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Court of Appeals forces state to tear up credit cards

Upon his arrival as governor of California in 2003, Arnold Schwarzenegger declared that he would “tear up the credit card” that the Davis administration and Legislature had used to borrow money for operational purposes in order to deal with the state’s major budget deficit.

Alas, the Davis administration’s credit card was not torn up, but instead used by the new governor. For the next four budgets, Gov. Schwarzenegger continued to propose more borrowing to finance his spending proposals. Five years and four budgets later it took the judicial branch of the government to tear up the credit card.

Borrowing money to fill the annual gap between revenues and expenditure has become a time honored tradition and part of the mix of budget solutions that avoid major spending reductions or tax increases. Borrowing money may solve the annual gap, but it complicates the ongoing operating deficit. Following the approval of authorizing legislation in 2003, the administration approved the issuance of $2 billion in long-term bonds to pay the state share of the employee-pension obligation. This was enough to satisfy the state’s pension obligation for two fiscal years.

An intervening lawsuit caused a delay in the issuance of the bonds, but that did not preclude the governor from assuming he would get some of the proceeds after the court validated his borrowing plan. The administration was counting on using $500 million as part of the solution to the growing revenue and expenditure gap in the 2008-09 budget.

On July 3, 2007, just nine days after it heard arguments in the case, the California Court of Appeal Third District in Sacramento ruled that the proposal to borrow money to pay the employer’s contribution to the public employee retirement system was not exempt from the constitutional requirement that voters approve state borrowing more than $300,000. The administration and the attorney general’s office have argued that pension-obligation bonds are exempt from the constitution’s popular-vote requirement because the obligation to pay the employer’s share of the pension was an obligation “imposed by law.” Because the underlying commitment was imposed by an initiative measure (Proposition 162 in 1994), they have no choice but to pay the bill.

This rather-tortured argument centers on the notion because the Legislature and the governor have limited control over the expenditure; they can borrow money to cover the obligation without a vote of the electorate. Imagine the mischief that would occur if the court had agreed with the governor and the attorney general. For example, there would be nothing to prevent the Legislature and the Governor from borrowing money to meet the education funding guarantee placed in the constitution in 1988 by the initiative measure known as Proposition 98. Even though the obligation can be suspended it must be made up in later years through the so called “maintenance factor,” and all of this out of the hands of the governor and the Legislature. You can see it now, Maintenance Factor Obligation Bonds, or MFOBs.

In years where there are insufficient revenues to meet spending obligations, governors and legislators use a variety of actions to ensure that there are sufficient funds in the treasury to support agreed upon state spending. One action that has become increasingly popular with policymakers is to simply borrow money and avoid the pain of reducing spending or increasing taxes.
But not all borrowing is the same. It is one thing to borrow funds for a short period from one designated account to cover the cash flow needs of another.

Think of the disruption to essential programs if there was not some flexibility in matching expenditures with the state’s volatile revenue stream.

On the other hand, it has long been held that borrowing money for a long period of time–say, 20 years to pay for operating costs (including pension obligations) is a bad idea. Which brings us to the “debt clause.” The framers of our first constitution adopted in 1849 included the debt clause, which requires voters to approve any indebtedness in excess of $300,000, to prevent the state from using borrowed money for operating purposes.

According to research conducted by the California Constitution Revision Commission in the mid-1990s, our founders were worried that the state would borrowing money to finance its budget as many eastern states were doing at the time. While debating the amount of the debt limitation, one delegate opposed any public debt at all, arguing “if we could not carry on our State Government without contracting a debt of that magnitude, we were certainly starting wrong.” How soon we forget.

The drafters accurately predicted a natural inclination among elected officials, regardless of party affiliation: Spend money on popular programs and avoid raising taxes. But their solution–the debt clause–has not been the bulletproof barrier they envisioned.

Over the last 50 years the courts have carved holes in the provision by authorizing exemptions from the voter-approval requirement. For example, when the state wants to build a prison or higher-education facility, it can avoid voter approval by issuing “lease obligation” bonds. The courts long ago bought into the idea that these bonds were not an obligation of the state because the government was simply financing the lease–even if another state agency is the landlord and the debt service for the bonds was paid out of the operating budget of the agency using the facility.

Indeed, ever since voters rejected a prison-bond proposal in the 1990s, policymakers have opted to use lease obligation bonds to pay for prison and court house construction, even though they are more expensive than voter-approved general obligation bonds.

Our collective desire to get state budgets adopted on time and with the least amount of pain to taxpayers or important services such as education and health care just received a wake-up call from the state Court of Appeal in Sacramento. After years of avoiding the conflict between the provisions of the debt clause and the desire to borrow money to balance the budget, the judicial branch of state government that has given new life to a 167 year old provision in the state’s constitution. If the governor and the Legislature were unwilling to “tear up the credit cards,” we can thank the three judge panel on the Court of Appeal for doing so (www.courtinfo.ca.gov/opinions/documents/C051749.PDF).

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