California’s outdated method of budgeting needs a retooling

According to Gov. Arnold Schwarzenegger, California’s new $146 billion state budget will have no operating deficit. But there are serious questions about the reliability of the numbers because California, unlike other states, does not require dynamic revenue analysis, contrary to the wishes of many state Democrats.

Dynamic revenue analysis, as opposed to static analysis used in California, looks at the effects of taxes on people’s incentives and the long-term fiscal impact. For example, a static analysis always concludes that a 10 percent cut in the tax rate will decrease state tax revenues by 10 percent. It assumes, despite the rate reduction, that the level of economic activity will remain unchanged.

Dynamic analysis, in contrast, recognizes that the lower tax rate will spur economic growth through more capital investment, entrepreneurship, and productivity. So, long term, a lower tax rate might actually increase tax revenue. Dynamic analysis presents a truer picture of the effects of government policy, something the state once required.

In 1994, the Legislature passed, and Gov. Pete Wilson signed, a bill requiring the Department of Finance and the Legislative Analyst’s Office to analyze the dynamic effects of major tax bills and budget proposals. UC Berkeley economists created a dynamic model that the state used until 2000 when the mandate was allowed to lapse.

In 2003 and 2005, then-Assemblymember Mark Ridley-Thomas, D-Los Angeles, authored bills that would have reinstated dynamic analysis, which then-state Treasurer Phil Angelides supported. Although approved by the Legislature, Schwarzenegger vetoed both bills. That is unfortunate, because dynamic analysis would improve California’s poor budgeting process.

For example, in recent months, state tax revenues were $800 million less than projected by state officials. The LAO’s revenue projections from fiscal year 2004 through 2006 were off by more than $5 billion each year. More precise estimates would enable state lawmakers to plan and budget more effectively and would inform the public of the full economic impact of proposed tax and spending legislation. Many current state officers see the value in dynamic analysis.

A dynamic analysis was recently performed by Ernst & Young on a tax-rate reduction bill authored by Assemblymember Fiona Ma, D-San Francisco.

In contrast with the static analysis performed by the Franchise Tax Board, the dynamic analysis concluded the bill would produce 56,800 new California jobs, a $3.7 billion increase in personal income, a $5.5 billion increase in gross state product, and $1.1 billion in new business investment through 2016.

A 2003 survey found that 10 states performed dynamic analysis and most used models produced by private companies.

Though not perfect, dynamic analysis provides a truer picture of the long-term consequences of government policies. And with competition and fine-tuning, the accuracy of dynamic analysis will improve over time. In November, CalEPA took the right approach when it held a conference to assess four different dynamic models. The state of California need not be in the business of creating its own dynamic model when competition among private companies that already produce these models will result in better models and improved forecasts over time.

Schwarzenegger should work to reinstate mandatory dynamic analysis that was first implemented by fellow Republican Wilson. And the Legislature should learn from Ma’s experience and pass legislation requiring dynamic analysis using privately produced models.

California’s taxpayers deserve a modern budgeting process that works.

Lawrence J. McQuillan, Ph.D., is director of business and economic studies at the Pacific Research Institute in San Francisco, where Matthew C. Piccolo is a summer policy analyst.

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