The Golden State's economic woes include the third-highest unemployment rate in the U.S. and a business climate that executives call the nation's worst.
Robert Galbraith/Reuters/CorbisThe Golden State’s economic woes include the third-highest unemployment rate in the U.S. and a business climate that executives call the nation’s worst.

In the aftermath of the 2010 midterm elections, a piece of conventional political wisdom—“Where California goes today, the rest of the nation goes tomorrow”—sounds a lot like a threat. A state that has long been a standard-bearer for liberal ideas and policies is finally coming apart at the seams. On Election Day, California suffered from the country’s third-highest unemployment rate, the worst business climate, and a public-pension shortfall of more than $500 billion.

Yet as the rest of the nation voted for smaller government and economic restraint, California moved decisively in the opposite direction. On a night when Republicans picked up six seats in the U.S. Senate, California gave ultraliberal senator Barbara Boxer a 10-point margin over an articulate conservative, Carly Fiorina. While Republicans acquired more than 60 seats in the House of Representatives—the biggest one-party swing in 72 years—not one of those seats came from California. And though other double-digit-unemployment states like Michigan, Nevada, South Carolina, and Florida used the midterms to bring reformist Republicans to their governors’ mansions, the Golden State elected Jerry Brown, the Democrat whose previous tenure as governor was the high-water mark for liberalism in the executive branch.

California needs to develop an economic-policy agenda that can save it from irredeemable second-class status. But the state’s economic problems are inseparable from its considerable institutional and political problems. And fixing those will likely prove highly difficult under Governor Brown.

To get a sense of the institutional problems, first understand that California is as polarized as the nation is as a whole. San Francisco is so left-leaning that the city’s name has become an adjective for liberalism. Orange County, by contrast, regularly boasts of being the most Republican municipality in the nation. Farmers in the state’s vast Central Valley tend to one-sixth of the irrigated land in the United States. Environmentalists in Los Angeles, meanwhile, mount regular bids to reduce water supplies to the valley in order to protect a local fish species. One-third of the U.S. Navy’s Pacific Fleet makes home port in San Diego. Up the coast in San Francisco, residents voted in 2005 to shut military recruiters out of high schools.

California’s byzantine political structure is woefully unsuited to resolve all these tensions. This is a state with the world’s third-longest constitution. It has a legislature that, until November, required a two-thirds majority to pass annual budgets and that still needs a two-thirds majority to pass tax increases (though California remains one of the highest-taxed states in the country). The state has more than 300 unelected boards and commissions, which range from the picayune (the Speech-Language Pathology and Audiology and Hearing Aid Dispensers Board) to the oppressive (the California Coastal Commission, whose land-use policies were once denounced by Supreme Court Justice Antonin Scalia as “out-and-out extortion”).

It’s also a state in love with the plebiscite, with a dozen popular initiatives or referenda on the ballot during most general elections. While initiatives dealing with hot-button social issues—illegal immigration, gay marriage, abortion, marijuana—grab the most headlines, proposals doing long-term economic damage go largely unnoticed. Particularly harmful are popularly approved mandatory spending requirements, such as the requirement that the state spend approximately 40 percent of its revenues each year on education. These measures leave as little as 15 percent of the budget to the discretion of the legislators in Sacramento. (And, like all popularly enacted policies, they can be altered or undone only by another round of citizen approval.) Thanks partly to these spending requirements, California’s budget deficit will widen to more than $25 billion over the next 18 months, the Legislative Analyst’s Office reports—a dizzying shortfall that must be closed, in accordance with the state’s balanced-budget requirement.

The budget crisis is only the beginning of California’s economic difficulties. Regulation is a silent killer of California’s prosperity, and much of it is imposed by unknown, unelected bureaucrats operating within the bowels of state departments and agencies. The regulatory environment is so uninviting that a recent survey of more than 650 corporate executives ranked it the worst state in the nation in which to do business. Each year, “the total cost of regulation to the State of California is $492.994 billion,” which is “almost five times the State’s general fund budget, and almost a third of the State’s gross product,” wrote Sanjay Varshney and Dennis Tootelian of California State University at Sacramento in a 2009 study. “The cost of regulation results in an [annual] employment loss of 3.8 million jobs, which is a tenth of the State’s population.”

California’s biggest long-term economic threat—implanted by an earlier generation of legislators in ways difficult to remove today—is its public-pension time bomb. For years, Governor Arnold Schwarzenegger’s doomsday projection for pension liabilities was a figure around $300 billion. It turns out that for once in his life, the governor was being too conservative. A study released by the Stanford Institute for Economic Policy Research in April 2009 put the total figure for California’s three largest public-pension funds—responsible for financing the retirement of 2.6 million government workers—at $535 billion, all of which, of course, will have to be paid somehow.

To address the institutional problems at the core of California’s economic crisis, a cottage industry of policy entrepreneurs has sprung up, such as Repair California, a group formed by Bay Area business leaders in 2008 for the sole purpose of calling a statewide constitutional convention. The appeal was undeniable: If the state is ungovernable, why not alter its governing charter? But Repair California’s agenda embraced California’s unfortunate tendency to believe that ever-greater citizen participation can make its problems disappear. Under a mind-numbingly complex series of representation formulas intended to factor in assembly districts, counties, and Indian tribes, Repair California would have 465 citizens chosen for the convention through a process too incoherent to be explained in paragraph form (the organization itself relies on an illustrated chart). In a rare moment of political sobriety, voters withheld the support that would have been necessary for Repair California’s plan to qualify for the 2010 ballot.

A far more useful reform would be reining in the excesses of direct democracy. On contentious social issues, referenda and initiatives may be beneficial, but on more technical aspects of government, oversimplified ballot language tends to obscure more than it clarifies. The most telling examples are those spending initiatives—often totaling billions of dollars at a time—that promise improvements in emotionally appealing areas like education, health care, and social welfare. Under current rules, these initiatives aren’t required to establish funding sources, so voters are essentially being asked if they’d like to feel socially virtuous free of charge. Mandating pay-as-you-go initiatives—that is, requiring initiatives that would spend money to propose offsetting spending cuts or tax increases—would at least require Californians to take responsibility for the sprawling debt increases that inevitably accompany such profligacy.

But what can California do about its current fiscal situation? To balance its budget, the state needs either to cut spending or to increase taxes (or both). The first option will be exceedingly difficult because of the ballot initiatives and locked-in spending requirements that have left legislators so little discretion over the budget. Ideally, California would eliminate all these complex spending formulas and start every year’s budgeting process from zero. But that would require a ballot initiative itself, and such an initiative would be strenuously opposed by the broad coalition of special interests that benefit from the current system.

The second option, hiking taxes, looks no more promising. In the past few decades, California’s requirement of a two-thirds majority to increase taxes hasn’t always been prohibitive, especially when Republican governors make common cause with Democratic legislators (a trend that continued into the Schwarzenegger era). But in today’s economic environment, increases are politically poisonous, as shown by a 2009 ballot proposal for widespread tax hikes that was defeated with just under two-thirds of the vote. Californians already labor under sales-tax rates usually reserved for states without income taxes (at 8.25 percent, the nation’s highest) and sharply progressive income-tax rates usually reserved for states without sales taxes (the state’s top rate is 10.55 percent, and it doesn’t allow you to deduct your federal taxes, as some states with income taxes do). These taxes, in turn, are a big reason that residents are fleeing the state; in 2008, 135,000 more people left California than moved there. If California keeps raising taxes, it can expect the migration of its tax base to continue unabated.

California would therefore do well to take the advice of economist Arthur Laffer, not just because of his status as one of the authors of Reaganomics but because he is an example of the state’s woes, having packed up his California-based fund-management business in 2006 and relocated to Tennessee. By Laffer’s estimates, if California abandoned its current, highly progressive income-tax system in favor of a statewide flat tax of no more than 6 percent on personal income and net business sales, it could completely abolish all property taxes, state gas taxes, and state payroll taxes, as well as all current state and local sales taxes, without losing revenue. And that’s without factoring in the increased economic activity that such a dramatic change to the tax code would almost certainly generate. This change would once again require the support of a two-thirds majority in the legislature, but its appeal just might be broad enough to attract such a coalition.

No matter how California taxes or spends, its heavy regulatory burden will hamper the state in rediscovering its former economic dynamism. The state should create a commission to subject its regulations to rigorous cost-benefit analyses. Any regulation that fails to generate more in social benefits than it does in social costs should be prevented from becoming law unless it is passed by a two-thirds majority of the legislature, rather than by the executive branch through the rule-making process. This approach would recognize that excessive regulation is just as economically poisonous as excessive taxation (which already enjoys the protection of the two-thirds requirement) and force legislators to take responsibility for job-killing policies.

And unless it defuses its pension bomb, California will become Greece on the Pacific. In the short term, avoiding that fate means renegotiating pension deals with current employees, increasing their retirement age, and requiring higher contribution levels from them. In the long term, it means shifting to a system of defined contributions instead of defined benefits. California’s organized-labor establishment is the state’s single most powerful political interest group, which will make achieving these reforms awfully tough sledding through the legislature. Real change on pensions is more likely to come through an initiative campaign that manages to hit the electorate’s panic button.

Jerry Brown’s gubernatorial victory, combined with a total Democratic sweep of statewide offices and pronounced Democratic majorities in both houses of the state legislature, leaves California subject to virtually unimpeded one-party rule. The big question is thus whether the impetus for reform can come from within the Democratic Party.

Among his defenders, Brown is often lauded for being ideologically heterodox. This is, after all, a man who supported the flat tax in his 1992 bid for the Democratic presidential nomination and who threatened to “starve the schools financially until I get some educational reforms” during his time as governor. Optimistic pundits have convinced themselves that this policy eccentricity will give Brown the reformist spirit necessary to keep California from being the nation’s best argument against federalism. That claim, however, is dubious. It was the state’s public-employee unions—the single biggest force behind California’s spendthrift ways—whose money allowed Brown to stay afloat in his campaign against former eBay CEO Meg Whitman. Will a Democratic governor with solid Democratic majorities in the state legislature be willing to spend most of his political capital to weaken the influence of his own financial base?

California’s future may depend on it. The state is on an unsustainable course. As the economist Herbert Stein famously noted, “If something cannot go on forever, it will stop.” As a new administration takes the helm in the Golden State, that’s another piece of conventional wisdom that sounds like a threat.


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