The capitol in crisis: estimated $22 billion shortfall among worst in state history.

The state's economy may be turning the corner, but California's budget is in a state of melt-down.

Just six months ago, the budget deficit for the upcoming 2002-03 fiscal year was projected at between $7 billion and $10 billion - large, but still regarded as manageable.

Then, when Gov. Gray Davis released his budget last January, he put the deficit at $12.5 billion -- and proposed $5.5 billion in borrowing to help close the gap.

Now, in advance of Davis' May revision next week (May 14), the budget deficit is being pegged at $20 billion to $22 billion, more than 20 percent of the total budget.

At $22 billion, the deficit would be larger than the total budgets of most states and many nations. As a percentage of the overall budget, it would nearly equal the 1991 budget deficit as the worst in state history.

"No question, whatever the final numbers are going to be, this is a huge, huge problem," said Assemblywoman Jenny Oropeza, D-Carson and chairwoman of the Assembly Budget Committee. "It means everything is going to be on the table, both on the revenue side and in cuts."

The reason for the size of the deficit: plunging income tax revenues, primarily from the vaporization of stock options. During the stock market boom of the late 1990s, the state took in up to $18 billion a year in taxes on stock options and other asset sales. That figure is now estimated at $9 billion or less. Other sources of revenue, like corporation taxes, are also sharply lower.

California is hardly alone in grappling with widening budget deficits. At least 40 states have reported revenue shortfalls in recent weeks as income tax receipts have come in way below expectations. But California's problem is by far the most severe, due to the disproportionately heavy use of stock options in the Silicon Valley.

Bigger than expected

While some falloff in the capital gains taxes was anticipated with the pricking of the stock market bubble two years ago, no one expected the drop to be this steep. And it has sent Sacramento policymakers scrambling to figure out ways to close the gap.

"Personal income taxes decreased far beyond expectations," said Sandy Harrison, spokesman for the state Department of Finance, which is now crunching the revised budget numbers for Davis. "Nobody foresaw the extent of the reduction we experienced. It means we have a very, very big hill to climb in trying to balance this budget."

Another indicator of the scope of the problem is this assessment from state Legislative Analyst Elizabeth Hill:

"If you closed all nine University of California campuses and all 23 California State University campuses in the state, that would save $6.1 billion," Hill said. "And if you closed down all 33 state prisons, that would save another $4.7 billion. Yet even such drastic steps wouldn't solve the problem we're facing now."

Nonetheless, politicians in Sacramento must come up with a balanced budget this summer -- and they're eyeing billions in potential revenues and cuts.

The most palatable option is borrowing against future revenues, to spread out the pain of the deficit over a period of years.

"Trying to balance the budget in a single year will be very difficult," said Ted Gibson, formerly the state's chief economist who is now senior economic adviser with Metropolitan West Financial & Strategic Services in Sacramento, a subsidiary of L.A.-based Metropolitan West Financial Inc.

"Also," Gibson said, "balancing the budget in a single year would have a considerable dampening effect on the state's economy."

Betting on the future

This, of course, assumes that the current crisis is temporary and that the nascent economic recovery takes hold and boosts state revenues in a couple years. Otherwise, such a strategy could backfire in future years, leaving the state government in worse financial condition than it is in now.

"We regard the depth of this problem as temporary," Oropeza said. "I liken this to someone who is injured on the job and must take a few months off. You make some adjustments, put some things on your Visa card, refinance your house, but you don't totally change your way of life."

Republicans argue that the budget deficit is not the result of an economic fluke, but of a structural imbalance. They accuse the Davis administration and the Democrat-controlled Legislature of embarking on a spending spree in permanent programs over the last three years with one-time revenues from stock options.

"This is the Enron budget," said Granada Hills Assemblyman Keith Richman, the assistant Assembly Republican leader. "It doesn't look at the structural problem, where spending growth has outstripped revenue growth. That needs to be reversed."

But Republicans are in the minority and not in a position to control the debate until the final budget package is presented. To get the necessary two-thirds majority in each house, legislative leaders will need at least five Republicans.

Meantime, the Davis administration and Democratic legislative leaders are considering one big future revenue target: the billions in national tobacco settlement revenues coming to the state over the next 20 years. Davis has proposed selling $2.5 billion in bonds against these future revenues. But Oropeza said her committee is looking at borrowing up to $4 billion to help close this year's gap.

Back in January, with a $12 billion deficit, state officials hoped this type of relatively painless borrowing could take care of the bulk of the shortfall. But now, the deficit is too big to avoid tax or fee increases and service cuts.

Targeting vehicle fees

On the revenue side, the prime targets are the reversal of reductions in vehicle license fees, which could restore $3 billion in revenues, and the elimination -- or temporary suspension -- of various tax credits. One such tax credit: up to $800 million in net operating loss carryover deductions for businesses. Also being talked about is an increase in the personal income tax rate on the wealthiest tier of taxpayers -- those with incomes exceeding $150,000 or $200,000 a year.

Businesses pay one-third of the vehicle license fees in the state; hiking those fees would hit fleet owners hard. And the suspension of business tax credits would increase costs for businesses at a time when they can ill afford it, said Fred Main, senior vice president with the California Chamber of Commerce.

But election year politics could derail such proposals, especially anything that's perceived as a tax increase.

"No way are you going to see a tax increase -- at least until after November 5," said one Sacramento political observer. "Of course, if the situation is bad enough, it's quite possible that the Legislature could be called back into special session after Nov. 5 and then do the dirty deed."

Even the restoration of the vehicle license fee is not considered likely, although it will definitely be debated.

On the expenditure side, Gov. Davis last month said he may not be able to meet the spending levels for education required by Proposition 98, which has raised howls of protest from the education community. Last week, the L.A. Unified School District made $380 million in cuts.

Also likely are cuts in health care and social services for the poor, such as $125 million in services for the state's Medi-Cal program.

"I'm really afraid that these human services, which have always taken a heavy hit because they have the least powerful constituency, will take an even heavier share of the hit this time," said L.A. County Supervisor Zev Yaroslavsky. "And that hits the county precisely where it hurts the most, since we are the provider of last resort when it comes to human services like health care for the poor, public assistance programs and the like."

Oropeza said her committee is "trying to keep the cuts away from children, the elderly and the needy." And Davis has publicly pledged twice this year that he wouldn't use funds ear-marked for local government to balance the budget, like state officials did in 1993 when they shifted $3 billion in property tax revenues destined for local government to state coffers.

But, Yaroslavsky said, "the Governor did indicate that local governments would have to share in the pain."

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