California: A high-revenue, low-services state

California Governor Jerry Brown has received praise for proposing a balanced state budget for the fiscal year starting July 1. The last time California proposed a balanced budget was in 2007, when Arnold Schwarzenegger was governor.

A recent report by California Common Sense, a nonprofit research group, describes how state finances changed over that period. (Disclosure: I am on the organization’s board.)

State revenue is expected to be $139 billion in 2013-14, a gain of $11 billion from 2007-08. This isn’t surprising, given that California raised the top income-tax rate to 13.3 percent from 10.3 percent, increased the sales-tax rate to 7.5 percent from 7.25 percent and boosted regulatory and other fee collections by 36 percent.

In light of the growth in revenue, one might expect spending on public services to be back at the levels of six years ago, if not higher. Recovery in this spending is important because in the U.S. federal system, it is the states that do the blocking and tackling. They “have the principal responsibility for most domestic governmental functions including education, safety, health, infrastructure, administration of justice and implementation of the social safety net,” as Paul Volcker, the former Federal Reserve chairman, and Richard Ravitch, the former lieutenant governor of New York, put it in their 2012 report on state budget crises.

Yet in California, spending on many of those services will be lower than six years ago. Social services, including welfare, will receive $1.3 billion less. The state will contribute almost $900 million less to the University of California and California State University. Even K-12 education will receive no more than it did six years ago.

Tuition Doubles

To make up the difference, citizens are paying more. Tuition doubled at California State University and more than doubled at the University of California. State park fees and court-filing fees cost 56 percent and 36 percent more, respectively.

Where did the revenue increase go? In short, to health care, employee compensation, retirement benefits and debt service. State spending on health care, almost $28 billion, will be 62 percent higher than in 2007-08. (Including federal funds, the state will spend more than $60 billion on health care.) Spending on salaries and retirement costs has been boosted by 18 percent to $23 billion a year (or more if university salaries are included). Debt service is up by 23 percent to $5.8 billion a year.

Spending on those categories is destined to keep growing for five reasons:

First, California has opted to expand Medicaid eligibility under the federal Patient Protection and Affordable Care Act, a step that, according to the RAND Corp., will increase state spending by as much as $4 billion a year starting in 2016, on top of normal growth in health-care costs.

Second, even after the recovery of investment markets, unfunded pension liabilities officially grew by $80 billion over the six years because pension liabilities increased faster than pension assets. (As measured by financial economists, pension liabilities rose even more.) Public-pension funds must not only make up for lost ground but also grow at a high rate or fall even further behind. As a result, pension costs for governments will keep rising.

Third, the California State Teachers’ Retirement System is seeking a source for an extra $4.5 billion a year in pension contributions (and more if it doesn’t achieve its unlikely earnings target). To meet that need, the state faces a dilemma. If school districts put up the money, $4.5 billion is more than those districts will receive in total each year from the tax increase passed by California voters in November, which means that newtax revenue won’t make it to the classroom. If the state puts up the money, $4.5 billion is more than the state’s share of that tax increase, which means more crowding-out of state services.

Unfunded Promises

Fourth, because the state doesn’t pre-fund health care for retired government employees, it has officially built up an additional $80 billion in unfunded promises. As more of the aging workforce retires, pay-as-you-go health costs for retired employees, which rose more than 60 percent over the six-year period, will keep growing rapidly.

Fifth, the state has issued $28 billion of general- obligation bonds since 2007, a 56 percent increase, and Governor Brown has ambitious plans for California’s transportation and water systems, subject to voter approval. (Unlike spending on health care, employee salaries and retirement benefits, voter approval is required for the issuance of bonded debt.)

California proves what Volcker and Ravitch concluded in their report, which is that state revenue simply cannot keep up with the rates at which health-care and employment costs are growing. Failure to address those problems portends even more tax and fee increases and the loss of public services.

To his credit, Brown has called for a special session on state health-care spending. He knows those expenditures must be addressed if other services are to be maintained. It remains to be seen what he intends to do about compensation and benefits.

California’s 2007-08 balanced budget was followed by five years of deficits, four tax increases and several fee boosts, proving yet another point made by Volcker and Ravitch: State and local governments must go beyond deceptive cash-basis budgeting to provide open, detailed and honest accounting. Then, to truly balance their books for the long haul, they must address root causes of deficits.

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Ed’s Note: David Crane, a Democrat, served as Gov. Arnold Schwarzenegger’s financial adviser from 2004 to 2011. He is president of Govern for California, a nonpartisan government-reform group. This commentary originally appeared at Bloomberg.com.