The Right Way to Bail out California

Generally speaking, a federal bailout creates bad incentives for elected officials in California and elsewhere. State legislators may propose even larger spending increases in the future, knowing that if deficits occur, Congress will force taxpayers in other states to pick up the tab. And it would be unfair in that it would penalize taxpayers in states that have exercised fiscal discipline.

However, incentives created by the bailout do not necessarily have to be bad. Indeed, if the bailout is designed correctly, it might even exert a beneficial influence. One way would be to require that states enact tight constitutional limits on either expenditures or revenues before receiving federal bailout funds.

California’s experience is instructive. In 1979, California residents approved the Gann limit, which placed a low constitutional limit on the annual growth of appropriations of tax revenue. During the 1980s, the Gann Amendment proved to be effective at keeping state spending in check. From 1980 to 1991, California’s rank in per capita state expenditures fell from 7th to 16th. Furthermore, when tax receipts exceeded the Gann limit in 1987, the state refunded $1.1 billion in surplus revenues to the taxpayers.

However, in 1990 Proposition 111 substantially raised the Gann limit. Since then the Gann limit has ceased to be a meaningful constraint. The sharp growth in government spending during the late 1990s and the large budget shortfalls the state consistently endures during economic downturns demonstrate that Californians are still paying the price for weakening the Gann limit. A well‐​designed fiscal limit could prevent these boom‐​and‐​bust cycles and help restore fiscal health to California.

The federal government would be well within its rights to require fiscal policy changes before offering bailout funds to the states. After all, lenders commonly impose fiscal restrictions on individuals, companies or countries in debt. When the United States offers foreign aid, the grants and loans are often tied to monetary and fiscal policy reforms. Of course, long‐​term enforcement of these policy changes is difficult, which is part of the reason why foreign aid programs are often unsuccessful.

The situation in California and other states is less complicated. States do not have to worry about currency stability or the rule of law. Their fiscal problems stem primarily from sharp spending increases. This straightforward problem can be solved through well‐​designed expenditure limits.

This approach might actually have a chance of succeeding politically. Forty‐​nine states, including California, have balanced‐​budget amendments. This means that elected officials either have to increase taxes or enact painful budget cuts to bring their books into balance. Needless to say, neither option is particularly appealing to most state legislators. To avoid such politically difficult trade‐​offs, some legislators would most likely be willing to abide by an expenditure limit.

The best policy is for Congress to refrain from bailing out the states. Governors and legislators would not then get a free pass from Congress and would instead have to deal with the political fallout from their spending spree. However, if a bailout is included in the final legislation, Congress should grant funds only to those states that enact tight state fiscal limits. And if California adopts a well‐​designed spending limit, it may not need a bailout in the future.