Sunday, November 23, 2014

California Bad Dreaming

STANFORD – While central governments’ fiscal problems plague many economies, a parallel crisis is enveloping many subnational governments around the world. From Spain to China to the United States to Italy, these governments – regions, states, provinces, cities, and towns – face immense fiscal challenges. Higher levels of government are “on the hook” to bail out local insolvent governments, and may even suffer bond downgrades as a result; in Spain, Italy, and China, that role falls to the national government, and for US cities and towns, to their states.

There are many similarities within and among countries in terms of the nature and causes of these local fiscal calamities. Local officials used growing revenues during the boom to fund pet projects or boost pay and benefits, with little regard to future costs. In the downturn, revenues and subsidies from the central government collapsed and the bills came due. Creative accounting gimmicks masked the full extent of the problem. Now comes the reckoning.

To finance local businesses, Chinese local governments use local-government financing vehicles (LGFVs) to circumvent bans on direct borrowing. In Spain, housing and employment collapses have hammered revenue. Rumors of an imminent default swirl around Sicily, whose governor has resigned as borrowing soared after cutbacks from Rome. A new report from a task force co-chaired by former Federal Reserve Chairman Paul Volcker indicates that unfunded pension and health-care costs make many American states’ medium- and longer-run fiscal prospects bleak.

California’s fiscal crises may also provide lessons for subnational governments around the world. Three California cities have recently declared bankruptcy: Stockton, the largest American city ever to do so; San Bernardino, the second-largest bankrupt city; and Mammoth Lakes. Compton is rumored to be next; most observers expect more to follow.

The state faces another large budget deficit, yet Governor Jerry Brown’s budget this year includes a substantial spending increase. Brown’s ballot initiative this November would raise California’s top personal income-tax rate to 13.3%, the nation’s highest. According to Brown, the tax hike would be temporary, yet it would last seven years. Meanwhile, he claims to be tough on California’s notoriously well-paid and powerful public-employee unions by negotiating a 5% pay cut. But the details reveal a net 1.6% pay cut in exchange for a 5% reduction in work hours.

Cities are declaring bankruptcy to escape the pressure of exponentially rising pension and health costs. In contrast to the state, cities have even cut back essential services, including 20% reductions in police and fire personnel.

Bankruptcy should allow local governments to renegotiate their bond debt and, perhaps, their retired employees’ pension and health-care costs (that’s up to a bankruptcy judge). The state would be expected to take over essential public services from bankrupt local governments. But the state itself is in dire financial straits; one of the cities’ problems is the sharp curtailment of state funds to localities.

Despite these problems, Brown has committed California to a San Francisco-to-Los Angeles high-speed rail boondoggle. To get the cost projections down to $68 billion from a $100 billion estimate, some existing low-speed rail will be used, likely doubling the time it takes to travel from Los Angeles to San Francisco to 5-6 hours. California will most likely be unable to pay for the entire project, leaving little use for the first segment in the sparsely populated Central Valley. And, if the project somehow is completed, it will be a not-so-high-speed rail that will drain badly needed resources from other essential government services for many decades.

These sorry episodes reveal some important lessons. One-party government weakens accountability and breeds hubris. The California legislature has been controlled by the Democratic Party for decades, and it takes its cue from its party’s most powerful special interests: public-employee unions, environmentalists, trial lawyers, and teachers’ unions.

They have concocted an extremely progressive social experiment: with 12% of the US population, California has more than 30% of its welfare dependents. From the mid-1980’s to 2005, California's population grew by 10 million, while Medicaid recipients soared by seven million; tax filers paying income taxes rose by just 150,000; and the prison population swelled by 115,000.

The state income tax is not only uncompetitively high, but the revenues are volatile. In the economic and stock-market upswing, revenues roll in far more rapidly than incomes rise, owing to the extremely progressive income tax (in good years, the top 1% pays about half the state’s income taxes).

The legislature spends it as if the elevated revenues will continue forever. Then the inevitable recession and stock-market collapse plunges the state into crisis. The progressive social experiment has gone so severely off-track that the state cannot even dependably provide essential services, from courts to education, for the most needy.

Not surprisingly, California’s economy, which used to outperform the rest of the US, now substantially underperforms. The unemployment rate, at 10.8%, is almost one-third higher than the national average, and higher than every other state except Nevada and Rhode Island.

California still has great strengths in technology, entertainment, and agriculture. But citizens and politicians alike must agree to target services far more carefully; reform the tax system with lower rates on a broader base of economic activity and people (almost half pay no state income tax); and modernize inefficient state programs to spend less and produce far better outcomes. Not coincidentally, that’s a perfect prescription for bloated, debt-ridden central and subnational governments worldwide.

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    1. CommentedDavid Cearley

      While there are several issues with prop 13, the biggest are;
      Taxation is heavily skewed to the most affluent, who's income as a class is far more volatile than the overall population, and it helps create an entitlement mentality even among the upper classes. If I understand correctly, the tax value never changes after you purchase a property until you sell it. The result is one neighbor (the older, established, higher wealth neighbor) gets a very low tax bill in relation to value, while the yound new buyer (lower wealth, more kids, etc) pays two to five times as much in taxes. Next, it has caused municipal taxing authorities to get extremely creative in how they borrow in order to sidestep mandated spending limits. The school district borrowing $100 million, but repaying $1 billion comes to mind. Lastly low local taxation has moved spending authority and accountability far above the local level, making it more susceptible to fraud, waste, abuse, and corruption. Public sector unions are so powerful the state has adopted laws preventing municipalities from breaking union contracts even under bankruptcy. Yes, California is a great example of the results of collusion between unions, democrats, and environmentalists wealthy enough that the policies they enact primarily harm the working class.

        CommentedMarc Sargen

        Property Values do increase but are limited to how much they can rise from year to year. If you get boom market like we did then Market Value may be substantially larger than the Assessed Value. This help prevent people from having their property taxes increase greatly in boom markets & have a home that they can no longer afford to keep. Since the value resets to Market Value when the property is sold this is often a moot point in boom markets where homes change hands often. In 2009, CA paid $2,839 (Rank 10) on the Media Home in Property taxes which was .74% (Rank 33) of the home value. This was 3.59% of Median Income for Home Owners (Rank 15). CA's current crisis is not due to Prop 13. It is because the Assessed Home Values have had be be reduced from Peak Values & local governments had significantly increased spending as rising home prices had increased property tax revenues greatly.

    2. CommentedF. W. Croft

      This is a well-reasoned article, and it's unfortunate that it won't have any influence on the future of CA. Calif. voters insist on looking for somebody else to pay for their indulgences, and businesses have decided that the "somebody else" shouldn't be them. Companies'll keep moving out; jobs will keep leaving, and CA will end up in default. The only rich who'll get soaked will be those foolish enough to buy CA bonds. Golden State? Iron pyrites is more like it.

    3. CommentedGreg Hill

      Dr. Boskin's remedy for California echos the Republican Party's remedy for the U.S. federal government's fiscal problems: 1) cut taxes; 2) broaden the tax base; 3) tax lower income earners who aren't currently taxed; and 4) "target social services," i.e., cut social spending.

      I'm sure California's public services can be managed more efficiently, but Boskin is really claiming that neither California, nor the U.S., can afford a generous welfare state. Yet somehow Canada isn't having problems of this magnitude, nor are the Scandinavian countries.

      Boskin complains about California's high taxes, but the U.S. flourished under Clinton's high-tax regime. It's true that taxation and social spending should be nationalized to avoid turning California into Alabama, but Boskin misses this dimension of the problem.

        CommentedMark Pitts

        The hugh difference between Canada and Scandinavian countries and the US is that those countries are big net exporters, while the US is a major net importer. (By definition, not all countries can be net exporters.) The failing European model is a more appropriate comparision.

        Mr. Hill should also keep in mind that Clinton created a great deal of growth through de-regulation, especially in the financial sector: he repealed Glass-Steagall and he made sure derivatives would not be regulated by the SEC or CFTC.

    4. CommentedLuke Ho-Hyung Lee

      Considering the current rapidly deteriorating situations in both the domestic and international economies, it seems we are already on course for the worst-case scenario, that is, another Great Depression. In this event, employment will inevitably plummet, and the Federal deficit will also skyrocket.

      What is the solution? I believe there is only a solution left at the moment: “The existing job-killing machines, that is, the private information-based supply chain networks, should be replaced as soon as possible by a new job-creating machine, that is, a new public information-based supply chain infrastructure (or platform) that helps rather than disrupts and destroys existing businesses.”

      Please see this article: “Job-Killing Machines in the Modern Information Age”

    5. CommentedRichard Roll

      Interesting and well written article. The inevitable is slowly unfolding in California. There is nothing to suggest any intervention that will change California's future demise. The situationcan and will, day by day, get dramatically worse.

    6. CommentedPaul A. Myers

      From about 1990 up to the 2009 fiscal crisis, California spending went up 9% per year, tax revenues 6% a year, and the state economy about 3% a year. This was always about living within your income. And the Proposition 13 argument has been proven lame again and again.

    7. Commentedmarvin sussman

      living is arizona for the past 5 years after being a resident of so cal for 37 years, i agree with mr. crouch. perhaps mr. nielen is too young to remember why prop 13 was voted in. property owners were getting bigger and bigger increases every year. local and state officials were putting an increasingly onerous burden on the ordinary homeowner. so the revolt took place. in az the taxes are low. the legislature balanced the budget and traffic is light. i'm happy

    8. CommentedErik Nielen

      I find it very interesting, and highly suspect, that there is no mention of Proposition 13. The lack of a realistic property tax system has led to the denigration of California' public education system, a proliferation of wasteful fiscal zones, and contributed to the hyper-optimism of property development. The real problem isn't a "progressive experiment" but a local and national public that wants lots of services and amenities, but don't want to pay the taxes that these things require. That is what has led to creative accounting gimmicks. Yes, there is too much public spending considering people don't want to provide the government revenue. By the way, I find the cartoon very misleading--it suggests that the state has a revenue source to suck from. The reality is, for both CA and the USA, that we need to learn to be responsible and pay our fair share in taxes--property and otherwise.

        CommentedStephen Crouch

        Mr. Boskin, a well organized and accurate article--to the point.
        Eric, you can't be a California resident with the view that CA tax payers don't pay enough or the state of CA's education system is due to lack of funds.
        You must do some reading and you will find that CA's taxes are near the top nation wide and our schools are near the bottom.
        Some thoughts to ponder--
        If prop 13's rules were changed to extract what you think should be taken from business/commercial land owners (to make it more "realistic"), who would ultimately pay the tax increase?
        And, do you think CA having 1/3 of the nations welfare takers might have something in part to do with non-citizens here illegally?
        "Fair share" indeed
        What is a person's "fair share"--30%, 50%, 80%?
        It takes a high IQ to evade the obvious--and CA has a lot of smart people at all levels of power.