The Once-a-Decade Crisis: California can get well -- and stay well -- with sensible, though politically difficult, reforms.

'What do we do now?" That was the question on the lips of Ronald Reagan's inner circle the day after he won his first landslide election as governor of California in 1966. In 2003, people aren't waiting for the election to turn their thoughts toward figuring out how to climb out of California's fiscal abyss. Democrats want to raise taxes; no news there. Republicans want to cut spending, but are vague on details, as Arnold Schwarzenegger admitted at his first press conference.

Can a $38 billion budget shortfall be closed with spending cuts alone? The precedents are not encouraging. The current budget crisis is the fourth in the last 40 years. In each case save one (the small shortfall of 1983), the eventual solution involved a large tax increase -- all from Republican governors, starting with Ronald Reagan in 1967. Reagan's $1 billion tax hike, at a time when the total state budget was only about $5 billion, would amount to more than $10 billion today, adjusted for inflation and population growth. Twelve years ago Gov. Pete Wilson, facing a then-unimaginable $14 billion budget shortfall, tried to split the difference, ordering up $7 billion in new taxes to go along with $7 billion in spending cuts.

The Wilson experience is an excellent case study in supply-side economic theory, for his tax hikes brought in far less revenue than expected, and the state's budget shortfall dragged on for several more years. The state's economy -- and tax revenues -- didn't start to recover significantly until Wilson cut tax rates in his second term. A tax hike now is certain to prolong California's agony.

Although most California citizens understand that overspending is the heart of the problem, not many appreciate how egregiously out of control state government has become. Republican candidate Tom McClintock has calculated that if the last budget of Gov. Pat Brown -- the "big spender" Reagan unseated in 1966 -- were enacted today, adjusted for population growth and inflation, it would be about $40 billion, as opposed to the nearly $100 billion budget Gov. Gray Davis proposed.

Brown built schools, college campuses, large water projects, and hundreds of miles of highways. Today, at twice the tax burden of the 1960s, the state builds virtually no public works; the budget is almost wholly devoted to social services and education. Spending under Davis has grown twice as fast as household income. Bonded indebtedness has soared from $7 billion to $40 billion in the past two years, and the state's bond rating has sunk to Third World levels. If California were an independent nation, its fiscal imbalance would qualify for International Monetary Fund intervention.

Arnold Schwarzenegger is correct in saying that few people have a clear understanding of how the budget is really spent, and is on to the cornerstone of fiscal reform in calling for a constitutional spending limit. The favored model at the moment is Colorado's taxpayer bill of rights, which limits increases in per capita state spending to the inflation rate (factoring in population growth) and requires a vote of the people for any tax increase. Colorado, almost alone among states at the moment, has no budget crisis; Colorado taxpayers have received several tax rebates in recent years and have enjoyed one of the highest rates of job growth in the nation.

If California had Colorado's spending limit in place, California taxpayers would have enjoyed $30 billion in tax rebates since 1998. But here the plot thickens. California had an effective constitutional spending limit in the 1980s, called the Gann limit, for its proponent, the late tax activist Paul Gann. (The Gann limit was enacted by voter initiative in 1979.) In fact, taxpayers received a $1.1 billion rebate in 1987; the rebate checks bore the signature of the state controller - - Gray Davis. The spending limit is actually still in the state constitution, but has become a dead letter. Understanding how this occurred is central to devising a strategy for long-term spending control.

California liberals hated the spending limit almost as much as they still hate the 1978 Proposition 13 limit on property taxes; and they eroded the spending limit, gradually but quite successfully, in the late 1980s and 1990s. Their effort to scrap the spending cap is a long and complicated tale, but it essentially involved exempting ever greater portions of state spending from being covered by the limit. The teachers union struck first, narrowly passing an initiative in 1988 that earmarked roughly half the state budget for K-12 education and exempted education spending from the calculation of the Gann limit. Soon, other "vital" aspects of spending were exempted, and before long the state budget had become a stampeding herd of sacred cows. Between earmarks, federal mandates, and the "current services" budget method, the California budget is on automatic pilot to a greater extent than even the federal budget. I once calculated that less than 8 percent of the state budget can be considered "discretionary" spending that the legislature can genuinely control through the regular budget process (that is, without major statutory change).

For any future constitutional spending limit to stick, all the earmarks and exemptions must be swept away. This is considered a political impossibility: The special interests that benefit from these earmarks - - especially the teachers union -- will be loath to surrender their pre-set pieces of the pie. There is one enticement that might break the deadlock. Liberals hate the two-thirds vote requirement for tax increases (and for passing a budget) that was an adjunct feature of Proposition 13, and have in the wings an initiative to scale back the supermajority to 55 percent. A reformist governor might offer to make tax increases and budget passage subject to a simple majority in return for the end of earmarks and a serious spending limit. Anti-tax activists would protest this retreat, but if a serious spending limit were in place, there would be less pressure for tax increases.

While long-term structural budget reform is necessary to prevent this year's budget catastrophe from recurring, the more urgent question is, What should be done right now? The Reason Public Policy Institute has produced the most extensive and serious short-term budget proposal: a 150-page, 10-point "Citizens' Budget" that would, if enacted, produce a $1.5 billion surplus within two years. The Reason budget plan, amazingly, has few direct program cuts. It would achieve most of its savings through aggressive use of competitive outsourcing and privatization; abolition and consolidation of numerous state agencies, boards, and commissions; reduction of state personnel by 5 percent (Gov. Jeb Bush has reduced state personnel costs in Florida by 5 percent every year); and adoption of a biennial budget process. The Citizens' Budget also lists over $15 billion in specific line-item cuts.

Much of this agenda is anathema to public-employee unions, making its adoption problematic. Yet California, whose once-a-decade fiscal crises always seem to be worse than those of other states, may have reached the end of the road this time. If Gov. Davis is thumpingly recalled on October 7, and his replacement selected with 40 percent or more of the vote (as many observers are predicting), the new governor will be in a strong position to demand serious reform in the state budget.