Budget Remedy Likely to Hurt State Economy

A cure for the state’s $12.6-billion budget deficit--in the form of tax hikes and spending cuts--will cause painful side effects, slowing economic growth just as the state’s slumping economy is poised for recovery later this year, according to analysts.

Some form of tax increase, which many view as inevitable, would come “at a most unfortunate time,” said David G. Hensley, a UCLA specialist on the California economy.

As the state’s budget crisis has grown in magnitude, so has recognition that the remedies will take a toll. Higher taxes, such as the proposed state levy on services, would increase the already high cost of living and doing business in California, further harming its image with industry.

Deep spending cuts, meanwhile, could hurt the poor and others who depend on government services and reduce funding for education, training and other long-term public investments.

“It gets to be a Catch-22,” said Jack Kyser, chief economist at the Los Angeles Area Chamber of Commerce. “You’ve got to solve the budget problem. But by solving the problem you tend to tarnish your reputation just a little bit more.”

Legislators and the governor have yet to agree on a final package of taxes and spending cuts. Yet even as debate continues in Sacramento, it is possible to look ahead to some likely side effects of the impending budget cure:

* Slower job growth. State and local government employment currently accounts for a hefty 13% of all jobs in California. Such employment growth had been expected to help offset losses in construction, manufacturing and other struggling industries.

But now, weaker government employment becomes “one reason to argue that the recession will linger here in the state,” Hensley of UCLA said.

* Reduced consumer spending. As last year’s oil shock showed, sudden cost increases can inhibit other forms of spending. A tax hike will swallow up income that otherwise could be invested or spent in retail stores. “You won’t buy as many washing machines, as many cars and so forth. The money has to come from somewhere,” said Phillip E. Vincent, an economist at First Interstate Bancorp.

* An added burden for business. In recent years, California has gotten a reputation as being costly for industry due to regulations on workers compensation and the environment, as well as high costs for labor and land. Many employers are choosing to expand elsewhere.

Tax hikes are considered particularly undesirable when the economy is weak. Thus few in Congress have pushed for a tax increase during the current U.S. recession, even though the federal budget deficit may exceed $300 billion this year alone.

“One could argue that the appropriate way of handling this thing is to run deficits during bad times and surpluses during good times to pay them off,” said Douglas H. Joines, associate professor of finance and business economics at USC.

Unlike the President, however, California’s governor is required to present state lawmakers with a balanced budget. And unlike the federal government, California officials have no printing press to churn out extra dollars when they wish.

These days, they may wish they did: The state budget gap, estimated to be in the $7-billion range earlier this year, is forecast to approach $13 billion over the next 15 months.

Added pressure, meanwhile, comes from the financial world. Standard & Poors, the rating agency, has said it will downgrade California’s AAA bonds unless the crisis is solved shortly. A downgrade could force the state to pay higher interest rates to borrow money, a potentially expensive problem.

“To get the kind of money they (state officials) are talking about, they’re going to have to look at the ‘big three’ ” taxes on sales, income and property, said John O. Wilson, chief economist at the Bank of America in San Francisco. “You can’t do it with smoke and mirrors.”

An income tax hike for the wealthy, higher motor vehicle license fees, reduced tax credits for renters and new taxes for candy and periodicals all have been suggested at one time or another to capture added revenue. But debate recently has focused on taxing services.

(The California sales tax is set at 7% in many counties; each 1% of the sales tax yields about $3.3 billion, according to the Assembly Office of Research in Sacramento. Each 1% of a broad-based service tax could yield about $900 million, preliminary analysis has found.

In California and other states, budgets have been squeezed by spiraling health care costs, burgeoning prison populations, expanding school enrollments and other demands in the last few years. At least 28 states have imposed spending cuts or other measures to avoid budget shortfalls recently, according to the National Assn. of State Budget Officers in Washington.

What is more, financial stress is affecting cities and their residents as well. Los Angeles, for example--struggling to narrow a projected deficit of at least $100 million--is considering a range of added fees, including charging homeowners for trash collection.

Such shortfalls typically have two distinct elements. The biggest part of California’s deficit--in the range of $8 billion by some estimates--comes from lagging tax revenues caused by the recession. Slumping business, rising unemployment and slow consumer spending have cut sharply into sales, income and corporate tax collections.

A separate portion of the deficit, perhaps $5 billion, reflects rising demand for public health services, crowded schools, growing prison populations and other costs associated with people moving to the state.

It could be a mistake, some analysts caution, to attack the two separate problems with a single, costly solution. Rather, a temporary tax surcharge could be a way to make up for the temporary dip in revenues caused by the recession, said Stephen Levy, director of the Center for Continuing Study of the California Economy in Palo Alto.

Otherwise, “You might move toward putting in a very long-term tax increase that is not justified on the basis of tiding over a recession,” he added.

For all its budget problems, California may still retain an economic advantage over many places. Continued population growth, while placing tremendous stress on public services, also brings with it the promise of continued economic growth. Newcomers often buy and invest in their communities and ultimately contribute to the future economy, economists say.

That’s why some experts worry that the state could pay a long-term price if it cuts back too far on the sorts of programs that help the less-fortunate lead productive lives. “Education and health care also have economic benefits,” Levy said.