California on 'verge of system failure'

Arnella Sims has seen a lot in her 34 years as a Los Angeles County court reporter, but nothing like this.

Case files piling up by the thousands, phones ringing off the hook, forced midweek courthouse closings and occasional brawls as frustrated citizens queue for hours to pay parking fines.

"People think we're becoming a Third World country," said Ms. Sims, 55. "They don't understand."

It's a story that's being repeated all across California - and throughout the United States - as cash-strapped state and local governments grapple with collapsed tax revenues and swelling budget gaps. Mass layoffs, slashed health and welfare services, closed parks, crumbling superhighways and ever-larger public school class sizes are all part of the new normal.

California's fiscal hole is now so large that the state would have to liberate 168,000 prison inmates and permanently shutter 240 university and community college campuses to balance its budget in the fiscal year that begins July 1.

Think of California as Greece on the Pacific: bankrupt and desperately needing a bailout.

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"We are on the verge of system failure," warned Jean Ross, executive director of the California Budget Project, an independent think tank based in Sacramento.

None of this would matter much to anyone outside the not-so-Golden State except that California's budget crisis is a harbinger of a grim dilemma that all Americans will soon confront. The country has built an elaborate and costly government machine, tied to a regressive tax system that can't generate enough revenue to pay for it all.

Canadians too have a stake in all this. Dramatic cuts by state governments are threatening to derail the U.S. recovery, dampening expectations for global growth.

"This is a classic American dilemma," explained Peter Dreier, a professor of politics and director of urban and environmental policy at Occidental College in Los Angeles. "Americans expect a lot of their government. But politicians have convinced them they're not getting what they want."

Americans have been "brainwashed" into believing they pay a lot of taxes, Prof. Dreier added. In fact, they are among the least-taxed people in the Western World, particularly if they're wealthy, he said.

After unveiling a grim budget last month that scraps a popular welfare program for a million children and slashes countless other programs for the poor and elderly, California Governor Arnold Schwarzenegger complained that the state's broken budget process has left him facing a "Sophie's Choice." That's a reference to the story of the Polish Jew forced by the Nazis to choose between saving her son or her daughter from the Auschwitz gas chambers.

Experts say the U.S. government will inevitably have to come to the rescue, using its borrowing clout to save the state from near-bankruptcy or devastating service cuts. Do nothing, and the entire U.S. economy could be put at risk. California, like the country's banks, may be too big to fail.

California is looking at a gap of $19-billion (U.S.) this year and $37-billion next year on a roughly $125-billion-a-year budget. Local governments, including the City of Los Angeles, are in similarly dire financial straits and are now scrambling to shed workers and services.

"We have to get some federal money," argued Ms. Ross of the California Budget Project. "The impact [of the Schwarzenegger budget]would be enough to slow down the U.S. economy. It would be bad for the U.S. and, arguably, bad for the world to do the shock therapy approach."

And California isn't alone in angling for a bailout. U.S. states are facing shortfalls totalling nearly $300-billion in 2010 and 2011; they also must wrestle with hundreds of billions more in unfunded pension obligations to their workers. "There are a few Greek crises brewing among the United States of America," said economist Ed Yardeni of Yardeni Research Inc.

The task is made all the more difficult because California and virtually all other states are barred by legislation from running operating deficits, forcing them to balance their budgets annually by slashing spending, raising taxes or both. Typically, states can only borrow short-term funds, or for capital projects.

Billionaire Warren Buffett, who advised U.S. President Barack Obama during his White House run, suggested recently that a Washington bailout of California and other troubled states is inevitable. How, he wondered, can Washington deny California after saying yes to General Motors, AIG and dozens of banks.

"I don't know how you would tell a state you're going to stiff-arm them with all the bailouts of corporations," Mr. Buffett said.

The alternative for many state and local governments may be default. Mr. Buffett said many state and municipal bonds are only triple-A rated because investors assume there's a federal backstop. "If the federal government won't step in to help them, who knows what [the bonds]are," he said.

California's credit rating is already the lowest of all 50 states.

How California, the largest and once most-prosperous state, got in this mess is a story decades in the making. It began with middle-class angst and a property tax revolt in the sprawling suburbs of Los Angeles. The movement would eventually sweep the country in the inflation-ravaged economy of the late 1970s, leaving government unable to pay for many of the services and entitlements people now take for granted.

John Serrano Jr., a social worker, was frustrated that he had to move his family out of East L.A. to find decent public schools for his children. He would eventually lend his name to a class-action lawsuit that would go all the way to the California Supreme Court. In a series of decisions, the court found the state's school finance system to be unconstitutional for relying too heavily on local property taxes, which vary widely in poor and wealthy neighbourhoods. For example, a school in tony Beverly Hills would often get more than twice the funds per student than one in poor East L.A.

The landmark case would forever change the fiscal landscape of California, and many other states, shifting the financial burden of kindergarten to Grade 12 education from local to state governments, but not the tax base. K-12 education is now the State of California's single largest expense, soaking up roughly a third of its budget.

A tax revolt would further tilt the tax burden to the state and deprive local governments of their most stable funding source - property taxes.

In the mid-1970s, California property taxes were soaring, along with real estate values, and incomes couldn't keep pace. The result was a campaign, financed by L.A.-area apartment landlords, that culminated in the now-infamous Proposition 13 ballot initiative in 1978.

Prop. 13 rolled back and capped both residential and commercial property tax rates at 1975 levels. And it virtually guaranteed that only a revolution would reverse the measure. Proposition 13 imposed a two-thirds majority requirement for all tax bills and required local voters to approve all municipal tax increases.

"California put itself in a straitjacket that it hasn't been able to get out of," Occidental College's Prof. Dreier explained.

In the years since Prop. 13, California has come to the rescue of local governments, taking on ever-greater responsibility for schools, low-income health care and welfare. And it has paid for all that with volatile sales and income tax revenue, making it tough to balance its budget when the economy stalls.

"A lot of people predicted doom and gloom in 1978. It just took a long time," said John Tanner, executive director of Local 721 of the Service Employees International Union, which represents 85,000 government workers in Los Angeles and throughout Southern California.

Prop. 13, according to Mr. Tanner, has put schools, courts, parks and a raft of other government services in a downward spiral. "We are at an unacceptable place right now," he said.

Perhaps no group of workers feels more targeted in the crisis than teachers. U.S. Education Secretary Arne Duncan has warned that without money from Congress as many as 300,000 teachers nationwide could lose their jobs to state budget cuts, including several thousand in California.

"It's not easy being me these days," said A.J. Duffy, president of the United Teachers of Los Angeles. "I have 45,000 members looking to me to save their jobs."

His union represents teachers and other employees at 700-plus L.A. schools, where as many as 1,200 jobs are threatened.

"We're destroying education as we know it," Mr. Duffy lamented. "My teachers will do a great job no matter what. But it's harder and harder to deliver the quality of education we've had."

California public schools were once a beacon for the country. Now, the state ranks dead-last in student-teacher ratios, 45th in per-student spending and 36th in high school graduation.

The tax structure may be badly flawed. But even union activists acknowledge that repealing Prop. 13 outright is probably a non-starter. Recent polls show support for keeping a lid on property taxes remains strong, in spite of the budget crisis.

Experts say tax reform is the only option for California, short of a massive and unprecedented shrinking of government. And that requires an "open conversation" between voters and their elected leaders, and almost certainly higher taxes, according to Ms. Ross, the economist.

If you want good schools, you have to pay for them," she said. "Cutting taxes doesn't raise revenue."

That kind of talk angers Kris Vosburgh, executive director of the Howard Jarvis Taxpayers Association, named after the L.A. homeowner who led the Prop. 13 campaign and dedicated to ensuring it's never overturned. He said California is a high-tax state with generously paid government workers, and recession-weary taxpayers have no money to pay more.

"The bank is empty," Mr. Vosburgh complained.

"We have tried to be all things to all people and we can't afford to do that any more."

But in California, and elsewhere, the price will be steep - in lost jobs and vanishing services.

Carliose Lane, 37, an animal licensing official for the City of Los Angeles, knows the city, and the state, are in a budget bind. But he can't understand why he and the city's entire team of animal fee collectors must pay the price with their jobs. Who, he wondered, will collect the money that pays for the city's shelters and pet control operations after he's laid off on July 1.

"Laying me off isn't going to solve the city's budget problems," said Mr. Lane, whose $32,300-a-year salary helps support a wife and three children. "It will make them worse."