Friday, September 26, 2003

A pretty good description of how CA got into this predicament:

California voters think the electricity crisis contributed to the state budget deficit. If only things were that simple. In reality, not a cent of the deficit was caused by electricity prices: the cost of the crisis will show up solely in future electricity bills.

The basic economic lesson is this: a deregulated wholesale market and a regulated retail market is a recipe for disaster. If you tell a supplier, "I'll buy the same amount no matter what you charge," don't be surprised if you are charged a high price.

So if the electricity crisis didn't cause the deficit, what did?

Fundamentally, the deficit is a hangover from the days of irrational exuberance. California was the epicenter of the dot-com boom of the late 1990's, and tax receipts flowed to Sacramento. Tax revenue from stock-option grants and capital gains alone rose from $7.5 billion in 1998-9 to $12.7 billion in 1999-2000 to $17.6 billion in 2000-1.

When money flows in, governments find it hard not to spend it. This is particularly true in California, thanks to mandated spending constraints. For example, Proposition 98, passed in 1988, requires the state to spend 40 percent of general funds on education from kindergarten through high school. As a result, spending, both automatic and discretionary, rose in parallel with tax revenue.

Then the house of cards came tumbling down. Revenue from options and capital gains fell to $8.6 billion in 2001-2, and $5.2 billion in 2002-3.

Reversing those spending decisions was not as easy as putting them in place: much of the increased revenue went for education, tax cuts and other long-term commitments.

This brings us to the second lesson in economics: don't spend transitory income on permanent commitments.

State tax revenues in California come basically from three sources: the sales tax, the property tax and the personal income tax. Stephen Levy of the Institute of Regional and Urban Studies in Palo Alto has looked at the historical volatility of these series. (His summary is available at

Surprisingly, he found that the sales tax base had the most volatility, in part because the sales tax excludes the rapidly growing services sector. Personal income, excluding capital gains, has grown relatively smoothly by comparison.
Mr. Levy argues that revenues from volatile sources, like capital gains, should have special treatment in budgeting: one-time revenue increases should be tied to one-time expenditures or automatically put into a rainy day fund. This is an eminently sensible suggestion.

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