses are not subject to constitutional requirements, but because the marketplace demands it. Legal requirements no doubt affect state fiscal practices. But the bond market and the interstate competition for tax base, not state constitutions, probably do the real work of imposing fiscal discipline on the states [from the Introduction]."
Eckl, Corina L.; Mackey, Scott R.; Snell, Ronald K.
State Strategies to Manage Budget Shortfalls. Denver: National Conference of State Legislatures, 1996. 56 p.
"This report explores a variety of strategies that states have used to manage budget shortfalls. It provides information, evaluations and case studies that policymakers can refer to when considering their options. Recommendations regarding which actions to take are not included because lawmakers must assess the potential effectiveness and political feasibility of various options in view of the social, economic and political context of their respective states [p. viii]."
Snell, Ronald K.
"State Balanced Budget Requirements: Provisions and Practice," Fiscal letter, v. 18, no. 4 (1996), p. 1-4.
"Considering the lack of specific constitutional mandates and enforcement structures, state compliance with the principle of a balanced budget is notable. Restrictions on debt play a part, but are an insufficient explanation for the fact that even states than can legally carry a deficit from one year to the next avoid doing so. It appears that the political convention that state budgets are supposed to be balanced is its own enforcement mechanism [p. 4]."
James E. Alt; Robert C. Lowry.
"Divided Government, Fiscal Institutions, and Budget Deficits: Evidence from the States," American Political Science Review, v. 88, no. 4. (Dec. 1994), p. 811-828.
From the authors' abstract: "Using a formal model of fiscal policy to guide empirical analysis of data covering the American states from 1968 to 1987, we conclude that (1) aggregate state budget totals are driven by different factors under Democrats and Republicans, the net result being that Democrats target spending (and taxes) to higher shares of state-level personal income; (2) divided government is less able to react to revenue shocks that lead to budget deficits, particularly where different parties control each chamber of the legislature; and (3) unified party governments with restricted ability to carry deficits into the next fiscal year (outside the South) have sharper reactions to negative revenue shocks than those without restrictions."
Poterba, James M.
"State Responses to Fiscal Crises: the Effects of Budgetary Institutions and Politics," Journal of Political Economy, v. 102, no. 4 (Aug. 1994), p. 799-821.
From the author's abstract: "More restrictive state fiscal institutions, such as 'no-deficit carryover' rules and tax and expenditure limitations, are correlated with more rapid fiscal adjustment to unexpected deficits. Political factors are also important. When a single party controls the state house and the governorship, deficit adjustment is much faster than when party control is divided. In gubernatorial election years, tax increases and spending cuts are both significantly smaller than at other times."
Debt Management Practices in the States. Washington, D.C.: National Association of State Budget Officers, 1994. 34 p.
"This report provides an overview of some of the central themes in establishing and/or revising a debt management policy. Topics include debt affordability policies, linking capital planning to debt management, and integrating debt policies with the operating budget."
Prepared by the staff of the IGS Library.
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